Why We're Not Panicking Over Europe Anymore

The VIX still has room to run lower from here

by 4/28/2012 9:15:30 AM
Stocks quoted in this article:

Stocks ended solidly higher last week, as traders effectively brushed off a Spanish debt downgrade, a disappointing unemployment report, a slimmer-than-forecast GDP rise... oh, and the collapse of the Dutch government. While any one of these headlines might have sparked a selling spree in the not-so-distant past, Todd Salamone breaks down a few notable data points that help to explain the market's growing resilience. But while Europe may finally be priced in -- at least, for now -- Todd also notes several looming technical levels that could keep a lid on stocks going forward. Then, Rocky White runs the numbers to find out which traits the market's monthly outperformers have in common. Finally, we wrap up with a preview of the key economic and earnings events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Quantifying the Growing Fear Among Investors
By Todd Salamone, Senior VP of Research

"A number of hedge funds bought Spanish CDS at the start of the month, say industry insiders, helping drive up the price to more than 500 basis points earlier this week from below 350 basis points in February... While funds have kept positions relatively small on concerns over lower liquidity in some credit markets and a fast-changing political environment, managers are generally still short stocks -- betting on falling prices -- looking at sectors such as banks... Most hedge funds are still bearish on the euro zone's debt crisis."

- Reuters, April 27, 2012

"... we find it interesting that some key U.S. equity benchmarks are trading just under key round-number areas, while others trade just above key round numbers -- creating potential crosswinds, from a technical perspective... The above technical and fundamental crosswinds could last for several weeks, but bulls should find it encouraging that price action has been somewhat muted relative to previous pullbacks induced by European sovereign debt issues. We think this is due to the fact that major players, such as hedge funds, have not been as heavily exposed to stocks, and therefore there are fewer sellers..."

"The VIX has plenty of room to move lower before retesting its March lows, even though Twitter sentiment suggests the VIX is 'cheap.' The VIX peaked at 21.06 on April 10 when earnings season began, continuing a series of lower highs in place since the beginning of the year. The peak this month was 50% above the mid-March low, continuing the uncanny behavior in which the VIX tends to peak 50% above -- or double or triple -- its previous lows."

- Monday Morning Outlook, April 21, 2012

Last week, we noted the resilience of the U.S. stock market amid headlines related to European sovereign debt issues, which have been surfacing on and off again since early 2011. Our explanation for this resilience was that hedge funds -- who have pretty much dictated the direction of the market, given that retail investors continue to flee domestic equity funds -- already had a relatively low allocation to U.S. equities, substantially removing potential selling pressure in the market.

As we ascertained from a Reuters article on Friday, excerpted above, hedge funds are making bets against Spanish debt through the purchase of illiquid credit default swaps (CDS). So, the market participants that have the power to drive the U.S. market one way or the other have been seeking bearish opportunities overseas, which may explain why you don't see the panic selling related to Europe that prevailed throughout last year. It appears funds are positioned for a negative environment in Europe, reducing the element of surprise as it relates to the U.S. market. In fact, amid a downgrade of Spanish debt and domestic GDP data that came in weaker-than-expected, both U.S. stocks and equities in Spain managed to rally on Friday.

In fact, just as the S&P 500 Index (SPX - 1,403.36) was hitting lows in the 1,360-1,370 area a couple of weeks ago, we observed that underweight hedge funds were dipping their toes back into the stock market, as evidenced by increased call buying on CBOE Market Volatility Index (VIX - 16.32) futures and an uptick in put buying on equity-based exchange-traded funds (ETFs), such as the SPDR S&P 500 ETF (SPY), iShares Russell 2000 Index (IWM), and PowerShares QQQ Trust (QQQ). It's encouraging for the bulls that such funds have ample cash to deploy to the market on pullbacks, and option activity that we continue to observe suggests that some hedge funds are again accumulating stocks, and using options on the VIX and major equity ETFs to hedge.


VIX 20-day buy-to-open call-put ratio

One thing that has particularly intrigued us, as contrarians, is the amount of fear that has come into the marketplace, in what has so far proven to be a mild short-term pullback within the context of impressive price action during the past several months.

For example, this past week, the American Association of Individual Investors' (AAII) weekly sentiment survey revealed that there are more bears than bulls, with only 27.6% of individual investors taking a bullish stance, as 37.4% claimed to have a bearish view. The bullish percentage is the lowest in 2012, and is also the lowest reading since September 2011, when the SPX was carving out a major bottom in the 1,100-1,150 zone.

In order to better quantify the fear by analyzing what traders are doing, as opposed to thinking, the bearish surge in the AAII survey is confirmed in the equity options market. Per the chart below, check out the spike in the 10-day customer-only, equity-only buy-to-open put/call volume ratio. As you can see, equity put option buying has reached its highest point since last fall, and is at a level that not only marked a bottom during the May 2010 flash crash, but also preceded the SPX's breakout above 1,350.


10-day equity-only BTO put-call volume ratio with SPX since 2009

As we head into this week's trading, the following indexes are above important round-number century or millennium levels:

  1. Dow Jones Industrial Average (DJIA - 13,228.31) - above 13,000
  2. Nasdaq Composite (COMP - 3,069.20) - above 3,000
  3. Russell 2000 Index (RUT - 825.47) - above 800
  4. S&P 500 Index (SPX - 1,403.36) - above 1,400

But work remains, as the Dow's high on Friday was the site of the April 2 closing peak, and the RUT is perched just below its February and March highs in the 830-840 area. Moreover, the S&P MidCap 400 Index (MID - 999.40) comes into the week below the important 1,000 millennium level, and the Dow Jones Transportation Average (.TRAN - 5,267.39) remains below 5,500, which has marked peaks since 2007.

While technical speed bumps remain in place, we are encouraged by the sentiment backdrop, as there is sideline money and short-covering potential to push major benchmarks through resistance.

Furthermore, the last time the SPX was trading in the 1,400 area, the VIX was bottoming around 14.00. With the VIX at 16.36 coming into this week's trading, a bull could argue it has more room to fall before another period of short-term weakness. In fact, the next major low in the VIX could occur around 11.50, which would be half the recent peak.


 Daily Chart of VIX since January 2012

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