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3 Supportive Signs for Bulls

Why gold bugs should be wary of March

by 3/2/2014 10:30:36 AM
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Markets finished February in fine fashion, bucking the month's historically bearish trend after Federal Reserve Chair Janet Yellen on Thursday confirmed that the central bank is, indeed, keeping a close eye on the state of the economy. In fact, despite volatile trading on Friday amid rising geopolitical tensions between Ukraine and Russia, the S&P 500 Index (SPX) closed the session at its loftiest perch on record. Looking ahead to March -- a month that's been known to be kind to bulls -- Todd Salamone offers up three encouraging sentiment backdrops for traders to keep watch of.

  • The importance of rising short interest amid the latest rally.
  • 2 theories surrounding the still-inflated CBOE Volatility Index (VIX).
  • Rocky White investigates what a strong February may spell for March.

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: Short Interest Remains High, Despite Strong Price Action
By Todd Salamone, Senior VP of Research

"Bulls should find it encouraging that the advance from the recent bottom has been led by groups typically deemed 'risky,' as leadership in these areas has typically been consistent with a strong market environment. Therefore, we anticipate that it will only be a matter of time before the larger-cap quality names, as measured by the SPX and DJIA, make their respective moves into the green for 2014 ... we enter the final week of the month with the more popular equity benchmarks slightly below their breakeven marks -- most notably the SPX, which must make its way above both 1,848 and 1,850, its half-century mark. We have touched on the importance of half-century marks on the SPX before, in terms of hesitation, resistance, and support areas."
-Monday Morning Outlook, Feb. 22, 2014

"$SPX Three consecutive intraday peaks above YTD breakeven at 1,848.36, but three consecutive closes below this level"

"$SPX component short interest up 4.13% in most recent report, highest level since mid '12 and +9.5% YoY"

"$SPX close above 1,850 and above YTD breakeven apparently giving bulls conviction"

-@ToddSalamone on Twitter, Feb. 26-28, 2014

After January's decline spooked traders and injected short-term fear into the marketplace, February was much kinder to bulls, especially those that stood their ground, unshaken by a pullback that was very similar to those we have witnessed during the past several months. In fact, February's 4.3% gain in the S&P 500 Index (SPX - 1,859.45) erased January's 3.6% loss, pushing the index into positive territory year-to-date (YTD). Russian/Ukranian news sparked a Friday afternoon selloff, with the SPX briefly dipping back below the key levels that had capped rallies since late December. But, the SPX bounced off the Friday afternoon lows in the last half-hour of trading, signaling potential support in this former resistance zone (1,848-1,850).

As you can see on the chart immediately below, Thursday's breakout and closing in all-time-high territory did not come without a fight from the bears, who managed to push the index below both its YTD breakeven point and the half-century 1,850 area on a closing basis Monday through Wednesday, even as the index ventured above these resistance levels intraday.

30-minute SPX chart since Monday, Feb. 24: Solid line is 1,850 half-century mark, dashed line is 2014 breakeven level of 1,848.36

30-Minute SPX Chart Since Monday, Feb. 24

So, in the last trading week of February, the SPX finally penetrated above another half-century mark, which proved a speed bump within the context of its impressive "march" higher. And speaking of March, next week's trading begins a month that has historically been strong (see Rocky White's commentary on the next page).

Amid the SPX's monthly close in new all-time-high territory, investors should note that short interest on SPX component names remains elevated, including a noticeable 4.1% pop in the last reporting period (mid-February). When the short interest data was gathered, the SPX had already lifted roughly 3% off its late-January low, which was the reporting period that preceded the mid-January level. This would suggest that short covering was not the driver off the late-January lows, although cautious hedge fund managers may have increased short exposure coincident with scooping up stocks they like on the latest dip.

Elevated short interest levels amid strong price action has been a theme that we have discussed repeatedly during the past several months. To our astonishment, this is a subject matter that remains firmly in place, even with most major benchmarks in new all-time-high territory. In other words, there are still many investors fighting the market's advance and/or approaching the market with a lot of caution. We find it interesting that SPX component short interest as of mid-February is up 9.5% year-over-year, coincident with the SPX's advance of roughly 22% in the same time period. Elevated short interest levels should keep declines in check, as short covering could put a floor on additional declines or at least prevent panic-selling episodes among those using short position as hedges to long positions.

Short Interest Remains High -- Caution Remains

SPX February Open Interest Configuration

With only 39% of retail investors surveyed expressing a bullish view in the latest American Association of Individual Investors (AAII) weekly survey, it appears institutional money is pushing the market higher. In fact, our options analysis suggests some hedge funds could be increasing stock exposure, even as they stay committed to short positions.

One thing we continue to monitor is the level of put buying relative to call buying on exchange-traded funds (ETFs) created to mirror major equity benchmarks. When the ratio of put buying to call buying is moving higher -- as it has been of late -- it is usually a sign that hedged money is shifting into equities, which has had bullish implications. Additionally, we have seen CBOE Volatility Index (VIX - 14.00) futures call buying increase relative to put buying since mid-February, and VIX calls are another tool for hedging. The ratio of VIX call buying to put buying rolled over just ahead of the pullback in January.

Hedged money moving into equities?

Put buying on equity-index ETFs is increasing relative to call activity, coincident with markets moving higher -- a sign that hedged money may be moving into stocks in a cautious manner

20-Day Buy-to-Open Put/Call Ratio on Equity-Index ETFs Since January 2013

Finally, bulls might find it encouraging that the VIX still has a ways to go before getting into the 12 area that in 2013 and early this year preceded short-term market weakness. The SPX moved into new record-high territory, so some might expect that the VIX would be lower than it is at present. But keep in mind that the market has been more volatile, as historical volatility recently peaked in the 16 area, twice the single-digit lows of December and January. Additionally, uncertainty related to the tensions regarding Russia and Ukraine is likely inflating the VIX at present. In fact, more than 500,000 VIX calls traded on Friday, and this was likely investors looking for protection against this uncertain outcome.

The key is that considerable caution exists, whether it is related to China, the Fed and uncertainty with respect to our own economy, or political uncertainty overseas. Such caution has transpired into protection-type trades among professional investors that should limit declines. Plus, frightening headlines have left many would-be investors behind, who are likely to support this market in the future.

VIX -- room to decline after SPX's technical breakout

Daily Chart of VIX Since January 2013

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