LinkedIn is just the latest in the slew of high profile IPOs and private equity deals that are trading for insanely high valuations. At the end of April, my colleague Greg Guenthner wrote to you about the similarly lofty valuation that was being put on social media giant Facebook – a company that the private equity markets have valued at $72 billion. That enormous price tag puts Facebook at four to five times the premium that’s being seen by the likes of Apple (NASDAQ: AAPL) or Google (NASDAQ: GOOG) on the public markets.

There’s clearly a valuation bubble in the private equity markets right now – one that you should avoid at all costs as a penny stock investor.

I’ll be the first to admit the fact that initial public offerings (IPOs) hold a special place in the hearts of small-cap stock investors. After all, the vast majority of all new stock offerings are for small companies that don’t see the same fanfare that social media stocks are seeing right now.

But for all but the wealthiest, most connected investors, it’s impossible to get a “good value” on any of these new firms in the current environment.

The trend doesn’t look like it’s slowing either. On Monday, Russian web search firm Yandex (NASDAQ: YNDX) opened for trading with an $11 billion market capitalization. Other prominent tech firms, like real estate data site Zillow have listings pending. And right now, I’d suggest avoiding all of them.

The fact remains that private equity firms are paying outrageous valuations for these growing web companies – and while their businesses may be attractive, the prices that private equity investors need to get to stage a successful exit make the possibility of making long-term gains incredibly difficult. There are a bevy of reasons why it doesn’t make sense for upstart names to claim massive premiums over mature, entrenched companies like Google or Apple – so, while enamored amateurs may sink their cash into these fundamentally queasy IPOs, you’d do well to avoid them.

That doesn’t mean that you should sit out the IPO game completely. While private equity backed internet IPOs are generating overpriced valuations, there are still quite a few upcoming public offerings in other industries that investors should be watching.

Some of the more interesting names include computer storage firm Fusion-io (expected to price on June 8), solar energy utility Brightsource Energy (pricing date to be announced), and private label retailer Bluestem Brands (pricing date to be announced). With more value opportunities in these lower profile names, investors actually stand a chance at getting in on the ground floor.

We’ll keep you updated on these IPOs as more details become available.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

May 26, 2011

Don’t Fall for the IPO Feeding Frenzy was originally featured in the Penny Sleuth.

“The cloud,” or cloud computing, is offering to change the way we interact with technology spanning from computers to cell phones and everything in between. In essence, cloud computing relies on a data network to fuel the device you’re using with content — in many cases, content uniquely tailored to you. That could mean, for example, that your personal photo album is stored remotely so that you can view it on multiple devices. Or it could be something as common today as a Gmail account that you can access from both work and home.

In both cases, the idea is data being on the network — not necessarily on the device. As high-speed data connections proliferate to nearly any conceivable location, innovative companies are creating new ways to take maximum advantage of the cloud. But we’re not writing to tell you about one of those this month. Instead, we’re writing to you to recommend the IT infrastructure stock that everyone else hates…

Why would we do that? Simple: Because like so many important technologies, the cloud is facing a serious scarcity problem, and in a manner of speaking, our company owns the “keys” to the cloud.

You see, while companies are creating amazing new cloud experiences, they’re reaching capacity problems when they reach a certain scale. That’s because firms have limited storage capacity on hand today — and that storage (and, more importantly, access speeds to reach the data) is only becoming more in demand as new data-intensive services come online.

That short supply of storage space has led some companies to take drastic measures.

Among the hardest hit have been U.S. cellular carriers. Overwhelmed by increased data demands from a new wave of smartphone customers, firms like AT&T and XO Communications are plowing billions into their data center infrastructures just to keep up. Another firm that’s dumping billions into cloud data capacity is Apple: The California-based iPhone maker is in the process of completing a $1 billion private data center facility in North Carolina ostensibly to handle the demands of the mammoth download volume used by its iTunes Store.

At the same time, scores of other firms are plowing truckloads of money into upgrading existing facilities or building new IT infrastructure of their own. There’s considerable capital spending going on in this industry right now.

This month, at Penny Stock Fortunes, we’ve found a firm with a solution to the data center problem. It’s also a firm that hasn’t been getting much love from Wall Street lately — shares have been beaten down more than 37% year to date. But that’s exactly why we think now’s the time to buy. And we tell readers exactly why in our latest issue…

Right now, you can subscribe to a full year of that Penny Stock Fortunes’ research for less than the cost of a monthly cup of coffee at Starbucks. For that, you’re entitled to our full array of small-cap research and recommendations – recommendations that have yielded open gains like 240% on Kapstone Paper and Packaging Corp. (NYSE: KS), 50% on Advance America (NYSE: AEA), and 40% on Solta Medical (NASDAQ: SLTM).

With our “cloud computing” play still well within our buy range, now’s the ideal time to start a risk-free subscription. Click here to learn more…

Sincerely,
Jonas Elmerraji
Managing Editor, Penny Sleuth

May 19, 2011

Why Now’s the Time to Buy the Tech Company Everyone Else Hates was originally featured in the Penny Sleuth.

I’m just getting back into the office after spending a few days in New York last week for a conference at the NYSE. One thing that’s always telling about any trip to Wall Street is the tone that’s exhibited by the market participants I interact with.

It’s painfully clear right now that trading is tough across the board – and that fact is showing up in major banks’ quarterly results this earnings season. Trading units simply aren’t posting the kinds of profits that they’ve been known for in the last few years…

For retail investors, the most pressing question should be why.

Ostensibly, the market has been throwing out signs of bullishness lately. The S&P 500’s break above 1,344 at the end of last month, for example, was a bullish move that suggested buyers were in control of the market. At the same time, solid economic data and earnings numbers on Wall Street indicated that those buyers had reason to be bullish. But that wasn’t the whole story…

Even though the S&P was moving higher, those moves were “easy”. In other words, they’ve been moves within ranges – not moves above resistance levels. We know that because of the lack of trading signals we’ve gotten from the technicals. Breakouts are a sign of market strength because they represent buyers overcoming challenging levels where sellers want to sell, not just share prices moving higher through neutral space.

Remember, major indexes like the S&P 500 are averages are the sum total of the price action of their constituent stocks. So even though a breakout may take place in the S&P itself, the bullish signal isn’t impressive unless it’s accompanied by breakouts (and not just weak-handed moves higher) in its stocks. The lack of breakout signals hasn’t gone unnoticed.

And the weakness is beginning to show itself in the marketplace: According to data from Bloomberg, 72% of the 417 S&P 500 companies that reported earnings results since April 11 have beaten analyst expectations. That’s a staggeringly bullish metric – one that doesn’t even include firms that merely met estimates. But at the same time, the S&P 500 has only increased in value by less than 1%. There’s a big disconnect there.

That’s hardly the only instance where the market is showing shakiness. From a technical standpoint, a big concern is the negative divergence in volume since the 2009 bottom – while early stage bull markets should see increasing prices on high volume, trading volume has actually been declining as the S&P makes its way higher.

A Strategy for May

It’s times like these when discipline is more important than ever. When trading gets tough, it’s tempting to make changes or force trades. But that’s how otherwise good traders lose money and miss important moves.

Generally speaking, markets trend. When they range (as the S&P is doing now), it’s temporary. In the meantime, don’t forget that being allocated to cash is a trade. By sitting out of the market when risk-reward doesn’t synch up, traders not only take advantage of small gains from interest rates, they also increase their risk-adjusted returns by decreasing their market exposure. That’s a crucial element to longevity in the market.

While I’ll be the first to admit that it’s frustrating to sit on your hands and wait out trading signals, it’s necessary to avoid getting stomped in this market. That’s why avoiding stocks could be the best trade you make this week. Wait for a decisive technical breakout signal before taking on new stock positions for your portfolio – holding out for that sort of objective buy trigger could end up significantly improving your gains in May.

I’ll be sure to fill you in as the trading environment continues to evolve…

Sincerely,
Jonas Elmerraji
Managing Editor, Penny Sleuth

May 17, 2011

Why Avoiding Stocks Could Be the Best Trade Right Now was originally featured in the Penny Sleuth.

In retrospect that was clearly a “profitable” idea. But more than a few investors who acted on silver are scratching their heads, wondering just how long they should hold. It’s great to take gains in silver, but those gains aren’t real until you know when to get out.

This brings me to a recent reader question:

“I was wondering if you feel Silver will continue to run a bit more like Gold? (I know they run together, but wondered if silver has gone too far?)”
- C.B., Houston TX

For starters, markets can go much higher or lower than we think or we feel. When “think” is the key emotional measurement, it often leads to trouble and lack of trading discipline. Truthfully, the less you think, the easier it is to evaluate trading opportunities.

Every financial investment has the same time tested process and methodology. Here’s the list I’ve shared with my Resource Trader Alert readers in the past:

1.    Identify
2.    Execute
3.    Manage
4.    Maximize

The number one focus always has to be on risk: What is the downside, and what are the implications on the portfolio if wrong?

Only after determining that the potential rewards outpace the potential risks does it make sense to move forward with a trade.

My preferred strategy is to trade limited-risk options with enough time to be right. The option vehicle has unlimited upside with limited loss – that’s why they’re ideal for traders who can’t sit and watch the markets all day long.

Silver Psychology

As of this writing, the recent high price in silver futures currently sits at $49.82. That’s the level prices reached briefly on April 25. It’s also a historically significant price – you see, the long-standing target from silver’s 1980 rally (aka the Hunt brothers’ fiasco) sits at a round, psychological $50 an ounce. Gold had long ago achieved those 30-year-old levels and it only made sense that silver would as well.

Previously, we haven’t seen a major unwinding that made the reward to risk appealing enough for a bullish silver play. The danger has been too high for our entry criteria and the market has gone without us. Sometimes it is better to miss a play.

With the price chart accelerated to almost unsustainable levels a breakdown is in the works. We’re already seeing it in the market’s last few trading sessions.

[Editor’s Note: This pullback in price could be the ideal entry point for silver. If you’re not comfortable taking on silver options trades, there are more accessible alternatives to get silver exposure in your portfolio today. The easiest comes in the form of the iShares Silver Trust (NYSE: SLV), an exchange traded fund that holds physical silver on behalf of its investors.]

It all comes back to commodities,
Alan Knuckman
Penny Sleuth

May 3, 2011

A Trader’s Take: Should You Still Buy Silver? was originally featured in the Penny Sleuth.

First, a bit of background…

Yesterday, a group calling themselves “Copperfield Research” posted a negative article on Seeking Alpha about OCZ Technology Group (NASDAQ: OCZ), a small-cap computer storage firm based in San Jose, California. The article provided evidence that OCZ has significant financial discrepancies – and that the stock, which opened at $9.94, should reasonably be worth “between $2.58 and $4.98” per share.

There was just one problem with Copperfield’s analysis: according to major firms and a forensic accountant, it was based on incomplete and misleading numbers. To complicate things further, Copperfield disclosed in the article that they were holding a short position in OCZ, making them far from an objective observer.

But the damage was already done – shares of OCZ crashed, falling as low as $6.25 during Wednesday’s trading session as investors fled shares.

A Common Occurrence

This isn’t the first time that we’ve seen this sort of “short attack” take place against shares of a small-cap stock. For the last year or two, similarly damaging articles have been claiming fraud in dozens of Chinese small-cap stocks as their authors collected on their already-disclosed short positions. I personally got a more firsthand experience with short attacks when one of the stocks that Greg Guenthner and I recommended to our premium readers was accused of being a fraud on the same day that our recommendation to buy shares was sent out.

In the case of that Chinese stock, the blogger’s article was convincing – and pretty damning. Media outlets like the Wall Street Journal picked up the story, and shares fell double digits by the market’s open. As with the OCZ story, however, there were some major flaws in the author’s analysis and bias.

Because we’d done our due diligence on our Chinese company’s business, we were confident in the stock’s numbers. But retail investors without the same degree of fluency in financial statements unloaded shares of the stock en masse. We had to issue a point-by-point rebuttal to the blogger’s claims, explaining why the fraud allegations were the result of his misunderstanding the company’s business and missing some key GAAP accounting principles.

By reacting quickly, we were able to ultimately book gains of 40.7% on the stock by the time we recommended selling shares. Not all investors are quite so lucky…

Avoiding Short Attacks

Until anonymous short sellers are held accountable for poorly researched, slapdash analysis, investors should expect the epidemic of short attacks to continue. That’s a deeply troubling trend. Even so, you can significantly reduce your chances of getting caught up in a short attack by following these suggestions…

1. Do Your Due Dilligence

While doing in-depth research on a stock may sound like an obvious solution, it’s shocking just how many investors are willing to sink their money into a stock without having a complete investment thesis on the company. Due diligence means gaining an understanding of what the company does, what it owns, and what being a shareholder entitles you to. It also means fully detailing the risks.

That’s not to say that you need to be an investment expert to buy a stock – but unless you’ve got guidance from an independent analyst or investment advisor, it’s advisable to avoid recommendations you read online.

2. Avoid Obvious Targets

Some companies are more susceptible to short attacks than others. Historically, Chinese small-cap stocks have been the most obvious targets because they represented the low-hanging fruit; with many of these firms half a world away, and fraught with cultural and language differences to focus on, there are plenty of red herrings to divert investors’ attention to. Companies that went public through reverse mergers are especially prone to short attacks.

OCZ isn’t a Chinese company – that’s one of the most disconcerting elements of yesterday’s short attack. Hopefully, this isn’t the start of a wider net for short hit pieces.

3. Buy Stocks with Coverage

When stocks get hit with a short attack, it’s incredibly difficult to hit the brakes on selling without having some form of reputable analyst coverage in shares. In the case of the Chinese small-cap we recommended, we were able to debunk the poorly researched fraud story and share our research with others. In the case of OCZ, reputable small-cap centric firms like Stifel Nicolaus and Needham have already defended their analyst research about the company.

That sort of analyst coverage also lends itself to more convicted institutional buying that’s less likely to be susceptible to rumblings from anonymous “research” firms.

In the current market environment, it’s disturbingly easy for short-sellers with almost no understanding of financial statement analysis to make millions of dollars by accusing a stock of an accounting fraud. Any numbers – no matter how misapplied – can be compelling to Main Street investors who don’t fully understand them.

Until some regulatory oversight comes into the picture, regular investors are going to continue to be the biggest victims in these situations. Follow the suggestions above to avoid being one of them.

Sincerely,
Jonas Elmerraji
Penny Sleuth

April 21, 2011

3 Ways to Avoid the Short Attack Epidemic in 2011 was originally featured in the Penny Sleuth.

Today, we’re going to fill that void by looking at head-and-shoulders trading tactics through the lens of a real-world trade that gave my Penny Momentum Trader readers a chance to book 51% gains in just five days. Here’s everything you need to know to do the same…

It’s important not to get too caught up with patterns. Ultimately, patterns are just an easy way to describe significant technical price action in stocks – they’re not an end unto themselves. That’s evident in the fact that an estimated 90% of traders lose money. But by applying trading rules to patterns, that number can shrink significantly.

Simply put, a head-and-shoulders pattern is a bearish formation that’s made up of three “peaks” in a stock’s price action – one large peak (the head), and two smaller peaks on either side (the shoulders). It signals a top in a stock. Remember, though, it’s not the pattern that’s important, it’s what the pattern represents: a head-and-shoulders is a good indication of exhaustion in a stock’s share price – as trading volume declines in the head, and prices fail to reach previous highs in the right shoulder, the market’s giving serious indications that bullish powers are waning.

Statistically, the head-and-shoulders pattern is worth watching. An academic study conducted by the Federal Reserve Board of New York suggests that the results of 10,000 computer simulated head-and-shoulders trades resulted in “profits [that] would have been both statistically and economically significant.”

Like I said before, though, the toughest part of successfully trading a head-and-shoulders pattern isn’t in identifying it in a stock chart; instead, it’s the challenge of picking the right entry and exit points.

For a real world example, let’s take a look at Endeavour Silver Corp. (AMEX: EXK), a small-cap silver company that I recommended to my Penny Momentum Trader readers back on March 2. Shares of EXK had been forming an attractive inverted head-and-shoulders pattern, an upside down head-and-shoulders that’s a bullish setup.

Take a look at the chart below for a visual description of this stock’s price action:

The “buy” trigger for EXK came on the first day that broke the stock’s “neckline” (also sometimes called shoulder level), the line that connects the small peaks on either side of the shoulders. It’s not enough that shares broke above the neckline, however – what traders should be looking for is a confirmed breakout. That means conclusive evidence that the push higher is more than just a minor intraday whipsaw.

Good confirmation includes a close above the neckline, followed by an open above it the next day. More conservative traders would be wise to wait for two consecutive opens above the neckline, just keep in mind that your extra margin of safety comes at a cost of lost potential gains.

The key to a successful exit on the trade comes from setting a realistic target price. In a head-and-shoulders pattern, the general rule for determining a target price comes from measuring the distance from the peak (or trough) of the head to the neckline. Then, measure that same distance on the other side of the neckline – that’s your price target.

For us, we opted to close out the trade on the first trading day that breached our target price (the dotted red line in the chart above). By doing that, we actually managed to capture near-maximum gains – as you can see from the chart, prices reversed just days after we sold.

Ultimately, readers who bought the option I recommended were able to cash out 51% gains in just 5 trading days.

By setting your trigger buy price (at the neckline) and your target price ahead of time, you’ll be able to take emotion out of your trades, define your potential gains ahead of time, and statistically improve the percentage of winning trades in your portfolio.

Obviously, there can be a steep learning curve to technical trading – but with practice, it can become as comfortable to you as any other investment method. When just getting started, I’d always recommend using paper trading before you sink real cash behind any new strategy.

Cheers,
Jonas Elmerraji
Penny Sleuth

March 18, 2011

Chart Smarts: How to Trade a Head-and-Shoulders for 51% Gains was originally featured in the Penny Sleuth.

Before you begin thinking about where to go from here, it’s important to take a critical look at the market at large. Things aren’t pretty right now, but that doesn’t mean you should sit on your hands. Now is the time for a critical look at your portfolio. In short, it’s time to get defensive. That’s why I’m detailing three steps you need to take to save your portfolio from a correcting stock market.

1.    If you have a weak hand, now is the time to fold. Get your weak, speculative stocks off the table. You shouldn’t get bogged down in the stories of these stocks. If these speculative names are falling with the market and breaking support, sell to preserve your capital. Remember, selling now doesn’t mean that you can’t revisit the stock at a later date. Cash is a viable position, and sitting on the sidelines to see where your speculative picks end up when the dust settles wouldn’t be a bad move.

2.    Check the market for recent misses. Look over your watch lists from the past few months. In these pages, you probably have the names of several potential trades that “got away” from you. Now, thanks to the correction, you might have the chance to buy one or more of these stocks at a more reasonable price.

This bit of advice comes with a caveat: don’t rush a new trade while the market is correcting—and don’t buy stocks that are in the middle of a free-fall. Calling a bottom can be difficult—and dangerous. Instead, look for names that have corrected, are on or above support, and are showing signs of life.

3.    The trend is still your friend. Here’s a helpful take on momentum versus trend. It comes from Jeff deGraaf, a highly respected technical analyst and alumnus of Lehman and Merrill Lynch. Recently, deGraaf detailed an important distinction between trend and momentum that I want to highlight for you.

When the market has momentum, deGraaf says, you need to participate. In other words, strong market movement should dictate your buying. On the other hand, deGraaf observes that trend is more flexible, allowing you the luxury to wait for good entry points.

Right now, it’s obvious that momentum is not dictating a strong market move to the upside. But it’s also important to remember that the primary trend is not yet broken. Your best bet is to disregard momentum trades in favor of trending stocks to add to your list of trade candidates.

Lately, the market has been opening a door one day, only to slam it shut the next. That’s why you need to be extra careful. You don’t want commissions eating your accounts because you get stopped out of trades every day. If you follow my three tips, you should be in a much better position to profit when the market finds support.

Sincerely,
Greg Guenthner
Penny Sleuth

March 16, 2011

3 Important Steps That Could Save Your Portfolio was originally featured in the Penny Sleuth.

Don’t think that anyone – present company included – is immune from the frustrations of seeing portfolio positions dip or watching as the S&P 500 sells off for yet another consecutive day. But stock market frustration only becomes a real problem when it starts to interfere with your decision-making process. Now more than ever, it’s crucial to follow your preset trading rules, and stick to the system.

Whenever you enter a trade, you should go in thinking about your exit plan from the start, whether the stock performs as expected or it doesn’t. Those two price levels need to be dictated by predetermined analysis, not by how we feel about the market; when used to guide your trading, they can spare you from premature selling.

It’s all about having perspective. With the right context for a stock’s move, suddenly sell-offs aren’t panic inducing. Today, I want to share some of the market context that my Penny Momentum Trader readers have been benefiting from:

I’ve been putting a lot of emphasis on the technical significance of the 1,300 level in the S&P 500 since late 2010. So, can you guess where last week’s sell-off stopped?

That’s right. Despite some flirtations in the mid-1,290s for around 20 minutes on Thursday, the S&P held up above our technical support level nearly perfectly. Remember, it’s important that the market is following our technical cues – it means that last week’s price action is probably just a healthy correction, and that our cautiously bullish outlook for the near-term continues to hold. Even though we were able to pin the market’s “floor” within a few points, I want to stress for newer members that we’re not in the business of making predictions here. As technical traders, we’re focused on contingent expectations – a framework for trading that’s based on if/then rules.

If the market stays above 1,300, we’ll continue to be cautiously bullish…

So that said, what would we like to see as we enter the first week of March? Ideally, we’ll get a bit of sideways consolidation in the S&P 500 this week as the market cools off from the rollercoaster ride we’ve just endured.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

March 1, 2011

Avoid Serious Losses By Following the Rules was originally featured in the Penny Sleuth.

Unfortunately for many airline investors, that piece of advice has held true for decades. Airlines are highly susceptible to rising commodity costs, the ebb and flow of consumer spending and even geopolitical risks. The string of bankruptcies, bargain-priced buyouts and outright failures that dot the industry’s history books should serve as a good warning to most investors by now.

But there are exceptions to every rule: A well-placed investment in Delta Airlines in mid-2009 could have netted you 99.8% gains. Buying shares of Southwest Airlines at the same time would have provided profits of 110%. And taking on shares of AirTran even as the market collapsed in mid-2008 could have put 270% gains in your portfolio.

To be sure, there are still significant challenges in the airline industry right now. While prescient investors could have generated some enviable returns by buying many airline stocks at historic discounts, few of those low valuations have withstood the rallies of 2009 and late 2010. Simply put, there are few sheer bargain opportunities left in the airline business.

At the same time, crude oil is maintaining its newfound triple-digit price, and the recovery in consumer travel spending remains tentative.

The Industry’s Diamonds in the Rough

But ultimately, the fact remains that there are attractive opportunities even in the most challenging sectors. That’s exactly we’re taking a look at a few of the market’s smallest airline stocks right now…

• Republic Airways Holdings (NASDAQ: RJET): This small, regional airline is no stranger to outsized gains – its shares have already rallied more than 20% in the last year. Even if you’re not familiar with Republic’s brand, this carrier happens to operate regional routes for nearly every legacy airline in the U.S., and management has wisely invested in bargain-priced competitors like Midwest and Frontier. With profitability back in this airline, this could be a low priced stock worth watching in 2011.

• SkyWest, Inc. (NASDAQ: SKYW): While shares of SkyWest haven’t made much of a move lately, this stock has nonetheless shown shareholders marked improvement in its fundamentals – the airline’s profitability crushed expectations in yesterday’s earnings call.

• Allegiant Travel Company (NASDAQ: ALGT): For a bit of a change, investors might want to take a look at Allegiant Travel, an airline that supports the firm’s leisure travel package business. By focusing on connecting small cities with popular vacation destinations, Allegiant is able to capture a bigger chunk of travelers’ vacation dollars. That’s translated into a nearly double-digit net margin for shareholders. Even so, with shares on the heels of a 22% decline in the last year, even the most speculative investors will want to be careful with this play.

Sincerely,
Jonas Elmerraji
Managing Editor, Penny Sleuth

February 24, 2011

Why Small-Cap Airlines Could Yield Gains in 2011 was originally featured in the Penny Sleuth.

Before 2008, the VIX wasn’t a household name for most retail investors. But as the index, which measures the implied volatility of the S&P 500 index, rose to new highs amid the crumbling stock market, this unique index got more than its fair share of attention. That said, ask even the most fervent market observers what the VIX really is, and you can expect answers to diverge a bit…

So, what exactly is the VIX?

The VIX’s full name is the CBOE Volatility Index. Essentially, this measure of volatility was created in 1993 for the Chicago Board Options Exchange (CBOE) by then Duke University Professor Robert Whaley to represent the market’s expectation of market volatility for the next 30 days.

Simply put, the VIX is a good indicator of just how much investors can expect prices in stocks to swing. A higher number means bigger moves (both up and down), whereas a smaller number indicates smoother sailing ahead…

But the VIX is actually designed to tell us much more than that – the value of the VIX is actually significant too. It tells us the expected movement of the S&P on a percentage-point basis.

Let me explain…

As I write this, the VIX sits at 19.46. That number is the expected annualized price movement of the S&P 500 in the next 30-days. By digging up a bit of finance class math, that tells us that right now investors are expecting the S&P to move 5.48% (either up or down) in the next 30-days. Although that’s a potentially large percentage move, it’s still far from game changing volatility.

That said, there’s another element of the VIX to look at – where it’s headed:

Taking a look at the chart above, a few things are clear about the VIX’s price action. For starters, the index has been trading in a downtrending channel. And for another thing, it looks like the VIX is finally finding support near its 52-week low of 15.23. With Friday’s test of channel resistance, a change of trend could be underway for the VIX.

For traders, that could be a very big deal – especially if volatility moves back toward previous highs:

• In May, the VIX hit a near-term high of 48.2, which suggests expected single-month moves of 13.9% in the S&P 500… That’s major volatility.

• In October 2008, the VIX hit a blistering all-time high of 96.4. That means that the markets were pricing in monthly expected volatility of 27.8%!

From a technical perspective, every time the VIX has tested support in the low 15 range (weekly), the index has bounced back significantly higher. Since the last few weeks have been another retest of 15 (see the chart above), that’s indicative that higher volatility may come back into play.

If that’s the case, it’s going to be crucial to wait for a broad trend in the S&P 500 and Dow before jumping into stocks. Remember, the VIX indicates movement in either direction, so unless an uptrend is defined, stocks can just as easily move lower.

Obviously, this is a theme we’ll be keeping a close eye on in 2011…

Cheers,
Jonas Elmerraji
Penny Sleuth

February 1, 2011

Don’t Be Afraid of the “Fear Index” was originally featured in the Penny Sleuth.