Why Bonds Aren't the Best Place to Hide Anymore

Amid growing headline risks to the stock market, large speculators have moved into a net long position on bonds

Senior Vice President of Research
Apr 24, 2017 at 8:30 AM
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"... one noteworthy historical pattern of the SPX is that it tends to respect half-century mark levels ... For example, after an early December move above 2,250, the SPX did not stray too far above this level, trading sideways in the final three weeks of the month and retesting 2,250 a few times into mid-January ... an SPX hesitation in the 2,350 zone could resemble the mid-December through mid-January action around 2,250."
    -- Monday Morning Outlook, February 27, 2017

"The SPX has not made a new all-time high since March 1, the day after President Trump's State of the Union address, and has shown visible weakness since the March 15 Fed rate hike... With the index's break of the 50-day moving average last week -- a break that garnered a lot of attention -- it remains above its 80-day moving average, situated at 2,321, which provided short-term support in September...  And, for what it's worth, the SPX 2,324 level represents a round $20 billion market capitalization for the index... The upside, for bulls, is that if the SPY can stabilize from the 'get go' this coming week, short covering related to the expiring put open interest could be a tailwind in the days ahead."
    -- Monday Morning Outlook, April 17, 2017

The S&P 500 Index (SPX - 2,348.69) came into last week just above technical support from its 80-day moving average and did, in fact, stabilize from the "get go." The result was an April expiration week rally, with short covering related to expiring put options on the SPX and SPDR S&P 500 ETF Trust (SPY - 234.59) likely aiding in the rally.

In February, I observed a historical pattern with respect to SPX half-century marks, and cautioned about the heightened potential for a hesitation around this area after an impressive rally that began in the days after President Trump's inauguration. Since this observation was made, bears have been unable to push the index too far below 2,350, while buyers have not been able to sustain a significant, sustained move above 2,350.

Admittedly, the "magnet effect" at 2,350 has been more apparent in the immediate days following the mid-March rate hike and a plethora of headlines that have led to investor unease in recent weeks --including this past weekend's French elections, which could further shake up the eurozone area, and rising geopolitical risk associated with a U.S. missile strike in Syria and increasing tensions with North Korea.

There have been other developments for investors to digest, including economic data that has come in below expectations, and exactly what policies our new president will be able to implement -- including tax reform, which came back into the forefront last week when Treasury Secretary Steve Mnuchin indicated a "sweeping" overhaul is coming soon, a sentiment echoed by Trump when he told the Associated Press that "massive" tax cuts for individuals and businesses are in the works. Additionally, Congress comes back from recess on Tuesday, with hopes of avoiding another debt-ceiling related government shutdown at the end of the month.

As such, stocks (as measured by the SPX) have been in a holding pattern as investors work to sort out the many lingering uncertainties that could impact the market and such things as the Federal Reserve's future decisions on rates and balance sheet reductions.  

spx daily 80-day chart 0424

"With the standard expiration of options, this week could prove pivotal as to where volatility heads in the near term. Wednesday morning, for example, is the standard expiration of April VIX futures options. If you follow me on Twitter, you know that it is not unusual for more than 90% of VIX call options to expire worthless, mainly because many calls tend to be purchased far out of the money..."
    -- Monday Morning Outlook, April 17, 2017

Volatility expectations have risen significantly amid perceptions that headline risk has grown. For example, the CBOE Volatility Index (VIX - 14.63) has risen almost 40% since its mid-February low, which was around the time that the SPX first probed the 2,350 half-century mark. The bulk of this increase has occurred since the beginning of the month, as the VIX broke out above post-election resistance at 14 earlier this month -- the site of its 2016 close and multiple post-election highs.

A pullback in volatility occurred early last week from a level that is roughly 50% above this year's VIX low and half of 2016's intraday high. The pullback, perhaps not coincidentally, occurred just ahead of the expiration of April VIX options. More than 92% of VIX call options expired worthless last Wednesday, as VIX call sellers smiled once again.

And to no surprise, ahead of the French elections and just a few days after more than 3 million VIX calls expired worthless -- leaving VIX call open interest 30% below the pre-expiration level -- volatility popped again on Friday from its 2016 closing level and former resistance. However, the VIX did not take out the prior week's high, as it is now sandwiched between key support and resistance.

Moreover, after again being on the wrong side of a volatility trade, the latest Commitments of Traders (CoT) report shows large speculators have cut their net short positions in volatility futures by 35% from the late-January peak. But they are still net short by a noticeable amount, so further short-covering activity could be supportive of increased volatility. This remains a risk to the bullish case -- a risk that has been in place most of this year, and which has grown because these traders are now feeling the pain as volatility increases.

So, in summary, with large speculators covering their still-massive net short position on VIX futures following a major expiration of VIX call options last week, and with many headline risks lingering, the risk of a volatility pop is heightened.

cot vix futures net short covering 0423

Furthermore, per the chart below, bonds may no longer be the best place to hide, as large speculators have now moved into a net long position. The last time this group moved into a net long position was June 2016, near a major peak. Therefore, move your stop on the iShares 20+ Year Treasury Bond ETF (TLT - 123.54) long position I recommended last month to a close below $121.70, which is near the February month-end close.

cot 10 year note net long 0423

Continue to avoid small-cap stocks if you're looking to reduce equity allocations amid ongoing macro uncertainties and the risk of a volatility pop. Additionally, the energy sector is a group to avoid, as it is overcrowded and underperforming.  

Finally, as we move through earnings season, option prices will become less expensive, which means you can once again use calls as a stock-replacement strategy. This method allows you to commit fewer dollars to the stock market, but still participate in leveraged upside if the intermediate- and longer-term uptrends in the market continue to trump the underlying risks.

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