The Nasdaq 100 futures (/NQ) is approaching a downward trendline.  Given recent lower highs, and the bearish environment today, there is a decent probability that this could reverse to send the Nasdaq down.

On this hourly chart, the beginning of the blue trendline begins 12/7.  In its middle is the peak on 12/17, where it quickly tumbled down.

Nasdaq 100 futures approaching trend-line.

Note that the yellow line it approached on 12/17 was its July high, a price line it seemed to ignore in November and the beginning of December, but has recently appeared to matter.  I have treated the points when it went above this line as “look-and-fail” rather than an outright breaking of it, which looks especially true when you consider its repeatedly large drop afterwards.

The bottom line is that today looks like a potential short market entry point.  I personally plan to accomplish this by going long volatility via UVXY options.

To provide some perspective, here is the 1 year chart of the /NQ.  You can see the same blue trend-line, and the yellow price line.

Nasdaq 100 Futures (/NQ) 1 year daily cahrt

Not a lot has changed fundamentally since the last sector analysis.  The cyclical flight to safety continues.  It has been hard to discern on the daily charts with the noise created by the interest rate hike via December sector changes.

A few key points outside the sectors to remember.  The Russell has continued to underperform this year.  That alone is a huge sign of a flight to safety, as the Russell is largely small cap growth, whereas the other major indices have more dividend paying recession proof large caps.  Gold has been turning its bottom into a cup, with a lift the past week in the gold miners following last week’s lift in gold.

The first big cyclical shift to safety is typical from risky stocks to less risky recession proof stocks.  Despite the rally this week, we did see a relative weakening of the tech giants.  Apple was down significantly two weeks in a row, and barely up this past week.  Google didn’t do much better.  Netflix was down all three weeks.  Ditto for Priceline.

S&P 500 Sectors – 3 Years – Weekly

All sectors were up this week, with Consumer Discretionary and Telecom, two “safety” sectors, performing exceptionally well, maintaining their uptrends.  Healthcare, still battered from its highs of the year, has been on a continued uptrend too.  The others that did well appear, more or less, to of recovered some of their recent losses, rather than showing continued uptrends.

Sectors that looked good this week, but are still showing a trend of lower highs on the weekly charts, include Energy, Materials, Industrials, Consumer Discretionary (still hasn’t broken long-term uptrend, yet, though), Financials, and, just beginning to break its uptrend, Information Technology.  Having 6 of the 10 S&P 500 sectors looking bearish on the weekly is consistent with the continued beginning of a bearish market, particularly since they are not the safety sectors.

A quick zoom into the chart, where each bar is still a week, shows the recent trends better.  View the previous chart to see which sector each chart is.

S&P 500 Sectors – Zoomed Weekly bars

ETFs, for the first time in history, created opportunity for retail investors that has, in many ways, leveled the playing field between them and large institutions.  Individual investors, with a simple purchase, like a stock, can hedge their portfolios to reduce market risk, benefit from opportunities in investment classes such as commodities or sectors, and otherwise choose a lower-cost alternative to traditional funds.

Leveraged funds permit an investor to allocate and risk a smaller portion of their portfolio.  By investing 5% of a portfolio to 3x ETFs, for example, an investor can allocate the other 95%, instead of 85%, towards other investments, creating a diverse approach to help weather the cycles in the market.

Now, the SEC, claiming to be protecting the consumer, threatens to remove this new tool from the retail investor.  As they exist today, many leveraged 2x and 3x ETFs will not be able to operate under the new rules if they are passed when the SEC votes in March.

To be sure, on the surface, the SEC goal looks noble.  By the wording of the proposal, it appears that it is trying to ensure that redemptions are protected in the unusual event their is a rapid withdrawal.   The only problem isn’t what the SEC is claiming to be trying to achieve, but how.

It has chosen to use a big net in a near admission that it does not understand the complexity of the derivatives markets.  The center of its proposal relies on cash accounting and current market value, instead of understanding the ability to build time-based safety into funds using the very tools the SEC is proposing to limit.

For instance, funds using near-term options could have a portion of the cash tied up until expiration of the contracts.  Liquidating at market value in certain volatile circumstances could prematurely decrease the net asset value of the fund.  However, a simple remedy that this SEC proposal prevents is including emergency redemption limits that simply permit these options to expire.  For short-term contract funds, this might impose a 30-60 day dilution limit to ensure that highest market value of the net assets; and, this redemption limitation would only be invoked in an emergency.  The prospectus should, of course, be required to make such scenarios clear, including how NAV is determined when a withdrawal request is made.

Yet, while this market driven solution could create the best-case scenario for investors, permitting them to take the risk of the leveraged fund, with the hope of maximum redemption value in the worst case crisis scenario with the trade-off that they might have to wait for redemptions for a short period of time, the SEC has chosen to limit the options of the fund to prevent this possibility.  In short, it will limit profit and hedging opportunities of retail customers in order to reduce the redemption time period in the case of dilution or rapid withdrawals.

The leaning of the SEC proposal towards cash and market value also precludes certain hedging opportunities the funds could take to protect the fund, hedging which technically increases total nominal exposure relative to cash, despite it being a hedge that protects the fund better than cash.  For instance, a fund might decide to use far out-of-the-money (OTM) option contracts with an underlying that has a negative correlation to the primary underlying to protect the fund from extremes.  Yet, this type of healthy hedging could be prevented due to the method of accounting that the SEC is proposing.  The SEC’s over-simplistic view of cash and current market value does not consider true stress testing scenarios and protection capabilities uniquely available in the derivatives markets.

In an era where an individual investor can use tools to beta-weight their portfolio to see how it will perform when the S&P 500 changes, you’d think the SEC could propose better stress testing than simply limiting notional value relative to cash and equivalents.  Does a gold fund really need to worry about gold becoming worthless overnight?  How does comparing the notional value of its gold exposure to its cash holdings really help?

What does matter with any notional exposure is the degree it can change, and whether a hedge is needed to handle extremes in its range.  If we are worried about the risks of being heavily weighted against the S&P 500, for instance, we can reduce that risk better by investing in something that will likely have a negative correlation to the S&P, and can do that best through leverage.  A high notional exposure to gold and volatility contracts can have a far greater risk reducing benefit for S&P 500 exposure than simply having a lot of underutilized cash available.  Where in the SEC proposal does it provide the opportunity for this type of protective hedging?

The real issue here is that if the derivative based funds use derivatives to diversify and protect their net asset value, they could have less liquidity in the short-term due to the need to permit contracts to either reach a desired market value or expire.  Yet, this is only limited by the length of their stated contracts, typically 30-60 days.  This is further reduced by the degree to which their hedge increases in market value relative to the decrease in market value of their primary investments.  In the case of volatility futures and options, their market value rises in sync with a rapid drop in S&P market value, thus providing much better NAV protection than cash.

Of course, hedging has a cost, notably in good times, when the fund’s primary investment strategy is working.  This cost would have to be considered, and like any, publicized in the prospectus.

The SEC should not pass this new proposed set of rules limiting leveraged funds as it is currently worded.  Rather, in the short-term, it should focus on investor education, improving prospectus reporting, and working with the markets to develop better stress protection using the free markets themselves to provide the solutions.  Then, when the SEC has demonstrated a competence for understanding the derivatives markets it is proposing to regulate, maybe then it can create rules that permit market based solutions instead of basic accounting concepts.  This would protect consumers in good times and bad, permitting them to make profits and hedge their portfolios with robust tools, while also permitting them to obtain the best possible redemption value should a crisis emerge.

Let the SEC know there is a better way that does not require crippling individual investors by commenting here on IC-31933 (S7-24-15), posted December 11th, titled Use of Derivatives by Registered Investment Companies and Business Development Companies.

Note that on 12/27, when I tried to submit a comment, I received this response from their server:

Access Denied

You don’t have permission to access “http://www.sec.gov/cgi-bin/ruling-comments” on this server.

Reference #18.b5a13d42.1451195263.421291e1

Also, this rule is missing when searching regulations.gov for open proposed rules.

Was able to get comment submitted by saving to a TXT file, entering “Comments attached” in the box, then attaching on the next screen.

You can view comments that miraculously made it through here.

The news came out yesterday that a Third Avenue fund was liquidating, and putting a halt on redemption, locking up the deposits investors put in the fund, possibly for months.  Being important news, and possibly the only really bad news event to come out yesterday, it is only natural that people attribute the 300 point decline in the Dow to this.

The news didn’t come out until 12:30pm, though.  If you read yesterday’s early morning post, Volatility Spiking Ahead of FOMC, you knew that the market was already in a downward pattern before the market opened, and well before the Third Avenue news hit the streets.

So, how did the volatility do before 12:30?  Just look at this chart, where you see it rapidly climbing all morning.

VIX futures. Each tick is a minute. Hours are on the X axis.

While the news certainly gave it a lift, it was on an uptrend prior to that, and continued the same uptrend after that news gave it a spike.

Similarly, the S&P futures show a continued downtrend all morning, with virtually no change in the trajectory between 12 and 1.

S&P 500 futures (/ES). Each tick is 1 minute. Hours are on X-axis.

The news can present a distorted view of why the market does what it does.  While the failure of junk bonds is a very important indicator of things ahead, understanding that there are larger forces here that trump a single news event is important for understanding the bigger trend the market is on.

What does correlate well with the rise in volatility is a corresponding drop in the price of oil.  While it would be nice for the price of oil if production decreased, the bigger issue here isn’t production, which has been relatively flat this year.  In supply and demand, when supply doesn’t change, but price goes down, what did change?  The only possibility is a drop in demand.  The drop in the price of oil is an indicator of a rapid drop in demand.

Light Sweet Crude Oil Futures. Each tick is 1 minute. Hours on X-axis.

On top of oil and other industrial commodities being the canary in the mine, their drop is also part of the reason there are other dominos falling, such as junk bonds, as oil and other commodity producers who cannot pay their debts are on the rise.

As the market approaches the historic day next week when the FOMC decides whether to raise interest rates for the first time in nearly a decade, the market is heating up with volatility.  To put the VIX (or /VX for futures) in perspective, I included summer’s low and August’s high.

This morning’s rise in volatility is being helped along by a retest of recent lows by the market indices.  You can see the current drop in the Nasdaq 100 futures:

If those recent lows hold, look for a nice bounce in morning trading. Otherwise, it could continue to 11/16 lows. In this latter case, it could take days to get there, and perhaps bounce back up before reaching it.

One of the early signs of a recession is a flight to relative safety by big money. When large fund managers want to continue to be in equities, yet want to be on solid ground in case the market tanks or a recession hits, they move from higher risk small cap growth towards large cap companies that have lots of revenue, cash, dividends and ideally growth.  These days, in addition to consumer staples, this large cap basket includes technology driven companies that are clear leaders in growing markets, such as Amazon AMZN 187,70 -1,29 -0,68%, Facebook Facebook, Inc. 195,13 +3,50 +1,83%, Google Google Inc. 160,89 -1,17 -0,72% and Netflix NFLX 1.133,47 +1,75 +0,15%.

With the Dow Jones Unfortunately, we could not get stock quote INDEXDJX:.DJI this time. just surging 370 points yesterday and Amazon, Google, Netflix, Facebook and other companies hitting new all-time highs this week, how can this be anything but an unstoppable bull market?  Despite the lofty rally, let’s not lose sight that the DJIA just inched yesterday into positive territory for 2015.  This was after 6 years of stellar growth.

Historically, consumer staples has been a leading sector when this cyclical flight to safety begins, as it is presumed that even in a recession, consumers need their bread and Pepsi PEP 133,75 +0,20 +0,15%.  Thus, it is no surprise that has been one of the strongest this month, along with a big run up for Telecom, another safe sector.

S&P 500 Sectors – 1 Month Daily – Dec 5, 2015

The obvious victim is Energy, due to falling oil prices.  The drop in commodities has been a very strong sign of slowing global growth; but, at least with oil, this could be partially explained with an increase in production in recent years.

Of notable optimism has been the Information Technology sector.  But, is this another tech run like 2000?  Or is this the result of large technology companies becoming the new consumer staples?  Can you live without Google and Netflix?  Indeed, they do seem to have found a sweet spot of being technology, growth and consumer staples.  This is one explanation of a decades old company like Amazon having a P/E ratio near 1000, albeit not the only possible reason.

The real evidence this rally is a cyclical shift away from small cap risk rather than an all out bull market, however, is in what didn’t do nearly as well yesterday, or this past month.  Comparing the heavy weight indices — the DJI and Nasdaq, with the mid and small cap filed Russel 2000 and Microcaps IWC 114,34 +3,03 +2,72% reveals the love has not been broadly received.

To put it in perspective, here is how the tech leaders and indices performed yesterday and for the week:

With a combined market cap of nearly 1 trillion dollars, Amazon, Google, Facebook and Netflix took the Nasdaq to a new high this week, as they themselves hit new highs.  As we can see with the Russel 2000, down 5.58% from its high, this is not a broad rally.  Microcaps are down 7.63%, near correction territory.  Traditional growth companies are being left behind.  Combined with the performance of consumer staples, this is looking like a pre-recession cyclical rally.

You can see from the last 5 daily ticks on the these charts that all 10 Sectors were down last week.

All sectors down for week (1 month daily charts)

Up until now, consumers were expected to hold the US economy up.  The lack of upwind in retail threw heavy doubts on that hope.  Some are hopeful that the poor performance in brick-and-mortar retails is largely due to the shift towards the online economy.  Internet retailers such as Ebay and Amazon have certainly performed well this year.

A couple of days ago, concerned about the reversal pattern on the S&P 500, I drew 2 support lines and a resistance line at the top.  The first support is at 2060.  The 2nd one, because it was a more critical longer-term support going back to March, I displayed its value of 2015.

S&P Supports and Resistance – November 10, 2015

Yesterday morning, we watched the first support become breached in pre-market trading around 9 AM.  You can see how clearly the S&P recognizes this line, as it bounces back against it as its new resistance.  It then pops it, giving hope to the bulls, only to come back down one last time before beginning its trail towards the next more significant support.

S&P 500 Supports Broken

You can see that today, the 2015 support was repeatedly tested during the last 2 hours of regular trading hours (RTH), each time with a lower high.  This is a clear sign the support is about to be breached.  Then, the bell rang with the bulls able to take a sigh of relief that they protected the flag.

The bulls were too quick to celebrate the end of the week, though.  Just as the first support was violated in yesterday’s pre-market trading, the bears took advantage of the extra hour of futures trading. The breach of the critical support occurred in the /ESZ5 at 4:50 PM.

Bears Capture The Flag

While the bulls ran to the pub at 4pm to celebrate protecting the 2nd support and begin the weekend, the bears hung around to win this week’s round and position the S&P for a very bearish looking time.