The Case for a Short-Term Breakout

The S&P 500 (SPX) has performed in 2015 much as it did last year -- which may suggest an impending breakout

by Todd Salamone

Published on May 18, 2015 at 8:48 AM
Updated on May 18, 2015 at 8:55 AM

"'Simple' has indeed trumped 'complex' during these last few weeks as buying year-to-date (YTD) breakeven support and selling round-number resistance has proven to be a profitable approach ... However, keep in mind that these round numbers have simply served as speed bumps amid a low-volatility, longer-term uptrend. In other words, selling pressure eventually subsides around the round numbers, punishing the shorts and rewarding the bulls."
-- Monday Morning Outlook, April 13, 2015

If you have been a loyal reader of our weekly commentary, you are well aware of the major levels that have defined support and resistance on major equity benchmarks during the past few months of this grueling trading range. In case you are not in the know, the simple observation we have made is that pullbacks to the December 2014 close have presented buying opportunities on benchmarks such as the Dow Jones Industrial Average (DJIA - 18,272.56) and S&P 500 Index (SPX 2,122.73), while selling opportunities present themselves when these same benchmarks rally above round numbers -- such as 18,000 and 2,100, respectively. Not to be forgotten, the Nasdaq Composite (COMP - 5,048.29) has consistently attracted selling pressure after moves above the 5,000 millennium mark, a level which marked the technology bubble's burst 15 years ago.

"The S&P 500, for its part, has repeatedly tested the 2120 area but moved back each time, most recently following Friday's employment report … But it wasn't supposed to be like this, at least according to the calendar. This is the third year of the current presidential term. Historically, that's the year that equities deliver the most robust returns. Also this year ends in a five. Absent 2005's 0.6% fall for the Dow Jones Industrial Average, that has meant an up year for U.S. stocks every decade in at least a century, with gains almost always being double-digit percentages … But the S&P 500 through Wednesday is up a meager 2.1% ... Might a 7-year curse ultimately cap Barack Obama's presidential stock performance as well?"
-- The Wall Street Journal, May 14, 2015

A major question moving forward, as investors ponder "sell in May and go away" -- and as some give up hope and become disgusted with this year's price action (see The Wall Street Journal excerpt above) -- is, "Are we on the verge of a breakout above the range?"  

For those who prefer keeping it simple, the knee-jerk reaction to this rally is to sell the top of the range. But one has to seriously entertain the idea of betting on a breakout, especially after many market participants have gotten used to the trading range pattern, wondering what the next catalyst is, and forgetting that the market is a discounting mechanism. 

As we said last month, round numbers have "simply" proven to be speed bumps within the context of this longer-term uptrend. In fact, last year at this time, multiple benchmarks were fighting to overtake round numbers. Specifically, round numbers in play last year at this time were 1,400 on the S&P MidCap 400 Index (MID - 1,531.28) (double its 2011 low), SPX 1,900, Russell 2000 Index (RUT - 1,243.95) 1,200, and DJIA 16,500. Plus, price action looked very much like it does now -- a trading range around the previous year's close, which had followed an uninspiring start to the year (see the chart immediately below). However, these round numbers were eventually taken out, and an impressive May and June rally followed.   

Daily YTD returns -- 2014 and 2015  are remarkably similar. Will May/June 2015 look like May/June 2014?

 SPX Returns 2014 v 2015


 "… even if stocks retreat back below round-number levels and last week's lows, there are other areas of potential support just below A potential headwind that we see in the short term resides in the sentiment of short-term traders, who -- as exemplified by action in the options market -- recently hit a seven-month optimistic extreme. But sentiment in this group is turning fearful, and could present a headwind … For now, this shift in the sentiment among short-term traders remains a risk to the market. That said, we don't expect a deep pullback."
--
Monday Morning Outlook, May 4, 2015

So, what is it that is different from only two weeks ago (May 4), when indexes were above round-number resistance levels and the risk we identified in the short term played out?

30 Minute Chart of COMP from May 4-13

The biggest difference we see is the build in short-term fear among equity option speculators, which we observed early this month, climaxed recently. Said another way, pessimism peaked and optimism is slowly returning, and such sentiment shifts from fear to optimism are usually supportive of stocks. The current sentiment shift occurs amid a backdrop in which the COMP, DJIA, and SPX are trading back above their respective round-number resistance levels. This could be a tailwind for stocks, unlike the headwind that presented itself to us a couple of week ago. Therefore, we see a heightened probability of a breakout above resistance.

Moreover, as you might gather from last Thursday's tweet on extremes in negative sentiment playing out among other market participants (also discussed last week), playing an upside breakout would not be a crowded trade. As we said last month, breakouts usually punish the shorts and prove rewarding to bulls. In fact, per the chart below, shorts appear to be throwing in the towel, with total short interest on SPX component stocks declining from a one-year high during the past couple of reports. Short covering played a crucial role in rallies last year at this time, as well as the 2014 end-of-year advance that began in mid-October.

Short covering could be supportive of stocks in the near future

SPX Since January 2011 with Short Interest

Of course, a breakout in stocks would likely pressure the CBOE  Volatility Index (VIX - 12.38) to new 2015 lows. The VIX comes into the week situated near its 2015 low, just above the 12 level -- or around half its 2015 highs that occurred in the 24 area. Something to keep in mind is that VIX May options expire this coming Wednesday, and there is big put open interest at the 12.50 through 14 strikes. So, from an options perspective, a near-term risk is a VIX spike that leads to a Wednesday morning settlement above 14 -- which would make the put contracts worthless -- or as high as 16, which is where the maximum number of call and put contracts expire worthless.

VIX Options May Open Interest

 


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