Equity markets have been drunk on the wine of federal stimulus for most of this year. While the increased volatility in the latter half of last week could amount to a mere hiccup in the reflation rally, indicators suggest that more participants are concerned about an equity market “hangover” than at any time since the market bottom. The transition to a different market environment may have just occurred, and in the absence of any plausible catalysts, I’m not yet giving serious consideration to the possibility of a market crash, so the remaining likely regimes are a continued momentum-driven rally or the return of mean reversion.
I’ve introduced a new element on the Implied Correlation Index chart  – the dark blue line tracks the ratio of near- and longer-dated indexes (currently CBOE:ICJ and JCJ). The near term index, ICJ, expires in in January 2010, while JCJ expires in January 2011. The ratio, therefore, tracks the extent to which short term expectations of increased equity correlations are being mirrored over the long term. That ratio spiked higher on Friday and could easily eclipse the high set just prior to the March bottom in equities. Likewise, the VIX Premium Ratio  hasn’t been this low since March 9th. Note the negatively skewed daily returns in the S&P 500 over the last three months. The VIX futures term structure is now (finally) flat. These indicators all register the heightened concern among market participants, and give weight to the view that the momentum-driven rally may be over.
Unless the market is gearing up to give back all of the gains of September or worse, it makes sense to be selling out of the money puts or put spreads here in equity index options.