Investors had a lot to digest this week, as economic and earnings reports hit the Street at a healthy clip. Results were mixed, as were the major market indexes. The Dow Jones Industrial Average (DJI) shifted only modestly higher, while the S&P 500 Index (SPX) notched a minor weekly loss, despite hitting a new all-time closing high in Wednesday's trading. But this sluggishness, Todd Salamone asserts, is nothing to fear. In fact -- it might be good news.
Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.
Notes from the Trading Desk: Looming Short Covering, and Continued Action in the VIX Options Pits
By Todd Salamone, Senior VP of Research
"Despite an impressive 2013 and fourth quarter, hedge funds are clearly underweight equities, professionals are still steering hefty amounts of cash into hedge funds as protection trades, and most retail investors still have little confidence in the market, after getting bruised and battered twice in a decade. If, like last year, the New Year ushers in a hint of improved confidence, equities could surge in 2014's first quarter. This may be an unpopular viewpoint, but the ingredients are in place."
-Monday Morning Outlook, Dec. 28, 2013
"...it would not be a major surprise for the 40-day moving average to be revisited, via a pullback or a consolidation period that lasts a couple of weeks. Meanwhile, the 1,860 area could prove to be challenging, as it is 20% above the 1,750 breakout level."
-Monday Morning Outlook, Jan. 4, 2014
"$SPX YTD B/E in play... Shot straight up from Mon lows at 1,815- went sideways on Wed. once 1,848 touched. 1,848.36 is 12/31/13 close."
"Shorts on $SPX component names finally covering... potentially early innings of this phase $SPY"
-@ToddSalamone on Twitter, Jan. 16, 2014
"'A lot of people are getting ready for higher volatility,' Ryan Detrick, senior technical strategist at Schaeffer's Investment Research in Cincinnati, said by phone on Jan. 16. 'The VIX has become the preferred instrument for hedging.'"
-Bloomberg, Jan. 17, 2014
The good news....
The S&P 500 Index (SPX - 1,838.70) is in negative territory year-to-date. Why is this good news? At this point in the year, with only two full weeks of trading behind us, whether up or down by a modest amount, it doesn't mean a whole lot. In our view, it is somewhat of a positive, as some have turned cautious as a result. Long-time readers know we like to see caution in a bull market, so, in the context of a sharp rally in 2013 and the fourth quarter, bulls should be encouraged by last week's lows being contained in the vicinity of its 40-day moving average as stocks consolidate. The current price pattern mirrors that of late 2012/early 2013, when the market embarked on an impressive short-covering rally during the first quarter.
More good news....
As some market participants fret about headline benchmarks such as the Dow Jones Industrial Average (DJI - 16,458.56) and SPX being in the red this year, other significant (but less-publicized) benchmarks, such as the S&P MidCap 400 (MID - 1,347.81), Russell 2000 Index (RUT - 1,168.43) and Nasdaq Composite (COMP - 4,197.58) are in the green.
With the SPX consolidating since late December, it appears the shorts are finally beginning to lose patience, as we speculated could happen. As seen on the chart below, the rally in the first quarter of 2013 was, in part, driven by short covering, and the likelihood of this occurring again in 2014 is growing.
For example, stocks have displayed tremendous resilience amid weaker-than-expected jobless numbers and voting Fed governors reminding us that asset-purchase tapering will, nonetheless, continue. Plus, a few popular retail stocks -- such as Best Buy (BBY), Bed, Bath & Beyond (BBBY), Lululemon Athletica (LULU), Family Dollar (FDO), and GameStop (GME) -- took hits on sales and earnings data. These are catalysts that could have easily pushed stocks sharply lower. Instead, negative news has failed to deliver for those betting against the market, and thus we expect short covering could be a supportive factor in the weeks ahead.
From a contrarian perspective, bulls might also be encouraged by the fact that there is a growing view that the probability of a market correction is rising, as evidenced by the record call open interest on CBOE Volatility Index (VIX - 12.44) futures. With fund managers buying VIX calls to protect against a correction, bulls can take some comfort in knowing that panic selling is lowered due to growing hedging activity. This could reduce, but not entirely eliminate, the odds of a correction occurring, even though some fund managers are placing increasing bids on a correction in the near future.
With put open interest on the VIX still 20% below its record level, it is clear that a surprise would be stocks continuing to grind higher amid lower volatility, a bet that is worth taking amid the short-covering activity that is apparent and a still-healthy technical backdrop. That said, January VIX options expire this coming Wednesday, so at least 2.5 million calls will expire. VIX pops (market selloffs) have generally occurred after VIX expiration, although only 32% of VIX call open interest is in the January series, down from the usual 40-50% in the front-month series. The implication is that VIX call open interest, used as portfolio protection, should remain relatively high following this particular VIX expiration.
In parting, we mentioned at the beginning of the year that when the VIX has approached the 12 area, the market has run into short-term trouble during the past year. As the SPX approached its year-to-date breakeven, the VIX again traded down to the 12 area, resulting in weak price action at the end of last week. One has to wonder, however -- with each bounce from the 12 area weakening -- if it is only a matter of time before the VIX breaks this support area and moves to the 10.50-11.00 area, which is half the highs reached during the second half of 2013?
Recent XIV Action May Bode Well for Bulls
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