Why Hedge Funds Might Be Feeling a Little Left Out

The Dow's performance over the next two months could provide some presidential clues

by 9/8/2012 10:36:13 AM
Stocks quoted in this article:

Once again last week, European Central Bank (ECB) President Mario Draghi proved he can spark a global equities rally simply by uttering the word "irreversible." Now, on the heels of the ECB's warmly received bond-buying initiative -- not to mention last Friday's less-than-stellar U.S. jobs report -- all eyes will be glued to the Fed this week. Chairman Ben Bernanke and his policy-setting cohorts are set to announce their next move on Thursday, and the general consensus seems to be that the time is nigh for QE3.

In the meantime, the uptrend remains solidly intact, with major equity benchmarks hitting fresh multi-year highs on Friday. Against this backdrop, Todd Salamone can think of a few reasons why the all-powerful hedge funds might be scrambling to ramp up their equity exposure. Though a case of pre-Fed paralysis is entirely possible early in the week, Todd highlights the crucial support and resistance levels to watch for the S&P 500 Index (SPX) once the Bernanke bomb drops.

Meanwhile, with the partisan festivities in Tampa and Charlotte wrapped up, Rocky White analyzes past election results to determine whether stocks might be a leading indicator for the Oval Office. Based on his findings, Obama and Romney will probably want to keep a close eye on the Dow over the next couple of months.

Finally, we wrap up with a preview of the notable earnings and economic events of the week ahead, along with a few sectors of note.

Notes from the Trading Desk: Risk-Aversion Still Reigns as Rally Continues
By Todd Salamone, Senior VP of Research

"It is our thought that the protection trade is alive and well, and the existence of this caution continues to put a floor on the market. The other outstanding put, or floor on the market, is Fed Chairman Ben Bernanke, who again left the door open for a third round of quantitative easing...

"The 1,420 area on the SPX continues to loom overhead as resistance, but a move above this level would likely spur more short covering, clearing a path to 1,500... Our best advice at present is to be open to both scenarios: a modest correction if ECB leaders disappoint investors, or a surprising assault on SPX 1,500 driven by more central bank support that spurs the shorts into covering."

-Monday Morning Outlook, September 1, 2012

"The ongoing flight from stocks runs afoul of the historical relationship between stock market returns and fund flows. Historically, cash has chased returns. But this time not even the S&P 500's 108% gain since the bull market began in March 2009 has been enough to lure jittery investors back in. Investors' overall exposure to stocks has also declined. The percentage of 401(k) investors in their 50s, for example, who have more than 80% of their account balances riding on stocks has dropped by almost half to 26% since 2000. That is due in part to an aging population in search of income and capital preservation."
-USA Today, September 5, 2012

"CBOE Futures Exchange, LLC (CFE) plans to expand trading hours for CBOE Volatility Index (VIX Index) futures to virtually 24 hours from eight hours beginning sometime in 2013, CBOE Holdings Chairman and CEO William J. Brodsky announced today at the CBOE Risk Management Conference Europe near Dublin, Ireland. VIX Index futures will be the first contract traded on a CBOE Holdings exchange with around-the-clock access, five days a week, pending regulatory approval."
-CBOE press release, September 6, 2012

Whether or not you agree with domestic and European central bank policies, or fiscal policy overseas (China's government announced $157 billion in infrastructure spending stimulus on Friday), it is clearly evident that the stock market is responding favorably to stimulus -- or hints of stimulus -- around the world.

This past week, for example, a strong private-sector payrolls report and the unveiling of the European Central Bank's (ECB) "Outright Monetary Transactions" plan combined to push the S&P 500 Index (SPX - 1,437.92) through resistance at 1,420 and above the May 2008 close of 1,426, which was the high prior to the "official" beginning of a violent 52% decline that would last into March 2009.

With the SPX closing at a four-year high amid central bank support (or, at least, the suggestion of central bank support), market psychology remains risk-averse, which is bullish from a contrarian perspective. An article in USA Today last week, from which I excerpted one of many interesting facts above, did a good job of summing up how market psychology has changed from "risk-on" several years ago to "risk-off" at present.

Moreover, one exchange is now talking about around-the-clock CBOE Market Volatility Index (VIX - 14.38) futures trading, which I find very fascinating. Many use VIX futures as a hedging vehicle for equity portfolios, and so the prospect of 24-hour trading underscores the cautious, risk-averse nature of many institutional investors. Contrast this with the late 1990s, when exchange officials were entertaining the idea of around-the-clock stock trading, just ahead of two gruesome bear markets that highlighted the turn of the century. So, whereas a market psychology of euphoria existed in the late 1990s, we now see evidence of widespread defensive posturing that is normally associated with market bottoms, which would imply that the bulls will remain in the driver's seat.

One point we've made in recent weeks is that hedge funds are under-exposed to equities, but evidence in the options market suggests their net exposure is growing. We think the net exposure is growing via short covering, as buy-to-open call volume on key exchange-traded funds (ETFs) is decreasing. This activity is pushing the 20-day put/call volume ratio on the SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 Index Fund (IWM) and PowerShares QQQ Trust (QQQ) higher, per the chart below. Assuming most of the purchased calls on these ETFs are used to hedge short equity positions, the decrease in call activity would be indicative of short covering. We have long said that with retail players fleeing traditional equity funds, the market has enjoyed its best performances when hedge-fund players are collectively increasing their net exposure to the market. As you can see, when this particular put/call ratio is rising from relatively low levels, as it is now, there is usually bullish price action.

In light of the fact that various indexes are experiencing technical breakouts on global monetary easing, and with the potential for another short-covering rally like we saw in September 2011 through March 2012, are hedge-fund managers feeling the pressure to get more equity exposure? This is a fair question, considering the following:

"Hedge funds continue to badly trail the broader markets, failing once again in August to participate in a stock-market rally.

"The average hedge fund rose 0.56% last month, the Dow Jones Credit Suisse Core Index shows. But the Standard & Poor's 500 Index rose almost 2% on the month and is up almost 12% on the year. By contrast, the Dow Jones benchmark is up just 2.02% this year, a gain recorded almost entirely in the last two months."

-FINalternatives, September 6, 2012

SPY, QQQ, and IWM combined 20-day put/call volume ratio with SPX

Last week, we said that a breakout above 1,420 on favorable ECB news would likely lead to short covering and pave the way for an SPX visit to the round-number 1,500 level, as there is little in the way of preexisting chart resistance with which to contend. That said, for short-term traders, one level to pay attention to is the area right above 1,450, which marks a trendline drawn through various higher highs dating back to late May. If a pullback occurs below 1,420 -- which we would expect to be brief -- a potential support level is currently around 1,405, where a trendline connecting the lows in June and July is currently situated.

 Daily Chart of SPX since February 2011

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.