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How a Small-Cap Slide Could Put Bulls at Risk

History says the S&P 500's low-volatility streak could continue

by 7/12/2014 8:51:56 AM
Stocks quoted in this article:

After setting record highs on July 3, the Dow Jones Industrial Average (DJI) and broader S&P 500 Index (SPX) pared a portion of their gains last week, with the former finishing below the critical 17,000 level. The big development came Thursday, when concerns over the financial stability of Portugal's second-largest listed bank shook investor confidence globally. However, a reassuring statement from the aforementioned bank helped stabilize U.S. equities -- right in time for earnings season to kick into high gear this week. While those results will certainly affect the market, Todd Salamone believes range-bound trading is more likely than a massive rally or sell-off.

  • Why market volatility is likely to remain low.
  • The key technical levels in play for the major equity indexes.
  • A look at the S&P 500's historical performance during low-volatility streaks.

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: Signs Point to Sideways Movement Ahead
By Todd Salamone, Senior VP of Research

"The sentiment backdrop suggests that there is a higher-than-normal probability that potential resistance levels discussed above are taken out in the near term, with a potential retest of these levels when an extreme optimism among traders is reached ... As such, there is a possibility that the SPX [1,949.44] breaks through its 1,950 half-century mark and moves on to the 1,980-2,000 resistance area, before retesting 1,950 once again."
-Monday Morning Outlook, June 7, 2014

"... the S&P 500 Index (SPX - 1,985.44) climbed above 1,980 -- the target for the inverse 'head and shoulder' breakout pattern that was signaled in late May ... round numbers are back in play, which could slow the current momentum. The RUT is trading just below its March peak around the 1,200 area, the SPX is trading just below the 2,000 millennium mark, and the Dow hit the 17,000 mark ... the 10-day, equity-only, buy (to open) put/call volume ratio recently hit a multi-month low of 0.44, but has turned higher to 0.49. When this ratio turns higher, as it is now, the market becomes more vulnerable than usual to a short-term pullback. But as we've said numerous times, we'd expect pullbacks to be shallow. As such, pullbacks should be viewed as buying opportunities ..."
-Monday Morning Outlook, July 4, 2014

"One of Wall Street's bullish strategists struck a surprisingly cautious tone on Monday, saying he expects a big drop in the stock market over the coming weeks ... 'I do think we are vulnerable to a 10%-12% decline in the weeks ahead,' Mr. Saut said."
-The Wall Street Journal, July 8, 2014

"Carl Icahn says 'Time to be cautious' on U.S. stocks'"
-Reuters headline, July 10, 2014

"Raymond James & Associates Inc. warned that equities are vulnerable, while Citigroup Inc.'s chief U.S. equity strategist cited concerns for a 'severe' pullback ... Leuthold Group LLC said it's trimming equities in some funds on concern the S&P 500 may slump as much as 8 percent in the coming months ..."
-Bloomberg, July 11, 2014

The excerpts above from past issues of Monday Morning Outlook give you an excellent flavor of the major themes we have been discussing during the past several weeks, with regard to the significance of round numbers on major benchmarks and the historical influence of S&P 500 Index (SPX - 1,967.57) half-century marks. Plus, we have been highlighting the sentiment among equity option players, which we use as a contrarian indicator. This group was extremely bearish ahead of an upside breakout above trading-range highs in late May, and became extremely optimistic ahead of a nearly 5% pullback from last week's close to Thursday's low.

SPX daily chart since our June 7 comments -- 1,980 was the target for an inverse "head and shoulders" breakout. Plus, another half-century mark on SPX (1,950 this time) is proving to have significance

Daily Chart of SPX since June 2014

As we suggested last week, the market was vulnerable to a short-term pullback, much like we just witnessed. However, given the widespread caution that persists among fund managers and strategists, we continue to think that pullbacks will be small, relative to the bigger declines being predicted, as excerpted above.

It bears repeating that the extreme caution among fund managers and strategists is likely keeping volatility low, as they have taken action to reduce exposure by raising cash or buying portfolio protection, via the purchase of equity exchange-traded fund (ETF) put options or call options on the CBOE Volatility Index (VIX - 12.08). When such precautions are taken, there is less probability of widespread selling when negative headlines surface, such as that which occurred this past week when a major Portuguese bank missed a debt payment. Volatility, therefore, is likely to remain low when such caution persists, even though the low-volatility environment is scary to some market participants.

Huge and growing VIX call buying is a sign of caution

VIX 20-Day Call and Put Volume with SPX Since 2012

As we move through the dog days of summer, we think the market is at an increased risk of sideways movement, much like we saw in March through May. Right now, it is being dogged by overhead round-number millennium and century-mark levels, as follows:

  • 17,000 on the Dow Jones Industrial Average (DJI - 16,943.81)

  • 21,000 on the Wilshire 5,000 (W5000 - 20,828.86)

  • 11,000 on the NYSE Composite (NYA - 10,936.35)

  • 2,000 on the SPX

  • 1,200 on the Russell 2000 Index (RUT - 1,159.93)

But then again -- and much like occurred in March through May -- round numbers, half-century marks, and year-to-date breakeven marks are coming into play as potential support. For example:

  • The RUT's year-to-date breakeven mark is 1,163.64, and the index closed just below this potentially supportive breakeven mark at 1,159.93 on Friday.

  • The S&P MidCap 400 Index's (MID - 1,411.48) low on Thursday was 1,404.25, just above a key century mark.

  • The Nasdaq Composite (COMP - 4,415.49) closed above the 4,400 century mark on Friday, after an intraday move below this level on Thursday.

  • The SPX lows on Thursday were just above the 1,950 half-century mark, which we speculated could act as support if the market experienced selling.

Per the chart immediately below, equity option buyers are in the early innings of growing cautious, on the heels of reaching an extreme in optimism, as we observed last week. The last time this group grew cautious after hitting an optimistic extreme, the SPX traded in a range (March-May). Therefore, we see the potential for another range to develop -- bound by 1,940-1,950 on the downside, and 1,980-2,000 on the upside. It is possible that if support levels on the major indexes hold, this ratio could turn lower again. But we are unlikely to see the upside in the stock market, relative to when this ratio turns lower from a high level, which last occurred in late-May ahead of an impressive rally.

Equity option buyers -- sentiment coming off an optimistic extreme

10-Day ISE/CBOE/PHLX Put/Call Volume Ratio with SPX Since 2013

Finally, expiration is next week. Big put open interest resides at the 110 through 115 strikes on the iShares Russell 2000 ETF (IWM - 115.10). The risk to bulls is that these put strikes could act like magnets if the IWM makes a major move below 115 during expiration week, as sellers of those puts must short the IWM to remain neutral when each strike comes into play -- a process called delta-hedge selling. Delta-hedge selling -- which occurs rarely, but is a possibility one must be open to -- could push the IWM (and RUT) below support in the 115-116 area (1,150-1,160 on the RUT), to the May lows in the 110 area (or 1,100 on the RUT). That said, barring any negative news that creates knee-jerk selling, bulls could benefit from the unwinding of short positions related to the expiring put open interest.

While we remain bullish longer-term, the momentum off the mid-May lows has clearly weakened. Unlike what seems to be a growing chorus expecting a correction, we don't see major downside from here. But then again, we think the upside could be limited, too, in the immediate weeks ahead.

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