Volatility Indicator Gives Warning

Positive performances for the stock and bond markets have been registered for most of the summer season. During the month of August, the Dow Jones Industrial Average (DJIA) has gained nearly 6%, an impressive performance, while the NASDAQ Composite Index (COMPQ) is up 7.6%. The yield on the 10-year T-note dropped to 5 3/4% and has narrowed the gap with the yield on the 30-year T-bond.

Investors remain confident that the Fed will refrain from tightening monetary policy during the next several months. Economic growth is positive but the rate of growth has been slowing. This is elevating some of the inflationary pressures. Retail sales slowed in July and indications for August appear to be weak.

Economic Threat
Rising oil prices are threatening the economy of the United States. Oil supplies continue to decline, according to the American Petroleum Institute. Crude oil has climbed back above $30 per barrel, and heating oil is now at new highs. As a result, consumers confidence and discretionary spending are expected to erode.

Positive Patterns
Charts of the DJIA and COMPQ have developed similar patterns during this summer when compared with the same charts of last year. Those patterns led to positive results during 4Q, especially for the NASDAQ. We note, however, that there was a correction during the summer before the rise last year, which is now overdue.

This year's gains are also expected to be pared back when compared to last year. Many speculators have not participated in the movement this year following the spring season correction. Additionally, volume has been waning this summer.

VIX in the PITS
The S&P 100 Implied Volatility Index (VIX) has dropped to its lowest level since last July. VIX set a low of 18.95% this week, an indication that option premiums have dropped due to investor compliancy. Readings below the 20% level are generally negative, but the "Sell Signal" is not confirmed until the trend turns up, usually breaking above the 20% level. For many investors, the signal comes too late to effectively protect their positions.

The Implied Volatility Index Mean for the S&P 500 Index (SPX) is near 15%, the lowest level since last September, according to ivolatility.com. This signals that the broad-based market is overbought.

Short-Term Indicators
The patterns for the DJIA are positive on both the daily and weekly charts. The daily Stochastic Oscillator is slightly overbought, but the Relative Strength Index (RSI) is still positive. The weekly oscillators are positive. COMPQ is also positive, but it's daily Stochastic Oscillator is overbought. Sell signals have not been issued as of yet. This is also true for the NASDAQ-100 Index (NDX).

Trading to Quiet
Following last week's meeting of the Federal Open Market Committee (FOMC), trading is anticipated to wane during the next week, ahead of the three-day Labor Day holiday. Volatility could expand sharply if a correction materializes during this period, due to a lack of liquidity. While we remain positive on the market for the intermediate and long terms, short-term hedging would be prudent, especially for those taking vacation.

S & P 100 Implied Volatility (VIX)
Indicator