Is More Whipsaw Price Action on Tap?

Examining the historical implications of the Financial Select Sector SPDR ETF (XLF) 'confirming' new highs in the Dow Jones Industrial Average (DJIA)

Senior Vice President of Research
Jun 15, 2015 at 8:50 AM
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"Trouble is brewing in an indicator measuring how many companies are keeping the stock market aloft in the U.S., just as the Standard & Poor's 500 Index threatens to give up gains for the year … About 59 percent of stocks closed above their 200-day moving averages at the end of last week, the lowest percentage in eight months … [A]ny sign that breadth is breaking down is viewed with concern by analysts who base trading decisions on charts."
-- Bloomberg, June 9, 2015

"Warning signals from a century-old stock-market analysis tool known as Dow Theory are sparking debate about whether stocks are headed for a fall … Dow Theory holds that any lasting rally to new highs in the Dow Jones Industrial Average must be accompanied by a new high in the Dow Jones Transportation Average -- the 20-stock index that tracks some of the largest U.S. airlines, railroads and trucking companies. When the transport average lags, it can presage broader stock declines."
-- The Wall Street Journal (subscription required), June 7, 2015



As the above excerpts might hint to you, in addition to macro uncertainties related to negotiations between Greece and its creditors and when (and if) the Fed will hike rates this year, certain technical indicators are making investors skittish. One such technical indicator is Dow Theory, which has been on the radar screen of many technicians for weeks, beginning when the Dow Jones Industrial Average (DJIA - 17,898.84) hit new 52-week (and all-time) highs last month.

Admittedly, the debate is intriguing, and lost in the discussion is the fact that financial stocks have been performing admirably during this period. In fact, last month, both the DJIA and the Financial Select Sector SPDR ETF (XLF - 25.04) made new 52-week highs, but as widely reported, the Dow Jones Transportation Average (DJT - 8,416.80) significantly lagged, worrying some technicians. Plus, the DJT was more than 5% below its 52-week high, even as the DJIA and XLF moved into 52-week-high territory.

Is the "non-confirmation" of the DJT worrisome? And what should we make of the strength in financials, even as transportation stocks lag? This stoked our curiosity, prompting us to look at the historical implications of transportations stocks and financial equities "confirming" and "not confirming" new highs in the DJIA.

Our study dates back to 2000, or roughly 15 years, and limits signals to a maximum of one every three months. A confirmation was quantified when the DJIA made a 52-week high and the XLF or DJT was trading within 5% of its 52-week high. Per the table below, we found that when the DJT confirms the DJIA 52-week high, the DJIA went on to underperform its expected return six months later. Moreover, the probability of the DJIA being positive six months later was slightly less than expected. 

Additionally, in the admittedly few instances when the DJT was more than 5% below its 52-week high, coincident with a new DJIA 52-week high, the DJIA actually experienced MUCH stronger returns than its typical six-month period. In fact, it was higher in all four instances! This data runs counter to the warnings we have seen in various publications and social media platforms.

During the past 15 years, we did find that confirmation and non-confirmation by the XLF have more relevance to underperformance or outperformance of the DJIA's expected returns, although by only the slightest of margins.  


"Perhaps more interesting is that the four-week moving average, or the mean percentage over the past four weeks, of AAII's measurement of optimism is now at its lowest level since the stock market's March 2009 bottom, according to Schaeffer's Investment Research … 'Significant outperformance usually follows an extreme in negative sentiment among retail investors,' said Todd Salamone, senior vice president of research at Schaeffer's."
-- The Wall Street Journal, June 12, 2015 

Whether it's the Fed, the economy, eurozone uncertainty, or various technical indicators that are "sounding alarm bells," there seems to be a fair amount of caution toward U.S. stocks. In fact, the $38.6 billion in outflows from domestic equity funds year-to-date compared to the $11.6 billion in inflows -- a statistic from Investment Company Institute that we highlighted last week -- confirms what we are seeing in the American Association of Individual Investors (AAII) data. 

It was my colleague, Schaeffer's Senior Quantitative Analyst Chris Prybal, who brought the AAII survey into focus this past week when he tweeted that the four-week bullish percentage in the weekly AAII survey had dropped to its lowest level since March 2009, which marked the end of the 2007-2009 bear market. 

The four-week bullish percentage, in fact, dropped to 24.9%, prompting us to study past instances when the four-week average dropped below 25%. The data is presented below, dates back to 1987, and reveals that signal returns compare quite favorably to the S&P 500 Index's (SPX  2,094.11) at-any-time returns.



The above tweets capture what we are observing with respect to price action during the current range. While we cannot say with any certainty how and when the European situation will resolve itself, if it is indeed like December 2012, we can expect various headlines regarding the progress -- or lack of progress -- in negotiations to continue to generate the whippy short-term price action we have all grown to hate.  

In December 2012, as budget negotiations took place with the potential of a "fiscal cliff" looming, the SPX traded in a range between 1,400 and 1,450 before exploding higher after it was evident that the fiscal cliff would be avoided. So, just as round numbers were in play in late 2012 (SPX 1,400, DJIA 13K, MID 1K, COMP 3K) as uncertainty persisted, we find ourselves in a similar situation at present -- only different round numbers under a different set of uncertainties.   

SPX daily Dec '12-Jan '13: Negative and positive headlines regarding budget negotiations made for whippy daily behavior until concrete plans were revealed in the eleventh hour and the SPX finally exploded higher 


In addition to Europe, the Fed is back in the spotlight this week, with a policy statement on Wednesday followed by a press briefing from Fed Chair Janet Yellen. Coincidentally, on Wednesday, June CBOE Market Volatility Index (VIX - 13.78) futures options expire, and Friday brings the expiration of standard June equity and index options, which can also bring unusual volatility around put-heavy strikes. 

With above said, the SPDR S&P 500 ETF (SPY - 210.01) finds itself in precarious position, trading around the put-heavy 210 strike. It is one of those situations in which a macro event (Europe, Fed) can drastically push the SPY in one direction or the other, which calls for exposure to both sides of the market amid the uncertainty this week. 

Sharper moves than usual can occur because those that sold portfolio insurance via SPY put options hedge themselves by shorting SPX futures. The closer to the put strike, or the further below the put strike, the more futures they must sell short. In situations wherein the SPY moves further above heavy put strikes, such as 210, those options become decreasingly sensitive to SPY moves, and the hedges are unwound via short covering, producing potentially powerful short-term rallies. But if the market reacts negatively to news, a move below or toward heavy put strikes increases the sensitivity of these options, forcing sellers of those put options to short more and more S&P futures in a process called "delta hedging," which exacerbates downside moves.  

So, while we remain bullish on the intermediate and longer term, keep in mind that the short term has heightened probabilities of sharp movement in either direction, so short-term traders should be positioned appropriately. 

SPY June Open Interest Configuration: With SPY trading around the put-heavy 210 strike amid the FOMC meeting and ongoing European negotiations, daily and intraday movement may be sharper than usual, with short covering one possibility, and another possibility being heavier put strikes acting as magnets on the downside 



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