Time to Hit the Panic Button? Not Quite

A look at what seven straight positive quarters on the SPX could mean going forward

by 9/27/2014 8:35:37 AM
Stocks quoted in this article:

Last week was a rough one for U.S. equities, as the major indexes each gave back at least 1%. However, an upwardly revised second-quarter gross domestic product (GDP) and positive consumer confidence reading (both of which came out on Friday) helped stem the tide, as stocks finished the week on a decisively positive note. Plus, as Schaeffer's Senior VP of Research Todd Salamone points out, there are still plenty of technical and sentiment indicators suggesting that a bear market is far from imminent.

  • 3 reasons equity bulls should be happy
  • Why the October SPY put/call skew may be on the verge of a roll-over
  • Rocky White runs the numbers on previous 7-quarter winning streaks for the S&P 500

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: High VIX, Small-Cap Support, and Other Reasons Not to Fear
By Todd Salamone, Senior VP of Research

"With SPX 2,000 still in the picture, the NYSE Composite's (NYA - 10,989.57) 11,000 millennium mark continues to be a barrier, as does the $100 century mark on the PowerShares QQQ Trust (QQQ - 99.98) ... The sentiment backdrop continues to suggest that if pullbacks occur, they will be modest ... there are a few risks to the short-term outlook, specifically: 1) Due to expiration of VIX futures options this past week, VIX call open interest has decreased from 7.6 million ahead of Wednesday's VIX expiration to 5.0 million at present, implying some market participants that typically hedge no longer have portfolio protection ... 2) volatility speculators have given up on making bets on rising volatility, which is normally associated with a weaker market ... 3) an unusually large skew in how out-of-the-money (OOTM) SPY put options are priced relative to OOTM call options ... when a large skew is present during an advance, weakness has followed in the past."
-Monday Morning Outlook, Sept. 20, 2014

"Our weekend comments on large $SPY skew (has grown even wider this morning when looking at Oct options)"
-@ToddSalamone on Twitter, Sept. 22, 2014

"$VIX closed at 15.64 yesterday, which is roughly 50% above 2014's low close in July. Many peaks have occurred 50% above lows"

"$IWM Huge put open interest at 110 strike, with this area essentially marking bottom of 2014 range. Key level in days ahead."
-@ToddSalamone on Twitter, Sept. 26, 2014

The bad news (for equity bulls):

  • Stocks retreated last week from (or back to) round-number areas, with the S&P 500 Index (SPX - 1,982.85) falling back below the 2,000 millennium level, the Dow Jones Industrial Average (DJI - 17,113.15) revisiting the pesky 17,000 level, the Wilshire 5000 (W5000 - 20,885.67) dipping back below 21,000, the NYSE Composite (NYA - 10,798.88) dropping below 11,000, and the PowerShares QQQ Trust ETF (QQQ - 98.78) rejected at the 100 century mark. Moreover, the Russell 2000 Index (RUT - 1,119.33) retreated further into negative year-to-date (YTD) territory, after a rejection in this area the week prior.

SPX continues to sputter around the 2,000 millennium level after first hitting it a month ago

Daily Chart of SPX since July 2014

The good news (for equity bulls):

  • The CBOE Volatility Index (VIX - 14.85) closed the week below 15.48 -- which is 50% above the July low -- after closing just a tad above this level during Thursday's sell-off. As we've observed before, on multiple occasions, the VIX has peaked at levels roughly 50% above a significant, recent low.

  • Small-cap stocks, as measured by the RUT and the iShares Russell 2000 ETF (IWM - 111.12) -- which is one-tenth the value of the RUT -- are trading near their respective range lows, with the 1,080-1,100 area supporting multiple RUT pullbacks since late 2013.

    Big put open interest resides at the 110 strike on the IWM and is an area of potential support. The 108 level, which is 10% below IWM's 2014 high and the site of its 80-week moving average -- a trendline that marked a key low in November 2012 -- offers an additional layer of support if 110 is tested and fails to hold.

    The downside is that a break of support levels mentioned above could mean continued disappointment for small-cap bulls.

VIX with a horizontal line at 15.48 -- 50% above its July closing low of 10.32

Daily Chart of VIX since April 2014 with Resistance at 15.48

Weekly Chart of RUT since July 2012 with 80-Week Moving Average

  • The SPX closed the week only 1.4% below its all-time closing high, after finding support at its 80-day moving average in the 1,970 area last week. But sentiment is far from optimistic, suggesting sell-offs will be minimal relative to the potential upside.

    For example, in the options market, the 10-day International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) put/call volume ratio is well above extreme lows, which preceded short-term declines in 2013 and 2014. For those of you that are new to reading this report, a low ratio is indicative of optimism among a speculative options crowd that has been wrong at key turning points in the market. When this ratio is high, as it is now, minimal declines have followed. That said, this ratio is currently trending higher from an unusually high level, and the market tends to behave best when this ratio turns lower from an extreme high. So, right now, it is the direction this ratio is heading that is a risk to an otherwise bullish case.

    Also, per the second chart immediately below, note that a weekly survey from the National Association of Active Investment Advisors (NAAIM) revealed that this group further reduced its allocation to stocks in the latest week. Such actions will coincidentally pressure stocks -- as they did last week -- but note that when this group is at a bullish extreme, the market becomes more vulnerable to a decline than usual, whereas when this group is nearing a bearish extreme, as it is now, the market is more apt to rally. Bulls would like to see this group begin to increase its allocation to equities, after sharply reducing it during the past few weeks.

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

NAAIM Exposure Index vs SPX since January 2013

Finally, a topic we discussed last week, and need to follow up on this week is the huge put skew on SPDR S&P 500 ETF Trust (SPY - 197.90) October options. In other words, options on put strikes 5% below SPY's current price have been extremely expensive relative to call strikes 5% above the current SPY price. When measured in terms of implied volatility (IV), the skew (put IV divided by call IV) is at multi-year highs. We observed last week that when this ratio reaches a relatively high level during a rally, market weakness soon follows, and this time around, weakness began soon after the market opened on Friday, Sept. 19. The skew, which is shown below with a 10-day moving average of the daily ratios, remains at multi-year highs. However, during the past couple of sessions, single-day readings have not been as extreme as the 10-day average, perhaps hinting at a roll-over in this ratio from an extreme level. A roll-over on the heels of a pullback has bullish implications, and such a scenario may very well be imminent.

SPY 5% out-of-the-money put skew -- rollover imminent?

SPY 10-Day Moving Average OOTM Put/Call Skew since 2010

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