Stock Market Getting Ready for a BIG Move; Risk to the Downside

Posted by Financial Sense

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“Pull” is a term used in shooting sporting clays, which are supposed to represent real birds and sharpen the shooter’s ability to actually hunt live birds. The term is yelled by the shooter to tell the person operating the trap to launch a sporting clay. “Pull” comes from an era long gone by when they actually had real birds in cages and the shooter would say “pull” to have the cage cord pulled and release the bird. The term “pull,” however, took on a whole new meaning last Friday when Speaker Ryan “pulled” the Republican healthcare bill (H.R. 1628) from consideration. I had literally said on CNBC earlier that day (as paraphrased): I lived in Washington D.C., and still have a pretty good network on Capitol Hill and typically what happens, if they don’t think a bill will pass, they pull it (read: withdraw it). But, there is NOTHING typical going on in D.C. these days! I also opined on the same show that – I was hearing that H.R.1628 was a few votes short of the ability to pass. Even if it had passed there would have been major revisions to it in the Senate. I guess it was once again the Russians that influenced the death of H.R. 1628 since they are being blamed for just about everything else. The question now becomes, “How will the various markets view Friday’s Foil?”

Speaking to many media types late Friday afternoon I suggested that a lot of technical damage has been done to the charts during the week. The S&P 500 (SPX/2343.98) broke down from its trading range of 2350 – 2400 that has existed since mid-February. The SPX has also closed decisively below its 20-day moving average (DMA) that has served as a support level since last December (Chart 1). Clearly, the gap in the price chart created by the Fed Fling (March 15, 2017) on the rate ratchet has now been filled raising the question, “Will the upside gap that occurred on February 10, 2017, to February 13, 2017, between 2311.08 and 2311.10 be filled?” Moreover, will the Trump agenda disappointments lead to a 0.328 Fibonacci retracement of the recent rally toward a downside target price of 2278? To be sure, the smart money is “betting” that way given the divergence between the CBOE SKEW Index and the Volatility Index’s (VIX) SKEW (Chart 2). As defined by the CBOE:

The CBOE SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal and the probability of outlier returns is therefore, negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the “SKEW”.

Ladies and gentlemen, the current CBOE SKEW is around 145, and well above what the CBOE website describes as, “As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant.” Further, the VIX SKEW has diverged with the CBOE SKEW suggesting something BIG is getting ready to happen in the equity markets. Additionally, there is still plenty of “internal energy” to foster such a move, but unfortunately, our internal energy indicator does not tell us if that energy is going to be released on the upside or the downside. Our hunch remains that it will be released on the downside for the aforementioned reasons.

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…related from Financial Sense:

Dan Wantrobski: Stock Market Breadth, Momentum Weakening