Why Bulls Should Stay in the Game

An historical look at Election Day -- and election week -- returns

by 11/3/2012 9:28:06 AM
Stocks quoted in this article:

Hurricane Sandy, unemployment data, and pre-election jitters made for an unconventional week on Wall Street, and it'll be interesting to see how the market -- and the nation -- reacts to Tuesday's poll results. In fact, as Todd Salamone points out, the last time expectations for a volatility spike were this high, the broader equities market was carving out a bottom -- an historical point of interest for the bulls. Furthermore, Rocky White looks back at not only Election Day returns, but breaks down the Dow's resume by weekday, winning party, and more.

  • The round-number level of utmost importance for the MID
  • A gauge of hedging activity that bodes well for bulls
  • Why a Romney win could translate into a short-term bump for blue chips

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: Despite Uncertainties, Bulls Should Stand Firm
By Todd Salamone, Senior V.P. of Research

"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."
-Monday Morning Outlook, October 27, 2012

"$SPX flat today, but $VIX pops higher from 200-dayMA"
-@ToddSalamone on Twitter, October 31, 2012

"$MID back at 1,000 - a tough nut to crack since first tested in April '11 - enough pent-up buying power to eventually bust through imo"
-@ToddSalamone on Twitter, November 1, 2012

It was a "Superstorm Sandy"-shortened trading week, but November -- a traditionally strong month for equities -- got off to an impressive start on Thursday. The S&P 500 Index (SPX - 1,414.20) rallied from support to notch a 1% gain on the first trading day of the month, following reports of stronger-than-expected same-store sales out of the retail sector, plus better-than-expected employment and productivity data. The SPX's strength on the first day of the month followed a CBOE Market Volatility Index (VIX - 17.59) pop the previous day, perhaps an indication of fear leading into a healthy dose of economic reports.

The stock market is following a script that we laid out in early October, when we said that lingering worries about the four E's -- earnings, elections, Europe, and the economy (fiscal cliff) -- combined with indications of short-term optimism, would lead to choppy price action. The SPX proceeded to sell off about 2% in October, but Thursday's advance erased about half of these losses. Meanwhile, Friday was another roller-coaster ride, with concerns about the election overshadowing a bigger-than-forecast increase in nonfarm payrolls last month.

With major indices rallying off support levels last week, and the VIX still below the area that is 50% above this year's low, and back below its 200-day moving average, bulls should stand pat. It appears that the consensus is still bracing for an imminent volatility spike, even though VIX advances continue to get turned back at resistance levels.

The chart below is a perfect visual for VIX expectations, as 20-day buy-to-open call volume is coming off its highest levels in two years and remains extremely high, even as buy-to-open put volume remains perched at two-year lows. The last time expectations for a volatility spike were this high was in the late-May/early-June period, when the SPX was carving out a major bottom. In fact, the VIX 20-day buy-to-open call/put volume ratio just hit its highest level in 2012, when it peaked at 3.50. Three of the previous four spikes above 3.0 were followed by strong SPX advances.

SPX and VIX 20-day Call and Put Volume Since 2011

Another chart that caught our attention this week is the recent outperformance of the S&P MidCap 400 Index (MID - 987.80) versus the SPDR S&P 500 ETF Trust (SPY - 141.56). When the small- and mid-cap groups are outperforming, the equity markets have experienced their best days. In particular, check out the "relative strength" breakout of the MID vs. SPY on the graph below. This could be signaling that the MID is finally about to sustain a move above the 1,000 area, which has turned back advances since April 2011, when the MID made its first-ever run at the millennium mark. For now, this resistance area remains a technical risk to bulls, although the sentiment backdrop gives us reason to believe that 1,000 can be taken out.

Weekly Relative-Strength Chart of MID vs. SPY since November 2010

Finally, we have been speculating for weeks that the hedge funds might soon deploy cash to the equity market, as they have been trailing the benchmark SPX by a wide margin this year, and the calendar year is about to come to a close. We attempt to identify real-time hedge-fund exposure by tracking option activity on major exchange-traded funds (ETFs) -- like the SPY, PowerShares QQQ Trust, Series 1 (QQQ - 65.17), and iShares Russell 2000 Index (RUT - 814.37) -- which some hedge funds utilize as hedging vehicles. For example, hedge funds will begin buying more puts than usual to hedge long positions they're accumulating.

This measure of hedging activity recently hit its lowest level since this time last year, but there is now evidence that some fund managers may be tiptoeing back into equities, as put buying has increased on the ETFs we follow. The last time the buy-to-open put/call volume ratio increased from such low levels, the SPX rallied strongly over the next few months. During this time of strong market seasonality, bulls have a lot going for them, even as major uncertainties linger.

SPY, QQQ, and IWM 20-Day BTO P/C Volume Ratio With SPX since Jan. 1, 2011

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