MorningWord 5/30/14: Hole Poking the Rally

by Dan May 30, 2014 9:34 am • Commentary

The most hated rally in the history of the stock market keeps chugging along and despite the SPX’s recent breakout to new all time highs, and a pretty one at that, its hard not to try to poke holes in it:

SPX 6  month chart from Bloomberg
SPX 6 month chart from Bloomberg

If I had a hundred bucks for every time I could have pointed out the poor breadth in the last 5 years while the S&P gained more than 150%, let’s just say I might not be slaving away on this post at the moment.

One of the brightest market “hole pokers” I have come across is Doug Kass of Seabreeze Partners, who this morning points out 5 “Significant” divergences that have developed of late. While Kass is not calling for a crash, he suggests that “All of these conditions have historically been a prelude to overall market weakness”.

Developing Divergences per Kass:

1. Financial stocks have failed to confirm the new high in the SPX

2. Russell 2000 (small caps) continue their relative under-performance to their large cap brethren

3. Weakening Breadth as new highs have been declining as the SPX breaks out

4. Head scratching price action of bond yields relative to equity strength

5.  Anemic trading volumes, cites Total U.S. equity share volume yesterday was 15% and 35% below the one- and three-month averages

And that’s just Kass’s observations from the last couple weeks.  In a post on this week (Prepare for a Minsky Moment), Kass highlights broader market conditions that draw similarities to the 2007 highs, prior to the market’s crash:

1. The VIX (and other fear gauges) have dropped consistently.

2. The Investors Intelligence bull/bear spread has rapidly expanded.

3. IPO activity is back.

4. M&A activity is soaring — the number of deals worth $10 billion or more are higher than both 2000 and 2007.

5. Share repurchases have accelerated — again, thanks to easy money and the funding of equity buybacks by bond borrowings).

The market (for now) is shrugging off ALL of these divergences and broader trends despite what feels like a lazy summer rally. The fact that both bulls and bears seem to want a pullback is probably why.  So how are we trading options in this market?  Well, we are not spending a lot of time on the VIX and why it is where it is, but we are very focused on protecting ourselves against front month decay on overall long premium trades in the form of calendar spreads,  targeting moves with overall short premium strategies like in the money flies. Obviously, the front month vol being sold in these scenarios is low, but if you think that this market is setting up for a correction, you want to own vol (options a few months out), not gamma (front month options.)