The Only Reason to Buy Equity Index and ETF Puts Right Now

Heading into the historically bearish month of August, the Nasdaq Composite (COMP) has been outperforming and sits north of potential support

Senior Vice President of Research
Aug 1, 2016 at 8:15 AM
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"From a short-term perspective, there are levels that could act as resistance on several benchmarks that we track. The iShares Russell 2000 ETF (IWM - 119.70) is bumping up against a round number that equates to roughly 1,200 on the Russell 2000 Index (RUT - 1,205.31) … [T]he COMP has run into a speed bump of its own, as the 12-month rolling breakeven return has acted as resistance on rallies since March. Through mid-August, the area between 5,020-5,170 represents its rolling 12-month breakeven … Don't be surprised to see a consolidation or a modest pullback in the days ahead. That said, the  risk-reward continues to favor the bulls when looking out over the course of the next year."

-- Monday Morning Outlook, July 18, 2016

After a sharp advance in equities that began in late June, we advised in mid-July that many benchmarks were running into potential resistance zones. A short-term consolidation phase was one possibility that we anticipated, which is what has occurred on equity benchmarks such as the S&P 500 Index (SPX - 2,173.60) and Russell 2000 Index (RUT - 1,219.94).  

From a bull’s perspective, the good news is that these resistance areas have not been followed by massive selling, even though events such as earnings and a Federal Open Market Committee (FOMC) meeting last week could have served as potential catalysts. From a sentiment perspective, earnings expectations were already low heading into earnings season, reducing the probability of a plethora of negative surprises. And the Fed, as expected, did not raise rates or deliver commentary about the economy that deviated strongly from expectations.

So the bulls remain in control. In fact, the SPX is trading above the 2,148-2,150 area. The 2,148 level represents double its five-year low and -- as we mentioned two weeks ago -- half-century marks on this index have historically represented major pivot points or hesitation areas within a longer-term trend. 

Meanwhile, the RUT, which is up more than 20% since its February low, took out the round 1,200 level before consolidating. As you can see on the chart below, this round number turned back rallies late last year. Note, however, that the 12-month rolling breakeven acted as a resistance level last week.  As we head into the first week of trading in August, the 12-month rolling breakeven on the RUT is between 1,230 and 1,238 -- suggesting minimal upside in the days ahead, if indeed this level continues to act as resistance. 


From a longer-term perspective, and as we mentioned in mid-July, the inverse "head and shoulders" technical breakout above 1,200 implies an expected move to about 1,450 in the next 10-12 months. From a sentiment perspective, short covering could be one driver.  

Note on the chart immediately below that after a multi-year peak in short interest on RUT component stocks, the shorts have been in covering mode, which is supportive. Plus, the shorts have a long way to go in terms of covering their positions before total short interest gets to the levels of 2012 and 2013.



"[W]e will turn to a couple of benchmarks that have been noticeable underperformers during this long lull in stocks. Below, I feature a chart of one of those benchmarks, the Nasdaq Composite (COMP - 5,029.58). Notice the bullish inverse ‘head and shoulders’ formation that no one is discussing on social media … The neckline is a trendline connecting lower highs since the July 2015 high. This neckline is currently situated around the round 5,000 millennium level, with the head sitting considerably south, around 4,250. With the difference between the head and neckline representing 750 points, and this pattern taking roughly a year to develop, one could target a 15% advance to 5,750 in the next 12 months."

-- Monday Morning Outlook, July 18, 2016 

Arguably, poor earnings reactions among energy and consumer staples names have weighed on indexes such as the SPX and RUT. However, a benchmark that has continued to follow through with sharp gains that began in late June is the Nasdaq Composite (COMP - 5,162.13), thanks to positive earnings reactions from the likes of Microsoft Corporation (NASDAQ:MSFT), QUALCOMM, Inc. (NASDAQ:QCOM), eBay Inc (NASDAQ:EBAY), Texas Instruments Incorporated (NASDAQ:TXN), Apple Inc. (NASDAQ:AAPL), Alphabet Inc (NASDAQ:GOOGL), and, Inc. (NASDAQ:AMZN). After multiple failed attempts to take out its year-over-year (YOY) breakeven level, the COMP spent the last week trading in the green on both a year-to-date (YTD) and 12-month basis.

There is work to be done, as 5,231.95 represents the COMP's all-time high in July 2015. With 5,007 -- its YTD breakeven level -- situated just above the round 5,000 millennium, we figure this to be a strong area of support in the event that this benchmark cools in the days ahead. As we said two weeks ago, a move up to 5,750 is expected after the COMP's bullish breakout.


Perhaps fittingly, energy stocks saw the biggest increase in sector weightings among long momentum investors in the first half of the year, while technology names saw the biggest decrease in their weightings.

Short-term risks include the fact that we are entering a period of negative seasonality in the months of August and September (see the table immediately below). August, in fact, has generated the worst average returns during the past 20 years. But if you take a "glass half full" perspective, just over half of these returns have been positive.


From a sentiment perspective, a risk is the weekly National Association of Active Investment Managers (NAAIM) survey last week showed the highest allocation to equities this year, and the third-highest reading since 2013 (see chart below). The last time the reading was this high, in May 2015, equities chopped around at their all-time highs for months before taking a spill in the summer months, as advisors unwound their bullish positions. So far, there is not evidence of unwinding of these positions, but this is something we’ll keep an eye on in the weeks ahead.



If the risks we discussed are enough to keep you up at night, consider hedging your long portfolio. Portfolio protection is cheap, with the CBOE Volatility Index (VIX - 11.87) trading around multi-year lows. Equity index and exchange-traded fund (ETF) puts should be bought only as a hedge to a long portfolio. While it is true that VIX spikes and equity corrections tend to occur after periods of low volatility, it is also true that volatility tends to remain low far longer than many anticipate. Therefore, many miss out on big stock gains when they "mistime" the next volatility pop.

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