THIS WEEK IN THE MARKETS

It was a short trading week this past week with Monday giving way to the Martin Luther King Jr. holiday.  However, there was no shortage of action or volatility (more on volatility below).  This was also the start of earnings season, and an options expiration week to boot.  Results were quite poor as the Dow, S&P 500 and Nasdaq all retreated sharply.  The nastiest session was witnessed on Friday, as the markets printed their worst one-day loss in quite some time.  Strong technical support was destroyed during this one session.  As of yet, markets are not even oversold, so we could see a continuation of the selling into this week.  There have been pressures mounting on the markets for weeks.  Some of these pressures boiled over this past week.  Oil traded near $68 at week's end, while gold is nearing 25-year highs.  Further, interest rates continue to be curiously low ... with higher expected short-term rates, long rates have not budged.  This perhaps sets up a severe inversion of the curve which can point to a drastic economic slowdown or even recession.  We mentioned the earnings confessional earlier, and companies who did not live up to expectations were severely beaten:  Intel, Apple and Yahoo among others.  Next week gives us a much bigger array of names to join in the fray.  Geopolitical issues plagued the markets, with terrorist threats and Iranian nuclear issues a clear worry for US leaders.

LET'S GET SENTIMENTAL

What are markets?  They are you, me and everyone else, of course.  Markets exist because of the willingness of two sides to trade issues based on perceived differences in value.  Regardless of the trade, parties are represented on either side.  With people involved, emotions tend to influence behavior .... afterall, we're not machines.  The emotions that are involved in trading markets are generally fear and greed:  Fearful of losing our fortune, greedy to make a mint.  With fear on one side and greed on the other, emotions race across the spectrum based on how we are 'feeling' at certain moments in time.  In most situations, market players' emotions run to the extreme of fear and greed.  We associate an overbought market with excess greed, while an oversold market reflects too much fear.  It is at these extreme points where market odds generally favor a turn in the other direction.  Why is this?  The investing public is 'herded' in the direction of popular opinion, as described in the media or other outlets.  With the plethora of information available and the lightning-quick reaction to news, investor sentiment can change on a dime.  In fact, we have found extreme cases of fear and greed are oddities, but should be closely watched.  Now, if investor emotions or sentiment can change market direction...how can this be examined or interpreted?  We can't just call every market player and ask how they are 'feeling' about the market each day.  There are several useful tools that provide good, timely information.  One of our favorite sentiment readings is the S&P 500 Volatility Index, or VIX.  This index measures put and call pricing to determine the relative fear or greed existing. It is a contrarian indicator in that the lower the reading, the more risky the market due to high complacency or greed, while a higher reading indicates potential upside due to an excess bearishness (high capitulation or fear).  We look for spikes in this index to relatively high or low levels to identify excess fear or greed in markets.  It's been a solid indicator of market turns near the end of market trends.  History has proven that overheated markets with very low VIX readings are soon to turn down, while bear markets with scorchingly high VIX readings tend to be near a market bottom.  In the near terms the VIX spiked up to 14.56 on Friday, which is a relatively high reading based on the spike over the upper 20-day Bollinger Band on the VIX. We'll have more in other issues on sentiment tools to help us read the market roadmap.         

The spike higher in the VIX is usually driven by a strong demand for puts as the market is starting to crater like it did last Friday when the Dow dropped over 200 points. Since puts are the right to sell a stock at a certain price, that right gets more valuable the farther stocks drop. When market participants rush for put exposure to either speculate on more downside or hedge their portfolio, this heavy demand for puts will drive the put option prices higher, which in turn leads to spikes higher in the option volatility readings like the VIX. So an option's value in the short run can rise from either a stock's plunge, but also an option's value can rise due to a jump in the option's underlying volatility level. That's why we like to use Bollinger Bands on the VIX, to gauge just how relatively high or low that demand for the options is. This gives us a leg up on market watchers who are only looking at the chart without regard to the underlying sentiment, as the VIX and other contrarian sentiment measures will keep you from rushing in to buy too late near a top, while also preventing you from feeling the panic most traders feel after sharp selloffs. Instead, you'll be positioned to buy into this weakness once fear truly spikes higher, like what we saw last Friday.

Price Headley is the founder and chief analyst of BigTrends.com.