7 Signs Caution Reigns Supreme

The cautious outlook seen from investors around Wall Street could help stocks move higher in the intermediate-to-long term

Senior Vice President of Research
May 23, 2016 at 9:53 AM
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"… [B]ulls can hang their hats on the fact that the SPY enters this week above its 2015 close, as the unpopular but significant 320-day moving average provides support, coincidentally situated just above the important 204 strike …Like last week, the 204 and 205 strikes are home to fairly heavy put open interest. Given the heavy call open interest at the 205 strike, it would not be a huge surprise if the SPY continues to waffle back and forth above and below this strike."

-- Monday Morning Outlook, May 16, 2016

Last week's expiration week played out pretty much as we expected. After hawkish commentary by a few Fed governors, the SPDR S&P 500 ETF Trust (SPY - 205.49) experienced a break of the 204 strike intraday on Thursday. It traded as low as 203, where there was a build of puts during the week, and the expiration-week magnet at this strike was in effect. However, the SPY never closed below the 204 strike, nor its year-to-date breakeven mark of $203.87. And, as I expected, the 205 strike was in play most of the week, with the SPY crossing this level four of the five days, as the sideways grind continues.

SPY Chart May 16-20

SPY Open Interest

"A potential scenario is the SPY entering a short-term choppy, directionless phase, in which the VIX finds itself swinging between the 14 and 16 levels. Such a scenario would make selling option premium, or concentrating on extremely short-term option-buying trades, attractive."

-- Monday Morning Outlook, May 9, 2016

Meanwhile, the CBOE Market Volatility Index (VIX - 16.22) continues to chop around between the 14 and 16 areas, which respectively represent half its closing and intraday highs in 2016. In fact, just as there was a fake-out move below 14.07 two weeks ago, Thursday's close above 16.05 proved to be a fake-out move as well, as the VIX immediately moved back below this level Friday morning. By Friday's close, the VIX found itself in a familiar place, situated between 14.07 and 16.05 for the 15th time in the past 17 trading sessions.

As we have cautioned you during the past couple of weeks, a risk to the bullish case is the positioning of large speculators on VIX futures, who have an extreme net short position. This group has been wrongly positioned ahead of major VIX moves. Therefore, a major pop higher would prove these speculators wrong again, and rising volatility would likely be coincident with lower stock prices.

Multiple VIX closes above 16.05 or a close above last week's closing high of 16.33 would likely be a hint toward higher volatility ahead. The risk is short covering among VIX futures players inducing higher volatility, therefore creating a headwind for stocks.

In fact, many VIX pops have occurred in the days immediately following a standard monthly expiration of options on VIX futures, when call open interest is low and many short VIX futures traders are not hedged against upside moves in volatility. Expiration of VIX options occurred last Wednesday, and 41% of VIX call open interest was tied up in the May expiration series, 97% of which expired worthless. VIX call open interest is now just over 4 million contracts, putting it in the 23rd percentile from the past 52 weeks.

So, with VIX call open interest relatively low amid an extreme short position in VIX futures, beware that in the event of negative catalyst we are at greater risk of a volatility pop, as VIX call hedgers are usually slow to replace expired call positions.

Daily VIX Chart May 23

As we stated last week, when you look outside of volatility expectations to gauge market sentiment, there are more signs of caution, indicating that not all market participants are in agreement with respect to direction of the next major move in stocks. In fact, such differences in opinion is what might keep both rallies and declines in check in the coming weeks. The following quotes and tweets sum up the caution that we are seeing outside the volatility asset class world.

As you can see below, whether it is retail investor, option player, traditional fund manager or hedge fund manager viewing the market through a technical or fundamental lens, there appears to be a decent amount of caution, especially with the S&P 500 Index (SPX - 2,052.32) not too far from its all-time high. It may take a short-term decline to wash out the optimism among volatility speculators, but from an intermediate to long-term perspective, we continue to like the prospects for the broader market from a sentiment and technical standpoint.

7 Signs Caution Reigns Supreme Among a Majority of Market Participants

"Investors have yanked a net $67.7 billion from U.S. equity mutual funds and exchange-traded funds so far this year through the week ended May 11, according to data from Thomson Reuters Lipper. … The S&P 500 has a trailing price/earnings ratio of 18.5, higher than its 10-year average of 15.8, according to FactSet."

-- The Wall Street Journal, May 18, 2016

"Fund managers cash levels at the equity low in February were 5.6%, the highest since the post-9/11 panic in November 2001, and lower than at any time during the 2008-09 bear market. This was an extreme that has normally been very bullish for equities. Remarkably, with the SPX now 15% higher, cash in May (5.5%) is still near the highs."

-- The Fat Pitch blog, May 18, 2016

"Goldman Sachs downgraded equities to 'neutral' over a 12-month time-frame on growth and valuation concerns…"

-- Reuters, May 18, 2016

"The Nasdaq Composite Index's 50-day moving average on Thursday climbed above its 200-day average. That's often thought to be a bullish sign. ... This time around, the Nasdaq's 50-day topping the 200 comes alongside a variety of bearish signals."

-- The Wall Street Journal, May 20, 2016

"The 50 largest hedge funds decreased their equity exposure by 6.9% in Q1 2016. This marks the second consecutive quarter in which equity exposure declined."

-- FactSet Insight, May 19, 2016

BTO putcall ratio May 23

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