Monday Morning Outlook: Why the Burden of Proof Is On the Bears

Taking a historical look at how the S&P performs during Thanksgiving week

by 11/22/2014 8:49:46 AM
Stocks quoted in this article:

U.S. stocks continued to climb last week, with central banks dominating the spotlight. While the Federal Open Market Committee's (FOMC) meeting minutes failed to generate much momentum, stimulus chatter from the European Central Bank (ECB) and a surprise rate cut from China sent the major market indexes into the black. That said, Schaeffer's Senior VP of Research Todd Salamone wonders, what's left to keep the short-term momentum alive?

  • The vulnerabilities facing the market
  • 2 sentiment indicators at odds with each other
  • Rocky White offers up 20 hot stocks to watch this week

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

Notes from the Trading Desk: Are There Any Catalysts Left to Keep the Momentum Going?
By Todd Salamone, Senior VP of Research

"A near-term risk we alluded to earlier is the short-term overbought condition of the SPX ... note that pessimism is receding at present, as evidenced by the declining equity-only, buy-to-open, put/call volume ratio (purchased puts are bets against a stock, while purchased calls are bets that a stock will advance). In May, the direction of this ratio was headed lower from an extreme high, and this is a period in which the SPX ignored its short-term overbought reading and continued to trend higher."

-Monday Morning Outlook, Nov. 8, 2014

"Smaller-capitalization benchmarks, such as the Russell 2000 Index (RUT - 1,173.81) and S&P 400 MidCap (MID - 1,430.85), progressed higher from last month's lows, but the MID stalled for the third time this year in the 1,450 zone, just short of all-time-high territory. The RUT rallied up to 1,180 this week, site of at least two short-term peaks this year ... both the RUT and the MID have yet to sustain a move above previous chart highs, which likely gives the bears hope."

-Monday Morning Outlook, Nov. 15, 2014

"2.6 million+ $VIX call contracts will expire this morning, or more than 50% of the total outstanding call open interest $SPY $SPX"

"Total outstanding $VIX option contracts stands at only 4.26 million, lower than 99% of daily readings during past 52 weeks $SPX $SPY"

"Close to 6 million $SPY puts expiring today, nearly 34% of total outstanding put contracts. New hedges could create headwind $SPX"

-@ToddSalamone on Twitter, Nov. 19 and 21, 2014

The equity market remains in an overbought condition, just as it was two weeks ago when we mentioned this as a short-term risk. However, we allowed for the fact that this overbought condition could be shaken off, as the market was being supported by the unwinding of an extreme in pessimism reached in mid-October -- very similar to the sentiment and technical pattern that was evident in June.

Here we are, two weeks later, and indeed, the equity markets have continued to advance, in spite of a persistent overbought condition. Tailwinds include central banks around the world surprising market participants with unexpected stimulus actions (Japan a few weeks ago, China this past week, and the European Central Bank (ECB) "threatening" more stimulus on Friday). Moreover, as we discussed last week, it is a strong seasonal period for stocks, driven in part by a tendency for corporations to execute a majority of their buyback programs in November and December. And, just like last year around this time, per the chart below, short interest on SPX component stocks is elevated, and with the S&P 500 Index (SPX - 2,063.50) carving out all-time highs, some shorts who are in a losing position could be pressured to cover. The aforementioned factors create a positive undertone for equities.

Short Interest on SPX Component Stocks: Elevated, and a potential source of buying power that is supportive

Short Interest on SPX Stocks Since January 2011

Speaking of short covering, below is the SPDR S&P 500 ETF Trust (SPY - 206.68) open interest configuration as of Friday morning, for November options that just expired. Note the massive put open interest, especially at strikes between 180 and 190. The SPY bottomed in the 180 area last month, and as the ETF moved higher above each of these put strikes -- and we moved closer and closer to November expiration -- short positions related to these puts were likely covered, helping the SPY move in "V-like" fashion off the lows. The more put open interest there is, the more the stock market can benefit from short covering related to this put open interest.

SPY Open Interest Configuration in November Series

We bring this up because, as we observe the current SPY December open interest configuration, total put open interest is only about 40% of the November put open interest, after nearly 6 million contracts expired. Moreover, with many December puts far out of the money, short covering related to these positions has likely already occurred -- implying a tailwind that the bulls enjoyed recently is likely to cease. In addition, hedging activity has dried up in the past few weeks as the market has advanced. This suggests that there are a lot of unhedged longs, which makes the market more vulnerable to bad news. Before the last correction, hedging activity dried up as well, but negative news caused a stampede into index put buying and volatility call buying, contributing to an accelerated decline as sellers of the portfolio protection had to short S&P futures to remain hedged.

It isn't uncommon to see hedging activity dry up around the end of the year, perhaps due to the tendency for markets to rally during this period. That said, without portfolio protection in place, the market does become more vulnerable than usual to bad news, which is something to keep in mind in the weeks ahead. Or, the markets may face a bit of a headwind in coming weeks, as those with expired portfolio protection decide to renew.

Absent any negative news, momentum players and those looking to cover short positions on individual stocks could very well keep the uptrend intact or, at the very least, keep pullbacks shallow.

December SPY Open Interest Configuration: Smaller put open interest strikes relative to November; plus, the heavier put strikes are far below the current SPY, which means less short-covering potential for SPY, relative to what we observed in the immediate days after the October bottom

SPY Open Interest Configuration for the December Series

Finally, we will update you on two sentiment indicators we have been discussing the past few weeks, which are now in conflict with each other. First, sentiment among equity option buyers continues to take on a more positive tone relative to last month at this time, which is supportive of the market. In other words, the direction of the ratio that calculates buy-to-open put volume relative to buy-to-open call volume continues to drift lower, favoring the bulls. The caveat is that this ratio is now back to the level that marked a turn higher around the beginning of the last sell-off that occurred. Therefore, bulls would like to see this ratio take out those lows.

But, active investment managers slightly reduced their allocation to equities for the first time in four weeks, according to the weekly survey of the National Association of Active Investment Managers (NAAIM). The fact that equities marched ahead even as this group reduced its allocation is impressive. However, should this group continue to decrease their exposure from the current, relatively high level, this would present another market headwind.

For now, however, the burden of proof is on the bears, with the SPX and Dow Jones Industrial Average (DJI - 17,810.06) continuing to carve out new all-time highs during a bullish seasonal period, and sentiment generally supportive of the bullish case. But, with two major central banks around the world positively surprising markets already (China and Japan), and another (the ECB) preparing the markets for more stimulus action, one has to wonder if we have seen the last of the catalysts that will keep the short-term momentum alive.

Moreover, the Russell 2000 Index (RUT - 1,172.42) and S&P 400 MidCap Index (MID - 1,444.39) have still not pushed above resistance at 1,180 and 1,450, respectively. At the very least, this would suggest that the outperforming large-caps should continue to be emphasized from the long side.

Buy-to-open put/call volume ratio continues to slide, although it is at the levels at which it turned higher in late September

10-day, equity-only buy-to-open put/call volume ratio with SPX since January 2013
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