Why We're Vulnerable to Even More Volatility

More volatility could be in store for the stock market, as major indices fell below vital levels last week

Senior Vice President of Research
Feb 8, 2016 at 9:10 AM
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"The bottom line is that short-term negative sentiment appears to have run its course, and with multiple indexes holding at longer-term support -- recovering from an apparent sell-off exaggerated by January expiration -- equity markets should advance in the coming weeks … If you have an investor mindset, continue to concentrate your holdings in larger-cap names, and avoid small-cap stocks. The Russell 2000 Index (RUT) -- a small-cap benchmark -- continues to hold the 1,000 millennium mark, but remains lower by close to 10% year-to-date, while the SPY is off only about half as much."

-- Monday Morning Outlook, February 1, 2016

After multiple indices closed January above round-number and longer-term moving average support following intra-month breaks, the first week of February picked up where the month of January left off -- with losses. The main catalyst was Friday's employment number, which was significantly below expectations. And just as it appeared that short-term traders could be in the early stages of taking on a more constructive view of the market, pessimism returned, pushing equity benchmarks back below support.

The most notable technical breakdown last week was in the PowerShares QQQ Trust ETF Series (QQQ - 98.12). The exchange-traded fund (ETF) declined significantly below the round $100 level, its first close below the century mark since last September. During last month's pullback, the QQQ experienced an intraday move below $100, but closed back above it. Also on Friday, the QQQ declined below its negative 10% year-to-date return.


"More importantly, the SPDR S&P 500 ETF Trust (SPY) closed January above its 36-month (three-year) moving average, which we viewed as a potential technical marker that the worst is over, at least for the time being."

-- Monday Morning Outlook, February 1, 2016

The SPDR S&P 500 ETF Trust (SPY - 187.95) was not spared from last week's selling, as it fell back below its 36-month moving average and the round 1,900 mark. Meanwhile, the 10-day, equity-only, buy-to-open put/call volume ratio moved higher once again, but it is moving higher from a relatively high level. Our thinking is that if this ratio turns higher from a high level, the downside could be limited. In fact, the last time this occurred was late December, and the S&P 500 Index (SPX - 1,880.05) retreated about 2.5% within one week. See the chart immediately below, which goes back to July 2015, to view what is happening currently with this ratio and for a glimpse into late September.


The SPY's price action looks similar to the September period (circled in the chart immediately below). In fact, after the put/call ratio turned up from an already high level, it preceded a retest of the previous closing low. If the SPY behaves similarly, the Jan. 20 close at $185 would be the immediate target. From a sentiment perspective, a relatively shallow decline from January's close would make sense, as there is not as much optimism to wash out.


HOWEVER, unlike late September, we are now only nine trading days away from a standard options expiration. And as we alerted you last month, the week before standard option expiration is the window when option mechanics can begin to influence the magnitude of market moves.

Specifically, heavy put strikes below the market, especially in the wake of a negative catalyst (Friday's employment report), can act as magnets, as sellers of those puts look to hedge their positions by shorting S&P futures as the options become more and more sensitive to the SPY's downward movement. Selling will therefore beget further selling, until put sellers are fully hedged. The bigger the put open interest, the more of a magnetic effect, as long as the underlying is somewhere in the vicinity of that strike.

The below open interest configuration of the SPY combines the February 12 weekly options with the standard February 19 options. Note the heavy put open interest at the 180, 183, 185 and 187 strikes. Unfortunately for bulls, this would suggest downside risk during the next two weeks to the $180 level, which would push the SPY significantly below the $185 area that we mentioned above.



The bottom line is even after Friday's sell-off, the market is vulnerable to another period of heightened volatility, following a negative reaction to Friday's employment data, standard expiration less than two weeks away, and the CBOE Market Volatility Index (VIX - 23.38) pushing higher near the 23.90 area -- double last year's low. Our message remains the same: continue to avoid small-cap stocks as a way of reducing your overall equity allocation during this period, and consider puts on the iShares Russell 2000 Index (IWM - 98.00) as a means for hedging your long positions.

Continue Reading: 

Indicator of the Week: Implications of a Volatile SPX

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