This Market's Most Important Data Point

The Trump rally has reignited, but the stock market may be running out of short covering fuel

Senior Vice President of Research
Jan 30, 2017 at 8:38 AM
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"...with Trump and Yellen making headlines last week, the (SPX) chart below bears the footprints of both figures... with the early November to mid-December Trump rally followed by the 'Fed stall' that occurred after hints of more aggressive rate hikes in 2017...

 "... to the extent that there is an extreme VIX futures short position among large speculators, some of which are no longer hedged, the risk of a volatility pop has increased. But, per the second CoT chart below, note how SPX large speculators are in an extreme net short position, too -- which is counterintuitive, because if you are positioned for stocks to go lower, you are likely expecting volatility to move higher... Piecing this together, the best conclusion is that stocks do not have the same magnitude of downside risk at the moment relative to the upside volatility risk... many market participants will be intensely in tune with the president's actions in his first 100 days in office. So, with an upcoming FOMC meeting only eight trading days away, a volatility-type hedge could be warranted."

    -- Monday Morning Outlook, January 23, 2017

Just one work day after President Trump took office, traders rejuvenated his post-election rally. Large speculators -- which some think are the hedge funds -- were on the wrong side of the equity breakout, per the extreme short S&P futures position that we noted last week; meanwhile, large speculators who were short CBOE Volatility Index (VIX - 10.58) futures were correctly positioned, with the February VIX futures contract moving from the 15 area to the 14 level.

With stocks rallying post-election, then stalling after the Federal Open Market Committee (FOMC) rate-hike and forecast adjustment in mid-December, and now rallying again post-inauguration (and coincident with several executive orders on Trump's first official full day in office), the "Trump rally" could be back, as market participants focus on the administration's moves in the first 100 days in office.

The next FOMC meeting, scheduled for Jan. 31-Feb. 1, comes just days after the inauguration -- a much shorter window than that which occurred between the elections and the December meeting. With only a 4% chance of a rate hike, and no press conference or summary of economic projections scheduled post-meeting, this Fed decision may not have the impact of December's meeting -- implying all eyes will be on the presidential administration up until at least the March 14-15 meeting, when the Fed will deliver new economic projections.

spx daily chart since october

So after the S&P 500 Index (SPX - 2,294.69) chopped just above the 2,250 half-century mark for just over one month, with a few pullbacks to this level, it finally broke out above its narrow range last week. The SPX distanced itself from the half-century mark and secured four consecutive closes above the Dec. 13 close of 2,271.72, which had acted as resistance during the narrow range.

And in case you missed it, which I highly doubt, the Dow Jones Industrial Average (DJIA - 20,093.78) finally moved above 20,000, after falling short of this level around the time of the December FOMC meeting.

Round numbers on three equity benchmarks are now in play: SPX 2,300; S&P MidCap 400 Index (MID - 1,696.67) 1,700; and Dow 20,000. While the MID peaked above December resistance at 1,700 for the first time ever last week, it closed below this century mark. Meanwhile, whereas the SPX, MID, and DJIA achieved new all-time highs last week, small-caps did not participate, as the Russell 2000 Index (RUT - 1,370.70) failed to overtake its December and early January high at 1,390. And even if the RUT takes out 1,390 (20% above the November closing low), the round 1,400 level lurks just above.

So the jury is out as to whether last week's breakout can sustain itself, and whether the Dow can hold above 20,000 in the immediate days ahead. SPX 2,300 immediately reared its ugly head in last week's trading, potentially signaling the DJIA's vulnerability to move back below 20,000 in the not-so-distant future, following the MID's retreat below 1,700.

SPX century levels have marked notable hesitation points in recent history, as noted in the chart below. There was the failure at 2,000 in August/September 2014 that preceded a correction. Moreover, the 2,100 level and the area immediately above acted as a lid from February 2015 through June 2016, with multiple corrections along the way -- and the zone just below 2,200 marked last August's peak, before a pullback of about 5% into the November elections. Stay tuned, as the days immediately ahead will tell us more about the significance (or insignificance) of 2,300.

Not seen in the chart below are a few divergences that might indicate a "fakeout-breakout" with respect to the short term. For example, while the SPX made a new high last week, its 14-day Relative Strength Index (RSI) did not make a high relative to its December peak. Furthermore, the 10-day moving average of the SPX's daily advance/decline ratio fell as the index made a new high -- indicating fewer stocks advancing as the index broke out relative to when the index was going sideways.

spx century levels

We will also be carefully watching the RUT, as this index is still stuck in neutral. The small-cap index has yet to manage three consecutive closes above 1,373.53, the Dec. 13 close that preceded the Fed rate hike.

rut daily resistance levels

That said, the current rally is based on a lot of short covering, with SPX component short interest plunging more than 9% since mid-December. There is more room for covering if component short interest levels take out of the lows of 2014 and 2015 and move down to the low of 2011-2012. But if the current short-covering rally is over, it is up to momentum players to come off the sidelines, as they did in 2013 when the SPX broke out above 1,500 even as short interest increased (albeit at a slow pace, relative to the 2015 ramp-up that has now been unwound).

spx total short interest

There are certainly risks worth mentioning, but the most important data point to keep in mind is that equity benchmarks are at, or just below, all-time highs. In that respect, you should not disturb bullish positions. But we still recommend using VIX futures or VIX call options to hedge, with equity benchmarks trading around psychologically significant round levels, and large speculators on VIX futures in an extreme short position on volatility. Per the chart below, one should not be surprised to see a VIX pop whenever these market participants are in an extreme short position on volatility, which is the case now.

cot lg spec vix futures 0127

Traders can also take long positions in gold and/or bonds as contrarian plays. Large speculators are short bonds -- and the last time this occurred was August-December 2015, ahead of a major bond rally. And net long positions on gold among large speculators have plunged from a peak of 330,000 contracts in early September to a low of 91,000 contracts in late December. Meanwhile, gold has outperformed the SPX this month. 

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