Monday Morning Outlook

New Highs Ahead! (Should History Repeat Itself)

A look at the market's response to holiday-shortened weeks

by 1/19/2013 9:12:00 AM
Stocks quoted in this article:

A fairly sleepy expiration week was not without its excitement, as we heard earnings from some big-cap bellwethers and had plenty of economic data to digest. More notably, all of the major market indexes achieved milestones, from all-time highs for the small-cap and mid-cap sectors, to a new five-year closing peak for the Dow. As Todd Salamone points out, these positive technical developments have forced the hand of some stubborn bears, and short covering is one factor keeping the rally in place. But for how long?

  • Signs that bears are beginning to "throw in the towel."
  • 3 short-term risks to keep in mind.
  • From Senior Quantitative Analyst Rocky White: Does the market hate holiday-shortened weeks?

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: Short Covering Continues as Indexes Approach Round-Number Levels
By Todd Salamone, Senior V.P. of Research

"...during the past 10 years, January expiration week hasn't been kind to the bulls, with only two of those weeks trading higher ... As for levels to focus on this week, we refer to the open interest configuration of the SPDR S&P 500 ETF Trust (SPY - 147.07). There is huge call open interest at the 148 strike on this ETF, which also happens to be the site of the mid-September 2012 high. Given these calls were purchased, this strike could act as a magnet if the market defies historical tendencies next week and advances."
-Monday Morning Outlook, January 12, 2013

For only the third time in the past 11 tries, the equity market moved higher during January expiration week. This advance was thanks to a Thursday surge in the SPDR S&P 500 ETF Trust (SPY - 148.33), which had literally moved nowhere up through Wednesday's close. As we suspected, if the market advanced, the call-heavy 148 strike on the SPY would become a magnet, which it was during Thursday's and Friday's trading sessions.

30-Minute Chart of the SPDR S&P 500 ETF Trust (SPY)

With January expiration behind us and the market off to a good start in 2013, the fourth quarter 2011/first quarter 2012 and fourth quarter 2012/first quarter 2013 rallies are looking more and more alike, under the same circumstances. Specifically, in both instances, there was a major bottom in November, a mild pullback in December, and a nice start to the New Year.

Meanwhile, there was huge short interest -- as negative political issues grabbed headlines -- followed by a short-covering rally that supported moves to new multi-year highs. The two graphs below depict both rallies through mid-January, and the good news for bulls is that the rally last year didn't end until the end of the first quarter. In fact, the S&P 500 Index (SPX - 1,485.98) rallied another 7.5% before going into correction mode. A similar 7.5% rally from here would push the SPX to around 1,590-1,600, or just above the October 2007 high of 1,576.

 Daily Chart of the S&P 500 Index (SPX) from November 2011 through January 2012

Daily chart of S&P 500 index (SPX) since November 2012

For those of you that have been following us, we have been discussing the short-covering possibility for weeks, as different benchmarks were probing resistance levels that acted as major speed bumps. Most notable was the S&P 400 MidCap (MID – 1,073.93), which endured a constant battle at the 1,000 millennium mark. Small and mid-cap outperformance was critical to unleashing the next leg of the rally (in our view), and this 1,000 area had been an insurmountable brick wall since early 2011. With small and mid-cap leadership in place, it appears some of the bears threw in the towel, as we are finally seeing clear evidence of the short covering we had been anticipating.

With the MID's last close below 1,000 occurring on Dec. 5, the next round-number challenge is the 1,100 area. While one would not expect 1,100 to be as robust as 1,000 from a psychological perspective, consider that the SPX could soon be challenging 1,500 around the same time and thus present a challenge. And speaking of round numbers, the Russell 2000 Index (RUT – 892.80) gets set to do battle with 900. This comes after the small-cap index reached an all-time high last week after breaking out above the May 2011 and September 2012 high in the 870 area, which could now act as support.

Per the short interest graph below, it appears we are about midway through the short covering, if indeed we end up at the short interest lows of 2012 that preceded the April-June correction. The good news for bulls is that short interest levels at present are higher now than at this time last year, implying even more underlying support.

 Short covering on S&P 500 stocks

A continued rally would certainly be a major surprise to those buying and selling options on CBOE Market Volatility Index (VIX - 12.46) futures options, as we have noticed the plunge in volatility concurrent with the passing of the "fiscal cliff" concerns in December. The recent rally in major indices has now inspired a preference for selling puts and buying calls on VIX futures options. Note on the chart below how opening put volume on the VIX has been predominated by sellers, who expect VIX futures to remain elevated.

With VIX call open interest hitting its fourth record high in the past six months prior to expiration of VIX options last Wednesday, the contrarian play would be to buy VIX put options on any short-term pops in volatility, as the volatility pop is likely to be short lived.

 VIX option volume

Stay the bullish course, emphasizing the small- and mid-cap groups, with the following short-term risks in mind:

  1. Three major benchmarks getting set to do battle with round-number areas simultaneously, most notably the SPX at 1,500.

  2. VIX pops tending to occur after VIX expiration, which occurred last Wednesday.

  3. Active Investment Managers are extremely bullish, as polled by the National Association of Active Investment Managers (NAAIM). This means continued short covering and retail flows into equity markets will have to be supportive in the weeks ahead.

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