The Dow Jones Industrial Average (DJI) and S&P 500 Index (SPX) both ended their weekly losing streaks on Friday, despite giving back some gains from earlier in the week. Of course, the big lift came on Thursday, courtesy of the European Central Bank's (ECB) monetary stimulus decision, which powered the aforementioned benchmarks to matching 1.5% daily gains. Despite these (and other) indexes now trading near resistance, Schaeffer's Senior VP of Research Todd Salamone explains why there's reason to believe these levels could be taken out.
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: Why It's Still Smart to Be Hedged
By Todd Salamone, Senior VP of Research
"... the SPX must break important support areas that are in play now before the October lows can be tested. For instance, the index comes into this week around the 2,000 millennium mark and its 120-day moving average -- a trendline we discussed last week as being supportive during multiple pullbacks since 2013 (exception being the October decline)."
"Additionally, SPX 1,980 could prove important as we enter the second half of the month, as it is the site of the index's 10-month moving average ... [T]he SPX has not experienced a monthly close below its 10-month moving average since January 2012 ..."
- Monday Morning Outlook, Jan. 17, 2015
"$DJIA YTD B/E = 17,823. Yesterday's close = 17,813...$COMP YTD B/E = 4,736. Yesterday's close=4,750."
"As major benchmarks, such as $SPX, $QQQ, $DJIA trade around 2015 B/E levels, $RUT getting set to do battle with round number 1,200 (again)"
-@ToddSalamone on Twitter, Jan. 23, 2015
On the heels of the European Central Bank's (ECB) decision to buy sovereign bonds on Thursday morning, world markets rallied. The S&P 500 Index (SPX - 2,051.82) began its ascent early last week -- ahead of the ECB's decision -- as buyers emerged with the index sitting on major support, which we've discussed previously.
Thursday's ECB decision propelled the SPX higher into positive territory for 2015 by Thursday's close. The move north of breakeven was short-lived, however, with the SPX moving back into the red by Friday's close. Perhaps investors are moving to the sidelines ahead of the Federal Open Market Committee's (FOMC) scheduled meeting next week -- and as indexes trade at resistance.
Moreover, the PowerShares QQQ Trust (QQQ - 104.26) and S&P 400 MidCap Index (MID - 1,455.79) rallied from round-number levels at 100 and 1,400, respectively. And the Dow Jones Industrial Average's (DJI - 17,672.60) low for the year remains barely above the 17,000 millennium mark.
Despite equities trading at resistance, there is an encouraging sign for bulls that short-term resistance levels will be taken out. Coincident with the ECB decision and subsequent market rally, the 10-day average of the equity-only, buy-to-open put/call volume ratio experienced a relatively sizable decline on Thursday. A single-day decline in this ratio of the magnitude we saw on Thursday has proven to be bullish historically. It is a sign that short-term traders are in the early innings of moving from an environment filled with caution and/or skepticism to one that is more optimistic. This transition typically lasts a few weeks and is supportive of stocks.
Specifically, the 10-day, equity-only, buy-to-open put/call volume ratio declined by 2.7% from a reading above 0.60, which is historically high. Since June 2012, it has done this 16 other times. On 14 of those occasions, the SPX was higher one week later by an average of 1.10%, or three times its anytime average over the same time period. Moreover, the SPX has advanced 88% of the time one week after this signal, more than the expected 61%.
Volatility expectations also remain on our radar. On the volatility front, the fact that single-day volatility is almost twice 2015's daily volatility is getting a lot of play on blogs and in various media.
One potential reason for the high single-day volatility could be the effects of a previous topic in this report -- extremely low SPDR S&P 500 ETF Trust (SPY - 204.97) put open interest and extremely low CBOE Volatility Index (VIX - 16.66) futures call open interest, which some investors purchase for portfolio protection.
If the low levels of VIX call open interest and SPY put open interest are indicative of market participants giving up on hedging -- after such activity proved to be a performance headwind throughout most of 2014 -- there may be more knee-jerk reactions to perceived negative headlines now, relative to last year, when portfolio protection was extremely popular. But the wide daily fluctuations have, so far, proven to be noise within the bigger picture. For example, the SPX's 10-month historical volatility is at its lowest reading since May 2013. On balance, monthly historical volatility continues to track lower since its peak in 2009.
If you are a longer-term investor, the longer-term, low-volatility trend suggests not disturbing your long positions, unless and until you see a significant break of longer-term support. After all, as the environment stands now, there is some rationale for portfolio-protection trades to lose their popularity from the perspective of a major decline in volatility during the past few years.
"Hedge funds' use of borrowed money, or leverage, to amplify the effect of their bets dropped last week to the lowest level in more than two years, Morgan Stanley told clients in a confidential memorandum. The drop in leverage signals a dwindling conviction that markets will push ever higher."
- The Wall Street Journal (subscription required), Jan. 11, 2015
We don't have a definitive reason as to why VIX call open interest and SPY put open interest have plunged in recent months. Another theory could be hedge funds have chosen to play in other areas -- currencies, commodities, emerging markets, bonds, for example. Or, as a recent Wall Street Journal article suggested (see excerpt immediately above), reduced leverage among hedge funds could be limiting demand for portfolio protection, which may ultimately prove bullish if leverage again increases.
All things considered, we reiterate what we said last week. That is, it is not a bad idea to be hedged or at least make preparations to hedge when necessary, as one risk to the market is a break of support potentially causing panic selling among unhedged longs and/or a sudden demand for portfolio protection, which could coincidentally push indexes lower than expected. And the cost of the hedge may prove to be very small in the context of the potential rally that we could witness if hedge funds begin increasing their leverage once again.
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