After the S&P 500 Index made a series of new closing and intraday highs, the top came last Wednesday, September 2 after making a gap up at the open. The entire advance above 3500 should probably be labeled a speculative crescendo or perhaps a blow-off top, as traders might say.

As the Invesco QQQ Trust began to stall out, it didn't take much to turn the tide since the VIX correlation indicator was flashing bright red. The Market Review explains, along with some thoughts, about what to expect this short week.  

The S&P 500 Index (SPX) 3426.96 dropped 81.05 points, or -2.31%, last week after making a new intraday high at 3584.90 last Wednesday, before heading south Thursday, thus blowing right through the upward sloping trendline. The next test comes at the 50-day Moving Average at 3298.91.

The Invesco QQQ Trust (QQQ) 283.58, called "the decider," tumbled 8.95 points, or -3.06%, last week after making new closing and intraday highs on Wednesday. Like the SPX, the upward sloping trendline failed to slow the decline, and with the 50-day Moving Average down at 269.19, near Friday's intraday low, a test of support should come quickly. Watch "the decider" closely this week.  

The CBOE Volatility Index® (VIX) 30.75 spiked up 7.79 points, or +33.93%, last week. Our similar IVolatility Implied Volatility Index Mean, IVXM, which uses four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, gained 7.45 points, or +43.98%, ending at 24.39%.    

The implied volatility indicators no longer support a bullish interpretation of the current situation. So far, the decline can be described as a modest pullback, however, there could be more to come. The IVXM chart shows a modest advance and the SPX chart shows a modest decline.   

VIX Futures Premium

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second month futures contracts as of last Friday.  

With six trading days until September expiration, the day-weighted premium between September and October allocated 35% to September and 65% to October for a premium of 10.67%, diverging from the volume weighted version at 5.91% and the open interest weighted version at 9.47%.

It seems confused, perhaps less bullish than the Day-Weighted version indicates. While the VIX advanced, the October futures contract at 36.28 was substantially higher than September at 29.85, and with six days to expiration, most of the weight was allocated to October. Nevertheless, for consistency and with reservations, the chart follows.  

The premium measures the amount that futures currently trade above or below the cash VIX (contango or backwardation) until the front month futures contract converges with the VIX at the next monthly futures expiration on Wednesday, September 16.

The relationship of the futures curve to the VIX, as measured by the premium, makes for a good real-time sentiment indicator based upon actual commitments of large Asset Managers and Leveraged Funds who bid October futures significantly higher last week.

Foremost Indicators - VIX 10-day Correlation Indicator

Last week's New Highs Everyday explained the inverse relationship between the SPX and VIX, and the significance of when it turns positive. This chart shows it provided ample warning of the upcoming decline, as it turned positive on August 26.

Now back into negative territory at -.08, it will likely continue declining while the VIX advances and the SPX declines.

Market Breadth, as measured by the NYSE ratio adjusted Summation Index, continued declining last week by another 130.26 points, or -19.31%, ending at 544.47 on a downward slope and well below the 50-day Moving Average at 741.13 and approaching the important 200-day Moving Average at 387.64.

In the past, advances above and declines below the moving averages have been good leading trend change indicators.

Speculative Crescendo

This long-term chart from The Daily Shot shows excessive, speculative out-of-the-money SPX call buying as of September 2.

Of course, without considerable research it is difficult to tell how many calls were hedged by selling further out-of-the money calls or with puts, but it does help explain the advancing VIX ten-day correlation indicator. Unhedged call buying in any time frame comes with time decay risk, and near term calls have the most. 

Equity Only Put/Call Ratio

Since the absolute low occurred on June 8 at .37, the most recent low on August 27 at .38 could be dismissed as just another in a series of lows. But the rapid advance last Thursday and Friday seems close to reversing the downtrend, so prepare for increased single equity put activity.

SPX Skew and Kurtosis

Here is one more indicator suggesting the pullback may have more downside. Skew and Kurtosis measures price movements compared to the assumptions made by options pricing models.

Friday's Skew -2.2712 with Kurtosis at 8.4460.

Notice that as Skew (blue line) declined and Kurtosis (orange line) advanced at the first arrow on the left, this movement created a spread of 9.7149. Now at the second arrow on the right, the same spread widened a bit more to 10.7172.

This chart shows the spread with both spikes.

Without making a claim of causation, this indicator from the options universe suggests previous episodes were associated with the start of market declines, some more important than others. Enough to call it a bell ringer. 

Strategy

In bull markets, the strategy is to stay long equities and/or ETFs and then tactically hedge declines as soon as they begin developing since ordinary pullbacks can become corrections when something unexpected happens. Then corrections can become downturns when something else unexpected happens, and downturns can become bear markets when many unexpected things change medium and long-term fundamentals.

Rather than waiting to see if a pullback will become a more serious downturn, consider hedging as soon as the first signs appear and consider it like the cost of insurance. If not needed, existing long portfolio positions will continue higher and the insurance protection can be cancelled. In addition, by watching and managing a put spread, it will keep attention focused should the pullback develop into something more serious requiring even more put spreads.

Now with clear evidence of an active pullback, the time has come to consider adding or starting collars, or opening new out-of-the-money put spreads with defined and limited risk. Since implied volatility will likely rise further, avoid selling more options than buying strategies that increase vega risk until there is evidence of a peak in implied volatility.  

Summary

The blow off top and the long awaited pullback began last Thursday, as everybody knows. However, nobody knows how long it will last or how much the major averages will decline. At least one indicator suggests it could be similar to the decline that began in October 2018. Increasing hedges before implied volatility spikes higher seems prudent.