2 Risks to the Bullish Case

Equity ETF option volume data suggests that market movers are no longer in accumulation mode

Senior Vice President of Research
Nov 16, 2015 at 9:29 AM
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"... With multiple indexes battling round numbers that defined the highs earlier this year, but year-to-date breakeven levels acting as support, a consolidation of last month's gains could be in store for the near term. But sentiment-based indicators are currently suggesting that a rally through chart and round-number resistance levels is a growing possibility in the weeks and months ahead."
-- Monday Morning Outlook, November 9, 2015

Last week, we observed that the key equity benchmarks we track -- such as the S&P 500 Index (SPX - 2,023.04), Dow Jones Industrial Average (DJIA - 17,245.24), and Russell 2000 Index (RUT - 1,146.55) -- were simultaneously batting round-number resistance levels. Moreover, the RUT was situated just a few points below its 2014 close of 1,204. A pullback occurred, and to some, this may not have been a major surprise. After all, RUT 1,200 posed a major speed bump last year, and the DJIA and SPX have been unstable when trading above the 18,000 and 2,100 levels this year. The decline pushed many benchmarks back below their year-to-date breakeven levels -- including the SPX, which fell below its year-to-date breakeven at 2,059 on Thursday. 

Last week's pullback was admittedly deeper than we anticipated in our prior commentary, with the SPX trading not only below its 2014 close and the 2,050 half-century mark, but the Nasdaq Composite (COMP - 4,927.88) also trading significantly back below the 5,000 millennium zone. Moreover, the RUT is now below October resistance at 1,165, which we expected could be supportive, following its failure at 1,200 and its 2014 close early last week.

For the most part, in 2015, there has been a tendency for round numbers and YTD breakeven levels to act as magnets, as benchmarks have trouble sustaining moves above and below these levels. The way it stands now, round-number SPX 2,000 looks like it will be revisited.

We mentioned last week that we view pullbacks as buying opportunities, given evidence that a multi-year extreme in pessimism is being unwound. This became more evident with the Oct. 31 short interest data that was released early last week. Per my comment on Twitter, posted above, short interest on SPX component names dropped 5.4% in the final two weeks of October, a period in which the index rose 2.8%.

As you can see on the graph immediately below, it was a sharp drop in short interest, indicating pessimists were in capitulation mode. In recent history, dramatic declines in short interest from high relative levels have been followed by short-covering rallies that eventually take out previous resistance levels. History repeating itself is not a guarantee, but bulls have the prospect of more short covering working in their favor.


The graph below zooms in during the past six months to give you a glimpse as to where the SPX was trading when the most recent spike in SPX component short interest occurred. This is useful information so one can get an idea as to whether or not the shorts are in a winning or losing position. It appears a majority of the recent short positions were put on when the SPX was between 1,900 and 2,000. Therefore, it is apparent that many of those who recently added short positions are still sitting on losing positions, and this is a potential source of support for the market if they use pullbacks to cut losses on losing short trades. However, there is a caveat to this short-interest observation, which I discuss immediately below.    


There are two developments in the options market that we view as risks to the bull case. The first is that deep-pocketed market participants, who are likely to buy puts on index or exchange-traded equity funds as a hedge during times of increasing market exposure, appear to be shying away from committing dollars to the market on retests of the highs. You can see this below in the recent behavior of the combined buy-to-open (BTO) put/call volume ratio on the SPX, SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 ETF (IWM), and PowerShares QQQ Trust (QQQ) options.

If the ratio in the chart below is rising, it is usually a sign that stocks are under accumulation -- thus, an increasing number of puts are purchased to open relative to calls. But put volume relative to call volume will typically dry up if these players are not in accumulation mode, and BTO put volume has decreased by 14% compared to two week ago.

Note that this ratio turned sharply lower as the market approached its old highs, indicative of fund managers suddenly losing interest in putting their heavy cash levels to work. Bulls would like to see this particular BTO put/call volume ratio turn higher again, as evidence that those with the muscle to move the market are in an accumulation phase on this pullback. While the current direction of this ratio is a threat to the bullish case, the good news is that it is back at levels where it has turned higher, from a historical perspective. We will monitor this indicator closely in the days ahead.


Also worth noting is the reversal in the direction of the 10-day BTO equity-only put/call volume ratio, which was heading lower following a multi-year pessimistic extreme among option speculators. Last Wednesday, this ratio ticked higher from 0.62 to 0.65, just ahead of Thursday's stock market rout. This turn in the ratio's direction presents another risk to the bullish case.


"… bears are hoping that the 2011 pattern continues, as November 2011 was merciless on the bulls. In fact, the rally back above the previous year's close in 2011 marked a short-term top before a short period of choppy trading, followed by a near-10% decline that occurred over a two-week period, ending on Nov. 23. From the perspective of 2015 continuing to follow 2011's price action, bulls should be on guard for potential instability in the market following the SPX's move back above its 2014 close. Moreover, with the Nasdaq Composite (COMP - 5,031.86) advancing back above the round 5,000 millennium area, some investors might use this as a cue to unload some long positions."
-- Monday Morning Outlook, October 26, 2015

If major equity benchmarks stage an extended decline beneath the key technical levels breached amid last week's rout, the options crowd will likely see a growing number of put buyers, which coincidentally is a market headwind. Moreover, the shorts would likely have increasing confidence to stick with those losing short positions we discussed earlier, removing a potential supportive factor. Such a scenario would put the bears back in the driver's seat, at least for the time being, and enhance the odds of 2015 continuing to repeat the pattern of 2011 -- specifically, a significant pullback in November.

While the SPX's October rally back above its 2014 close lasted longer this year relative to the rally back above its YTD breakeven in October 2011, which we observed last week, the early November peaks in both years look eerily similar. That said, if this pullback continues, and if the 2015 pattern continues to echo 2011, one would not expect the 2015 lows to be taken out.

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