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The markets appear bewildered switching back and forth from "risk on" to "risk off" as if there is nothing in between. Now equities are in the risk off position as they accelerated to the downside creating a dramatic change in the technical condition. After a few strategy thoughts, we offer a few risk on ideas in the event there is an oversold rally and then more risk off ideas.
Strategy Actually, the markets seem to be reacting rationally as the fundamental economic data coming from China and the US is creating serious doubts that the global economic recovery can continue. Stocks and commodities suffered selling pressure as money flowed into US Treasury bonds as the benchmark 10-year fell below 3 percent. However, the nature of the risk seems to have changed as the deflation arguments gain strength with the deteriorating economic fundamentals. Gold, previously impervious to the earlier decline in other sensitive commodities made a small Head & Shoulder Top pattern adding its support to those who argue the problem is deflation not inflation. In addition, the TED Spread interbank liquidity fear barometer continued improving last week.  Support for the euro seems to have arrived from out of nowhere. Perhaps it was the Swiss National Bank or perhaps it was other yet unnamed sources coming to the rescue. The result was a declining US dollar index that offered no support whatsoever to equities and commodities. As of now, the US dollar risk correlation with equities and commodities has broken down. If the divergence continues, it could be an early warning of developing new macroeconomic relationships. As for equities as measured by the S&P 500 Index, last week’s acceleration to the downside took it into oversold territory and remember this is just a week or so before the third quarter earnings reports begin. We have seen his movie once or twice before, called "run'em down before earnings." However, the question remains if there will be enough fundamental enthusiasm to turn them higher even if the majority of the reports are better than expected. Regardless of the current oversold condition, major technical damage was inflicted on SPX last week as the long awaited Head & Shoulders Top was activated.   S&P 500 Index (SPX) 1022.58 With the close below the Neckline, the operative pattern for the S&P 500 Index is now a Head & Shoulders Top with a minimum measuring objective down at 862.
To make the chart more legible, the values for calculating the downside-measuring objective are shown in the table below along with an explanation how it was calculated.
The pattern objective is calculated by taking the difference from the high of the Head to the Neckline low (1219.80 – 1040.78) which is 179.02. This value is then subtracted from the Neckline low (1040.78 – 179.02) to determine the downside Measuring Objective of 861.76 shown above on the chart at the MO. Based upon the volume of the SPDR (SPY) 102.20 at 374 million shares on Tuesday and 383 million on Thursday, there appears to be little doubt that the Head & Shoulder Top has been activated. However, since the SPX is known to give some false signals and since it is now oversold we suggest waiting to see if it can make a key reversal, defined as a lower low and a higher close on Tuesday or Wednesday with volume in excess of 400 million SPY shares. In addition, watch the new overhead resistance at the neckline low of 1040.78. If it can overcome this resistance with good volume in the next week then we suggest considering long strategies, using call spreads. If it cannot make the reversal on high volume or if the overhead resistance cannot be overcome then consider put ratio back spreads with more short puts than long to benefit from the likely increase in implied volatility that should come with a continuation of the decline.
IVOLalerts™ Now the best plan is conditioned on the behavior of the SPX in the next few days. If a solid oversold rally develops then we suggest long call spread positions with defined risk in the previous strong sectors. Here are a few ideas.  Conditional Longs Las Vegas Sands Corp. (LVS) 21.59. The current Historical Volatility is 63.79 and rising.
If the stock closes below 20 on the July expiration, plan to take in the stock by assignment and then sell calls against the long stock. Teck Resources Ltd. (TCK) 29.55. The current Historical Volatility is 71.04 and declining as the stock appears to have support at 30.
If the stock closes below 28 on the July expiration, plan to take in the stock by assignment and then sell calls against the long stock. Visa Inc. (V) 73.18. The current Historical Volatility is 36.95 and declining, as the stock has found support at 70.
If the stock closes below 70 on the August expiration take in the stock by assignment and then sell calls against the long stock.   Conditional Shorts Although equities now appear oversold and may rally, the macroeconomic fundamentals are still deteriorating, so the more likely scenario is a continuation of the downtrend. In the event, there is no oversold rally, or if it does not overcome the overhead resistance, then here are some short suggestions in currently weak sectors. If the downtrend continues, it is likely that implied volatility will increase more from current levels. In that event, positions will more long options than short options will benefit from the increase in implied volatility. Some structures that fit this description are long straddles and strangles as well as ratio backspreads. Here are a few ideas. Lennar Corp. (LEN) 13.65. HV 43.57
Use a close back above 15 as the SU (stop/unwind).   Harley-Davidson, Inc. (HOG) 21.85. HV 43.16
Use a close back above 24 as the SU (stop/unwind).   Apollo Group Inc. (APOL) 41.86. HV 36.39
Use a close back above 45 as the SU (stop/unwind).   ITT Educational Services Inc. (ESI) 79.32. HV 30.25
This trade indicates a large debit, but interestingly this stock had a substantial bearish put-call ratio of 4.3 on Friday. Use a close back above 85 as the SU (stop/unwind).   Research In Motion Ltd. (RIMM) 48.14. HV 53.66
Use a close back above 50 as the SU (stop/unwind).   CVS Caremark Corporation (CVS) 29.08. HV 35.56
Use a close back above 30 as the SU (stop/unwind).   All of the suggestions above are based upon last Friday’s closing prices using the mid price between the bid and ask. On Tuesday, the option prices will be somewhat different due to the time decay over the holiday weekend and any price change.   Summary There was a dramatic change in the technical condition of equities last week. The market made the transition from one to that could have gone in either direction to one that was clearly headed lower. Now oversold and with earnings reports starting in about two weeks, the challenge will be for it to overcome resistance on any rally attempt since the economic fundamentals are deteriorating and will not be providing much assistance.
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In next week’s issue, we will update our market indicators as we do every other week. All of the previous issues are available on our website in the blog section.

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