Why Now Is the Time to Scale Back on Big-Caps

While the Dow Jones Industrial Average (DJIA) and S&P 500 Index (SPX) have struggled, the Russell 2000 Index (RUT) and S&P MidCap 400 Index (MID) have fared well

Senior Vice President of Research
Jun 8, 2015 at 9:01 AM
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 "… an area of risk that we continue to see is the positioning of volatility players … [B]ets on a decline in volatility among these participants are at the highest level since August 2014, which preceded a VIX spike. And even though the number of short VIX futures positions is on par with August 2014, hedging activity (via VIX call open interest) is not nearly as high at present. The implication is negative news could send short VIX futures traders covering, sending volatility sharply higher and stocks lower ... The risk identified above, plus the uncertainty related to this week's economic data and the European news, would suggest that you have a hedge -- VIX call or equity index put -- in place to protect long positions as we head into a potentially volatile week."
-- Monday Morning Outlook, June 1, 2015

It was only a couple of weeks ago that we observed that the routine selling that typically greeted moves above 18,000 and 2,100 on the Dow Jones Industrial Average (DJIA - 17,849.46) and S&P 500 Index (SPX - 2,092.83), respectively, was appearing to dissipate -- enhancing the possibility of a breakout. Moreover, some of the sentiment indicators that we track had reached negative extremes, such as the buy-to-open equity put/call volume ratio; but optimism was returning among option speculators, which we said was usually supportive of stocks in the short term. When we made these observations, the SPX was at 1,230 and the DJIA was at 18,232, heading into a holiday-shortened week.

However, stocks have traded lower since these comments, and after the DJIA and SPX stubbornly held round-number support during that holiday-shortened week in the final week of trading in May, Thursday's news that Greece would delay a debt payment due this past Friday, and aim to make all June debt payments at the end of the month, pushed stocks below these round-number levels. The "kick the can down the road" approach, the first time a country used this option since the early 1970s, didn't sit well with market participants, who appear to be getting frustrated with the never-ending uncertainty.

Additionally, bonds sold off both overseas and domestically, sending U.S. 10-year yields from 2.1% to 2.4% during the week. Friday's stronger-than-expected employment number marked the tail end of a dismal week for bonds, as market participants maneuvered once again for a higher interest rate environment.

The CBOE Volatility Index (VIX - 14.21) pushed higher above its 80-day moving average, which had capped advances since March. But on Friday morning, the VIX peaked at 15.65, which is in the area that marks half its 52-week high at 31.06, and 50% above its 52-week low at 10.28. We have observed on numerous occasions that the VIX has had a peculiar tendency to peak or trough at 50% or 100% above or below major inflection points. With that being said, there is an increased chance that the mean-reverting VIX put in a short-term top last week. If, however, the VIX takes out last week's highs over the course of this upcoming week, bulls should take caution.


Moreover, VIX futures did not pop and remained relatively tame, reducing any urgency for VIX futures players to cover short positions. But VIX futures call buyers were extremely busy last week, with 20-day cumulative buy-to-open call volume spiking to the highest level since this time last year. VIX call buying could be hedging activity related to the big VIX futures position that we discussed last week. Call buying on volatility futures creates a coincidental headwind for stocks and a future tailwind when unwound.  


From a technical perspective, while the DJIA dipped back below 18,000, loyal readers are well aware that a critical support zone for the past few months is the 17,820 area, which is its year-to-date (YTD) breakeven point. So, for now, the DJIA remains above support, although a break of this level could lead to a retest of the 2015 lows in the 17,200 area.

The SPX's move below the round 2,100 area was in part driven by huge put open interest at the 209 strike on the SPDR S&P 500 ETF Trust (SPY - 209.77) for weekly options that expired this past Friday. This strike is equivalent to SPX 2,090.  Big put open interest strikes like this can sometimes act as magnets when the market reacts negatively to headlines, particularly when expiration is right around the corner. A bright spot was the put-heavy 209 strike held Friday morning, as did SPY's 80-day moving average -- a trendline that has marked multiple bottoms over the years and in the recent past.

SPY 6/5 expiry -- Heavy put open interest acted as magnet, but held as support

DJIA (blue line is YTD return) -- potential support at 2014 close in 17,820 area

"Fund flows were defensive in the 5-day period ending May 20th with total net equity products in outflow. Investors instead moved to the sidelines with +$20.6 billion of cash being added to money market funds last week. There were some pockets of strength with international equity mandates experiencing their second largest inflow in 2015 of +$4.3 billion. However, this was not enough to balance out the -$5.4 billion withdrawal from domestic equity funds. Investors have now pulled -$38.6 billion from domestic equity funds so far in 2015 versus +$11.6 billion in contributions over the same period last year."
-- Investment Company Institute, June 1, 2015

The sentiment backdrop continues to be generally supportive, with the risk to the bull case being the "lower volatility ahead" bet among volatility players and the failure of the market to rally amid a decline in the equity-only, buy-to-open put/call volume ratio. This ratio is still in decline and could be supportive, but it is nearing a level that has preceded short-term market weakness.

But SPX component short interest is still just below three-year highs, as mutual fund investors pull cash out of domestic equity funds. Despite the retreat from equity mutual funds this year, the SPX has achieved all-time highs -- though it has been a struggle. Furthermore, other indexes have carved out respectable performances this year.  

For example, the Nasdaq Composite (COMP - 5,068.46) has remained above the key 5,000 level since mid-May. In fact, last week, the COMP came within 20 points of its all-time intraday high at 5,132, and has posted a respectable 7% gain this year.   

While large-cap stocks have struggled, small-caps and mid-caps have quietly posted respectable gains of roughly 5% through the first five months of the year, with the Russell 2000 Index (RUT - 1,261.01) and S&P MidCap 400 Index (MID - 1,526.62) still comfortably above former round-number resistance levels at 1,200 and 1,500, respectively.

If you are looking to reduce equity risk given the underlying concerns, avoid Europe -- where there is a lot of uncertainty, despite being a popular destination among many investors. And even though the DJIA and SPX are trading around support, you can reduce exposure in these underperforming areas of the market.  

Maintain your current allocation to outperforming areas, such as small-cap and mid-cap stocks. These areas have been relative-strength leaders in recent weeks and have rewarded investors this year, more so than their larger-cap counterparts.


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