Monday Morning Outlook

Technicians Turn Bearish on SPX Trendline Break... Should You?

The crowd on Wall Street is bracing for a volatility explosion

by 10/27/2012 9:25:15 AM
Stocks quoted in this article:

A generally bleak round of corporate earnings set a bearish tone on Wall Street last week, and the next five days aren't going to be any easier for stocks. In addition to another wave of quarterly results, traders will be looking ahead to the October payrolls data that's set to hit the Street this Friday -- the last such report before the general election on Nov. 6. Ahead of these events, Todd Salamone notes that expectations for a November volatility spike appear to have, well ... spiked.

  • The crucial VIX level to watch in the weeks ahead
  • One sentiment indicator that's cause for concern, and another that bodes well for bulls
  • How to find bullish and bearish sector plays, courtesy of contrarian quant Rocky White

Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, plus an update on one of our favorite sectors.

Notes from the Trading Desk: Why Bulls Should Stand Firm, but Carry a Tight Leash
By Todd Salamone, Senior V.P. of Research

" ... the CBOE Market Volatility Index (VIX - 14.33) is struggling to take out its calendar-year 'half-high' in the 13.33-13.80 area, after bouncing from this level on Friday for the third time since late August ... VIX call buying is another headwind for the market in the immediate term, but also has the potential to unwind in bullish fashion in the future."
-Monday Morning Outlook, October 6, 2012

"$VIX in the vicinity that is 50% above '12 low - would not be a bit surprised to see a peak in the area between 19.95-20.17"
-@ToddSalamone on Twitter, October 23, 2012

Long-time readers of Monday Morning Outlook are familiar with the various methods we use to analyze the CBOE Market Volatility Index (VIX - 17.81) to predict where volatility expectations -- and stocks -- could be headed. For example, we look at the VIX's relationship to S&P 500 Index (SPX - 1,411.94) historical volatility, whether or not the VIX is trending, key levels on the chart, and certain historical tendencies that sometimes define peaks and troughs.

Within the realm of historical tendencies, we have noted how the VIX often peaks at levels 50% or 100% above previous lows, and troughs at half-highs. With various calendar-year highs and lows in 2012, this has certainly been the case, as you can see on the chart below. Just as "50% discount" promotions may attract buyers in a shopping mall, a 50% discount on the VIX may attract those seeking portfolio insurance. But if an asset advances 50% or even 100% in price, buyers may quickly disappear. With that said, the VIX last week advanced to an area 50% above its calendar-year low before peaking. This region around 20-21, as underlined on the chart below, is one that we are carefully watching -- particularly since earnings season hits full stride next week, key economic data is due to be released, and U.S. elections are set for Nov. 6.

We would expect the VIX to remain elevated and perhaps above its 200-day moving average, as VIX call buyers continue to replace options that expired in October and uncertainty continues to loom over the market. While the VIX might remain inflated for the time being, bulls would prefer to see it remain below the 20-21 area that's 50% above those calendar-year lows. If this level is taken out, be on guard for a continued advance in the VIX that is coincident with lower stock prices.

That said, previous VIX advances to this neighborhood have presented multiple buying opportunities in 2012, with the one exception being mid-May. In May, VIX put open interest -- which consists of bets on lower volatility, and therefore higher stock prices -- was hitting record levels, unlike the situation today.

In fact, the heaviest VIX open interest is at the 25 and 35 call strikes in the November series, as some are speculating on (or hedging against) a volatility explosion before the expiration of November options, with 48% of VIX call open interest located in this series.

Daily Chart of VIX since December 2011 With 200-Day Moving Average

Below are two charts of the SPX, with the first being a daily chart of the index in 2012. Among technicians, much has been made during the past couple of weeks about the break of the trendline connecting higher lows since the June rally and the subsequent breakdown below 1,425 -- site of the April peak and short-term resistance in late August.

The second chart is a bigger-picture take, and would suggest that bulls stand pat in the short term. We cannot say for certain if the first chart or second chart proves to be "correct" -- but our thought is there is a lot more focus on the first scenario than the second, which would suggest there might be more opportunity in playing the second chart. If support at 1,400 on the second chart breaks, we could see the SPX pull back to last year's high in the 1,350-1,360 area.

 Daily Chart of SPX since December 2011

 Daily Chart of SPX since March 2011 With 80-Day Moving Average

A couple of weeks ago, we highlighted multiple sentiment-based reasons for the long-term bullish case, and we remain in the bullish camp. However, some of our short-term and intermediate-term measures, much like the technical picture, are mixed. For example:

  1. The National Association of Active Investment Managers (NAAIM) reported last week that this group's allocation to stocks is below the 2012 average. That said, their allocation is still far above the level of June 2012 -- which we viewed as a market risk, because if sentiment continues to weaken among this group, the market will likely weaken, too.

  2. On the other hand, the five-day, equity-only, buy-to-open put/call volume ratio is currently around extreme lows during the past year (see the second chart below). This would suggest short-term traders have turned extremely bearish, and their timing hasn't exactly been the most prescient.

Amid a technical backdrop that can be viewed as bearish if focused on the near term -- or bullish, if your chart goes back a year -- many short-term traders have turned bearish, playing an SPX trendline breakdown that's been in place since June. Be open to the possibility that they are correct, but also be aware that this could be a crowded trade. With potential SPX support in the 1,400 area and the VIX still south of the region that's 50% above its lows for the year, stand firm on your bullish positions, but maintain a tight leash.

Finally, don't forget that many hedge fund managers are underweight stocks and trailing the market in 2012. There is the possibility that these big-money players use the current pullback to increase their exposure, and one way to achieve this is by covering short positions. The current pullback might be the opportunity to do just that.

NAAIM Sentiment since 2011

ISE,CBOE,PHLX 5-day, equity-only, buy-to-open call/put volume ratio with SPX since 2011

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