Diary of a Financier

Major market top analogue on track, but VIX curve warns of upside risk

In Capital Markets on Thu 27 Dec 2012 at 19:49

Bears need little more ammunition but this comparison I’ve been making between the SPX 2007 top and COMPQ 2012. Today’s QQQ is still aligned with its analogue to SPY 2007. (The SPY precedent has actually progressed into 2008 now.) I wanted to provide an update, because this is where the rubber meets the road: SPY began its preliminary slide at this point in its progression (around January 3, 2008)¹, breaking through neckline support of its Head & Shoulders top.

Here’s the daily comparison:

SPY 08 v QQQ 12 analogue (daily)

SPY 08 v QQQ 12 analogue (daily)

Slowly, weekly fractals have aligned so neatly that they’ve dispelled a lot of my misgivings about the analogue’s consistancy:

SPY 08 v QQQ 12 analogue (weekly)

SPY 08 v QQQ 12 analogue (weekly)

~~~~

As a followup to my entry last night, the multiday Head & Shoulders failed before a short term rally up to right shoulder resistance in both SPY and QQQ. With SPY having been down as much as -1.4% intraday, even a late day rally back into the black didn’t save the pattern, since neckline support held as latter day resistance. Like I said yesterday:

“If the H&S thesis fails, at least it’ll fail pretty quickly and definitively. Such failure would morph QQQ’s 30-minute chart into a failed consolidation channel, portending a continued risk-off slide… The bigger picture cannot be lost amidst this minutia. Yes, I expect the risk-on switch to be engaged in the very near term, but I maintain my bearishness for the ensuing period.”

Failure–that’s where we stand. I haven’t blown out all my holdings and allocated to cash yet, but I had sold my QQQ to fund a VXX purchase as a technically sound hedge on Monday, and I sold some gains just before the close today. The portfolio’s beta sits at 0.72 v. 0.76 benchmark.

That’s underweight, but not as light as I’ve been approaching corrections in the past. Why am I so slow to react? Two reasons…

First, the fiscal cliff negotiations could trigger a rally, which pulls my portfolio’s exposures closer to the benchmark than I’d otherwise tolerate given the technical air today. Objectively, that upside risk is manifest in the front end of the VIX futures curve, which is in backwardation. (The meat of the curve is also uncharacteristically flat.) To translate, volatility is worried about a near-term grey swan (i.e. sequestration), but constructive on the market’s prospects thereafter. The VIX is as prone to error as any other indicator/derivative (maybe more), but its term structure is telling, particularly given the tape since November’s Presidential election. The New Year’s first great trade will be a pair trade, short spot VIX/long VIX futures,² as vol comes cheap beyond the front month upon the expectation that politicians will reach a comprehensive deal before January 1–supposing we’ll leave the “uncertainty” behind us and not defer resolution.

Second, trading activity in holiday weeks should be taken with a grain of salt. Most portfolio managers are on vacation, trading books are closed, and associates are manning terminals with limited authority. That goes doubly for these last two weeks of the calendar year, when Christmas and New Years abut one another. The low volume accompanying these weeks’ selloff is a testament of such; the broad intraday trading ranges are also characteristic.

I’m comfortably positioned given these realities. The first week of January will provide more robust data for decision making.

–Romeo

¹Since the analogue has progressed into 2008, I’ll hereafter refer to it as “the SPY 2008 analogue.”

²Long Jan 19 puts & long Feb 20 calls

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  1. […] of the magnanimous, binary risk at hand, I came in only slightly underweight my benchmark,¹ as mentioned. I did nothing today except close my VXX exposure, bringing me up to market […]

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