Why Traders Shouldn't Fret Over a Weak Start to 2014

Volatility and sentiment data still hint at a positive first quarter

by 1/4/2014 8:47:11 AM
Stocks quoted in this article:

The market finished 2013 on a positive note, with the major equity benchmarks tagging record highs and notching annual gains. Then, stocks rang in 2014 by finishing in negative territory on the first trading day of the year. However, Todd Salamone discusses why bulls need not fear the market's sluggish start, particularly when comparing it to the beginning of 2013.

  • Why a lackluster beginning to 2014 isn't cause for alarm.
  • How the CBOE Volatility Index (VIX) could be signaling a strong first quarter.
  • Rocky White offers up 19 trading ideas for 2014.

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: Is the VIX Forecasting a Strong First Quarter?
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."

"The first day of trading in 2013 got the bulls off to a gangbuster start, but a short-term risk we see as we move into 2014 is the relatively tame VIX, which hit a low of 11.69 late last week. While the 'fear gauge' is still not low relative to the SPX's single-digit historical volatility, and we continue to think a move down to 10.50 is possible (half its recent high), it is not a secret that the market has struggled from a short-term perspective after the VIX has moved down to this area during the past year ... We remain bullish, although a modest pullback or sideways movement to work off the current short-term overbought situation would not be a major surprise."
-Monday Morning Outlook, Dec. 28, 2013

"Last year at this time (just ahead of fiscal cliff), there were 4.3 million open $VIX calls. Now, there are 5.3 million call contracts."

"$TWTR more volume than $SPY"
-@ToddSalamone on Twitter, Dec. 30, 2013

" ... in the Dow's history, there have been 76 years where the first day and the year matched, and only 39 where it did not ... For the S&P 500, it's almost literally a coin flip: there have been 42 years where it did correlate, 42 years where it did not, one year where the index was flat for the year."
-The Wall Street Journal, Jan. 3, 2014

Last week at this time, the CBOE Volatility Index (VIX - 13.76) was at levels that preceded short-term trouble for U.S. stocks in 2013. As such, it may not be a major surprise that the first day of trading in 2014 was quite different than the first trading day of 2013, when the SPDR S&P 500 ETF Trust (SPY - 182.88) rallied 2.6% on volume of 225 million shares. In contrast, Thursday's first day of trading in 2014 saw the SPY lose nearly 1% on volume of only 119 million shares.

The circumstances were different at the end of 2012 and 2013, as we discussed last week, with the VIX hovering at multi-month highs at the end of 2012, and the last-minute deal to avoid the "fiscal cliff" welcoming market participants for the first day of trading in 2013. With the VIX relatively low and absent a market-moving, macro-related event to react to in 2014's first day of trading, volume remained "holiday thin," as stocks pulled back from record levels.

Bulls, especially those who are looking to the first trading day history on the Dow Jones Industrial Average (DJI - 16,469.99) (see excerpt above), would have preferred 2014 to get off to that banner start like 2013, but it didn't happen. However, if you are following the statistic on the first day of trading with respect to the S&P 500 Index (SPX - 1,831.37), bulls can be more optimistic about 2014's prospects.

That said, one day generally does not make or break the market and, as such, we view Thursday's low-volume trading as "just another day," likely to have little impact on how 2014 plays out. Moreover, there is a lot to digest in the immediate days ahead, as traders return from vacation. For example, the December Federal Open Market Committee (FOMC) meeting minutes will be released this coming Wednesday, the official start of earnings season begins with Alcoa Inc's (NYSE:AA) report on Thursday, and the FOMC meets again later this month.

From a short-term perspective, one piece of good news for bulls is that the VIX has rallied from the "sub-12" level that we observed last week, without noticeable damage to the market. The SPX, in fact, has gone mostly sideways. If the VIX puts in a short-term top here, it would follow the pattern of mid-December, when the VIX retraced 50% of its October high and November low before peaking in the 16.60 area. A 50% retracement of December's high and low is in the 14.20 area, which marked Thursday's peak.

VIX -- another 50% retracement of prior high and low in the making?

Daily Chart of VIX since September 2013

If the VIX advances in the days ahead, note that the SPX is still trading about 20-30 points above short-term support in the 1,800-1,810 area that we discussed last week. The 1,800 level is a round number and coincides with the SPX's 40-day moving average, which marked the December low, in addition to troughs that marked minor pullbacks in February and April of last year. With the SPX currently working off an overbought condition from the end of 2013 [see 9-day Relative Strength Index (RSI) in bottom pane on chart below], 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.

SPX daily with 40-day moving average -- 9-day RSI second pane

Daily Chart of SPX since January 2013 With 40-Day Moving Average

Based on the price levels discussed above, the outlook for the next week or two might be characterized as neutral. That said, last week we outlined several reasons -- from a liquidity perspective -- why the market is set up to experience a repeat of last year's first quarter, which was marked by a low-volatility, impressive march higher.

Even with an uninspiring week start to the new year for bulls, nothing has changed with respect to the heightened potential of a strong first quarter of 2014. In fact, while stocks posted small losses, bulls are likely encouraged by the fact that there is less optimism now relative to last week, with the VIX popping and the percentage of bulls surveyed in the weekly American Association of Individual Investors (AAII) survey dropping to 43% from 55%. Finally, with Wall Street strategists expecting sub-par returns for 2014 of about 4.5%, one has to wonder if they'll be quickly adjusting higher their average SPX year-end target of 1,925.

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