Six Signs of Rising Investor Dread, and Why We Like Them

Bears and bulls both lost conviction last week, according to the Investors Intelligence survey

by 5/12/2012 9:00:00 AM
Stocks quoted in this article:

It was a week chock-full of harsh realities for Wall Street. Over in the birthplace of democracy, disgruntled Greek voters managed to produce a kind of un-government, with both pro- and anti-austerity advocates alternately scrambling to assemble a coalition throughout the week. As investors pondered not only the potential breakup of the euro zone, but also the voter-mandated breakup of two-headed political powerhouse Merkozy, global equities responded with equal parts volatility and melancholy. And all of this drama happened before JPMorgan Chase (JPM) admitted that it's not quite sure how this whole "hedging" thing works. Needless to say, it was a negative week for stocks -- but intriguingly enough, the bottom didn't fall out.

Quite the opposite, in fact, as Todd Salamone observes, with major equity indexes finishing firmly atop significant support levels. Amid multiple signs that a healthy amount of doom is already priced into the market, Todd is also encouraged to see a bullish chart pattern quietly developing under the radar. Meanwhile, Rocky White reports that both bulls and bears seem to have lost conviction. Taking a look back in history, he finds out what happens when everybody's afraid to trade. Finally, we wrap up with a preview of the notable earnings and economic events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Tracking Global Volatility Trends
By Todd Salamone, Senior VP of Research

"...we continue to see evidence of big-money investors moving into equities. As I mentioned last month, call volume was picking up on the CBOE Market Volatility Index (VIX), and this has historically been bullish. Our thinking is that this activity is a sign institutions are in the process of making bullish bets on stocks, and using the VIX call options as a hedge."
- Monday Morning Outlook, May 5, 2012

"... mutual-fund investors mostly have shunned domestic equities in both good times and bad. For example, domestic equity funds as a percentage of 401(k) retirement accounts have dropped from 69% in 2000 to 43% at the end of last year while bond funds climbed from 6% to 15%. The recent market downturn seems to have accelerated the exodus. Since 2007, there have been just over half a billion dollars in net outflows from domestic equity funds and a little over $1 trillion of inflows into bond funds."
- The Wall Street Journal, May 10, 2012

"$VIX intraday high so far is 20.90 - 50 percent above March low and 0.20 below 4/10 peak... $SPY 14 of 15 most active options are puts, with put volume running about 2.14 million - YTD high is 2.5 million, according to TradeAlert ... $QQQ Big 30k block Aug 50-56 put debit spread - crash protection? Fits the Yale data, which says confidence low there won't be crash..."
- @toddsalamone on Twitter, May 8 and 10, 2012

The headlines this past week were downright ugly. Political uncertainty in Europe festering concerns about credit markets overseas, two major brokerage houses downgrading China growth expectations, an earnings blow-up by tech bellwether Cisco Systems (CSCO), and a surprise announcement that JPMorgan Chase (JPM) experienced a $2-billion loss on a trade meant to hedge credit risk. Moreover, throw in the fact that the S&P 500 Index (SPX - 1,353.39) broke below a level that flashed a sell signal among the technical crowd, and you have a disaster recipe for U.S. equity markets, right?

As bad as the headlines were, and as ugly as the price action was on four out of the five opening bells last week , domestic equities were relatively resilient, with the SPX declining 15 points and the Russell 2000 Index (RUT - 790.06) losing only two points. In fact, while the SPX fell below its 80-day moving average last week, it found support in the 1,340 area, a site of former resistance in 2011.

Of course, the bullish technical interpretation discussed above conflicts with those technicians who are betting on the bearish head-and-shoulders pattern on the SPX that Ryan Detrick discussed in detail -- especially since the SPX broke below the neckline of this pattern early last week, flashing an official sell signal for bears.

Moreover, the Nasdaq Composite (COMP - 2,933.82) low was 2,900, just 13 points above last year's highs in May and July. So, just as we had multiple benchmarks trading around potential round-number resistance areas since March, at present we have multiple benchmarks trading near major support levels.

Additionally, the RUT's low last week was just above its 80-week moving average -- a trendline that has had historical importance from both a support and resistance perspective, and which coincidentally is situated at the 2006 peak and just above the 2008 peak. In fact, the RUT formed a Japanese candlestick pattern called a "doji" on a weekly chart, in which the opening and closing prices for the week were about the same. Dojis sometimes mark key reversals, which in this case would be bullish.

I'll take this one step further and point out that with the lows in place from last week, a potential bullish inverse head-and-shoulders formation is not out of the question. The RUT's recent lows and those from June 2011 represent the shoulders, and the October 2011 trough forms the head. A breakout of the neckline at 860, which may take time, could lead to an explosive move higher.

Our thinking is there are more technicians playing the bearish pattern discussed last week than the potential bullish patterns we are noticing. This implies the short trade is crowded and risky, and the long trade is less risky and more opportunistic.


Weekly Chart of RUT since May 2004 With 80-Week Moving Average


Weekly Chart of RUT since December 2010

While on the subject of crucial levels for major benchmarks, let's round out the discussion with a few key volatility indexes, starting with the CBOE Market Volatility Index (VIX - 19.89), and then going overseas to the Euro STOXX Volatility Index (V2TX), which uses real-time options prices on the Euro STOXX 50. As long-time readers know, we have been fascinated by the behavior of the VIX to sometimes peak at areas such as 50% above -- or double and triple -- previous lows, if it doesn't respect former areas of support and resistance. Moreover, when volatility declines, the VIX will sometimes stall at half the prior high. For example, the VIX made a key low at 24 on Oct. 24, 2011, following a peak at 48 in early August 2011. Therefore, the action in the VIX last week was not a huge surprise when it again peaked in the 21 area, 50% above the mid-March low.

If you consider this behavior when viewing the Euro STOXX Volatility Index (V2TX), you may not be surprised that the peak last week was at 33.28, very near a doubling of its recent low at 17.26 in March. If the VIX and V2TX advance above 21 and 34.50, respectively, a sharp rise in volatility would likely ensue. But for now, volatility appears to be nearer the high end of a range.


Euro STOXX Volatility Index (V2TX)

Daily Chart of VIX since September 2011

As you might suspect with major market indexes pulling back to support levels, sentiment is downright negative, and appears to be at the kind of bearish depths more consistent with major lows than highs. For example:

  1. The customer-only, equity-only, 10-day buy-to-open put/call volume ratio is at its highest level since Oct. 27, 2011, indicating option speculators are not that enthusiastic about stocks.

  2. The American Association of Individual Investors (AAII) weekly survey indicates that only 25% of respondents are bullish, the lowest since Sept. 22, 2011.

  3. Confirming the negative sentiment in the AAII survey, Investment Company Institute (ICI) reports that there have been 10 consecutive weeks of outflows from U.S. equity funds, totaling more than $29 billion.

  4. The average strategist allocation to equities is only 52%, the lowest since 2009.

  5. Short interest on all optionable stocks is at a new 2012 high.

  6. Hedge funds, likely buyers on the recent dips, are still underweight equities, as evidenced by the fact that hedging activity in the options market is far from levels that suggest these funds are overweight equities.

As you well know, nothing in the stock market is guaranteed. But the sentiment and technical backdrops continue to favor the bulls, especially if we see improvement in the European headlines to act as a short-covering catalyst. In the absence of positive headlines, a range between last week's low and key overhead round-number areas on major benchmarks, as discussed in prior weeks, is possible during the next couple of months.

Page 1Page 2

ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT

Partner Center

© 2014 Schaeffer's Investment Research, Inc. 5151 Pfeiffer Road, Suite 250, Cincinnati, Ohio 45242 Phone: (800) 448-2080 FAX: (513) 589-3810 Int'l Callers: (513) 589-3800 Email: service@sir-inc.com

All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.

Market Data provided by QuoteMedia.com | Data delayed 15-20 minutes unless otherwise indicated.