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Are We Due for Another 'Stock Dump & Volatility Pump'?

A half-century hesitation keeps the S&P 500 in the red for 2014

by 2/22/2014 6:56:11 AM
Stocks quoted in this article:

It was a flattish finish for the major equity indexes last week, even as the S&P 500 Index (SPX) came within a stone's throw of all-time high territory. A mixed bag of data (both at home and abroad), along with a series of hot-and-cold earnings reports, kept stocks from making any significant headway on the charts -- but the bulls didn't give up too much ground, either. As February winds to a close, Todd Salamone surveys the landscape to see what pitfalls may loom ahead.

  • Why a VIX pop might be on the horizon
  • How open interest can exaggerate the "half-century effect"
  • Analysts' surprisingly sober stance on S&P 500 stocks, courtesy of Rocky White

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: Will Yellen Help Trigger a VIX Surge?
By Todd Salamone, Senior VP of Research

"One source of concern is that the RUT is now underperforming, and is still below support at its 80-day moving average. If you reduced exposure to small-caps on the break of support, you can hold off adding to exposure until the RUT trades back above this important trendline... That said, bulls should be encouraged by the fear that this pullback has generated, and might look to mid-caps for exposure, with the MID back above the 1,300 level and the VIX back below 18.21."
-Monday Morning Outlook, Feb. 8 2014

"Stocks should continue to move higher over the intermediate and longer term, although short-term speed bumps related to year-to-date breakeven points on some indexes are just overhead."
-Monday Morning Outlook, Feb. 15, 2014

"$RUT back in green YTD with move above 1,163.64... $SPX still four points below its YTD breakeven point"
-@ToddSalamone on Twitter, Feb. 21, 2014

After a pullback in January that was very similar in magnitude to the pullbacks observed in 2013, and which injected short-term fear in the marketplace, the month of February has been kinder to the bulls, with equity benchmarks rallying strongly from support areas. The Nasdaq Composite (COMP - 4,263.41) was the first to move into year-to-date (YTD) positive territory when it crossed above 4,176.59. The S&P MidCap 400 Index (MID - 1,356.56) quickly followed, crossing into YTD positive territory on Valentine's Day, and the Russell 2000 Index (RUT - 1,164.63) peeked its nose above 2014 breakeven at 1,163.64 on Friday, and closed just a shade above it.

Meanwhile, the Dow Jones Industrial Average (DJI - 16,103.30) and S&P 500 Index (SPX - 1,836.25) remain below their YTD breakeven levels at 16,576.66 and 1,848.36, respectively.

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 DJI, make their respective moves into the green for 2014.

While we find the action in risky names encouraging, 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. The visuals below should put the "half-century mark phenomenon" in perspective for you.

One theory as to why this phenomenon occurs is that open interest in the options market tends to build around these round strike prices, which reinforces the resistance/support concept. With February expiration now behind us, the SPX may not be subject to any options-related resistance, as the open interest in March 1,850-strike calls pales in comparison with the February 1,850 calls that expired at last Friday's close (per the second chart below).

SPX since June 2012 -- horizontal lines denote half-century marks

Daily Chart of SPX since June 2012

SPX February open interest configuration -- big open interest tends to build around round numbers, such as 1,750, 1,800, 1,850, and 1,900

SPX February Open Interest Configuration

Nonetheless, with the headline DJI above 16,000 but still below its YTD breakeven, and the SPX facing short-term resistance overhead, it is of interest to pay attention to key levels in overseas markets, too. For example, after pulling back to support from double its 2008-2009 low at the 14,000 level, the Japanese Nikkei faces potential resistance again from the 15,000 millennium mark overhead, which impeded rallies in the summer and fall of 2013.

Japan's Nikkei -- 15,000 lies just overhead, with certain U.S. benchmarks also facing potential resistance

Daily Chart of Nikkei 225 since June 2013

With headline benchmarks situated just below potential short-term resistance levels, another thing traders should keep on their radars is the expiration of CBOE Volatility Index (VIX) futures options, which occurred this past Wednesday. As you can see on the chart below, courtesy of Trade Alert, the market has been more vulnerable than usual to VIX pops following expiration-related drops in VIX call open interest.

This correlation makes sense, as more investors are prone to panic when they don't have portfolio protection. If those utilizing VIX calls to hedge a long portfolio are slow to replace expired calls and negative headlines surface, a sudden resurgence in demand for portfolio protection will drive up its cost, as measured by the VIX. Sellers of portfolio protection will usually hedge by selling S&P futures, creating a stock dump-and-volatility pump situation, much like we witnessed last month. It doesn't take a lot for investors to panic these days -- something to keep in mind, as Fed Chair Janet Yellen is scheduled to appear before the Senate this Thursday.

VIX Daily Call Open Interest

The good news for short-term bulls is that we are still not in an overbought condition, as measured by the SPX's 14-day Relative Strength Index (RSI), pictured in the second pane in the chart below. Therefore, there is room for stocks to move higher and take out lingering resistance levels.

Regardless of how the short term shakes out, we remain bullish on an intermediate- and longer-term basis for the reasons outlined last week. As such, pullbacks should be used as buying opportunities, even though the investing crowd tends to bail at the first hints of trouble.

SPX with 14-day RSI not yet in the overbought condition that was evident as we entered January

Daily Chart of SPX since September 2013 with 14-Day Relative Strength

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