Underwater Shorts Could Prop Up a Wobbly Post-Fed Market

What the lackluster reaction to tax reform means for stocks

Senior Vice President of Research
Dec 26, 2017 at 8:36 AM
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"It will be interesting to see if the area around the SPY's Fed-day closing level continues to mark resistance on the heels of last week's rate hike, as the 'wild card' factor of pending tax reform legislation didn't impact the stock market action around prior rate hikes in the current tightening cycle. Traders should keep this region on their radar in the days ahead...

"When and if signed into law, how the market responds relative to the key SPY and SPX levels discussed above may give you a hint as to the market environment over the next month. Bulls will hope that the pattern of weaker-than-normal equity performance in the immediate days and weeks following a rate hike is broken."
    -- Monday Morning Outlook, December 18, 2017

After the SPDR S&P 500 ETF Trust (SPY - 267.51) closed below the $266.75 and $266.78 levels on Friday, Dec. 15 -- just two days after the Fed's third rate hike this year -- this resistance area was taken out first thing the following Monday morning. The catalyst was weekend news that the Republicans had enough votes in the House and Senate to pass The Tax Cuts and Jobs Act, which (among other things) cut corporate taxes, gave some individuals a tax break, and removed the Obamacare individual mandate.

The Monday close of $268.20 was just 3 hundredths of a point shy of the $268.23 level that is exactly 20% above the SPY's 2016 close. And that Monday close proved to be the SPY's closing high for the week, even as the House initially passed the GOP tax overhaul on Tuesday, followed by the Senate's approval on Wednesday evening, and the bill being signed into law on Friday. In other words, the rumor of passage was bought, but the news was sold.

On Monday, the pattern that I have noticed and discussed in this forum about stocks tending to struggle in the immediate weeks after a Federal Open Market Committee (FOMC) interest rate hike in the current tightening cycle looked to be breaking down. However, by Friday afternoon, amid a lackluster response to congressional approval and the President's signing of the tax reform bill into law, the short-term weakness that has tended to follow rate hikes appeared to be "in play."

spy 30-minute chart dec 22

"The Russell 2000 Index (RUT - 1,530.42), after being engaged in a retreat since its end-of-November peak at 1,544, found support just above the round 1,500 level last week ... But note that this group has underperformed in 2017, and more retests of RUT 1,500 may be on the horizon -- especially if the passage of a tax bill becomes a 'buy the rumor, sell the news' event, as the 1,550 half-century mark resides just above current levels."
    -- Monday Morning Outlook, December 18, 2017

As the SPY sparred with resistance levels last week, the Nasdaq Composite (IXIC - 6,959.96) and Russell 2000 Index (RUT - 1,542.93) followed suit, experiencing their own respective closing highs on Monday, too. The IXIC failed to take out the round 7,000 millennium mark, with Monday's close just 6 points shy of this psychologically important level. The RUT achieved an all-time closing high; however, it was 2 points shy of the 1,550 half-century mark discussed last week, before modest selling pushed the index back to its previous November all-time closing high in the 1,544 area.

Seasonality favors stocks. However, after a mid-December Fed rate hike, a lackluster response to the passage of a tax bill that slashed corporate tax rates, key benchmarks failing at resistance levels, and a bearish divergence in the Relative Strength Index (RSI) of the SPY, RUT, and IXIC, signs point to a grind for both bulls and bears in the immediate weeks ahead. While bears may be happy to see a lackluster reaction to the tax bill headlines, it is also important to note that there was not nearly enough selling pressure to push key benchmarks below support -- such as IXIC 6,850, RUT 1,500, or SPY 250.

Additionally, after taking a glimpse into the equity options market, a period of short-term weakness would not be a major surprise. For example, per the chart immediately below, note how the 10-day ratio of equity put buying to call buying reached a multi-year low recently and is moving higher (albeit only slightly). Historically, when this ratio turns higher from an extreme low, the market is vulnerable to a pullback at worst, or choppy, sideways environment at best.

equity put-call volume ratio dec 22

"Fund flow data indicates that investors in the US are not at all bullish: domestic equity ETFs and mutual funds have had outflows for 8 months in a row. Notable peaks in the S&P in 2010, 2011 and 2015 were accompanied by fund outflows; this time, investors seem to be selling these funds as price rises..."
    -- The Fat Pitch, December 15, 2017

"Fund investors have favored overseas markets all year as long-dormant economic growth kicked into higher gear in Europe, Japan and across emerging markets. Investors have added $221 billion into international equity funds in 2017, on pace to be the biggest one-year haul since at least 2000, according to the Investment Company Institute. Meantime, some $35 billion has exited U.S. stock mutual and exchange-traded funds in 2017."
    -- The Wall Street Journal [subscription required], December 22, 2017

"Everyone's got a bull case nowadays.... Credit crisis savant Gary Shilling says deregulation is driving equities. Even Jeremy Grantham, venerated advocate of buying cheap, says it'll be a long wait....'I've temporarily broken ranks with the general tone of the value community.'...Bears that once roared at any sign of trouble now seldom make a peep. Too many dire predictions failed to come true...Bearish bets as a percentage of total U.S. shares available for trading is hovering around 4 percent, higher than the average of 3.8 percent, according to exchange data compiled by Bloomberg that goes back to 2008."
    -- Bloomberg, December 21, 2017

When I read the above-quoted Bloomberg article entitled, "Are There Any Stock Bears Left in America?", I expected that the article would have a never-ending list of indicators suggesting market euphoria and the end of the bull market. Instead, what I read was a fairly balanced article, with the takeaway being that even though there are some pockets of the market seeing increased optimism among participants, there are still bears among us, although they are less boisterous relative to the past

The Bloomberg article made a solid point about the number of shares shorted relative to its historic norm. I have made a similar argument that there's still a healthy number of bears by charting the trends in S&P 500 Index (SPX) component short interest (see chart below). Data as of the end of November show that short interest is slowly coming off a multi-month peak from just above pre-election 2016 levels.

Short interest has risen with the market, implying many shorts are underwater. This should keep pullbacks in check, as shorts look to exit losing positions when the opportunity presents itself. In fact, it might explain why the SPX has only experienced mild pullbacks, as the shorts look to use pullbacks as opportunities to exit losing positions.

Moreover, it isn't as if there are only a few stocks that account for this year's surge in SPX component short interest. Since its February 2017 low, SPX component short interest has increased 16.4%. Nearly 40% of SPX components have experienced a 16.4% increase in short interest over the same period.

spx component short interest dec 22

Even though the market has tended to struggle in the immediate days and weeks after a Fed rate hike during the current tightening cycle, Fed rate hikes have been taken in stride from a bigger-picture perspective. I would expect the same to continue in the months ahead, as there are currently no major signs of technical deterioration in the market, despite short interest increasing and fund investors perceiving better opportunities elsewhere.

I hope the holiday season has been a joy for you and your families. Thank you for reading Monday Morning Outlook in 2017, and I hope to provide you valuable insight in the coming year.

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