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3 Signs of Hope for Bulls

Taking a historical look at third-quarter SPX returns

by 6/28/2014 8:18:56 AM
Stocks quoted in this article:

Escalating tensions in Iraq and hawkish comments from St. Louis Fed President James Bullard pressured most U.S. markets last week, although bursts of late-session buying power helped ease the blow. By the time the closing bell sounded on Friday, the Dow Jones Industrial Average and broader S&P 500 Index were sitting slightly in the red for the week. Bucking the trend lower, however, was the tech-laden Nasdaq Composite, which managed to notch a second consecutive weekly win. Heading into the third quarter, Todd Salamone highlights three contrarian indicators that could help buoy markets during a historically bearish period.

  • 3 key benchmarks face off with critical technical levels
  • Why we're keeping a close eye on this indicator
  • Rocky White offers up 17 stocks that tend to outperform in the third quarter

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: Why Complacency May Not Be as Widespread as Advertised
By Todd Salamone, Senior VP of Research

"With 1,900 on the S&P 500 Index (SPX - 1,949.44) in the rear-view mirror, and now targeting 1,980-2,000 (1,980 is the target for the inverse head-and-shoulders breakout pattern, and 2,000 is triple the 2009 low), traders should not lose sight of the historical significance of half-century marks on the SPX as the index approaches 1,950 ... the SPX either hesitated for a couple weeks to a couple months around such half-century marks (1,550 and 1,750), or became unstable after moving above a half-century level (1,650). The 1,650 level, in fact, was first tested in May 2013, but was not cleared for good until marking a bottom in early October, after a 4% pullback that lasted just under a month."
-Monday Morning Outlook, June 7, 2014

"After another $22 billion in new capital was allocated to hedge funds in May, the industry now has surpassed $3 trillion in assets under management for the first time on record."
-24/7 Wall St., June 25, 2014

"4.5% increase in $SPX component short interest, which is far above the '12 lows - and there is a lack of fear?"
-@ToddSalamone on Twitter, June 26, 2014

"At least five Wall Street firms on Thursday slashed their growth forecasts for the current quarter. Among them, Goldman cut its second-quarter GDP target to 3.5% from 4.1%. Barclays went to 2.9% from 4.0% and RBS trimmed its target to 2.2% from 2.7%."
-The Wall Street Journal, June 27, 2014

Despite weak economic reports -- including lower-than-expected gross domestic product (GDP) data -- and persistent warnings from market technicians that low volatility is indicative of complacency in the marketplace, U.S. equities displayed some resilience this past week, when various headlines could have easily shaken market participants. This resilience suggests that complacency is not as widespread as advertised (more on this to follow).

The S&P 500 Index (SPX - 1,960.96) has moved into another choppy pattern during the past seven trading days. The half-century mark of 1,950 has become an important level recently, as we speculated could happen a few weeks ago. It acted as resistance earlier in the month, and, following a June 18 breakout above this level, it was retested on two separate days last week.

30-Minute Chart of SPX Since Monday, June 2

We still think a move into the 1,980-2,000 level is possible, but it will not be a huge surprise if 1,950 is revisited multiple times as we move through the summer months. As the SPX challenges its half-century mark, other key benchmarks could be challenged by round numbers just overhead.

For example, per the study below, millennium levels on the Dow Jones Industrial Average (DJI - 16,851.84) have proven to be short-term speed bumps since 10,000 was first touched in 1999.

Since Dow 10K, the Dow Jones Industrial Average has displayed weaker-than-normal price action in the one to two weeks after rallying to a millennium mark that has never been touched:

Dow Returns After Crossing 1,000 Point Intervals

Dow Anytime Returns Since 1999

Moreover, the round 1,200 century mark on the Russell 2000 Index (RUT - 1,189.50) lingers just overhead, after a failure at this level in March. This round number is 10% above the May lows, which were being carved out over a two-week period. So, not only is there the potential for sellers to emerge as the March highs are tested, but profit-taking could also surface amid those timely traders who bought the May lows.

The RUT 1,090 level served as support in January and May, while the 1,200 area continues to shape up as potential resistance

Daily Chart of RUT Since January 2014

A contrarian indicator that we have been following closely the past few weeks reflects the sentiment among equity option speculators, who were at a bearish extreme ahead of the SPX's breakout above the 1,900 century mark in late May. This group has grown increasingly optimistic the past few weeks, as the unwinding of fear continues among these traders. Right now, the 10-day average of buy-to-open put volume relative to call volume is nearing the levels of January, which preceded a 5% SPX pullback. As long as the direction of this ratio continues south, the market is likely to advance. However, if the sentiment shifts and this ratio heads higher, the market becomes at increasing risk of another pullback. As such, we'll continue to closely monitor this indicator.

SPX 10-day equity only, buy-to-open put/call ratio Since January 2012

While equity option traders have become believers of late, there is little evidence that complacency -- the type that usually precedes a bear market or double-digit SPX correction -- is widespread. For example, note in the latest reporting period that SPX component short interest increased 4.5%, and still remains far above the "complacent" levels that existed prior to the last 10% correction levels that we witnessed in 2011. The fact that short interest moved higher amid a breakout above resistance suggests there is still a healthy dose of caution, and such caution represents future buying power that is likely to keep pullbacks muted and/or be a driver for a breakout above the potential resistance levels we discussed above.

Moreover, as one of the excerpts at the beginning of this report suggests, note that big dollars continue to be directed toward the hedge fund industry, as investors seek alternative investments outside the U.S. stock market. Whether they are directing cash to other assets, or markets outside the U.S., or using the flexibility that hedge funds offer to make both long and short bets against the market, the fact is that the hedge fund industry is still growing by leaps and bounds. This is occurring in the context of performance that is not deserving of these inflows, and as the market grinds higher in impressive fashion to new all-time highs. In other words, such flows into hedge funds are not supportive of a "complacent" marketplace. In fact, even though $93.3 billion has flowed into hedge funds in 2014, only $3.75 billion has flowed into U.S. equity funds -- including outflows in April, May, and June that have totaled $15.1 billion (see the table below the short interest graph).

We continue to favor U.S. stocks, so maintain long exposure, and view pullbacks as buying opportunities.

Total Short Interest on SPX Stocks Since January 2011

Fund flows are not indicative of complacency toward U.S. stocks
Monthly Domestic Equity Flows Since January 2014

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