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Short-Term Risks to the Bullish Case

Taking a historical look at what to expect in the second quarter

by 3/29/2014 8:11:36 AM
Stocks quoted in this article:

Choppy trading continued this week, with the price action eventually resolved to the downside. Relatively sanguine domestic data points -- as well as overseas stimulus speculation -- were unable to save an early week sell-off in Internet and biotech stocks. By the time the dust settled on Friday, the Nasdaq Composite had logged its worst weekly loss since October 2012. Heading into the second quarter, Todd Salamone revisits the first quarters of 2013 and 2014, and breaks down what bulls must be aware of going forward.

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: Year-to-Date Breakeven Levels Remain in Play for Major Indexes
By Todd Salamone, Senior VP of Research

"Should follow-through selling occur this week, one level of potential support is 1,848.36 for those interested in seeing the SPX close the first quarter of the year in the green ... As noted a week ago in this space, the short-term environment could remain choppy in the days ahead, as major benchmarks find support at breakeven levels on pullbacks, but do battle with overhead round-number resistance levels. For traders, this means you should either shorten or lengthen your time frames."
-Monday Morning Outlook, March 22, 2014

" YTD breakeven continues to be in play as potential support on $SPX - closed barely above it today."

"$RUT failure around YTD breakeven (1,163.64) earlier this morning; $COMP back in red YTD after going green in first half of day $IWM $SPX"

-@ToddSalamone on Twitter, March 27 and 28, 2014

"Hearing several sharp movements lower this afternon in emini's is down to US institutional funds buying downside protection in options."
- @TradeDesk_Steve (Global Head of Dealing at London & Capital Asset Management) on Twitter, March 25, 2013

"Starting at 11:57 a.m. ET, a major player started buying May 1,995-strike put options on the S&P 500 for $133 per contract ... Since the market makers who stepped in to sell the options contract don't necessarily want to make the bullish bet on the market that being on the other side of the trade would imply, they likely hedged their exposure to the options by shorting the S&P e-mini."
-CNBC.com, March 26, 2014

Last week was a tough one for small-cap investors, with the Russell 2000 Index (RUT - 1,151.81) falling further from the round-number 1,200 area to book a 3.5% loss for the week, and moving back into the red for 2014. The only good news is that the half-century 1,150 mark -- which had significance in December 2012 -- acted as support. For those observing the S&P 500 Index (SPX - 1,857.62), it was the same old choppy action we have become accustomed to in recent weeks, with support coming in around its year-to-date (YTD) breakeven mark (see chart below).

Horizontal line marks 2014 YTD breakeven
SPY 30-Minute Chart, March 24-28

The similarities between March 2013 and 2014 are striking. It begins with what the last two excerpts above describe -- large portfolio protection trades that occurred around the same time in both March 2013 and 2014 and spooked the markets.

But the similarities do not end with these massive portfolio protection trades being put on late in the month. For example, the SPX traded in a choppy, directionless mode, with the 1,540 area marking the bottom of the March 2013 trading range, and SPX 1,840 marking the bottom of the March 2014 range.

Moreover, round-number percentage YTD gains came into play in both March 2013 and 2014, with the SPX's 10% year-to-date gain marking the top of the SPX's March 2013 range, whereas support in the March 2014 range has been in the area of 0% YTD.

While 2013's first quarter got off to a great start after a weak fourth quarter in 2012, 2014 has gotten off to a much slower start, but following a rather robust 2013 fourth quarter. However, if you compare the prior six-month returns through the end of March 2013 and end of March 2014, the returns are similar -- 8.9% from September 2012 to March 2013, and a slightly stronger 10.5% advance from September 2013 through March of this year.

Finally, as you can see in the chart below, the SPX's upward-sloping 40-day moving average was playing "catch up" in both March 2013 and again in March 2014.

SPX March and early April 2013 With 40-Day Moving Average

SPX March and early April 2013 With 40-Day Moving Average

In March 2013, overseas headlines -- specifically, European sovereign debt issues -- dominated the newswires. Now, it is the conflict between Russia and Ukraine that is exercising control over headlines. In March 2013, technical analysts were looking for a pullback, some even predicting a major correction of 20%, as "too far, too fast" was among the many worries. Now, a worry is, "too long without a significant correction."

Option pricing on SPDR S&P 500 ETF (SPY - 185.49) options has been remarkably similar in both March 2013 and 2014, too. As speculators and those hedging long positions braced for the possibility of a correction, out-of-the-money (OOTM) put options -- bought to insure against a market decline below a certain level before a certain date -- grew expensive relative to similar percentage OOTM call options, as measured by the implied volatility of these OOTM calls and puts.

Out-of-the-money puts have strike prices below the current SPY level, whereas out-of-the-money calls have strike prices above the SPY's current level. Sometimes, out-of-the-money calls are used to sell away upside above a certain level to generate income to help insulate against a market decline or expectations of a continued trading range.

As you can see in the chart below, in both March 2013 and March 2014, implied volatilities of 5% OOTM puts became almost twice as expensive as OOTM calls. If the past is prologue, the roll over in this ratio could hint at higher prices ahead, perhaps in the next few weeks.

10-Day Moving Average for OOTM Put/Call Skew Since January 2013

If this indicator is correct in forecasting bullish action in the weeks ahead, the market would follow its historical seasonality tendency. For example, as you can see on the table below, the month of April has been the strongest during the past 20 years in terms of the percentage of market advances and its average gain. Beware, however, that the market has not been in tune with historical tendencies in 2014, with a traditionally strong January coming in weak in 2014, and a historically weak February coming in strong.

Average Monthly Returns of the S&P 500

Bulls should be slightly encouraged by the fact that the SPX and S&P 400 MidCap Index (MID - 1,358.20) remain above their respective year-to-date breakeven support levels. The significance of this is somewhat downgraded by the fact that the RUT and Nasdaq Composite (COMP - 4,155.76) closed the week below their YTD breakeven points of 1,163.64 and 4,176.59, respectively. Bulls would prefer to see leadership in these names. Plus, advances in the Wilshire 5000 Total Market Index (W5000 - 19,809.28) continue to be capped in the vicinity of the 20,000 millennium mark, which reminds us of the difficulty the Dow Jones Industrial Average (DJI - 16,323.06) has had in recent years in taking out millennium levels.

As the SPX continues to grind in a frustrating trading range just like March of last year, the "below the surface" action is not as pretty as March 2013. For example, whereas the percentage of daily advancers among optionable stocks was increasing ahead the eventual upside breakout, the current percentage advancers has been plunging throughout this month.

The weakening market internals, following a decline from round-number resistance levels on key equity benchmarks, are admittedly risks to the bullish case. With this in mind, if support at SPX 1,840 (SPX 40-day moving average) and its YTD breakeven level of 1,848 fails to hold in the event of a pullback, be prepared for a decline much like we saw in the second half of January. Note in the put/call implied volatility skew chart that we discussed above, the January sell-off was preceded by an upturn in this ratio from a relatively low reading coming into the year.

Market Internals -- Daily Percentage of Advancers Among Optionable Stocks
Daily Percentage of Advancers Among Optionable Stocks Since January 2013

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