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As Fear Emerges, All Eyes on the VIX

5 signs of growing fear among investment managers, option buyers, and short sellers

by 2/1/2014 8:34:42 AM
Stocks quoted in this article:

The bears maintained control during the last week of January, and there was ample grist for the mill, between emerging market currency woes, mixed earnings results, and additional tapering measures on the part of the Federal Reserve. Against this backdrop, the S&P 500 (SPX) and Dow Jones Industrial Average (DJI) suffered their worst month since May 2012. This week, Todd Salamone details how the latest leg of the sell-off prompted additional fear among market participants, and highlights some critical levels to watch in the near term as the challenging month of February begins.

  • The uncommon moving average everyone should be watching
  • Tips for balancing your long exposure
  • One important market lesson we can learn from the Super Bowl

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: A Fluid Situation from Day to Day
By Todd Salamone, Senior VP of Research

"$IWM 80-dayMA (111.46) an important area of support since January '13, breaks in '12 lead to 7% more downside"

"$MID closed just above 1,300- round # that was a major speed bump in 4Q '13 - now area of potential support"

"$VIX hasn't closed above 18.21 in Jan, which is 50% above 1/10/14 closing low of 12.14. Many $VIX peaks occurred 50% above prior low"

-@ToddSalamone on Twitter, various tweets from Jan. 27-31, 2014

"VIX trader takes 750% gain on massive call spread. Nearly half a million VIX calls traded in the first hour today as VIX made a brief run toward 19. Feb 16 - 20 call spread traded electronically 120,000x with the crowd indicating the initiator sold. This same spread traded in the same size on 1/9 (with a sale of Feb 13 puts) for a 14cent debit and today's trade likely takes a $12.7M gain on the 3 week trade."
-Henry Schwartz on Trade-Alert, Jan. 31, 2014

"Many people were looking for a pullback in the stock market ... Now they've gotten their pullback but they don't yet know if it's over. They don't know if these are the dips they want to buy on."
-Marc Chandler, global head of currency strategy at Brown Brothers Harriman, The New York Times, Jan. 31, 2014

We move into a month that hasn't been the kindest to bulls, as February has produced gains only 55% of the time during the past 20 years, with its average return of negative 0.58% the second-worst among all months (with August producing the worst returns).

With that said, from a chart perspective, equities enter February at a critical juncture, after January's declines. For example, the iShares Russell 2000 ETF (IWM -112.16), which is a small-cap benchmark, pulled back to its 80-day moving average. As you can see on the chart below, pullbacks to this trendline have provided excellent buying opportunities during the past year and on multiple occasions prior to 2013, even though this trendline is not popular among most technicians.

Despite being an uncommon moving average, this trendline has been especially significant since July 2009, with pullbacks to it marking several buying opportunities, and crossovers signaling future strength or weakness. Therefore, from a technical perspective, it is logical for bulls to hang in there amid the recent market turbulence, unless this small-cap proxy breaks beneath support at this trendline.

The current pullback, so far, is not unlike those that we have already witnessed during the past several months, even though some market commentators think it is time for the much-awaited 10% correction to occur.

Daily Chart of IWM from May 2009 through December 2011 with 80-Day Moving Average

Daily Chart of IWM since December 2011 with 80-Day Moving Average

Amid the scary headlines (the Fed reducing bond buying, the emerging markets issues, and 2014's weak price action), there are some positives going on underneath the surface. For example, another index that represents equities at the riskier end of the spectrum -- the S&P 400 MidCap Index (MID - 1,313.08) -- found support at 1,300, a round number that acted as a major speed bump in the fourth quarter of last year and is roughly 10% above the August 2013 closing low.

MID – Support at round-number 1,300, which is 10% above August low (circled)

Daily Chart of MID since July 2013

Per the table immediately below, bulls should be encouraged, in fact, by the strong relative performance of the indexes deemed "risky," as their "safer" blue-chip counterparts took the brunt of the punishment in January. Relative strength in risky names has been indicative of a strong equity environment during the past several years.

Outperformance among equity names traditionally deemed "risky," plus JNK resilience amid emerging market bond rout

Table of January Returns

Fear among market participants is emerging once again, despite the fact that we hear over and over again that potential investors are looking for a good entry point. With major indices pulling back to potential areas of support, one has to seriously wonder if those that have missed buying opportunities in the past will miss yet another opportunity? We are seeing this fear develop among many participants:

  1. The American Association of Individual Investors (AAII) weekly survey revealed more bears than bulls for the first time since August, which marked a buying opportunity.

  2. Investment managers are bailing, with the National Association of Active Investment Managers (NAAIM) weekly survey dropping from 95 to 70 (100 is fully invested). Of course, this group could further lighten exposure, which would likely coincide with a break of support.

  3. Option buyers, who were bullish ahead of the market's decline, have suddenly changed their tune. For example, the five-day, equity-only, call/put volume ratio dropped from 2.40 to 1.94, its lowest level since November.

  4. The NYSE reported on Monday that short interest rose 2.98%, the biggest bi-weekly increase since the middle of last year. Short interest remains relatively high, but bulls would prefer to see the shorts bail, as a continued increase in short interest could be a headwind.

  5. A near-52-week high in CBOE Market Volatility Index (VIX - 18.41) futures call volume on Friday, Jan. 24.

As we said last week, it is important for the market to stabilize quickly, because if VIX futures continue to climb, those who sold portfolio protection via VIX calls will short more and more S&P futures to balance their risk to further increases in volatility. That said, as it stands now, we find it encouraging for bulls that:

  1. A volatility trader that correctly expected higher volatility at the beginning of January took his trade off on Monday, and

  2. The VIX is still in the vicinity of 18.21, which is 50% above the Jan. 10, 2014 closing low of 12.14. Since late 2012, multiple (not all) VIX peaks have occurred in an area 50% above a prior low. In the event that this 18 area fails to hold, we could easily see a move up to the 24-25 area, or double its low.
VIX – 50% above January low (circled) is 18.21 –- important for bulls that VIX peaks in this vicinity in the coming days

Daily Chart of the CBOE Volatility Index (VIX) since November 2013

It remains a fluid situation from day to day. Emerging markets, Europe, and large-cap domestic names appear to be the biggest areas of vulnerability, as fund managers saw these areas as one of the biggest areas of opportunity (or safety, in the case of the large-cap domestic names). If you are looking to balance your long exposure, look to emerging markets, Europe, and large-cap domestic names as emphasis for short ideas. Stand pat with your long positions in the small- and mid-cap domestic names, but be ready to reduce exposure if you see support areas that we discussed above break down.

Finally, per the table immediately below, we leave you with a statistic to chew on related to our February seasonality comments at the beginning of this report. While February has historically been weak, bears beware that the past four years have been strong, and seven of the past 10 years have been positive.

Table of February Returns, SPX

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