Will the Fed Push Stocks Out of Their Holding Pattern?

Why the market's muted action could change next week

by 12/14/2013 10:00:16 AM
Stocks quoted in this article:

Tapering fears ran amok last week, with investors dissecting the latest round of economic reports for clues as to what the Fed's next move will be. As a result, the Dow Jones Industrial Average (DJI) and the S&P 500 Index (SPX) finished a second consecutive week in negative territory -- and below the 16,000 and 1,800 marks, respectively. As Wall Street waits with bated breath over whether the central bank will decide to scale back its asset-buying program at next week's meeting, Todd Salamone takes a closer look at key market levels, and sifts through the bearish sentiment that lingers among investors.

  • Why traders should watch these round numbers ahead of the Fed.
  • Examining high short interest levels on S&P 500 and PowerShares QQQ Trust components.
  • Rocky White highlights contrarian plays 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: Examining Key Market Levels and Mixed Sentiment
By Todd Salamone, Senior VP of Research

"Our main theme over the past few weeks has been multiple benchmarks rallying up to round numbers that could serve as speed bumps, particularly millennium marks like 4,000 and 16,000 on the COMP and DJI, respectively ... One has to wonder if these round numbers are still in play, and for how long? ... The market's rally up to these multiple round-number levels appears to be driven by a combination of un-hedged, short-term traders jumping on directional trends and the retail player that continues to slowly come back into equities ... our option indicators suggest a lot of hedged money has sat out the rally that began in mid-October."

-Monday Morning Outlook, Dec. 7, 2013

"$QQQ component short interest at highest level since '09 and up 14% since YTD low in January"

-@ToddSalamone on Twitter, Dec. 10, 2013

"For now, the selloff isn't causing much concern among market watchers. 'This is more of a lack of buyers than any type of real panic,' Mark Newton, chief technical analyst at Greywolf Execution Partners, wrote to clients Wednesday afternoon."

-The Wall Street Journal Morning MoneyBeat, Dec. 12, 2013

"Next week's Fed meeting can't come fast enough...Whether the Fed starts tapering at the Dec. 17-18 meeting, or waits until early next year, the timing uncertainty has prompted stocks to retreat from record highs...Others point to the market's bullish seasonal patterns at the end of December, which we wrote about in yesterday's column, that could pull stocks out of their recent funk."

-The Wall Street Journal Morning MoneyBeat, Dec. 13, 2013

With multiple U.S. equity benchmarks dancing around respective round-number levels the past few weeks, the plot may thicken next week. There is a Federal Open Market Committee (FOMC) meeting on Tuesday and Wednesday, with Wednesday also marking the expiration of CBOE Market Volatility Index (VIX - 15.76) options. Plus, there is the expiration of standard equity and index December options at week's end.

As we move into next week, stocks have been in a major holding pattern -- going nowhere fast. Bulls might be encouraged with the action in the Nasdaq Composite (COMP - 4,000.98), which held above 4,000 at Friday's close (albeit, barely). Plus, the small-cap Russell 2000 Index (RUT - 1,107.05) is still above the 1,100 century mark. However, such optimism could be tempered, with the Dow Jones Industrial Average (DJI - 15,755.36) retreating back below 16,000, and the S&P 400 MidCap (MID - 1,289.42) again situated below that pesky 1,300 level. It sure seems that after these benchmarks surpass their respective round-number levels, a "buyer's strike" will occur. But at the same time, pullbacks created perceived buying opportunities, with the next effect being a grueling trading range.

The COMP is the latest major benchmark to get pulled into this range action, following its move through 4,000 in late November. Meanwhile, it has been nearly two full months since the MID hit 1,300 for the first time, and we are going on a full month since the SPX first touched 1,800. Also of interest is the fact that, as of the end of this month, the 1,806.50 level would mark a five-year double on the SPX, which closed at 903.25 on the last trading day of 2008, as the financial crisis was unfolding.

COMP 30-minute chart -- 4,000 proving significant
30-Minute Chart of the COMP Since November 2013

SPX 30-minute chart since November 15 -- choppy action since 1,800 touched in mid-November (dotted line is the level that marks a 5-year, 100-percent return as of the end of December)
30-Minute Chart of SPX Since November 2013

The sentiment situation is still mixed. On one hand, and as we discussed last week, those that are short-term traders and possibly un-hedged remain optimistic, as equities gyrate above and below key century marks. For example, the 10-day, equity-only, buy (to open) put/call volume ratio is extremely low, suggesting call buying relative to put buying is at an optimistic extreme. When option speculators are this bullish, it has preceded weaker market environments. Moreover, anecdotally, the positive seasonality seems to be getting a lot of media attention, which is somewhat concerning as the market moves sideways at resistance levels. If these speculators become disenchanted with their positions, or get blind-sided by negative market news, an unwinding of this optimism could be a future headwind, especially if tailwinds from call buying become headwinds as put buying increases.

Equity option buyers extremely optimistic amid recent market weakness
SPX Versus 10-Day Put/Call Volume Ratio Since 2011

That said, bulls might be encouraged by the still-high short position in the market. In prior discussions, we pointed out the high short interest on SPX component stocks. This weekend, we present a chart that gives you perspective on outstanding short positions on Nasdaq-100 Trust (QQQ - 84.85) components. With both the markets' primary trend higher, the shorts remain a source of buying power, as they look to cover positions on pullbacks. The bearish view is a technical breakdown in the market, which could embolden the shorts.

QQQ Stocks Versus Short Interest

With expiration next week, we will pay close attention to December's SPDR S&P 500 ETF Trust (SPY - 178.11) open interest configuration, as support and resistance levels are likely to be defined by strike prices with heavy open interest. As you can see on the chart below, it appears that little unwind selling from overhead call open interest remains after a rejection in the 180 area, and the sensitivity of the call options to market movement is now minimal. Moreover, put open interest on strikes around current levels is small and partially offset by decent call open interest, which may reduce the "magnet" effect related to delta hedging. This occurs when there are put-heavy strikes, and sellers of the puts must short more and more S&P futures to offset losses during market declines, creating a snowball effect.

It will likely take a catalyst (think the Fed) to push the SPY significantly below the 178 strike, a strike that could be a volatility dampener, given the big call and put open interest. If the SPY takes a dive below 177, it will become at increasing risk of delta-hedge selling to the 174 strike, as the 174-176 strike prices are home to huge put open interest relative to call open interest. If the Fed meeting becomes a non-event, it would not be a major surprise to see the SPY trade between the 178 and 180 levels. Coincidentally, the 178 area is the site of the SPY's 40-day moving average, whereas the 174 area is the site of the 80-day moving average and the September high.

SPY December Open Interest Configuration
SPY December Open Interest Configuration

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