Monday Morning Outlook

Why We're Watching These Two Uncommon Moving Averages

Is a consolidation in the cards? This sentiment indicator may be flashing red

by 2/9/2013 9:28:08 AM
Stocks quoted in this article:

The major market indexes extended their quest for new highs last week, though the Dow couldn't maintain its perch atop 14,000. However, the blue-chip barometer isn't the only index dancing around key round-number levels, which, as Todd Salamone points out, will remain in focus this week. In addition, he says, investors should keep an eye on two unconventional trendlines that could have broad-market implications. Meanwhile, Rocky White takes a look at the latest sentiment polls, and what the results might suggest for contrarians.

  • Why bulls should consider this stock-replacement strategy
  • The potential impact of VIX options expiration
  • One sentiment indicator that could be flashing red

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Round Numbers, Rare Trendlines, and Options Expiration
By Todd Salamone, Senior V.P. of Research

"During the first-quarter rally last year, short covering was persistent -- as it is now -- and the market experienced only a few minor hiccups along the way... there were several periods in which the SPX went sideways for a week or two, but the sideways action was resolved with an advance to new high, followed by a very mild pullback that presented a buying opportunity. Overall, the SPX rallied at a few points here and there amid low volatility, which appears to be the case at present ... With short interest on SPX component stocks higher now than at this time last year -- and rolling over sharply from the fourth-quarter 2012 peak -- we continue to think there's a possibility we could be in for a repeat of the first quarter of 2012, as supportive fuel remains from those still looking to cover short positions and those waiting for a better entry point."
-Monday Morning Outlook, January 26, 2013

" $SPX 1500 touch 10 of past 11 days; round # implications $RUT $MID $DJIA"
-@ToddSalamone on Twitter, February 7, 2013

"Blizzard of '78 and after Sandy $DIA held tough. Also Feb. expiration next week. Up 6 past 7 times."
-@RyanDetrick on Twitter, February 8, 2013

If you've read Monday Morning Outlook during the past few weeks, you're familiar with comparisons of the low-volatility, short-covering rally that occurred during the first quarter of 2012 with the low-volatility, short-covering advance we have witnessed in the first quarter of this year.

Additionally, we have observed that many major benchmarks are trading around key round numbers that came into play and ended the rally during the first quarter of 2012, when the S&P 500 Index (SPX) was bumping into 1,400 as the S&P 400 MidCap Index (MID) was trying to push the important 1,000 mark. Key round numbers coming into play at present are as follows, with the SPX and Dow Jones Industrial Average (DJIA) perhaps most notable:

  • S&P 500 Index (SPX - 1,517.93) -- 1,500
  • S&P 400 MidCap Index (MID - 1,109.09) -- 1,100
  • Dow Jones Industrial Average (DJIA - 13,992.97) -- 14,000
  • Russell 2000 Index (RUT - 913.67) -- 900

The momentum, short-covering potential, round numbers, and a recent surge in buying from institutional players -- evident by record-setting CBOE Market Volatility Index (VIX - 13.02) call buying -- are at the top of the radar for us. On one hand, should the market track higher on the heels of continued short covering, it wouldn't be a major surprise.

On the other hand, it wouldn't be a huge surprise if the market stalls or experiences a pullback of note from round-number resistance, just in time for the underperforming hedge-fund players who recently increased their exposure to equities.

Given the ambiguity, we have been advocating a stock-replacement strategy, in which you use call options in lieu of bullish stock plays to play your directional outlook. Options allow you to reduce your dollar exposure to the market, but also allow you to leverage upside moves if the current trend persists.

That said, what are some signs to indicate that momentum in the market is slowing and putting long positions more at risk? Once again, I looked to the first quarter of 2012 to provide some guidance while attempting to keep it simple.

As you can see on the first chart below, there were two uncommon moving averages that supported market pullbacks in 2012's first quarter (and, for what it is worth, the first two months of 2011, too), Specifically, the SPX's 15-day and 30-day moving averages provided support during these momentum days and, once broken, signaled notable pullbacks. I find these trendlines of interest, as traders focusing on more common moving averages, such as the 10-day or 20-day, were likely shaken out of the market early.

On the second chart, note that during this past week, the 15-day moving average held at various lows, before advancing to another multi-year high on Friday. A hold of this moving average would suggest that momentum is in place. Therefore, pullbacks contained in the 1,480-1,500 zone would not be unlike the minor pullbacks that occurred in the first quarter of the previous two years, which proved to be buying opportunities within a strong uptrend.

 Daily Chart of SPX from January to May 2012 With 15-Day and 30-Day Moving Averages

 Daily Chart of SPX since January 2013 With 15-Day and 30-Day Moving Averages

Next week, there are a few certainties: Northeasterners digging out from a snowstorm, the expiration of more than six million VIX options on Wednesday, and Friday's expiration of stock, index, and exchange-traded fund (ETF) options. To those digging out, stay warm and stay safe -- I suppose the storm hitting on a weekend is better than a weekday.

For those trading during expiration week, the market usually experiences weakness in the immediate days following VIX expiration, perhaps due to VIX call buyers looking to replace expired options, which creates a headwind. January expiration, however, did not follow this pattern.

If you follow the SPDR S&P 500 Trust (SPY - 151.80), the current open interest configuration suggests the SPY could trade between 150.00 and 152.00 next week. There is huge call and put open interest at the February 150 strike, which is around the aforementioned 15-day moving average. The February 152 strike is home to more than 300,000 open calls, most of which were purchased options. Sellers of the options would like to see the SPY finish below 152.00 on expiration Friday, but like last month, if the SPY is trading just above this strike late in the week, delta hedging could fuel a late-week gain into the Friday close.

 SPY February Open Interest

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