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Embrace the Pessimism, Bulls

Did we hit a bottom last week?

by 2/8/2014 8:15:00 AM
Stocks quoted in this article:

It was a rough start to the month, with the Dow Jones Industrial Average (DJI) dropping more than 300 points on Monday. However, by the time the dust settled, the bulls ultimately prevailed, with the major market indexes barreling to a weekly gain, in spite of lackluster employment data. What's more, as Todd Salamone points out, "The anxiety that this pullback has stirred up is a welcome sign" for contrarians.

  • One group that could be supportive of the market
  • Analyzing the changing sentiment backdrop
  • What we can gather from watching VIX futures

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: Pessimism Is a Necessary Ingredient
By Todd Salamone, Senior VP of Research

"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."
-Monday Morning Outlook, Feb. 1, 2014

"$VIX call volume set a record yesterday, but resulted in more than 220k net call liquidations, as call open interest dropped."
-@ToddSalamone on Twitter, Feb. 4

"$VIX call open interest down 400k contracts from 2/3 peak, the day the VIX peaked at $21.44."
-@ToddSalamone on Twitter, Feb. 7

"The Standard & Poor's 500 stock index dropped 3.5 percent in January and the average hedge fund slipped 0.24 percent, according to data from Hedge Fund Research."
-Reuters, Feb. 4, 2014

"Traditional U.S. stock mutual funds and exchange-traded funds together saw withdrawals of $18.8 billion in the week ended Feb. 5, their biggest weekly withdrawals on record."
-The Wall Street Journal, Feb. 6, 2014

A lot occurred since last weekend's commentary, when we observed that equities were at a critical juncture, trading just above key support areas. Moreover, the CBOE Market Volatility Index (VIX - 15.29) was 50% above its prior low -- a percentage that has marked multiple VIX peaks in the prior two years.

Small- and mid-cap stocks, for example, which had held up relative to their larger-cap counterparts throughout January, took a beating on Monday, as the Russell 2000 Index (RUT - 1,116.55) fell below support from its 80-day moving average, and the S&P 400 MidCap Index (MID - 1,308.39) fell below the round-number 1,300 level. Plus, the VIX surged, reaching a high of 21.48, a level that marked climaxes in June and October last year, prompting some volatility sellers to cash in on the sharp advance.

Daily Chart of RUT since March 2013 with 80-Day Moving Average

Daily Chart of VIX since 2013

Despite the RUT and MID breaking below support areas, the market stabilized fairly quickly as short-term sentiment hit pessimistic extremes. In fact, all indices and averages staged a Tuesday-through-Friday rebound, with the Dow Jones Industrial Average (DJI - 15,794.08), Nasdaq Composite (COMP - 4,125.86), and S&P 500 Index (SPX - 1,797.02) advances strong enough to thrust them into the green for the week and month.

The VIX plummeted from Monday's high in the 21.50 area, and more importantly, VIX futures retreated too, as those positioned for a sharp advance in volatility liquidated. This action perhaps signals the worst of the volatility advance and stock decline is over, continuing a lengthy period without the much-awaited 10% correction.

The sentiment landscape has changed quite a bit since we entered 2014, when we pointed out that short-term optimism had crept into the marketplace, prompting us to warn that choppy price action or a pullback could lie immediately ahead. Admittedly, this pullback has been more than we anticipated. That said, although we have experienced deterioration in the market from a short-term technical perspective, the anxiety that this pullback has stirred up is a welcome sign for bulls, as pessimism is a necessary ingredient to forming a bottom.

If we hit bottom last week, one has to wonder how many of those who sat out most of this rally and were looking for an ideal entry point on a pullback missed another buying opportunity? Perhaps the pullback wasn't deep enough (10% or more), or maybe headlines related to the Fed and the turmoil in some emerging markets have created more doubt about the economy. Regardless, it is clear that this pullback has not generated excitement in terms of buying stocks, even as the 10-year Treasury yield has retreated from 3.00% to under 2.70% since the Fed's bond buying was reduced. The decline in interest rates could be a tailwind for the economy, even as many fixate on recent weaker-than-expected economic data.

The $2.6 trillion hedge-fund industry is still underweight U.S. stocks, as evidenced by its "outperformance" (in quotes due to negative performance) during January's decline, and the relatively high short interest on S&P 500 component names. This is a group that could be supportive of the market in the months ahead, either by increasing long exposure or reducing their short exposure, with total S&P 500-component short interest still at relatively high levels.

SPX vs Total Short Interest since January 2011

In addition to retail market participants retreating from the market in a big way (see the aforementioned excerpt from The Wall Street Journal related to fund outflows), another group that showed a mass exodus last week was active investment managers, as revealed in the weekly National Association of Active Investment Managers (NAAIM) survey. The average respondent in this survey was fully invested a few weeks ago, but after last week, this group is roughly 50% invested (see graph below).

NAAIM Sentiment since 2011

One other sign of potentially market-bottoming fear last week was in the unusual relationship that occurred between the cash VIX and February (front-month) VIX futures. Normally, the VIX is trading below front-month VIX futures, which is known as contango. But last week, the headline cash VIX traded above February VIX futures, which is known as backwardation. Backwardation is unusual, and occurs during times of panic, as market participants bid up S&P 500 option prices in an effort to buy portfolio protection.

We find it interesting that as those that were cashing in on profits from bets on higher VIX futures prices (the VIX call liquidation referenced earlier), latecomers to the "higher volatility" trade bid up SPX options to the point that the VIX was trading significantly above February VIX futures at Monday's close. As you can see in the graph below, when the (VIX less VIX futures) five-day average spread moves above zero, buying opportunities typically occur. Last week's surge above 1 was the highest since the fall of 2011, which proved to be a major buying opportunity.

SPX vs Five-Day Avg Spread VIX Futures

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.

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