Summer Trading Plan

Leadership from the S&P 500 continues, leaving the broad-based index poised to own the previously insurmountable 1900. There seems to be little in the S&P 500's way except, perhaps, a bit of market inertia.

With few profit reports scheduled in the days ahead and a light economic calendar until the second half of the week (see figure 3 at the end of this post), it will take select asset classes to rise up to lead the market heading into the summer months. Which will it be? After all, low volatility has not extended to all stock sectors.

For now, nearly all members of the S&P 500, or 98% of the index's total market capitalization, have reported Q1 earnings. Total results were up 1.3% from a year ago on a 2.7% increase in revenues, according to Zacks Investment Research. Nearly 70% of reporting companies beat Street expectations, but a slimmer 52% had positive revenue surprises – a fact not lost on investors already looking ahead to the Q2 reporting season.

As the latest round wraps up, homebuilder Toll Brothers (TOL) is among a handful of companies to report Wednesday. Retailers are back in focus Thursday as Costco (COST), Abercrombie & Fitch (ANF), and PacSun (PSUN) are due to report. Ann Taylor (ANN) issues its latest results Friday morning.

The relatively orderly earnings reporting season is one possible reason for the quiet trading of the past few weeks. Keep in mind that the CBOE's Volatility Index (VIX) has dropped to levels not seen in over a year, at 11.36, and is now a far cry from its 2014 high of 21.48 hit February 3.

VIX tracks the implied volatility priced into S&P 500 Index options and typically falls to low levels when market participants feel confident (sometimes overly confident!) about the outlook for the stock market. VIX is sometimes called the "fear gauge" due to its tendency to spike during periods of market turmoil and heightened investor anxiety.

One Size Does Not Fit All

Indeed, implied volatility eased across much of the listed options market, but the size of the decline has varied from one asset class to the next. For instance, the CBOE NASDAQ-100 Volatility Index (VXN) fell below 14 but is still above the mid-November lows of 12.17. VXN is computed using the same VIX methodology, but applied to NASDAQ 100 (NDX) options contracts—an index largely made up of technology shares and some of the momentum-stock darlings that have yanked the stock market in two directions in 2014.

At current levels, VXN is 20% higher than the CBOE Volatility Index. There were times in 2013 when the VXN actually dipped below VIX. However, when the large-cap tech names that dominate the NASDAQ 100 were under pressure in April, VXN hit a high of 22.65 while VIX stayed in the mid-teens (figure 1). At its most extreme, VXN was 40% higher than VIX—the largest difference since before the financial crisis.

Figure 1: Chart showing the percentage difference between the S&P 500–tracking VIX and the NASDAQ 100–tracking VXN, with VXN running well above VIX. Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

Picking on the Little Guy

Small-cap stocks have underperformed the S&P 500 over the past few months as well. Consequently, the CBOE Russell 2000 Volatility Index (RVX) has not seen the same dramatic decline as VIX. RVX uses the same VIX methodology applied to options on the small-cap Russell 2000 Index (RUT). While VIX is dropping below 12, RVX is north of 18. The percentage difference between the two recently increased to 62%—the greatest difference since 2006 (figure 2).

Figure 2: Chart showing the percentage difference between the S&P 500–tracking VIX and the Russell 2000 small cap–tracking RVX, currently at 62% or the greatest difference since 2006. Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

The S&P 500 is making another stab at record highs and VIX is falling to its lowest levels in over a year. Yet, the NASDAQ Composite is 2.1% below its March highs and the Russell 2000 is still 7.6% from 2014 highs. With the decline in volatility jagged across asset classes, it will be interesting to see whether some groups, such as the NASDAQ big-tech names or the Russell small caps, will grab the flag and charge in the weeks ahead. Or, will volatility in the large-cap names dominating the S&P 500 begin to catch up?

Welcome Back

There's no question that volume has been paper thin and in this holiday-shortened week, there's little reason to believe volume will increase significantly. I know you may be tired of the lectures that have been this blog's recurring theme: "Be vigilant." "Watch the downside." How about if I frame it in the form of that well-worn market mantra: The market goes up using the stairs and down by jumping out the window.