Playing the Momentum Trade in a Mean-Reverting Market

If what's past is prologue, it could be another frustrating first quarter for the bears

by 1/26/2013 9:05:39 AM
Stocks quoted in this article:

It was another positive week for stocks, despite the tech-sector mayhem unleashed by Apple's (AAPL) disappointing quarterly report. The action was punctuated by multi-year highs for the Dow and S&P 500, as the latter cruised above the 1,500 level for the first time since 2007. But with uncertainty still lingering about U.S. fiscal policy and the European economy, have stocks now come too far, too fast? After looking back at the first quarter of 2012, Todd Salamone suspects the skeptics may be caught off-guard again this year.

  • How short sellers could keep the uptrend alive
  • Why options are the perfect way to play this market
  • After eight straight winning days, can the S&P 500 keep climbing?

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: Don't Hold Your Breath for that Big Pullback
By Todd Salamone, Senior V.P. of Research

"... 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 ... 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.

" ... 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 ... 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."

-Monday Morning Outlook, January 19, 2013

Last week, we discussed the similarity in the equity market's price action relative to last year, when the S&P 500 Index (SPX - 1,502.96) posted an impressive 12% advance in the first quarter. This week, I decided to analyze the first-quarter action in more detail to get a feel for what might occur during the next several weeks if, indeed, a repeat is in store.

During the first-quarter rally last year, short covering was persistent -- as it is now -- and the market experienced only a few minor hiccups along the way. These mild bumps in the road frustrated both the shorts who were looking for a "better" exit point and the sideline players awaiting a "better" entry. The closing high-to-closing low first-quarter "pullbacks" in 2012 were as follows:

  1. Jan. 25 - Jan. 30: -0.9%, as the Russell 2000 Index (RUT - 905.24) was doing battle with 800

  2. March 1 - March 6: -2.2%

  3. March 19 - March 22: -1.2%, as the S&P 400 MidCap Index (MID - 1,096.70) was doing battle with 1,000

In the first quarter of 2012, there were several periods in which the SPX went sideways for a week or two, but the sideways action was resolved with an advance to new high, followed by a very mild pullback that presented a buying opportunity. Overall, the SPX rallied at a few points here and there amid low volatility, which appears to be the case at present.

In 2013, the SPX's biggest pullback to date occurred from Jan. 4 to Jan. 8, and was a miniscule loss of 0.6%. And so far, we have seen the SPX experience a few days of sideways action, but advance steadily on multiple minor rallies -- creating an exceptionally low-volatility market environment.

In 2012's first quarter, the SPX advanced on 63% of trading days. So far in 2013, the index has gained ground on 71% of trading days.

 Daily Chart of SPX - First Quarter 2012

 Daily Chart of SPX - January 2013

With short interest on SPX component stocks higher now than at this time last year -- and rolling over sharply from the fourth-quarter 2012 peak -- we continue to think there's a possibility we could be in for a repeat of the first quarter of 2012, as supportive fuel remains from those still looking to cover short positions and those waiting for a better entry point.

 SPX Stocks with Total Short Interest

One subtle difference is that it wasn't until March 2012 that the SPX had to do battle with a psychological number, which was 1,400. In March 2012, momentum began to wane and the SPX experienced a couple of its biggest pullbacks of the quarter (albeit extremely mild ones). This is something to keep in mind as we enter this week's trading, with the SPX doing battle with the 1,500 area as other major indexes challenge psychological round numbers, too -- particularly the RUT and MID at 900 and 1,000, respectively. If last year's action around century marks is indicative of what to expect when major benchmarks push up against significant round-number levels, it would suggest near-term sideways action or a very mild pullback is on the horizon for the near term -- but a pullback that would not be nearly as steep as many are hoping to see.

A scenario like this would suggest that stocks you are looking to accumulate may not pull back as steeply as you envisioned. Instead, you could leg into a position(s) with fewer dollars than normal, given the "trifecta" risk of three major benchmarks simultaneously testing psychological round-number resistance levels.

Another "option" is to use call options to reduce your exposure relative to a stock play, yet still take advantage of a possible continuation of the short-covering rally. Options are cheap, with 290 underlying vehicles hitting 52-week implied volatility lows on Friday, compared to only 11 underlying vehicles hitting 52-week implied volatility highs (implied volatility statistics courtesy of Trade-Alert).

Playing the momentum trade in an environment that has typically been one of mean reversion may be uncomfortable. This would be another reason to utilize option buying as your strategy to play additional upside. As Rocky White explains on the next page, upside momentum as quantified by streaks usually does not end badly and, in fact, often leads to additional gains, perplexing the crowd.

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