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We're Not Giving Up on Higher Highs

Can energy stocks extend their recent rally?

by 6/13/2014 10:00:00 PM
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The Dow Jones Industrial Average halted its string of record highs on Wednesday, suffering two straight triple-digit drops in the wake of a downwardly revised World Bank forecast and amid escalating tensions in Iraq. However, as Todd Salamone points out, anticipated support levels held for most major benchmarks -- and we remain hopeful that higher highs are on the way.

  • How sentiment among market technicians points to more buying power
  • Why Wednesday will be big for VIX watchers and Fed followers
  • What does expiration week mean for the market? Rocky White takes a look.

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: Support Held -- Now What?
By Todd Salamone, Senior VP of Research

"With 1,900 on the S&P 500 Index (SPX - 1,949.44) in the rear-view mirror, and now targeting 1,980-2,000 (1,980 is the target for the inverse head-and-shoulders breakout pattern, and 2,000 is triple the 2009 low), traders should not lose sight of the historical significance of half-century marks on the SPX as the index approaches 1,950 ... Similarly, the Russell 2000 Index (RUT - 1,165.21) may have to contend with resistance immediately overhead ... 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 ... Finally, while we are wary about getting caught up in the 'low volatility' cautionary remarks that are making their way around, we should note that a potential floor in the CBOE Volatility Index (VIX - 10.73) is around 10.75, which is half the October 2013 and February 2014 peaks in the 21.50 area."

-Monday Morning Outlook, June 7, 2014
"In early January, the average $SPX YE '14 forecast among 21 strategists was 1,950. Friday's close was 1,949.44. $SPY"
-@ToddSalamone on Twitter, June 9, 2014

Following a rally that began in mid-May, potential resistance levels that we discussed last week came into play over the past few trading days, with the S&P 500 Index (SPX - 1,936.16) getting turned back at its 1,950 half-century mark, the Dow Jones Industrial Average's (DJIA - 16,775.74) high just 30 points shy of the round 17,000 mark, and the Russell 2000 Index (RUT - 1,162.68) getting beat down back below its year-to-date (YTD) breakeven mark of 1,163.64, after a brief rally above this level.

In fact, the RUT's high last week in the 1,180 zone was a popular theme among some technicians in the Twitter crowd, who highlighted the potential for a bearish "head and shoulders" formation pattern, as the high would mark the right shoulder if a break of the neckline at 1,090 occurs.

The fact that technicians continue to be quicker to point out potentially bearish patterns and are less inclined to recognize bullish patterns on major indices has been a hallmark of this bull market and is a welcome sign for bulls, as it is indicative of a generally cautious or bearish disposition among traders -- many of whom have unsuccessfully fought an impressive uptrend and represent future buying power.

The good news is that the market moved out of a short-term overbought condition on a muted pullback. The SPX's nine-day Relative Strength Index (RSI) hit an overbought reading of 81 early last week, hit a low of 55 on Thursday, and ultimately settled at 59 by Friday's close.

Additionally, anticipated support levels held, with the S&P 400 MidCap Index (MID - 1,402.38) holding the round-number 1,400 level, and the RUT bottoming last week just above its 80-day moving average, which has been significant in the recent past. Last week's action brought flashbacks to the March-May trajectory, when several major indices were in a narrow range -- either being supported by or sold at round-number levels or YTD breakeven points.

Daily Chart of RUT with 80-Day Moving Average and YTD Breakeven

Half-century marks have historically been important on SPX, and this area also marks the average year-end price target among Wall Street strategists
30-Minute Chart of SPX

Also of interest is that the CBOE Market Volatility Index (VIX - 12.18) found a floor at 10.73 -- its close on Friday, June 6. As we mentioned last week, with the VIX usually peaking at 50% or double a prior low, it would not surprise us if the VIX bottomed at half its late-2013 high in the 21.50 area. The VIX popped 17% to its peak last week. Should additional selling occur, one target for the VIX would be 16.10, which is 50% above the aforementioned June 6 low. Finally, expiration of June VIX options occurs Wednesday morning, the same day the Fed announces its latest policy decision.

Of the 7.5 million VIX call contracts, 2.95 million -- or roughly 40% -- are in the June series. But a scant 13,000 of these calls will expire in the money next Wednesday if the VIX settles between 11.50 and 12.00, going by Friday's open interest numbers. Therefore, there might be an incentive for sellers of the calls to see the VIX settle below 12.00 at expiration, but they will still be happy campers on a settlement price below 15.00, as call open interest is biggest at the 15 and 16 strikes. Bear in mind, however, that if negative headlines spark a sell-off early next week, sellers of these call options are exposed to a sharp move higher in the VIX, and thus may take bearish actions to remain neutral. For more on VIX expiration and its potential impact on the market, see Rocky White's "Indicator of the Week" commentary below.

Daily Chart of VIX since June 2013

While resistance levels on the Dow, SPX, and RUT that we identified last week came into play, and the VIX advanced off support that we anticipated, we are not giving up on key equity benchmarks such as the SPX and RUT moving above resistance levels at 1,950 and 1,163, respectively, before month's end.

As you can see on the chart below, the short-term pessimism among equity option players -- which recently reached its highest levels since July 2013 -- is currently being unwound, supporting the market. Another shift in sentiment -- evident by the put/call volume ratio turning higher or moving to an extreme low -- would make the market vulnerable to a period of weakness, defined by sideways movement or a pullback along the lines that we have experienced during the past few years, anywhere from 3% to 5%. For now, however, the unwind is a net-positive for the market if indices such as the RUT and MID continue to hold above support levels.

Pessimism among equity option speculators peaked at multi-month highs ahead of the recent breakout -- increasing optimism is currently supportive, but not yet at an extreme
10-Day Equity-Only BTO Put-Call Ratio with SPX since 2013

Finally, standard June options expire at the end of next week, so we'll be focusing on price action with respect to heavy call and put strikes on various index and exchanged-traded fund (ETF) options, such as the SPDR S&P 500 ETF Trust (SPY - 194.13), which is one-tenth the value of the SPX. As you can see on the chart below, the last heavy call strike in the area of the current SPY price is 195, and was briefly taken out early last week. We anticipate the $195 area will be a layer of resistance in the week ahead, whereas the $192-$193 region -- where there is a decent balance of call and put open interest -- should be supportive. For what it's worth, the SPY's 20-day moving average is currently situated between the 192 and 193 strikes, which might be perceived as an entry opportunity.

SPY June Open Interest Configuration

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