3 Risks to the Short-Term Outlook

After record highs, now what?

by 9/20/2014 10:20:58 AM
Stocks quoted in this article:

It was a solid week for U.S. stocks, with the Dow Jones Industrial Average touching a record high in four straight sessions, and the S&P 500 Index notching an all-time peak of its own. Nevertheless, as Schaeffer's Senior VP of Research Todd Salamone points out, the major benchmarks are stuck in neutral around key levels, and the bulls could be due for a modest breather.

  • Why you might want to dodge small-cap stocks for now
  • What to watch in the event of another "scary" pullback
  • Where have all the bears gone? Rocky White investigates.

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: After Record Highs, Now What?
By Todd Salamone, Senior VP of Research

"For the S&P 500 Index (SPX) and SPDR S&P 500 ETF Trust (SPY), 2,000 and 200, respectively, have presented quite the challenge, as they represent millennium/century marks and significant returns from a key point in time. Specifically, we pointed out during the past two weeks that 2,000.37 is triple the SPX's March 2009 low, and we find it of interest that last week's high on the SPY (at $201.58) was just 28 cents above $201.30, which is triple the March 2009 low of $67.10."
-Monday Morning Outlook, Sept. 6, 2014

"If the VIX settlement on Wednesday morning is anything like the past few months, look for the VIX to settle below 14, as this would mean a major bulk of the September call open interest would expire worthless."
-Monday Morning Outlook, Sept. 13, 2014

"Short sellers are abandoning an exchange-traded fund that becomes more valuable during times of market tranquility after it soared 24 percent this year. Bearish bets on the fund, known as the VelocityShares Daily Inverse VIX Short-Term ETN, make up 0.2 percent of outstanding shares, a record low, compared with 19 percent in June ..."
-Bloomberg, Sept. 15, 2014

"$VIX settle price ($VRO) was 13.03 ... 97.1% of VIX September calls expire out of the money --- pretty much par for the course."

"$SPY 5% out of money Oct. 191 put offered 61 cents while 5% out of money 211-strike call is offered at four cents - post Fed!"

-@ToddSalamone on Twitter, Sept. 17, 2014

A key Federal Open Market Committee (FOMC) policy statement, the expiration of September CBOE Volatility Index (VIX - 12.11) futures options, quadruple witching, the $168 billion Alibaba Group Holding Ltd (NYSE:BABA) initial public offering, and the Scottish referendum "no" vote for independence are all behind us. The good news for bulls is that quadruple-witching expiration week ended positive, and such weeks have been profitable in 15 of the past 19 instances since 2010.

However, despite the potential catalysts mentioned above and the S&P 500 Index (SPX - 2,010.40) and Dow Jones Industrial Average (DJI - 17,279.74) hitting all-time highs, multiple benchmarks are essentially "stuck" in neutral around key round numbers.

Yes, the SPX rallied up to 2,020 to new highs, but pulled back to the Sept. 4 peak in the 2,010 area, as questions remain whether or not this is the last of 2,000 that we will see in the days ahead. With 2,000 potentially supportive on pullbacks, the 2,030 area is the next major short-term hurdle that the SPX will likely contend with, as 2,029.59 is triple the March 2009 closing low of 676.53, and 2,033.20 is around 10% above last year's 1,848.36 closing level.

With SPX 2,000 still in the picture, the NYSE Composite's (NYA - 10,989.57) 11,000 millennium mark continues to be a barrier (first chart below), as does the $100 century mark on the PowerShares QQQ Trust (QQQ - 99.98), which was pinned at this level on expiration Friday. This allowed both call and put sellers at the 100 strike to pocket the premiums they received from the sale of September expiration options.

Daily Chart of NYA since April 2014
Chart courtesy of StockCharts.com
30-Minute Chart of QQQ with Resistance at $100

Meanwhile, the price action in the small-caps, as measured by the Russell 2000 Index (RUT - 1,146.92), continues to disappoint, with the RUT's 2014 breakeven level at 1,163.64 acting as resistance again this past week. This index has been trading in a grueling range year-to-date, with multiple touches of its 2014 breakeven level and the various peaks and troughs roughly equidistant from the 2013 close. Given the poor price action of small-caps relative to mid- and large-cap equities, we would avoid the small-caps group, unless and until you see much improved price action from this area of the market.

Weekly Chart of RUT with YTD Breakeven

From a bigger-picture perspective, the SPX continues to grind higher in a defined channel -- much to the dismay of bears. And the bears are plenty, as evidenced by the amazingly still-high short interest on SPX component names, per the chart immediately below. Short interest on SPX component names remains nearer the top of a range going back more than two years, and is far above the levels that existed prior to the SPX's last 10% correction in 2011. Ironically, the fact that we have gone so long without a 10% correction has the bears holding out hope that their short positions will eventually work out. Meanwhile, the bulls look at this short position as future buying power that is supportive of the market.

SPX stocks vs Total Short Interest since January 2011

If the SPX experiences a retreat below short-term support in the 2,000 area and we experience another one of those "scary" pullbacks, the 1,950 level is potentially supportive, as this is the bottom of a channel in place since 2012. The 1,950 level is only about 3% below Friday's close, but pullbacks of this magnitude have proven to generate a lot of fear in the recent past. Also note that there is considerable put open interest at the SPX 1,950 strike in the October series, in addition to notable put open interest at the SPDR S&P 500 ETF Trust (SPY - 200.70) 195 strike, which is one-tenth the SPX's value.

SPX Weekly since August 2012 with Upward Channel

The sentiment backdrop continues to suggest that if pullbacks occur, they will be modest. With many benchmarks perceived as overbought and around round levels, some market participants have already decreased exposure, as is evident by the most recent National Association of Active Investment Managers (NAAIM) weekly survey, which shows a big decrease in long exposure after the SPX tagged 2,000 a few weeks ago.

And in the options market, the 10-day average of puts purchased (to open) versus calls purchased (to open) is at 0.53, which is neither an extreme high nor low. In the context of the SPX and some big-cap technology names hitting highs, one might conclude that there is still a good degree of pessimism among equity option players, which one with a contrarian mindset would view as bullish.

NAAIM Exposure -- Lightening Up as SPX Toys with 2,000

NAAIM Exposure Index vs SPX since January 2013

Above being said, and with round-numbers still acting as resistance on some benchmarks, there are a few risks to the short-term outlook, specifically:

  1. Due to expiration of VIX futures options this past week, VIX call open interest has decreased from 7.6 million ahead of Wednesday's VIX expiration to 5.0 million at present, implying some market participants that typically hedge no longer have portfolio protection. If negative headlines hit, those without portfolio protection may be more apt than usual to liquidate long positions, leaving the market more vulnerable to negative news.

  2. As noted in the Bloomberg excerpt above, volatility speculators have given up on making bets on rising volatility, which is normally associated with a weaker market. One must leave open the possibility that they threw in the towel at the wrong moment.

  3. Finally, we have noticed an unusually large skew in how out-of-the-money (OOTM) SPY put options are priced relative to OOTM call options. In other words, it will cost you a lot more money to bet on a 5% decline over the next month, relative to betting on a 5% advance. Betting on declines is usually more expensive, but at present it is much more expensive than usual. When this occurs after a decline, it usually has bullish implications. However, when a large skew is present during an advance, weakness has followed in the past. That said, this skew may be a symptom of fear heading into the various potential market-moving events during the past week, implying that it may disappear without harm.
SPY puts are very expensive relative to calls, with the implied volatility of the puts more than twice that of the implied volatility of calls

10-day MA of OOTM put-call skew

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