Is the Glass Half Full for the S&P 500 Index?

The SPX rally may still have fuel, but peak call open interest could present a short-term challenge

Senior Vice President of Research
Apr 11, 2016 at 10:00 AM
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"It is the pessimism that looms that makes the present rally from the February lows different from the September-November double-digit percentage advance."

-- Monday Morning Outlook, March 28, 2016

"…whereas short covering was evident in the September-October rally that ended with a great big THUD, short interest on SPX component stocks has risen 3.6% since the February low, according to figures released last week and updated through mid-March."

-- Monday Morning Outlook, April 4, 2016

If you read Monday Morning Outlook from week to week, you fully understand why I was intrigued by Friday’s article in The Wall Street Journal, headlined, "Skeptics Argue Stock-Market Rally Fueled By Short Covering".

I found it interesting on the heels of past observations I have made in making comparisons to double-digit percentage rallies in the S&P 500 Index (SPX - 2,047.60) and the SPDR S&P ETF Trust (SPY - 204.49) in September-October 2015 and more recently, off the February lows. But, one contrast I have pointed out is the behavior of the shorts, as we detailed last week, suggesting there is more short-covering potential and skepticism greeting the current rally, relative to last fall's.

As I read this article, I was struck by the anecdotal pessimism from market watchers and analysts, which leads me to believe that this rally continues to be greeted by skeptics. Essentially, skepticism was expressed throughout the column, with analysts and market watchers suggesting short-covering rallies are not healthy and the short covering is largely complete.

Such sentiment contrasted with my two cents, in which I was quoted as saying, "There’s still a lot of short-covering potential. That means there could be a lot left in this rally."

So, what data are the skeptics looking at? The data point discussed in The Wall Street Journal article was the Commitment of Traders (CoT) report that is released each Friday. Specifically, the positioning of large speculators on E-mini SPX futures was put under the microscope, and indeed, the gap between the number of short positions and number of long positions has been closed during this rally.

The table below compares the net positioning of the large speculators from the late-September 2015 bottom to the November/December top with how the large speculators have behaved during the current rally.


On an absolute basis, there are 50% more net short positions at present, relative to the net short positions that existed when the shorts' contracts began to increase relative to long contracts in December 2015. From this perspective, "the glass is half full," as there is still room for shorts to close the gap between long and short contracts to a level that existed in December. Moreover, if the SPX breaks out to new highs, we wouldn’t be surprised if large speculators move back into a net long position, as many are likely anchoring to chart resistance from old highs.

But as the article suggested, the "glass is half empty" argument from the CoT data is that net short positions have been halved, suggesting short covering has occurred in this particular segment of the market. So, yes, there have been some elements of short covering among some market participants.

However, as we observed last week, whereas short covering occurred among equity players on SPX component stocks in the first month of the fall rally, short interest actually increased in the first month of the current rally. Short interest on SPX component stocks as of the end of March will be updated sometime this week.

So, while we acknowledge that short covering has occurred among some market participants, we maintain our stance that it is not to the extent that many think, and that there is still plenty of short-covering potential to support the market in the weeks ahead that could push the SPX to its former high, and perhaps beyond.

— Todd Salamone (@toddsalamone) April 8, 2016

4/8 $SPY open interest configuration - 205 & 206 call strikes potential capping action

Turning to the what to expect in the immediate days ahead, one would not be surprised if the market continues to trade in a range much like it has done for nearly a month. Since March 18, the first day the SPX moved above its 2015 close, price action has been noticeably choppy.

As you can see on the chart below, the 2,050 level has been like a magnet, as the SPX cannot sustain a move too far above or below this level. In the past, we have observed how these half-century marks on the SPX have proven to be significant, which is apparently the case now, with the 2,050 level being touched in the last four days of last week.

Since late March, the 2,043 and 2,070 levels have generally marked the peak and trough of the trading range. Coincidentally, or perhaps it's more than coincidence, the 2,043 zone is the site of the SPX’s 2015 close, while the last heavy call open interest in options expiring this past Friday and this coming Friday resided at the 207 strike on the SPY, which is roughly equivalent to SPX 2,070.



With April 8 expiration behind us, the April 15 SPY open interest configuration is immediately below. As we said last week, unlike January and February, put delta-hedge selling is not an immediate danger as we head into the week. But the peak call strike at 205 could present a challenge to push though.


"This equity rally has few believers … By FactSet’s count, first-quarter earnings are forecast to log a contraction of 8.5%, with energy companies garnering much of the blame…With pessimism, and short interest, so high, earnings surprising to the upside could prolong the recent rally."

-- The Wall Street Journal, April 7, 2016

Finally, earnings season officially launches this week, with Alcoa (AA) traditionally kicking off the season. Expectations are low, with analysts now expecting a contraction of 8.5%, down from expectations of being slightly positive December. From a contrarian standpoint, a lower earnings bar to hurdle is advantageous for bulls. Moreover, the market may be discounting better-than-expected reports, as it has "held" its own during a period in which forecasted earnings projections have been slashed. This is true for the energy group as well, as measured by the Energy Select Sector SPDR ETF (XLE), which is currently trading at its December levels. This is the group that has led forecasters to revise earnings downward.

Above said, the earnings calendar is light, and will heat up as we approach the end of the month and the beginning of May. Therefore, if earnings act as the next market catalyst, trading-range behavior may take hold through the end of this month.

Read More:

Indicator Of The Week: What Happens After A Big Quarterly Comeback?

The Week Ahead: Alcoa Inc (AA), Banks Kick Off Earnings Season

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