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Tom McClellan

Chart In Focus

Correlation Between VIX and SP500

 

Chart In Focus

June 15, 2017

When the normally inverse correlation between the VIX Index and the SP500 gets crazy, if offers us a great message.  That is the point behind this week’s chart, which is based on a great observation by Jesse Felder of www.TheFelderReport.com

Jesse first wrote about it in a Tweet here back on March 3, 2017, and that same day it was featured in a MarketWatch article.  I did my own investigation, which revealed that this is indeed a really cool insight. 

What Jesse did, and what I have replicated here, is to calculate a 10-day Pearson’s Correlation Coefficient between the VIX and the SP500.  You can do this incredibly easy in any spreadsheet program, or even more easily as Jesse did at www.stockcharts.com.  Just call up a chart of $SPX, choose as your indicator “Correlation” from the list, and set “$VIX,10” in the parameters window.  It is that easy.  Then you can adjust the period under observation as you might wish. 

What we see is that most of the time, the correlation hangs around down near -1.00, meaning that they have a strongly negative correlation.  In other words, if the SP500 goes up, the VIX usually goes down, and vice versa.  That’s what is normal.  But the instances of abnormal behavior contain the really interesting information. 

Here is a regression chart showing the one-day SP500 change versus the one-day VIX change:

VIX SP500 scatterplot

Each dot represents one day’s combination of the SP500 change and the VIX change.  You can see that most of the dots line up close to the linear regression line, and that makes complete sense.  It is not a perfectly inverse correlation, but it is a very strong one.  Over this entire study period since January 2014, the correlation for their daily percentage changes is -0.83, which is pretty close to a perfectly inverse correlation.

But if you calculate the correlation coefficient using the raw VIX and SP500 indices rather than their daily changes, then the math is different.  I don’t want to get too deep into the statistics, but I want to make the point that there are differences between running correlation analyses of the raw indices and those of their daily changes.

What’s more, real statisticians will tell you that Pearson’s Correlation Coefficient is the wrong statistical tool to use for a time series anyway.  There are other more suitable tools for analyzing the strength of relationships between two contemporaneous time series.  But they are a whole lot harder to use and to program, and so a lot of technicians just use what is easier.  And sometimes what is easier can sometimes be good enough. 

The chart of the 10-day correlation between VIX and SP500 is good enough to tell us when there is a moment of strange behavior between the two data sets.  And those moments of strange behavior just happen to be pretty good at marking tops for stock prices.  The higher that the Correlation Coefficient goes, especially when it gets above zero, the more important the message.  And that usually means a more significant the price top.  But meaningful tops can be found when the Correlation Coefficient gets up to a level shy of the zero line. 

Ten days seems like a good period for this purpose, but others may work as well.  Darshan Dorsey asserts that a 22-day correlation coefficient works even better. 

On June 7, 2017, the 10-day correlation went up as far as -0.17.  That was not quite to zero, but big price tops have been found on lesser readings.  Usually the corrective mode suggested by one of these readings lasts until this 10-day correlation gets back down closer to -1.0, or perhaps longer.  So there is still a lot of room for a correction to do its job from here before we can say that the correlation has returned to “normal”.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

Chart In Focus

The Unexplainable 4-Year Rerun

 

Chart In Focus

June 08, 2017

President Obama and President Trump are entirely different types of leaders.  No one would contest that.  And the second term of a presidential term is a lot different from a first term in the way that a president interacts with the public, with Wall Street, with Congress, and with the economy.  So there should not be any stock market similarity between Trump’s first term and Obama’s second term. 

And yet the pattern correlation to four years earlier which began during Obama’s second term persists even now, with Trump in office.  That is the point of this week’s chart, and it is a relationship I have shown before

I confess that I had figured that the relationship would break correlation by now, but it seems to want to persist, for reasons of its own.  This is where the news followers’ heads explode.  Some people think that it is the news that drives the stock market.  But if the news is wholly different, and yet the behavior is the same, then perhaps that hypothesis about the news driving the market needs to be revisited. 

If this strong correlation continues, then we can look forward to a late-June price bottom, followed by another surge to a higher high in July.  Given how strong this correlation has been, would you want to bet against it continuing?

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

Chart In Focus

When Not To Go Short Volatility

 

Chart In Focus

June 02, 2017

The VIX is a supposed “volatility index”, but it does not really measure actual volatility.  Instead, it measures what options traders think about volatility.  All of the various investment vehicles that have popped up in recent years that are tied to the VIX have enabled traders to go long or short “volatility” with relative ease compared to a few decades ago. 

And the short volatility trade has been among the most profitable, especially since the Fed, ECB, and BOJ started various flavors of quantitative easing in 2009.  Betting on increased volatility has only worked a small fraction of the time. 

VXX and XIV are ETNs that allow investors to pretty easily go long or short volatility.  VXX bets on a rising VIX, or perhaps I should more precisely say that it bets on rising prices for VIX futures, since that is what it actually invests in.  And XIV is a short VIX ETN which tracks the overall stock market very closely.  So as stock prices rise, the VIX typically falls, and thus XIV goes up. 

What’s more, XIV gets a further boost from the contango in VIX futures.  It goes short at a (usually) higher priced contract 3 months out, and then covers when that contract is in its final month before expiration.  Usually that works out well for XIV investors who get to harvest that “contango”.  Here is what the current term structure in VIX futures looks like:

VIX futures maturities

So as long as the spot VIX Index remains low, and VIX futures retain their nice, steep contango, it is a gold mine to own XIV and harvest that contango.  That is what has led some analysts to proclaim that XIV is a great solution as a permanent part of one’s portfolio.  But there are times when XIV turns out not to be such a good investment, times when there is very little opportunity left to harvest. 

This week’s chart helps us to see when those times are, and the key is to look at the price level of the highest priced VIX futures contract.  When that falls to a low level, there is little opportunity left to harvest that contango, and there is also arguably too much optimism.

The price of the highest VIX futures contract is shown in the top chart on an inverted scale, the better to correlate with price action.  When that price gets “below” 18 (high readings on the chart), that tends to mark a topping condition for XIV.  In other words, there is little opportunity left. 

Here is a longer term chart of that inverted scale price history of the highest VIX futures contract, versus the SP500:

Highest priced VIX futures contract

Clearly the better opportunities to invest in the stock market, or to short volatility, come when the VIX futures are at really high prices (low chart readings).  And when the highest VIX futures contract’s price falls into the teens, there is not much opportunity left to be short volatility, at least not profitably. 

This is not to say that the market has to go down, nor that volatility has to shoot up right now.  All it says is that risk/reward is now no longer in favor of those who have enjoyed and profited from shorting volatility in the recent months.  Someday, the market will present us with a better opportunity.

Tom McClellan
Editor, The McClellan Market Report

 

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Tom McClellan

Chart In Focus

Junk Bonds Don’t Confirm Higher Highs

 

Chart In Focus

May 25, 2017

The SP500 has rebounded from the May 17 one-day panic to push to a higher high.  But high-yield bond ETFs like HIO are not confirming that higher high, and that’s a problem.

High yield bonds typically move in sync with the stock market rather than with T-Bonds.  They are all about liquidity and default risk, much more so than inflation and other interest rates.  So when liquidity starts to dry up, that condition often shows up first in the high-yield bond market.  Eventually those liquidity problems come around to bite the rest of the stock market.  So it is important to pay attention to these divergences.

Sometimes the divergences are bullish, as we saw when HIO made a pattern of higher highs in March and April 2017 while the SP500 was making lower highs.  That foretold the stock market strength which eventually materialized.

The message does not always work, though.  Right after the November 2016 elections, it got a bit screwy.  Lots of things were screwy then.  So don’t assume that it is always perfect.  The same point applies for all technical analysis techniques and “rules”. 

Right now, this divergence between HIO and the SP500 fits well with my expectation for a 2-3 week dip into a low due in June 2017, which should be followed by a strong new uptrend.  Such a selloff could serve the useful purpose of scaring out the weak hands.

Tom McClellan
Editor, The McClellan Market Report

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Tom McClellan

Chart In Focus

Will Labor Shortage Kill Housing Boom?

 

Chart In Focus

May 20, 2017

We know by the message from lumber prices that the next 12 months should be a positive period for all sorts of housing related data.  New home sales, for example, tends to follow in the footsteps of lumber price movements with a lag time of about 1 year.  So because lumber prices have been trending strongly higher, that should mean higher numbers of new home sales.

This is especially true with all of the “echo-boom” generation getting into their late 20s, and starting to look at buying versus renting.  The peak birth year of the echo boom was 1990, and those kids are now 26-27.  Zillow says that the average age of a first time home buyer is 33 years, so that pig is still moving through the python.

But there are new worries that those homes won’t get built for those kids to buy, because there may not be enough trained labor to build those homes.  Data from the Bureau of Labor Statistics (BLS) shows some tightening in labor rates for the construction industry.  And when the overall unemployment rate is at 4.4% (yes, I know about the problems with those numbers), it is harder to attract workers out of other industries to come and work construction. 

Here is total employment in the construction sector, all types, seasonally adjusted:

Construction employees

It has had a big overall rise, just as total population has in the U.S.  And there are obvious big swings during recessionary periods. 

Looking deeper, here is the unemployment rate for construction workers:

Construction unemployment

There is an obvious seasonal fluctuation, as winter gets in the way of construction work.  Spring 2017 is seeing the jobless rate drop as normal.  But the 12-month moving average shows that the overall rate is already down to the same low level it reached in 2006.  This suggests that there is not a whole lot of slack remaining in the market for construction workers.

Meanwhile, job openings continue to climb.

Construction job openings

The 12-month moving average (MA) is back up to where it peaked in early 2007.  Back then the housing bubble was choking itself off with all of the speculative buying, condo-flipping, and overleveraging with junk mortgages.  Now it seems that the genuine demand for workers to build the houses that the echo-boomers need is exhausting the available supply of trained construction workers. 

This has all sorts of implications for the housing economy, and anecdotal reports show that twenty-somethings are having a hard time finding available stock of housing to buy.  That is likely to mean continued price increases for starter homes, although not necessarily for other parts of the housing market.  Whether it has implications for Congress addressing immigration laws to allow more construction workers to come in from Mexico and Central America is a wholly separate question.

Tom McClellan
Editor, The McClellan Market Report

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