The Bullish Small-Cap Indicator Signaling Long-Term Strength

U.S. stocks rallied after last week's favorable central bank outcomes, sending the small-cap ETF to an annual high

Senior Vice President of Research
Sep 26, 2016 at 9:20 AM
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"…Another volatility pop would likely push the VIX into the range between 26-30. If such a spike occurs, it would likely happen after the expiration of standard September options on VIX futures, which occurs Wednesday.…Most of the time, a large majority of VIX call options expire worthless…sellers of VIX call options will be especially happy if the Wednesday morning settlement price is below 17.

“If there is good news in the SPY open interest configuration through the end of the month, it is that there is little in the way of long positions being unwound due to overhead calls in the immediate vicinity of the SPY, and there is the potential for a gradual unwinding of short positions related to expiring put open interest in the absence of a negative surprise. In other words, the put-heavy 210 and 212 strikes will either be a friend or a foe amid the macro events that I have discussed."

-- Monday Morning Outlook, September 19, 2016


Key central banker meetings in Japan and the United States took place last week, with the Bank of Japan switching its policy to target the yield curve in an effort to boost bank lending margins and spark more lending and economic growth. Meanwhile, in the U.S., the Federal Open Market Committee (FOMC) met expectations by not boosting rates, although three officials dissented from this decision -- the most dissension in two years -- raising expectations for a December rate hike. At the same time, the FOMC projected a slower pace for rate hikes in the future. Market participants responded favorably, bidding equities higher as volatility indexes, such as the CBOE Volatility Index (VIX - 12.29), declined sharply.

So, while we noted last week that the risk of a volatility pop was higher than usual, favorable central bank outcomes did not generate the need for large speculators to engage in massive short covering of volatility futures. For those who follow our weekly commentary, we have observed that large speculators, per the weekly Commitments of Traders (CoT) reports, are (and remain) in an extreme short position on VIX futures, and historically, have been notably wrong at key turning points in volatility direction. We suspect that the large short position will persist with Fed uncertainty removed for the time being.

The perceived favorable outcome of the central bank meetings unleashed an impressive rally in stocks. As we mentioned last week, with big put open interest in weekly (9/23) and quarterly (9/30) options on the SPDR S&P 500 ETF Trust (SPY - 215.99), we suspected positioning related to this open interest might exert some influence. This time, it proved "friendly." Specifically, short covering related to the big put open interest at the SPY 210, 212, and 215 strikes may have added extra support during the Wednesday and Thursday rally, as short positions were unwound while the SPY lifted further above these strikes. Short covering likely dried up as the SPY moved significantly above the 215 strike, setting up Friday's retreat.

There are other macro events on the horizon, including this week's informal Organization of the Petroleum Exporting Countries (OPEC) gathering in Algeria. A production freeze likely won't be implemented at this meeting, as it seems to be more exploratory in nature. If there is a consensus reached among ministers that a production freeze should occur, an extraordinary meeting will be called. Just as market watchers did not expect a rate hike, they do not anticipate a production freeze from the cartel.

From an options standpoint, SPY options sellers would like to see a pin at the 217 strike, where there is a healthy amount of put and call open interest. The 217 strike is also sandwiched between heavy out-of-the-money call open interest overhead, and heavy put open interest at strikes below. If the SPY moves higher, be careful about chasing the SPY at the $220 level, as there is a "call wall" at the 220 strike. It has been problematic in recent months for the SPY to take out heavy call strikes.

From a chart perspective, we come into the week smack in the middle of the range explored since the SPY broke out above its June closing high at $212.37. This level acted as support on the pullback in the days preceding last week’s FOMC meeting, while the August highs were just short of the round 220 strike. Moreover, note how the SPY traded in a narrow range for a two- to three-week period in July around the area of its Friday close. From a chart point of view, a case can be made that the SPY remains directionless, with U.S. elections only weeks away and visible boundaries above and below current levels.

SPY Open Interest Configuration September 23



Small caps, as measured by the iShares Russell 2000 ETF (IWM - 124.81) -- roughly one-tenth the value of the Russell 2000 Index (RUT - 1,254.62) -- are showing more promise than their larger-cap counterparts, as they appear to be "more directionally established," almost doubling the return of the SPY this year.

Moreover, I noticed that the Schaeffer’s open interest put/call ratio (SOIR) on the IWM is above 4.0 -- an extreme high. In fact, total IWM call open interest is at an extreme low, looking back over the past year. I was curious as to the implications of the IWM SOIR moving above 4.0, so I called upon Schaeffer's Senior Quantitative Analyst Rocky White to research the historical consequences.

As you can see in the table below, which covers data since 2010, the short-term (two-week) returns are impressive only if you are looking to play a move to the downside. However, the longer-term implications -- looking out one month and beyond -- are much more favorable, and support the bullish technical pattern we observed on small caps in early August. Below the table, I go more in depth on this pattern, as it is worthy of a follow-up.

IWM Returns Since 2010

"Meanwhile, the RUT, which is up more than 20% since its February low, took out the round 1,200 level before consolidating…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."

-- Monday Morning Outlook, August 1, 2016

In early August, we discussed the RUT’s breakout above the round 1,200 level -- the neckline of a bullish "head and shoulders" pattern that no one was talking about, which as contrarians we view bullishly. The RUT 1,200 level corresponds with the $120 level on the IWM chart below. Before the FOMC meeting, the IWM pulled back to retest the neckline, or former resistance, in the $120 zone. The retest has been quickly followed by a 52-week high and a weekly close above the round 10% year-to-date return level at $123.88, which is also the site of last month's close.

As such, our target based on the bullish "head and shoulders" pattern remains 1,450 on the RUT, or $145 on the IWM, by June-to-August 2017. Indeed, we have noticed short covering on components of the RUT and IWM, and more short covering could occur as short interest related to heavy put open interest is unwound, barring such put open interest below the market acting as magnets in the weeks and months ahead.

IWM Daily Chart September 23

Continue reading:

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The Week Ahead: Fed Presidents Take the Mic; GDP in Focus

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