Benchmarks Hit Resistance Ahead of the Fed

By Scott "the-strategist" Fullman
May 14, 2001

Following four weeks of straight gains for the Dow Jones Industrial Average (DJIA) and the S&P 500 Index (SPX), the advance of the market stalled as concerns that the economy is growing at a faster-than-anticipated rate pushed bond prices lower. The major benchmarks have stalled at what appear to be critical resistance levels. DJIA has not been able to overcome the 11,000 level, even after several attempts; SPX has resistance at the 1275 level; and the NASDAQ Composite Index (COMPQ) has hit a barrier below 2250.

Bond prices have been under pressure since reaching highs during the third week of March. The yield on the 10-year T-note, which fell to a low of 4.689%, climbed to the 5.492% level last week. This has caused investors to become concerned that the Fed might be near the end of its accommodation phase. Prices may remain under pressure if the economy exhibits signs of strength.

When compared to the rest of the world, there appears to be room for additional easing. The Bank of England reduced its lending rate last week, and the 10-year T-note Yield for the United States remains above most comparable rates worldwide, as shown on the chart below. This is one factor that is positive for the bond market. Additionally, the U.S. Dollar remains strong when compared to most other currencies.

Comparison of 10-Year Government Rates

VOLATILITY LEVELS
The implied volatility levels for many of the benchmarks have been holding steady during the past two weeks. As the chart below illustrates, the implied volatility level for the S&P 500 Index (SPX) has been in a tight, sideways trending pattern between 20% and 23%. This indicates some indecision among investors, who are complacent with their outlook for the market, as opposed to being concerned about a possible correction from these levels. Similar patterns are noted for other market benchmarks.

S&P 500 Index (SPX) Implied Volatility Reading - Daily Chart

Some implied volatility levels, such as those on SPX and the Mini-NASDAQ 100 Index (MNX) have declined to levels that signal that the underlying indices are near overbought.

Implied volatility levels for energy companies are extremely low. Oil companies and several electric utilities have risen, and investors may have become too content with the shares of these companies, as evidenced by the declining option premiums. Depressed e-business companies continue to hold some of the top premium slots. However, several of the drug manufacturers are also near the top as speculation rises that the Food & Drug Administration contemplates moving several allergy medications from prescription status to over-the-counter.

WAIT FOR THE FED
The periodic meeting of the Federal Open Market Committee (FOMC), scheduled for tomorrow, is expected to yield another 50-basis point cut in short-term interest rates. If Mr. Greenspan & Co. fail to meet the market's expectations, prices could sell off sharply, pushing implied volatilities sharply higher. Prices could also decline following the Fed's announcement, just on a "sell the news" event.

Ask yourself the following question - "Is it prudent to hedge your position ahead of the Fed?"