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The Risk-Reward View Looks Good from Here

The sentiment stars could be aligning for even more upside on the horizon

by 8/9/2014 9:19:04 AM
Stocks quoted in this article:

Last week was all about overseas, as Wall Street got whiplash from watching the action unfold in Portugal, Gaza, Iraq, Russia, and Ukraine. Easing concerns between the latter two, however, helped the major market indexes secure weekly wins on Friday, overshadowing news of U.S. airstrikes in Iraq. As Schaeffer's Senior VP of Research Todd Salamone explains, the sentiment stars could be aligning for even more upside on the horizon.

  • The group that keeps getting it wrong -- and why that's a good thing
  • The S&P 500 Index (SPX) streak on our radar
  • How options expiration could impact the charts this week

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: The Stars Are Aligned for a Rally
By Todd Salamone, Senior VP of Research

"Even if the 80-day moving average breaks, the SPX's 120-day moving average sits just below at the round 1,900 level ... this trendline has marked numerous troughs ... Continuing our focus on uncommon, yet important moving averages, we bring your attention to the RUT's 320-day moving average -- currently situated near 1,100, a round-number area that marked the lows in February and May."
-Monday Morning Outlook, Aug. 2, 2014

"Why There Could Be Trouble Ahead for Stocks"
-CNBC headline, Aug. 4, 2014

"Single-day buy (to open) equity put/call volume highest in our database- 10-day avg at levels of past bottoms"
-@ToddSalamone on Twitter, Aug. 4, 2014

"And U.S. equity funds have seen outflows in eight of the last 10 weeks when exchange-traded funds are excluded, supporting the notion that investors remain fearful, and not displaying the kind of euphoria that acts as a precursor to big pullbacks."
-Reuters, Aug. 8, 2014

"Bears Come Out of Hibernation"
-Headline from The Wall Street Journal, Aug. 8, 2014

If you are a contrarian and a market bull, you should be encouraged with the way that the sentiment backdrop has developed in recent days, on what so far has been a modest pullback from last week's peak -- and on the heels of a week in which the small-cap ("risky") stocks outperformed larger-cap ("safety") names.

In fact, if you read our commentary at the beginning of last month, when we warned of increasing vulnerability to short-term stock market weakness, the indicators that we used then now support an increasing likelihood for an impressive rally over the coming weeks.

As you can see from the various excerpts above, sentiment has finally turned negative, unlike the optimism we observed at the beginning of July, when several indices were battling round millennium marks. The S&P 500 Index (SPX - 1,931.59) was one benchmark trading just below an important 2,000 level. At the time, the SPX was trading at 1,980 -- its target objective from an inverse "head and shoulders" pattern that developed in March through May.

And like early July, we have seen an extreme sentiment shift (from one of extreme optimism to extreme pessimism), just as a couple of key benchmarks troughed at support levels this past week, both around round numbers.

For example, observe the recent behavior of equity option buyers in the chart below, which regular readers of Monday Morning Outlook should be familiar with now. This group has been wrong at key turning points, including the July peak, when equity put buying (bets on a decline in an individual stock) relative to call buying (bets on an individual stock to advance) hit a multi-month low (see the circle on the chart, which represented optimism).

Now, this group has turned extremely negative, as the ratio of put buying to call buying has soared from 0.44 at its low to above 0.70, north of the ratios that have marked past bottoms. A risk to bulls is that this ratio continues to advance, which would pressure stocks as pessimism hits even more of an extreme. But a roll-over in this ratio, signaling that pessimism has peaked, would signal that the probability of a significant rally over the coming weeks has greatly increased. Given the strong rally off of support on Friday, the probability increases that a negative extreme among short-term has been reached, setting up the potential for a bottom.

10-day Equity-Only BTO Put-Call Volume Ratio with SPX since 2013

Bulls should also be encouraged by the plunge in sentiment among active investment managers, as is evident in the weekly survey of the National Association of Active Investment Managers (NAAIM). This survey represents the average exposure to U.S. equity markets reported by its members. Note in the chart below that this group has reduced its exposure to the levels of February, which marked a key trough in the market. That said, their exposure is not at the levels that marked key lows in 2013, so a risk to bulls is that this group continues lightening exposure, after staying nearly fully invested in June and July (fully invested is an average NAAIM reading of 100).

NAAIM Sentiment since 2011 with SPX

As you can see on the charts below, the SPX and the Russell 2000 Index (RUT - 1,131.35) found support late last week at round-number levels: 1,900 and 1,100, respectively. It is these same indices that recently peaked at 2,000 and 1,200.

The round 1,900 level on the SPX coincides with its 120-day moving average, a trendline that has marked several buying opportunities on pullbacks since June 2013. We find this intriguing, as the moving average is not popular with technicians, but has proven significant over the past 14 months, nevertheless.

Meanwhile, the RUT low last week was 1,107.31, just above the round 1,100 level, site of its 320-day moving average. The 320-day moving average marked important troughs in 2010 (not shown on chart below) and 2012 (shown on chart below). Round century marks on the RUT have been important this year, with the 1,200 area marking resistance and 1,100 providing support.

Daily Chart of SPX since May 2013 with 120-Day Moving Average

Daily Chart of RUT since October 2012 with 320-Day Moving Average

Next week is the standard expiration of August options. As always, a risk to bulls during expiration week is that heavy put strikes on major equity exchange-traded funds (ETFs) can sometimes act as magnets when the market is under pressure for any given reason. These puts are usually bought as hedges to long portfolios (insurance), but sellers of these puts, or portfolio insurance, become more and more exposed to losses as the ETF approaches and breaks below a particular strike. Therefore, sellers of the puts tend to short more and more SPX futures when the underlying ETF approaches a put strike, in a process called delta-hedge selling.

We may have seen some of this play out last week, especially in the SPDR S&P 500 ETF Trust (SPY - 193.24), which is one-tenth the SPX's value. The SPY was under pressure Tuesday through Thursday, hesitating at strike prices, and then finally plunging below them.

And in Thursday/Friday overnight futures session, SPX futures traded as low as 1,890 on news that President Obama authorized targeted strikes in Iraq. With SPY put open interest heavy at 190, but minimal at 189, we found it interesting that SPX futures bottomed at the 1,890 area in the overnight session, which corresponds to 189 on the SPY.

In the absence of any new negative surprises on the geopolitical (or domestic) front next week, bulls could benefit from the opposite mechanics of delta-hedge selling. That is, as August put contracts at strikes below the market get set to expire, short covering associated with the expiring put open interest could create a tailwind, especially with the SPY coming into expiration week above the put-heavy 192 strike.

While a risk next week is negative headlines generating exaggerated selling due to delta-hedge selling, the short-term sentiment backdrop now suggests that there is more reward than risk over the next month.

SPY Open Interest Configuration Weekly August 16 Series

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