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SKEW Index Flashes Caution Signal

|Includes:SPDR S&P 500 Trust ETF (SPY)

We wrote an article on January24th suggesting that it may be a good time to enter some hedges against a market decline. Our analysis was based on a model we built using the Gold/VIX ratio and comparing it to the S&P 500. Taking it a step further, based on the CBOE SKEW Index the market appears ripe for at least a modest pullback from here.

The VIX volatility index is widely followed as a proxy for potential upcoming large moves in the market. Tail risk, or the chance that some unanticipated two to three standard deviation event happens, may be better measured by option skew. As defined by the CBOE, "Similar to VIX, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the skew". In other words, a high SKEW reading is bad for the market, and a low SKEW reading is good for the market.

The first chart shows the relationship of the VIX (black line) and the Skew Index (blue line). Since SKEW is a volatile measure day to day, we converted it into a 10 day simple moving average (NYSE:SMA).

In the next chart, we compared the S&P 500 to the SKEW's 10 day SMA (blue line) and 50 day SMA (red line). There appears a clear relationship that when the 10 day SMA spikes above the 50 day SMA, as the S&P (NYSEARCA:SPY) usually sells off soon thereafter. Conversely, when the 10 day SMA falls well below the 50 day SMA, a rally may be forthcoming. Our crossover analysis suggests ( 30 observations) that when the 10 day SMA crosses above the 50 day SMA, the S&P on average has a negative return until it crosses back below. Conversely, when the 10 day SMA crosses below the 50 day SMA, the S&P typically has positive performance until it crosses back above. At present, the 10 day SMA sits 5% above the 50 day SMA, which has represented short-term trading tops numerous times over the past few years.

There is one more indicator in which we will present in a separate piece called the Farrell Index. This is a sentiment indicator based on a formula using the American Association of Individual Investors (AAII) data, and that too is showing warning signs. In summary, we would not chase the market here and recommend either short-term profit taking or hedging your positions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment professional as to the suitability of such investments for his or her specific situation.

Stocks: SPY