Filtering through the political and geopolitical noise surrounding this market can be a daunting task. Early last week, the
Washington Post reported that President Trump might have improperly shared highly classified information with Russian officials at a White House meeting.
Before this could be fully digested or investigated, participants received another nugget of market-rattling news on Wednesday, when
The New York Times published a report suggesting that Trump told former FBI Director James Comey that he hoped the FBI could "let go" of its investigation of Trump's former national security advisor, Michael Flynn. Phrases like "
obstruction of justice," "special counsel," and "impeachment" started hitting the headlines, and helped spark volatility that we haven't experienced in quite some time.
There is no doubt that political events can shape and affect the daily movements of the stock market, but participants would be better served to keep an eye on the fundamental, technical, and sentiment backdrop that ultimately shapes the overall theme and trend of the markets. As Todd Salamone discussed last week, many of the broad-market indexes entered last week at or near potential overhead
round-number resistance areas. In addition, historical volatility on the S&P 500 Index (SPX - 2,381.73) -- and expected volatility, as measured by the CBOE Volatility Index (VIX - 12.04) -- entered the week trading near
multi-year lows. Although the headlines may have helped spark volatility, the immediate presence of technical resistance and unusually low volatility expectations were the real catalysts behind the scenes.
Speaking of volatility expectations, large speculators have been continually short VIX futures for quite some time, per the weekly Commitments of Traders (CoT) reports. This basically means that this group expects low volatility to continue. As Todd has noted in this space, this group was most recently caught flat-footed when volatility spiked in March. And on Friday, the new report was released showing that large speculators had established a record-breaking short position on VIX futures as of Tuesday, May 16 -- the most extreme degree of shorting we've seen since they began tracking this data.
What's also interesting was the timing of the volatility spike on Wednesday, which happened to mark the expiration of VIX futures call options. VIX calls would profit from an increase in volatility, so they have been a preferred hedge for these short volatility positions. But as these
option hedges expired, perhaps some of the large speculators covered short volatility positions in response to the unexpected news, and/or began to replace their call hedges. Either of these scenarios, in combination with the unexpected headlines on Wednesday, created a prime opportunity for the spike in volatility we experienced.
Technically, many of the major U.S. equity indexes have been bumping up against round-number resistance levels for the past few months. The SPX has contended with the 2,400 level, the Russell 2000 Index (RUT - 1,367.33) has faced the 1,400 area, and the Dow Jones Industrial Average (DJIA - 20,804.84) has been capped by the 21,000 level on multiple occasions. While these areas certainly came into play during the sell-off last week, let's not forget how strong of an uptrend we are in, and how powerful the tide of a strong trend can be.
For example, the SPX found support just above the 2,350 area and its 80-day moving average, which has been trending higher since April 2016. It can be easy to get caught up in the daily or hourly movements of the market during volatile weeks, like the one we just experienced -- but it's important to always keep it in context of the bigger picture. Although we experienced a spike in volatility and price action unlike anything we've seen in months, most of these indexes remain firmly in a consolidation pattern within an intermediate- and long-term uptrend.
Chart courtesy of StockCharts.com
Taking a look at other sentiment indicators is also a useful exercise as we navigate the markets on a week-to-week basis. One of the many indicators we watch is the Bank of America-Merrill Lynch fund manager survey, which polls upwards of 200 global fund managers who manage more than $600 billion in assets. Based on the latest survey released last week, it's interesting just how deeply underweight this group is on U.S. equities. They are currently -17% underweight, near a multi-year low for these managers. This could indicate there is even more sideline money that could flow back into this uptrend during the coming months, especially if U.S. stocks can break out of this consolidation pattern and play a little catch-up with their foreign counterparts that have really performed well in 2017.
Elsewhere on the sentiment front, one concern would be the 10-day equity-only
put/call volume ratio we track. This basically takes put and call volume from three major options exchanges, and creates a ratio of the buy-to-open option activity on individual equities. The current ratio is 0.55, which is the lowest level since June 24, 2015. In other words, investors are buying significantly fewer bearish puts than calls on individual stocks relative to the recent past. I would put this in the category of a risk to the upside.
We are also starting to near the end of earnings season, and it's going very well. At nearly 14%, we are on pace to have the highest earnings-per-share growth rate since the third quarter of 2011. More than 75% of the companies that have reported topped expectations, as well, and revenue guidance for the full year has been very strong. Overall, the fundamental side of things look positive for the U.S. equity market. Valuations remain high, but that has been an "issue" for the last couple years.
If you had taken a nap last Monday morning and woken up on Friday afternoon, you might not even know we had any volatility last week. The surge on Friday pretty much erased all the mid-week damage, and so the market is in a similar place entering this week as it was last week. Technically, we are still contending with overhead obstacles on multiple indexes -- but the longer-term uptrend remains in place, and there are many reasons to remain bullish.
That said, the extremely low equity put/call ratio is something to monitor going forward. With large speculators continuing to bet on low volatility, out-of-the-money
put hedges are relatively cheap for equity portfolios. On the other hand, the positioning of fund managers leaves significant room for sideline money to flow back into U.S. equities, which could support these round-number levels being taken out at some point. Trying to time the exact day or week of this breakout is difficult, but the probability of a breakout should increase with every attempt.
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