5 Stumbling Blocks to Watch for Stocks

"After nine consecutive losing days for the S&P 500 Index (SPX - 2,164.45), we kicked off last week with a change in trend and a strong surge higher on Monday... U.S. equities surged dramatically higher through the end of the week... In fact, the Dow is now trading at an all-time high."
-- Monday Morning Outlook, November 14, 2016

For anyone following the mean-reverting nature of the stock market during the past several months, it is likely of little surprise that, following the S&P 500 Index's (SPX - 2,181.90) nine-day losing streak to end October and begin November, the Dow Jones Industrial Average (DJIA - 18,867.93) answered with a seven-day winning streak. The Dow's string of consecutive daily wins began on Nov. 7, and the index concluded last week's trading with gains in eight of the past 10 trading days. The bulls won, as gains from the winning streak proved to be more powerful than the declines during the losing streak.

"...our Senior V.P. of Research Todd Salamone outlined in last week's column several reasons why any post-election decline would likely bottom out in very short order. Unlike the action ahead of the Brexit vote, investors were buying SPDR S&P 500 ETF Trust (SPY - 216.42) puts to hedge at their highest rate in 15 months. In addition, we saw heavy CBOE Volatility Index (VIX - 15.39) call activity ahead of the election, which is also a popular hedge against market panic."
-- Monday Morning Outlook, November 14, 2016

As we had discussed in prior weeks, there was a lot of caution heading into the U.S. presidential election -- significantly more so than the uncertainty leading into the "Brexit" referendum in late June. With that said, standard November options expiration passed last week, and with it the expiration of more than 4.5 million outstanding SPDR S&P 500 ETF (SPY - 218.50) puts, or roughly one-quarter of the 17.4 million outstanding puts going into Friday's expiration.

One might argue that, after some election uncertainty was removed, short covering related to huge SPY put open interest contributed in part to the "V"-type rally from support at its 200-day moving average and its year-over-year breakeven level. And if you were paying attention to the overnight trading on Election Day, S&P futures bottomed at the equivalent of SPY 202, just above the put-heavy 200 strike. So, just as these heavy put open interest strikes may have acted as magnets during the decline, they also had a positive impact on equities after the worst was over.

As we look ahead, we find that, like November, standard December options are home to over 4 million put contracts. Perhaps the heavy put open interest in the standard December options expiration series echoes Fed caution, with fed futures currently indicating a 95% chance of a rate hike when the Federal Open Market Committee (FOMC) meeting concludes on Dec. 14 -- just two days before front-month expiration. However, such a move should not come as a major surprise to investors, after Fed Chair Janet Yellen and Boston Fed President Eric Rosengren, another voting FOMC member, indicated last week that a December rate hike is likely.

Most of the SPY options action since the election has been at the 200, 210, and 215 strikes, where about 200,000 put contracts have been added. That said, there are heavy put open interest strikes significantly below Friday's SPY close, suggesting short covering related to those puts has likely already occurred in the past few weeks. This implies that if we experience additional gains in the weeks ahead, they won't be as powerful as those off the pre-election bottom, because short covering won't be as predominant. In fact, a risk is that these strikes act as magnets, if a negative surprise emerges and the ball gets rolling to the downside once again.

There is a lot to like about the technical backdrop. Per the chart below, the SPX has rallied powerfully from support at its 200-day moving average and year-over-year breakeven toward the area of its all-time highs. Moreover, when it moved above the 2,040 area, it completed a breakout from a bullish falling wedge pattern.

Additionally, small-cap and mid-cap names displayed leadership off the bottom. The iShares Russell 2000 ETF (IWM - 130.99) troughed at the convergence of its 200-day and 320-day moving averages. In fact, it finally made a clear break above $123.88, which represents a 10% year-to-date gain. Since August, this area had capped rallies. The exchange-traded fund (ETF) achieved new all-time highs in the process, taking out its June 2015 high at $129.10. For what it's worth, the IWM bottomed earlier in the year when it was 15% below its 2015 close. Now, it is 15% above the 2015 close.

While the technical backdrop favors the bulls, beware that buyers have been quicker to embrace pullbacks than to make purchases near highs (or much beyond previous highs). So it wouldn't be a huge surprise -- especially if short covering wanes, like we anticipate -- that we consolidate or experience a slight pullback in the weeks ahead.

Also, beware that multiple indexes are trading around or just above round-number levels, which tend to act as speed bumps. This occurs as many equity benchmarks are in or near overbought levels, as measured by the 14-day Relative Strength Index (RSI). Specifically:

1. The SPX's high last week was around 2,190, just below its August high and the round 2,200 level. SPX 2,200 equates to SPY 220, where there is heavy call open interest in the December series that could act as resistance.


2. The Russell 2000 Index (RUT - 1,315.64) is trading at 1,315. In July, after it hit 1,200, it both peaked and troughed 3% above and below this level in a sideways trading pattern that lasted into this month.


3. The S&P MidCap 400 Index (MID - 1,605.93) closed just above the round 1,600 level. After the MID took out 1,500 in early June, it remained above this level for about a week before experiencing a 7% pullback from its 1,525 peak into the Brexit lows.


4. The Nasdaq Composite (COMP - 5,321.51) is trading just above the 5,300 century mark, an area that has capped rallies since it first began flirting with this level in August.


5. Finally, the DJIA is less than 1% away from the 19,000 millennium level. There is certainly room to move higher before the average touches 19,000 for the first time ever. That said, our research indicates that since Dow 10,000, the DJIA typically experiences underperformance relative to its norm after a touch of a new millennium level.

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