With Hedge Funds on Edge, Are Stocks Doomed to Drop?

Our options analysis suggests hedged players are losing their appetite for equities

by 3/24/2012 9:55:14 AM
Stocks quoted in this article:

It was a rocky week for stocks, as traders were preoccupied by signs of an economic slowdown in China. As a result, the S&P 500 Index (SPX) closed lower for the first time in five weeks, while the Dow Jones Industrial Average (DJIA) gave up about 1% by the time the dust settled. However, as Todd Salamone notes, the market remains north of key support levels, suggesting that stocks are simply taking a breather from their breakneck year-to-date surge. According to Todd's analysis, there could be more choppy trading ahead, as a few option-based indicators are pointing to a case of cold feet among big-money players. Meanwhile, Rocky White explains how you can use contrarian analysis to find out which stocks have the muscle to keep climbing in the suddenly wobbly market environment -- complete with a list of potential bullish and bearish picks. Finally, we wrap up with a preview of the major earnings and economic events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Round Numbers and Retracements Come Into Play
By Todd Salamone, Senior VP of Research

"... technical indications are being thrown around as corrective warnings, yet our own research on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID) making its second run in as many years at the 1,000 millennium mark. Overall, we still see a favorable environment for the bulls."
- Monday Morning Outlook, March 17, 2012

"Thirty-four percent of respondents to Bloomberg's monthly consumer expectations survey said the economy was improving, the largest share since January 2004. The pickup boosted the monthly expectations index to the highest in a year. Figures from the Labor Department today showed jobless claims decreased by 5,000 to 348,000 in the week ended March 17, the fewest since February 2008."
- Bloomberg, March 22, 2012

Stocks retreated slightly last week, digesting impressive year-to-date gains so far, as key benchmarks -- such as the Dow Jones Industrial Average (DJIA - 13,080.73), S&P 500 Index (SPX - 1,397.11) and the S&P 400 MidCap Index (MID - 990.93) -- simultaneously battled round-number areas. For example, the DJIA broke out above the 13,000 millennium mark in mid-March, and advanced to nearly 13,300 by expiration Friday, but pulled back to the 13,000 level in last week's trading. The 13,000 area is a 50% retracement of this month's low and high. Meanwhile, the SPX slipped back below 1,400, while the MID enters Monday's trading south of the important 1,000 millennium mark once again. Like the DJIA, the MID's low in the 980 area this past week was at a 50% retracement of the March low and high, while the SPX's low at 1,387 was a 38.2% retracement of the calendar month peak and trough.


30-Minute Chart of SPX since March 2

As we stated last week, our research on various technical indicators suggests a pause within the uptrend could be at hand, even though some technicians view the same indicators as signs of an imminent correction. The pullback over the past five days was mild, as the SPX continues to trade comfortably above last year's high at 1,370, following a breakout above this level in mid-March.

As major benchmarks trade at key century and millennium marks, one risk we see is that a few institutional players, who had been accumulating stocks earlier this year, have now backed off -- perhaps taking a "wait and see" approach as to how the market behaves, given the numerous calls for a correction.

Evidence that some hedge fund managers are shying away from equities comes from our analysis of option activity, as put buying on major exchange-traded funds has declined, in turn driving put implied volatilities on the SPDR S&P 500 ETF Trust (SPY) lower relative to call implied volatilities (first chart below). As you can see on the second chart below, cumulative put buying at the recent peak never reached the levels of late July 2011, when hedge funds were overweight equities ahead of a 20% decline. But recent put buying on major exchange-traded funds (ETFs) did reach the levels of spring 2011, which preceded a 7% pullback in the SPX.

In the absence of a technical breakdown, the decrease in put buying and the plunge in out-of-the-money put implied volatilities relative to call implied volatilities is not yet alarming, but it remains on our radar, nonetheless. If the market remains in good shape from a technical perspective, we'd expect to see more fund players actively accumulating equities, which would correspond with another increase in put buying.


20-Day Cumulative Buy-to-Open Volume since 2011 - SPY,QQQ,IWM


SPY 10% out-of-the-money, 10-day average p/c skew

Whatever materializes over the course of the next few weeks, we remain bullish, and any pullbacks should be used as opportunities to buy your favorite equities. While some fund managers are backing off of equities at present, this group is far from an overweight equity position, even as the market displays strength. Moreover, retail investors are still yanking money out of equity mutual funds, driven by disbelief in an economic recovery. Retail investors still represent enormous buying power, despite the market's surge from the 2009 lows and, more recently, the October 2011 trough.

Resistance for the SPX is in the 1,440-1,450 area, its target after the inverse "head and shoulders" breakout above 1,360. The 1,450 area was also the site of a peak in May 2008. Support lies in the 1,360 area, site of its 40-day moving average and area of the 2011 high. For what it is worth, some traders are keying on the 14-day moving average, which has supported multiple pullbacks since the middle of January, with the exception being the early March decline. The rising 14-day moving average on the SPX is currently sitting at 1,386.40, which corresponds with the 38.2% Fibonacci retracement level referred to earlier.


 Daily Chart of SPX since February 2011 With 14-Day and 40-Day Moving Averages

We still favor homebuilders and the retail/restaurant group, where price action is strong amid skepticism. Financials are another area you can dip your toes into, as we are seeing evidence of these stocks rallying on good news, and holding their own on bad news. For example, Bank of America (BAC) rallied 2.6% on Friday amid a brokerage house downgrade, while Morgan Stanley (MS) surged almost 4% on a broker upgrade.

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