VIX & Put:Call starting to make puts attractive again

A fair degree of complacency has snuck back into markets over the last month.  We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:

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Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:

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The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:

The distinct possibility of a crash

Technical trading is a game of probabilities involving indicators, patterns and history. There are times, like near the peak last month, when the odds of a certain outcome are very high, since you have so many indicators in positions that have been followed by the same outcome. There are other times, like right now, when you don’t have strong odds of any particular outcome, but you do have a higher than usual chance of a rare outcome: in this case, a violent resumption of the deflation trade from relatively oversold conditions. A hard decline from oversold conditions can lead to panic, since it feels like the market “just isn’t going to stop falling.”

I still very much like the summer 2007 analogue, since this winter, as then, the market fell hard off of a very long and calm stretch of gains on low volatility and extreme complacency (the “Goldilocks era”). What I see now is a market that, with yesterday’s rally to 1080 and this week’s little ramp in DSI bullishness, has corrected its oversold condition just enough to resume the decline. Stock bullishness now has 20% or so of downside to go before reaching the level seen at the bottom of declines of this nature (hard first plunges from long periods of complacency: May-June 2006, Feb-March 2007, July-August 2007, Oct-Nov 2007).

The VIX has the room to spare, as does the put:call ratio. I see in early trading this morning that several markets are showing weakness as they approach support. It is still possible that they bounce and we charge ahead towards 1100 and beyond, but I would not count on it. Like I said a few days ago, and Daneric actually mentioned last night, perhaps this decline resembles the start of wave 3 of primary 1 (May-July 2008), a stair-step process of small rallies just big enough to keep people guessing, followed by new lows.

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I’ll be away from the markets for the next few hours, unfortunately, but I have sell-limit orders in place for the above possibility. This of course would negate the Euro rally I’ve been considering.

Party like it’s July ’07

I have been watching the parallels between the last few months and the first half of 2007, and they are still very close. The late June – early July 2009 drop lines up with the late Feb – early March 2007 correction. In each instance, the markets then ramped up, then zig-zagged higher still as the put:call ratio oscillated at a low level. The final euphoric highs of July ’07 (when Chuck Prince said he was “still dancing” and Paulson said he had never seen such strength in the global economy) were marked by a brief lower low in CPC, which further compressed the springs for a stunning spike in fear as the equity markets cracked and Cramer threw a fit.

The crack here is likely to be even more violent, since everyone knows deep down just how bad things really are in the economy. It won’t take more than a shift in psychology to get people focused on the problems again, which are now fully developed, not just vague fears of some temporary “liquidity” issue in obscure debt instruments.

Source: indexindicators.com

The CPC does not linger at under 0.55.  Caution is creeping in already, as yesterday CPC made a higher print and the VIX, Russell and Nasdaq failed to confirm the Dow’s new high. The commodities complex may also be stalled out, and the dollar has corrected enough to continue far higher than in December. This time, the stars are aligned for an “all the same markets” rush to safety. Even Treasury bonds have sold off enough to rally nicely:

Source: Yahoo! Finance