Shorts' Post-Fed Shock Could Lead to More Upside

Triple-witching expiration week could bode well for bulls

by 9/15/2012 9:50:35 AM
Stocks quoted in this article:

Stocks skyrocketed to multi-year peaks last week, as the Federal Reserve unveiled another round of quantitative easing -- better known as "QE3." The central bank's highly awaited announcement lured more than a few buyers from the sidelines, with both the Dow Jones Industrial Average (DJI) and S&P 500 Index (SPX) approaching five-year highs. Meanwhile, the tech-rich Nasdaq Composite (COMP) soared to its highest level in 11 years, with a little help from Apple Inc.'s (AAPL) much-hyped iPhone 5 debut.

However, the stimulus announcement wasn't as expected as you might think, as Todd Salamone points out. In fact, the post-Fed rally epitomizes what we've seen in 2012, as skeptics continue to fight the Fed and the tape. Against this sentiment backdrop, and with evidence of more bears still doubting the uptrend, there could be even more upside on the horizon.

Meanwhile, Rocky White offers a history lesson that should inspire the bulls. Based on his findings, the stars may be aligning for some expiration-week upside -- and it doesn't hurt that it's September, either. Furthermore, he offers a few stocks you might want to keep an eye on this week.

Finally, we wrap up with a preview of the notable earnings and economic events of the week ahead, along with a few sectors of note.

Notes from the Trading Desk: Risk-Aversion Still Reigns as Rally Continues
By Todd Salamone, Senior VP of Research

"The 1,420 area on the SPX continues to loom overhead as resistance, but a move above this level would likely spur more short covering, clearing a path to 1,500... Our best advice at present is to be open to both scenarios: a modest correction if ECB leaders disappoint investors, or a surprising assault on SPX 1,500 driven by more central bank support that spurs the shorts into covering."
-Monday Morning Outlook, September 1, 2012

"It's Coming: One Pro Sees Major Stock Selloff in 10 Days"
-CNBC.com headline September 4, 2012

"$XHB up 75% during past 52 weeks - BUT component buy ratings lower than Sept. '11, and short interest on component stocks is higher"
-@toddsalamone, retweeted by @schaeffers, September 12, 2012

"Housing activity remains at low levels and is contributing much less to the recovery than would normally be expected at this stage of the cycle."
-Ben Bernanke August 31, 2012

"Our mortgage-backed securities purchases ought to drive down mortgage rates and put downward pressure on mortgage rates and create more demand for homes and more refinancing."
-Ben Bernanke September 13, 2012

The equity market continues to rally on central bank actions, with this week's advance coming on the heels of the Federal Reserve announcing Quantitative Easing: Part III. Specifically, in an effort to inject more life into the housing market, which according to Chairman Ben Bernanke is "one of the missing pistons in the engine," the Fed will expand its holdings of long-term securities through the purchases of $40 billion of mortgage debt a month.

Contrary to what was fed to you ahead of the announcement, the central bank's move and subsequent stock reaction was unexpected. In fact, in a CNBC segment that I did on the day ahead of the Fed's announcement, another guest said that the Fed's actions were baked into the market, thus making it a "sell the news" scenario. As a side note, only about 60% of economists were expecting Fed action on Thursday, and among the commentary we saw ahead of Thursday's meeting, many market analysts suspected the Fed would do nothing.

The "sell the news" opinion was shared by the consensus, as we witnessed the following just ahead of the meeting:

  1. The latest survey from the National Association of Active Investment Managers (NAAIM) indicated a decrease in stock exposure ahead of the Fed meeting.

  2. Short interest on S&P 500 Index (SPX - 1,465.77) component stocks showed a slight uptick since the last report -- a surprise to us, as we were expecting to see a decline in short interest (see first graph below).

  3. Option activity on major exchange-traded funds (ETFs) indicated that hedge fund managers, who had been increasing equity exposure in the weeks prior to the Fed announcement, suddenly shifted gears in the days ahead of the meeting. For example, the 20-day buy (to open) put/call ratio on the three major ETFs that we follow rolled over, as call buying suddenly increased -- evidence of increased shorting activity ahead of the report (purchased calls are used as a hedge to short positions being initiated).

  4. A surge in CBOE Market Volatility Index (VIX - 14.51) call buying -- a sign that hedgers of long positions were getting extremely nervous ahead of the Fed meeting, or a large contingent of traders was betting on a post-Fed sell-off (second chart below). After all, a couple of high-profile strategists went on record in early September telling investors to expect a sell-off. One would buy VIX calls in anticipation of implied volatility on SPX options surging on a vicious market decline.

SPX and Total Short Interest Since January 2012

VIX 20-day BTO Option Volume since Mid-August 2012

The point in reviewing the sentiment backdrop just ahead of the Fed's announcement is that the equity market continues to post strong calendar-year gains, with the latest advance in reaction to the Fed's QE3 announcement on Thursday. The post-Fed reaction was a microcosm for 2012, as many were blindsided by the positive reaction, just as they've been blindsided by the 2012 rally.

Therefore, the sentiment backdrop remains one in which there is plenty of demand via short-covering and/or asset reallocations (think of the massive inflows into bonds that could be directed back to stocks) to provide fuel for the current rally, or at least provide support on dips. It is an environment in which the shorts are fighting the tape and fighting the Fed. While many do not believe in the policy actions of the Fed, and they may very well be proven right in time, the fact of the matter is that central bank actions have been supportive of the market since early 2009, and this time may be no different.

Despite a bullish cover story on homebuilding a few weeks ago, this group remains our favorite sector. The Fed is obviously on a mission to inject more life into the housing recovery, as is evident by the policymakers' announcement to focus its efforts in mortgage debt. The price action speaks for itself, with the SPDR S&P Homebuilders ETF (XHB - 25.87) up 51% year-to-date, and 78% over the past 12 months. However, the sentiment backdrop suggests that there is still a great deal of skeptics surrounding this group, as noted in my tweet earlier this week. Such skepticism is a future source of demand for homebuilding stocks.

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