S&P 'Rally Fuel' Back at Pre-Election Levels

Stocks have kept climbing, despite steady headwinds from short sellers

Senior Vice President of Research
Oct 2, 2017 at 8:33 AM
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"We enter this week's trading with multiple benchmarks trading at psychological round-number levels that have historically marked hesitation points or profit-taking levels…perhaps the benchmark on most radars is the S&P 500 Index (SPX - 2,502.22), which took out the round 2,500 century mark to begin last week's trading, but eventually retreated back below it Friday morning, closing the week just 2 points above it. Lingering just above is the 2,506-2,508 area, which represents the closing prices over the course of the two-day Federal Open Market Committee (FOMC) on Sept. 19-20."
    -- Monday Morning Outlook, September 25, 2017

In last week's commentary, the S&P 500 Index (SPX - 2,519.36), Russell 2000 Index (RUT - 1,490.86), and Nasdaq Composite (IXIC - 6,495.96) were in focus, as they were simultaneously trading in psychologically significant areas that could spur profit-taking. However, last week's action favored the bulls, with the SPX taking out the resistance alluded to in the excerpt above, while the RUT burst through its July peak at the 1,450 half-century mark -- and, by week's end, was looking down the barrel of its next psychologically important level, the round 1,500 mark.

While the IXIC moved above 6,459 mid-week on an intraday basis -- a round 20% above last year's close, and a notable resistance level throughout September -- it failed to close above this resistance in Wednesday and Thursday's trading. But on Friday, it too experienced a technical breakout, and ran straight into another of its own potentially major psychological areas: the round 6,500 century mark.

Market participants did get more clarity on the Republican vision of tax reform, and this may have acted as a catalyst. And while last week was not a standard options expiration week, the sharp rally in the SPX and RUT may have been partly driven by the expiration of quarterly options on the SPDR S&P 500 ETF Trust (SPY - 251.23) and the iShares Russell 2000 ETF (IWM - 148.18).

In retrospect, I regret not covering September quarterly expiration in last week's discussion, as the option market likely had some influence once equities established direction, with tax reform details serving as the spark that ignited more buying than usual. There was healthy open interest on SPY options that expired on Friday, with the call open interest overhead acting as a magnet as sellers of the calls were likely forced to buy an increasing number of S&P futures to hedge after the SPY rallied through heavy call open interest at the 249 and 250 strikes.

spy quarterly open interest by strike 0929

Long-time readers of this commentary know this process as delta hedging. As the SPY moves higher and through the heavy open interest strikes, the delta on the calls increases, meaning the option's price becomes more sensitive to the underlying's movement. Therefore, the sellers of the calls are forced to buy S&P futures to protect themselves against bigger losses on the sold call options. There was a futile attempt to keep the SPY around $249 early in the week, but in the middle of the week the SPY made a convincing move above $249 -- and it was pretty much straight up from there.

The point of this discussion is that if, indeed, the breakout was due in part to the quarterly expiration of equity, index, and exchange-traded fund options, the incremental buying that pushed the SPY above resistance is not likely to sustain itself much longer. That said, there is a higher probability of an upside breakout sustaining itself, even if driven by options expiration, if the breakout is in the direction of the primary trend -- which is obviously higher. If a technical breakdown occurs due in part to delta-hedge selling in a bull-market trend, such a breakdown is likely to be only temporary.

Regardless, last week's SPY breakout above $250 -- which is equivalent to SPX 2,500, and coincides with SPY's Sept. 20 "Fed day" close at $250.06 -- paves the way for a continuation of a pattern we have seen for most of this year. That is, Federal Open Market Committee (FOMC) meetings where members vote to stand pat on interest rates have typically been followed by bullish price action.

spy 30 minute chart 0929

One source of fuel to sustain a rally, or at the very least contain pullbacks, is short covering. I continue to be impressed with the fact that, even as the shorts continue to add to their positions on components of the SPX, RUT, and PowerShares QQQ Trust (QQQ - 145.45), these equity benchmarks continue to carve out new highs. With the QQQ up more than 20% in 2017, short interest is almost 9% above its year-end 2016 level.

qqq short interest 0929

Moreover, short interest on RUT components is up 13% in 2017, implying components of this index have been contending with greater headwinds related to shorting activity than their SPX and QQQ counterparts. Nonetheless, as of Friday, the RUT was nearing a double-digit 10% return for 2017. With the RUT now above 1,450, it must content with the round 1,500 level overhead. And, for what it's worth, based on its 2016 close of 1,357.13, the 10% 2017 gain resides at 1,492.84, around the area of Friday's high.

rut short interest 0929

SPX component equities have had headwinds this year related to shorting, but not to the same degree as QQQ and RUT components. Nevertheless, the SPX begins the last quarter of trading up more than 12% for the year. Total short interest on SPX components hit its lowest level in 2017 with the release of the Feb. 1 data. This trough in short interest marked the end of short covering that occurred during the post-election rally. Now, total short interest on SPX components is back above its pre-election level, and 20% above the Feb. 1 low. Despite the 20% increase in short interest from the February low, the SPX rallied more than 10% during this period.

spx short interest 0929

With the shorts fighting a losing battle, the fighting goes on until they are ultimately squeezed out of their positions, which becomes a source of buying power and thus an argument for bulls to stick with their upside bias.

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