Monday Morning Outlook

Is the Low VIX Signaling Complacency -- or Opportunity?

With the SPX revisiting the key 1,550 level, one indicator says stocks may be overbought

by 3/9/2013 9:40:59 AM
Stocks quoted in this article:

Stocks set a series of new highs last week, with the Dow finding its way into uncharted territory day after day. By the time the dust settled on Friday, the major equity indexes were all more than 2% higher -- or more than 3%, in the case of the small- and mid-caps. With the Dow tapping unprecedented peaks, the S&P 500 revisiting its 2007 highs, and the Nasdaq Composite blazing a path toward dot-com territory, is it time to panic about a pullback? This week, Todd Salamone explains which levels and indicators cautious bulls should be watching.

  • The crucial SPX round number that needs to be on your radar
  • Which oscillator is flashing an overbought signal for stocks?
  • Why it's good news that the VIX is left out of this week's triple-witching expiration

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Will "Cheap" Portfolio Protection Support Stocks?
By Todd Salamone, Senior V.P. of Research

"As we look ahead to next week, the VIX is trading in an area that is a 50% retracement of last week's high and the 2013 low. Bulls should be encouraged by the potential downside back to the 2013 low, but be on guard if the VIX experiences another sharp advance through the 50%- above-2013-low area ... The short term is still a toss-up in terms of direction, as traders remain trigger-happy to buy pullbacks and the SPX is still on sound technical footing. But short-term sentiment measures are around levels that have historically preceded trading ranges or pullbacks ... The intermediate-to-longer-term outlook continues to look rosy for bulls, as some skeptics continue to be sidelined by a low VIX, low volume, and retail inflows into equity funds in 2013. Our response to these concerns: Fears of low volume have been voiced since the market bottom in 2009, low volatility can persist for years, and recent inflows into equity funds are peanuts relative to the outflows in prior years."
-Monday Morning Outlook, March 2, 2013

"$SPX component short interest up 11.5% since ths time last year, $SPX up 14.5% over same period #wallofworry"
-@ToddSalamone on Twitter, March 6, 2013

"'Huge' Doesn't Begin to Describe S&P 1,550"
-Bernie Schaeffer on Charts, March 8, 2013

Last week, we observed that the CBOE Market Volatility Index (VIX - 12.59) peaked late last month at an area 50% above the prior low. VIX peaks in an area 50% above the prior low occurred on multiple occasions in 2012, and our theory is that portfolio insurance is perceived as "expensive" at such junctures, and thus demand from those speculating on higher volatility or buying portfolio insurance -- which creates a headwind for the market -- slows.

Hedge fund managers, who have been underperforming in aggregate, have been increasing their market exposure, and they might go about this in a few different ways:

  1. Accumulate stocks as the market rallies for fear of missing further gains, BUT simultaneously buy perceived "cheap" portfolio protection via the purchase of VIX calls or puts on equity indexes/exchange-traded funds (ETFs); and/or
  2. Wait for a pullback to accumulate stocks, BUT wait for the price of portfolio protection to decline before purchasing hedges; and/or
  3. Cover short positions on pullbacks.

With the above said, when portfolio insurance is viewed as expensive (50% or 100% above prior lows), some of the V-rallies we have witnessed could be attributed to points 2 and 3 above, as a combination of (1) "buying the dip"; (2) slowing portfolio insurance demand; and (3) short covering can create a fast, furious advance.

At the same time, contrary to popular belief, the stock market has been known to advance even when the VIX is low, although the momentum of these advances may not measure up to the early stages of a "V-bottom" rally. The best explanation as to why the market might rally amid a low VIX is that fund managers are buying stocks and buying portfolio protection -- "cautious optimism" playing out. Sellers of the portfolio insurance will short S&P futures to hedge risk, creating a bit of a headwind for the market and slowing its momentum relative to a rally that occurs following a significant VIX peak, such as that which occurred on Feb. 25.

As we enter March expiration week, the VIX has declined to an area just above its multi-year and 2013 lows. Many view the low VIX as a sign of complacency, since some of the more memorable corrections and long, drawn-out bear markets began with a low VIX. But as explained above, a low VIX -- particularly when hedged money is in accumulation mode -- might be viewed as an opportunity, as perceived cheap portfolio protection gives them the opportunity to "chase" the market higher and protect against their worst nightmare, which is a huge sell-off. So, with the VIX near its lows, the market may continue to advance, but at a slower pace than the 4.5% rally from the low two weeks ago.

 Daily Chart of VIX since December 2012 - Another Peak at 50% Above Prior Low

How long hedge-fund managers will continue to add market exposure is anyone's guess. But, to the best of our knowledge, these deep-pocketed players remain in accumulation mode, as the purchase of put options on major ETFs continues to grow relative to the purchase of call options, as seen in the graph below. When this ratio is moving higher -- either due to growing put demand to protect new long positions, or decreasing call demand because there are fewer shorts -- the market has experienced its best days, behind the growing support of institutional fund managers. A roll-over in this ratio, along with a deteriorating technical backdrop, would suggest the growing optimism from this crowd has peaked -- but from what we can see at present, this is not yet the case. As a side note, the purchase of call options on the VIX remains elevated relative to put options, and this has been the case since the June 2012 bottom.

 SPY, QQQ, IWM Combo 20-day buy-to-open put-call volume ratio

Judging by the current level of short interest, and with multiple indexes above major round-number areas (Dow 14,000, S&P 1,500, etc.), short covering could be further supportive of this market. We made these same comments back in mid-January, and since this time frame, little has changed. In other words, short interest on S&P 500 Index (SPX - 1,551.18) component stocks remains significantly above the lowest levels of last year, even with the SPX trading higher, which suggests there are still quite a few short positions in the red and ripe for being squeezed.

So, momentum remains on the bulls' side, with short-squeeze potential and hedge funds (and, to a smaller degree, retail investors) continuing to provide support for the market. Outside of the ever-present "unknowns" that could quickly shift sentiment and create a preponderance of sellers, what are some technical risks at this particular juncture?

First, you should have SPX 1,550 on your radar. As our Chairman and CEO, Bernie Schaeffer, outlined on Friday, this level has been extremely important since 2000. The chart immediately below is a good long-term reference for the significance of SPX 1,550.

 Monthly Chart of SPX since September 1998

Also worthy of your radar: on a weekly chart, the SPX is in an overbought condition, with the 14-week Relative Strength Index (RSI) crossing above 70 last week for only the fifth time in 10 years.

As you can see on the chart below (solid vertical lines), "overbought" historically has not meant that the market immediately peaks and experiences a significant decline. This indicator is an oscillator, and is weakest in trending market environments. But given the importance of 1,550 historically, we thought the RSI note might be worthwhile, as two notable corrections have occurred shortly after the 14-week RSI crossed above 70.

For now, do not disturb any long positions. If a pullback occurs, we could see SPX 1,500 providing support as both a round number and as the site of the 40-day moving average, which acted as a floor in late February.

 Weekly Chart of SPX since March 2003 With 14-Week RSI

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