Painting a Bullish Picture Amid a Volatile Backdrop

A big-time surge in volatility may have bulls on edge, but should they be?

by 10/18/2014 9:45:01 AM
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It was another week of volatile trading, with the Dow Jones Industrial Average (DJI) and S&P 500 Index (SPX) making big moves in each session. Most of the week's action occurred to the downside, though, as fear over Ebola and the global economy continued to weigh on investor sentiment. Although the indexes staged a late-week rally thanks to a round of upbeat earnings and economic reports, as well as stimulus chatter from across the pond, they were unable to escape a fourth consecutive weekly loss -- the longest such streak for the S&P 500 since 2011. Looking ahead, Schaeffer's Senior Equity Analyst Joe Bell, CMT, explains that although a number of major market indexes are sitting below key trendlines, the "sentiment backdrop is definitely in the bulls' favor."

  • The issues that could continue to keep volatility high
  • 2 rays of light on the sentiment front
  • Rocky White explains what to expect from the S&P 500 after its 200-day moving average break

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: Taking Wall Street's Pulse
By Joe Bell, CMT, Senior Equity Analyst

What a week. Volatility is back, and it's back in a big way. It has been nearly three years since we've had the type of craziness we are experiencing. Although there are many culprits and plausible scenarios for why the market sold off so sharply this week, the truth probably lies in a combination of factors.

We came into last week a bit uneasy after the semiconductor sector gave back five months of gains in one day, and we were greeted with our daily dose of Ebola scares. Many of the big financial names also reported mixed earnings this week and we received a worse-than-expected retail sales report. Early on, Europe remained a bearer of bad news, with a flurry of worse-than-expected economic reports coming in from several countries, most notably a decrease in Germany's gross domestic product (GDP) outlook. When it seemed all hope was lost, a European Central Bank (ECB) official sparked a rally Friday morning after saying that ECB purchases of asset-backed securities were set to begin within a few days.

All of these issues will continue to play a role in the current volatility, but it's also important to highlight some of the option mechanics related to October options that expired this past week. In last week's edition of Monday Morning Outlook, Todd Salamone discussed the enormous put open interest at the SPDR S&P 500 ETF Trust's (SPY - 188.47) October 190 strike. At the start of the week, north of 550,000 puts were sitting at the strike, which was more than twice the amount sitting at the October 195 strike. We warned that a breach of the 190 strike could generate further sharp selling related to this heavy put open interest until the sellers of the puts were fully hedged.

Technically, the 190 level was also a key area of potential support. It acted as resistance on multiple occasions between March and May, and provided support in early August. In addition, the SPY's 200-day moving average was near this level to start the week. Once this area was broken, we saw sharp selling all the way down to the 182 area. On a closing basis, the SPY never finished below 186, though, as the intraday sell-offs were finally met with buying pressure in this region. It is worth noting that the year-to-date (YTD) breakeven for the SPY is 184.69 -- a psychological level that certainly coincided with the incoming demand mid-week.

Daily Chart of SPY Since October 2013 With 200-Day Moving Average and 190 Level

With the big bounce to end the week, the 190 level overhead could once again become short-term resistance and an area to watch. Some other major indexes also broke below important technical levels of support this past week. The Russell 2000 Index (RUT - 1,082.33) -- a barometer of small-caps -- fell below the 1,090-1,100 area and found support near 1,047, which is 10% below last year's close and is triple the April 2009 low. The Dow Jones Industrial Average (DJI – 16,380.41), meanwhile, broke below its August low as well, but found support near the round-number 16,000 mark.

Daily Chart of RUT Since October 2013

Although some of these indexes will now have to contend with these technical levels overhead, the sentiment backdrop is definitely in the bulls' favor. The National Association of Active Investment Managers (NAAIM) survey asks active investment managers what their current equity exposure is on a weekly basis. Historically, when they have low exposure, it indicates there is a lot of cash that could flow into the market. This week, the exposure index nose-dived to 9.97%, which is the lowest level since Oct. 12, 2011. As you can see on the chart below, this period was a nice time to be long the market.

NAAIM Sentiment Index Since January 2011

In addition to the bearish sentiment from active investment managers, option speculators have become increasingly bearish during the past several weeks. As you can see in the chart below, the put/call ratio on individual equities is at its highest level since February of this year. Once again, that was not a bad time to be long.

ISE, CBOE, PHLX 10-day, equity only buy-to-open put/call ratio and SPX Since January 2013

Aside from the sentiment backdrop, a look at the total number of selling climaxes that occurred this week may indicate this weakness has exhausted itself for the time being. A selling climax is where a stock makes a new 52-week low, but then settles above the previous week's close. Historically, important market turning points are often accompanied by a huge spike in the total number of these types of climaxes. This past week, we had the most selling climaxes since Sept. 29, 2011.

Selling Climaxes and SPX Since July 2011

With such dramatic volatility and the sharp sell-off, did we finally get the infamous 10% pullback on the S&P 500 Index (SPX - 1,886.76)? Not quite. Based on the intraday 2014 high on the SPX and this week's low, we officially had a 9.8% pullback. Based on the 2014 closing high on the SPX and this week's closing low, we officially had a 7.4% pullback. Despite "failing" to reach this mark, the SPX did break below its 200-day moving average. Although this may seem like a negative thing at first glance, check out Rocky White's Indicator of the Week on the next page for a look at what this means historically.

Since March, one theme that's remained the same is small-cap underperformance. One interesting thing to take note of is that during the large mid-week reversal, small-caps -- as evidenced by the iShares Russell 2000 ETF (IWM - 107.49) -- took a leadership role. This outperformance occurred on Tuesday, Wednesday, and Thursday, but then small-caps once again lagged significantly on Friday. We have seen periods historically where large-caps have led during rallies, but often small-cap leadership is associated with a healthy risk appetite by investors. (Click on the chart to enlarge.)

Daily Relative Strength Chart of IWM and SPY since April 2013
Chart courtesy of eSignal

With a sentiment backdrop that has become very pessimistic, there is a very real possibility that much of the major selling pressure was exhausted during this week's sharp sell-off and reversal. With that being said, it still may be a little premature to think we are going to simply revert back to a low-volatility uptrend right away. Technically, many of the support areas that were broken this past week could now serve as short-term hurdles overhead. In addition, there is still a lot of uncertainty regarding the potential spread of Ebola and Europe, which could continue to spill over into our markets.

This upcoming week is pretty light on economic data, but we are entering the heart of earnings season and names like Apple Inc. (NASDAQ:AAPL), The Coca-Cola Company (NYSE:KO), McDonald's Corporation (NYSE:MCD), and Yahoo! Inc. (NASDAQ:YHOO) are all set to report. With the October Fed meeting right around the corner, market participants will continue to look for clues for how the Fed may or may not react to European weakness, the strengthening dollar, and recent volatility in U.S. equities.

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