DOES THE VIX GAP = MARKET CRASH?

July 10, 2009

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Here’s some rather discouraging correlational data for the green-shoot believers.

DOES THE VIX GAP = MARKET CRASH?

Courtesy of The Pragmatic Capitalist

Interesting confluence of seasonal, fundamental and technical elements all coming together here. Researchers at Citi tie together the technicals and seasonal factors nicely:

“most importantly we have opened up a significant topside gap between the 55 and 200 day moving averages (About 14% gap) that appears to be the widest topside gap between these averages posted since our data begins back in 1986.

While we may not see a decisive break of the 55 day moving average (At least a daily close) the implications if we do, look quite serious:

• It would suggest the potential for a quite rapid move towards the 200 day moving average now at 44.88%
• The last time we saw a good move of this magnitude (A virtual doubling of volatility) was in November 2008 with impulsive rallies of lesser proportion in January 2009 and Feb. 2008
• This yielded losses of 26%; 15% and 24% respectively over periods of 3-4 weeks.”

I would generally cast off such technical analysis if it wasn’t backed by highly suspicious options trading a few weeks back, strong seasonal trends and deteriorating stock market fundamentals (which we’ve covered quite thoroughly here at TPC). Just days after getting short at S&P 945 we noted suspicious options trading that traders at the CBOE pointed our way:

However, the noise coming out of the Chicago Board Options Exchange today is over a July call spread using VIX options that relies on a market swan dive over the coming 41 days before it would earn profits. One trader spent an $850,000 premium on buying 20,000 July calls at the 45 strike while selling the same amount of 55 strike calls, thus lowering the overall premium to 42.5 cents. The VIX hasn’t traded above 40 since April 21 and we’re wondering what this guy knows that no one else does.

It doesn’t end there. Citi goes on to note some interesting seasonal facts over the course of the last 25 years:

1982: DJIA having started to turn sharply lower had a short-term bounce which peaked at 843.80 on 21st July. (Missing the magic date by 4 days) But by 09 August it was nearly 9% lower
1987: DJIA was in a solid bull market, which peaked at a new high of 2,520 on 17th July. By 21st July it was 2.7% lower and while it then rallied strongly we of course ended up with a stock market crash in October.
1990: DJIA was in a solid bull market, which peaked at 3,011 on 17th July. By 23rd July it was 5.25% lower and by mid October it was 20% lower.
1998: DJIA was in a solid bull market, which peaked at 9,413 on 17th July. By 28th July it was 6.6% lower and by mid September it was over 20% lower.
2001: DJIA hit a corrective high of 10,758 on 19th July (again a small miss of the magic date). By 25th July it was 5.5% lower and by the 21 September it was over 26% lower.
2002: DJIA hit a corrective high of 8,765 on 17th July. By 24th July it was 13% lower and by October lower still at the base of the bear market.
2007: DJIA hit a trend high of 14,022 on 17th July. By 01 August it was 6.3% lower and by mid August nearly 11% lower
2008: DJIA had started to move lower but began a bounce on15th July. On 23rd July it had a quick 3 day fall of just under 5% It then rallied again into 11th August but we of course ended up with a stock market crash in October/November in a development eerily similar to 1987.

“So if we look back over all these major years in over a quarter of a century (9 instances) in 7 of them the period from the 17th to the 21st July we have begun a significant move lower in equities. In the 2 instances (1987 and 2008) that we did not immediately head lower we ended up with stock market crashes later in the year…..all in all an ominous set up.”

Despite having moved to a more neutral position yesterday the high risks in the equity markets remain on the long side. With skepticism creeping back into the fundamentals, the technicals collapsing, suspicious trading from big players and highly unfavorable seasonal trends it would not be surprising to see the losses pick up momentum towards S&P 800 as summer comes to a close – hardly a crash as Citi calls for, but painful nonetheless.