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Hurricanes, Financials, and the End of Summer

Thu, Aug 28 2008, 06:16 GMT
by Online Trading Academy Team

Online Trading Academy

As the end of summer nears, the market remains mired in a sideways pattern full of fits and starts.
August has seen some large swings. So far though, the S&P's - as of this writing - are right where they began the month. Investors must feel like they just got off a roller coaster. After all the ups, downs, and sharp turns, they're right where they started, and from anecdotal evidence, they're starting to feel a little nauseous.

In recent days, the activity has been limited to the first two or three hours of the trading session, leaving the afternoons with low volume, and small ranges. This price action typifies late summer trading patterns as most market participants are vacationing. After all, there are perks to being a successful trader, and taking advantage of the last few weeks of warm weather is one of them. Other traders (such as myself) are enjoying the last days of summer with their kids, before they return to school.

And speaking of the weather, this time of year also happens to be hurricane season. This normally would be of more concern to commodities traders. However, the fact that equity prices - to a large extent - are being driven by the cost of crude oil, makes tracking this storm more meaningful.
Hurricane Gustav, the latest storm in the Gulf of Mexico, is being closely monitored as it begins to gain force. The concern is that if turns into a category 3, it could cause major disruptions to the supply of oil coming from that region. This in turn could cause prices to spike and put pressure on an already fragile stock market.

This worry, along with the ongoing banking crisis continues to plague the market. Fannie and Freddie Mac have been in the spotlight lately, as the question of a bailout has been raised daily in the press. Lehman Bros. is another investment house that's on the ropes. Its plight has been well publicized, and if it can't get a buyout or raise large amounts of capital soon, it too will be in big trouble. This is important to watch, because if Lehman ceases to exist, it will surely have an impact on the overall market.

In the last several weeks, I've received a number of emails asking about the ISEE Equities-only sentiment index, and how I utilize it. To better understand how this indicator works, here's a brief explanation. The ISEE is a composite of equity option transactions (no index options are used). The transactions are compiled by dividing long call (opening positions) by long put (opening positions) and multiplying them by one hundred. To put this in simple terms: if the preponderance of options being purchased are calls (a bullish bet), market participants are very optimistic. Conversely, if volume is largely skewed towards put purchases (a bearish bet), this is an indication of angst among investors. The ISEE index, as is the case with most technical indicators, is most useful as a trading tool when it exhibits extreme readings. In this case, readings under 100 are bullish and over 200 bearish; remember this is a contrarian indicator. Historically, when small option speculators have moved "en masse" to one side of the market, they have been uncannily accurate at marking major turning points. Here is the link International Securities Exchange, LLC. :: Market Data & Trading Tools :: ISEE Index. Once on the site, the equities only (center) column is where you look for these extreme readings. Presently, sentiment is neutral which is worrisome for the bulls going forward.

In this week's technical review, I'd like to focus on the divergences currently in place among all the major averages. Namely, the relative strength of the Russell 2000 versus its Big brother the S&P 500 shown in the charts below.

Figure 1: E-Mini Russell 2000

Figure 2: S&P500

Here we see the Russell testing its June highs two weeks ago, forming a double top; whereas the S&P is nowhere near its May peak. Ultimately, something has to give; my best guess is that the big caps (S&P) will drag down the rest of the market.

To recap: The rest of this week brings with it a slew of economic reports: inflation, durable goods, and oil inventories. Recent market action has been sloppy and volume anemic. Credit spreads are at all-time highs, which is a bad omen for the financial sector. Moreover, we're entering what historically have been two of the worst months for the stock market in the past 100 years. All in all, investors should be wary, as there seem to be a lot of countervailing forces acting upon stocks now. The good news for traders though, is that volatility should continue to stay elevated for some time and thus provide plenty of opportunity - no matter what the market decides to do.

Until next time, I hope everyone has a profitable week.

If you have questions, comments or you'd like a specific topic covered, please email me at gvelazquez@tradingacademy.com

Published on  Thu, Aug 28 2008, 06:20 GMT