Monday Morning Outlook

Monday Morning Outlook: Two Key Trendlines to Watch on the S&P 500 Index

Hedge funds could be starting to unwind their bearish bets on stocks

by 8/27/2011 11:56:38 AM
Stocks quoted in this article:

Stocks ended higher for the first week in five, giving investors a brief respite from the long, grueling slog that has been the month of August. Fed Chairman Ben Bernanke's Friday speech helped boost the bulls, even though he neglected to unveil any revolutionary new stimulus measures. Instead, Bernanke promised that the Federal Open Market Committee (FOMC) would take a long, hard look at its tool kit during September's two-day meeting -- which means we can all look forward to another solid month, at least, of "will he or won't he?" speculation about QE3. In the meantime, the major market indexes are still on shaky ground, and Wall Street is staring down the barrel of three straight days' worth of jobs data.

In this uncertain environment, Todd Salamone is still keeping a watchful eye on the market's deep-pocketed players. Recent options activity suggests that hedge funds may be regaining their appetite for equities, just as gloomy headlines are stacking up about these big-money investors. Meanwhile, Rocky White takes a retrospective look to find out whether the market's miserable August is a harbinger of more pain to come. Finally, we wrap up with a preview of the major economic events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Has Hedge-Fund Pessimism Already Peaked?
By Todd Salamone, Senior VP of Research

"Hedge-Fund Bets Against S&P 500 at Highest Since 2008"
The Wall Street Journal, August 25, 2011

"Icahn Gained on $2 Billion Bet Against S&P"
Bloomberg, August 22, 2011

"Hedge Funds Most Bearish Since July 2009 After Global Equities Retreat 15%"
Bloomberg, August 19, 2011

During the past few weeks, through our analysis of option activity on major exchange-traded funds (ETFs) -- the SPDR S&P 500 Trust (SPY), iShares Russell 2000 Index Fund (IWM) and PowerShares QQQ Trust (QQQ) -- we suggested that hedge funds were turning sour on the market, and went so far as to speculate that they were actively shorting the market. As you can see by the headlines above, various news stories last week confirmed our words of warning.

Hedge fund managers can change course in the blink of an eye, with $2 trillion in assets at their disposal. Bears, take note: This group, which has disappointed investors lately with lackluster returns, has unusually low equity exposure, even as the major market indexes have shown signs of stabilization during the past couple of weeks. Sure, hedge funds could use this week's rally to add to their short positions, and this would likely pressure equities. But, at this juncture, might they be thinking of covering their bearish bets? After all, equities rallied on the heels of Fed Chairman Ben Bernanke's keynote speech at Jackson Hole, Wyo., where central bankers from around the world gathered this past week. For those of you who don't remember, this annual event sparked the year-end rally in 2010, and a potential replay of last year is likely top-of-mind for market-moving players.

At the very least, it appears the relentless shorting activity has lightened up, as the combined 20-day buy-to-open put/call ratio on the SPY, IWM, and QQQ has finally turned higher. Remember, an uptick in this ratio is what bulls would like to see as evidence of a potential bottom forming. Since calls are used to hedge short equity exposure, a rising put/call ratio indicates that major players, such as hedge funds, are turning less negative, which means short-covering activity and/or cash moving in from the sidelines could spark a rally. And the timing of this ratio turning higher is certainly intriguing, as it comes at a time when the general investing public is finally made aware that hedge funds have turned negative on the market. In other words, just as retail-level traders are catching on, there is new evidence that the pessimism that has driven stocks lower is decreasing.

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

If a post-Jackson Hole rally occurs, like it did last year, it would happen in the context of a weaker technical backdrop. For example, ahead of the 2010 meeting, the S&P 500 Index (SPX - 1,176.80) was sitting just above its 80-week moving average, whereas it's trading below this trendline at present. After Friday's rally, bulls would prefer that the SPX immediately trade back above this moving average, which is currently at 1,209.40.

That said, we find it interesting that in both 2010 and 2011, equities had tested a long-term moving average of historical significance just ahead of the central bank summit. This year, it was the 40-month moving average, which was tested earlier in August. As you can see on the chart below, this trendline has carried major significance, having previously caught the 1987 crash low, and then acting as support in 1990 and 1994. Moreover, this trendline acted as resistance right ahead of the May 2010 "flash crash." If the SPX immediately heads lower from here, this is a moving average that we will continue to focus on in the weeks ahead.

Monthly Chart of SPX since September 1985 With 40-Month Moving Average

The 1,133 area could also prove psychologically important through the end of the month, as it marks the 10-year breakeven on the SPX as of the close of trading this Wednesday, Aug. 31. For what it's worth, the 10-year breakeven based on the September 2001 month-end close is 1,040, just above the SPX's July 2010 low.

After Friday's advance, there is still work to be done to repair the technical backdrop, as it has been a volatile, choppy ride since the Aug. 9 lows. Encouraging for the bulls is that the CBOE Market Volatility Index (VIX - 35.59) remains well below 50, major equity indexes remain above historically significant long-term moving averages, and there are signs that heavy pessimism among hedge fund managers is dissipating.

In this environment, we recommend you dip your toes into highly shorted equities that are trading at long-term support -- such as consumer discretionary stocks that have pulled back recently, but are still in the black for 2011. If a bottom is in place, these equities will likely outperform. However, continue to maintain exposure to gold and bonds, and avoid the large-cap financials.

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