By Ryan Detrick
After big down days to start last week, we saw the 50th 300-point up day ever for the Dow Jones Industrial Average last Thursday. In fact, it was the best day for the S&P 500 Index (and SPY ETF) since the first day of the year. In the end, the SPY was able to finish green on the week after dropping the previous two weeks, thereby extending its streak without a three-week drop to a very impressive 73 weeks.
The CBOE Volatility Index soared above 18 and peaked just beneath 22 before imploding later in the week.
The VIX recently moved to "backwardation" in the VIX futures market -- meaning October VIX futures were trading at a premium to November futures. This usually occurs when extreme fear is coming into the marketplace. Also, the VIX was trading at a 100% premium over the SPX's 20-day historical volatility (actual, or realized, volatility), which is another rare event. These two events combined is even more rare, and it is the options market's way of signaling expectations for extreme volatility in the near future.
Going back to 2004, this is just the fourth time ever these two signals have been flashing in tandem. The two instances directly prior to this one were great times to be long, but the other came right at the 2007 peak. Still, each occurrence correctly predicted a good deal of volatility.
Worth noting is that the third time these indicators coincided was right in the midst of the fiscal-cliff drama of late 2012. Sound familiar? For more on the VIX, be sure to read Bernie Schaeffer's thoughts on why a short-term peak in volatility might be near.
What are the charts telling us? The action in small- and mid-caps is very important. Both the Russell 2000 Index (and IWM ETF) and S&P MidCap 400 Index (MDY ETF) found support from key areas before bouncing. Sure, there are concerns out there, but it is tough to be very bearish with these key groups holding up so well. The RUT once again found support from its upward sloping 80-day moving average, while the MID bounced from its 40-day moving average and the +20% year-to-date area of 1,225.
The Dow found support right at its 200-day moving average before bouncing. Now, the Dow has been the weakest index by far over the past few months, but it's still worth pointing out that it last touched this trendline in late December, as the fiscal-cliff drama was in full gear. This, of course, was right before one of the best six-month starts to a year in a generation.
Earnings season is ramping up this week, as well. Similar to the past 11 quarters, we think the bar is again being set rather low, which could translate into positive reactions. Expectations are for earnings to grow about 4.5% in the third quarter versus last year. But what really stands out is the fact that earnings warnings have now increased every quarter since the second quarter of 2012, according to FactSet, and there have been a record number of warnings heading into this earnings season. Sure, the news could be horrible -- but again, a good deal of the bad news is probably priced in already.
One more note on earnings: This is an encouraging chart that shows the SPX has broken out to new all-time highs, while earnings are also making new highs. Not much wrong with this picture. (Earnings data courtesy of Trinity Asset Management.)
That said, everything isn't perfect. As we saw the last time we had debt-ceiling issues in August 2011, bad news can turn into about a 20% drop in three weeks. One big concern is margin debt, which is near all-time highs. This isn't bearish by itself, but a big move lower in the SPX could lead to margin calls and a cascade of selling.
Next week is options expiration. Something to keep in mind is these weeks can be extra volatile, so if last week was any clue -- brace yourselves. Still, October expiration week has been positive in seven of the last 10 years, and has been up the past five years.
Finally, October has marked some major bottoms over the years. In fact, looking at the average year for the Dow since 1950, October lows have lead to some very impressive gains in November and December. There's a good chance this year could be playing into this pattern perfectly.
Good luck out there, and here's to some profitable trading.
