Read This Before You Try to Buy the Dip

Did we just get another Greenspan sell signal?

Senior Vice President of Research
Feb 5, 2018 at 8:51 AM
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"Another headline that took me back to the mid-1990s was the one describing the longest overbought streak in 21 years. On Friday, the SPX's 14-day Relative Strength Index (RSI) was above 70 for the 17th straight day. According to the Bloomberg article, the last time the index had an 'overbought' streak like this was 18 days in November-December 1996...This overbought streak may be worth watching in the days ahead, as a near 4% pullback occurred after the 1996 RSI streak above 70 ended after 18 days. This short-term pullback was around the same time that then-presiding Fed Chair Alan Greenspan uttered 'irrational exuberance' in a speech."
    -- Monday Morning Outlook, January 29, 2018

"Former Fed Chair Alan Greenspan Sees Bubbles in Stocks and Bonds"
    -- Bloomberg, January 31, 2018

Last week, I concluded my commentary discussing the "overbought" streak in the S&P 500 Index (SPX - 2,762.13). Of the multiple concerns being broadcast by strategists and money managers, I thought that this indicator was one worth watching, based on history. As it turned out, on Tuesday of last week, the SPX's 14-day Relative Strength Index (RSI) finally dipped below 70 for the first time in 18 trading days, eerily similar to the 18-day streak in November and December 1996.

Just one day later, another echo of 1996 surfaced, with former Fed Chair Alan Greenspan telling Bloomberg Television, "There are two bubbles: We have a stock market bubble, and we have a bond market bubble."

On the heels of these two developments, short-term bears hope that we get a repeat of early December 1996, when the SPX went on to decline another 4% after its RSI moved back below 70 and Greenspan uttered "irrational exuberance." A 4% decline from last Tuesday's close would push the SPX to 2,709, roughly 30 points above its 2017 close.

That said, bulls hope that the "stock bubble" Greenspan described lasts about as long as the "irrational exuberance" that he observed in 1996, as the bull market lasted nearly three and a half more years before peaking in March 2000.

With many strategists and money managers bracing for a stock market correction, in rare cases such caution becomes a self-fulfilling prophecy. In other words, they may act on their caution through the purchase of index and exchange-traded fund (ETF) puts, or call purchases on CBOE Volatility Index (VIX - 17.31) futures. Often, such worries prove unnecessary and the options expire worthless.

If a sharp pullback does occur, the gains from such option plays can insulate losses on bullish positions. Most of the time, these managers are looking to control hedging expenses, so they opt for out-of-the-money options, which are cheap on an absolute basis and the most likely to expire worthless.

For example, in the case of a put purchase, the strike purchased might be 5-10% below the index or ETF's value at the time of the purchase. Those selling the puts do not hedge their exposure immediately, since such options are "low delta," or not very sensitive to the underlying's movement.

If, however, the underlying eventually moves closer to the strike, those who sold the put option to the money manager hedging his long portfolio might begin to hedge as well by shorting the underlying; i.e., shorting S&P futures to hedge a SPY put that was sold to a money manager.

This process is called "delta hedging," and it is not something we have been vulnerable to in months. But it is a process that likely began on Friday morning. Despite the Friday meltdown, there are still some big put open interest strikes on the SPDR S&P 500 ETF Trust (SPY - 275.45) that could act as magnets as we enter the two-week window preceding standard February expiration.

To the extent that delta-hedge selling helped aid Friday's onslaught, it began with the open below the put-heavy SPY 280 strike. Sellers of the 280-strike puts were likely forced to short more and more S&P futures as the SPY traded further below the strike, creating a snowball effect wherein momentum players likely jumped aboard. Eventually, the put-heavy 277 strike was in site, and the delta-hedge process likely picked up again.

spy 10 minute intraday since jan 29

If last week's decline continues, the 273 strike could act as a stabilizer, given the huge put and call open interest sitting here. However, if the 273 strike -- equivalent to SPX 2,730 -- is breached, the 270 strike is another potential magnet. Coincidentally, this level is the area equal to about 2,700 on the SPX, which would be a 4% pullback... which matches the percentage decline that occurred in December 1996.

Above said, smaller put open interest strikes do not have the "gravitational pull" of the larger put open interest strikes, which means there is less options-related selling as these levels are approached. Also, strikes with roughly equal put and call open interest, like the 273 strike, are less prone to have a major gravitational pull. This would imply that the 273 area is the first line of defense, from an options-related perspective, as we enter this week's trading.

spy 2-week open interest mid-feb 2018


The Friday sell-off pushed the SPX below its 20-day moving average for only the second time since Aug. 30. After being overbought for so long, the index still is not technically oversold, according to its 14-day RSI. However, it is just barely above the levels at which it has troughed dating back to February 2017.

In other words, using the past year as a guide, one would expect that there is still a little more selling at hand, with the potential for the SPX 2,730 area to act as support in the near term. This is the site of its 40-day moving average and is roughly equivalent to the SPY 273 strike, where there is heavy call and put open interest in the February series.

A move below SPX 2,730 could result in the round 2,700 area being visited rather quickly. Given the sharpness of Friday's decline, I may as well mention that SPX 2,673.61 and SPY 266.86 are the site of 2017's closing levels, and the next "line in the sand" if the levels above are taken out.

Turning to an analysis of volatility to help guide us, there is some good news and bad news.  

The good news is that VIX futures closed the week in backwardation, which means the nearer-term February futures closed higher than March, April, and May futures. This is unusual, as typically the nearer-month futures are cheapest across the term structure, which is known as contango. In the recent past, backwardation has occurred at or near short-term troughs -- such as August 2017, coincident with nuclear tensions between President Donald Trump and North Korean counterpart Kim Jong Un rattling markets.

Backwardation occurs because market participants, fearful of a short-term plunge, bid up the nearest month VIX futures, which tend to be more sensitive to short-term market movements.  Such fear has usually rushed in at bottoms, but as a warning, backwardation can last for more than a day.

As for the bad news, the VIX closed above 16.05, which I see as key because it represents half the 2016 intraday high and is also the site of the 2017 closing high. That said, the close is just barely above 17.28, 2017's intraday high.

If you are looking to buy the dip, I would advise that you allow for the VIX to move back below 16.05 first, and look for the VIX futures curve to move back into contango. If the VIX remains above 2017's high mark, and/or takes out 18.30 -- double this year's closing low -- more trouble could be on the immediate horizon as continued demand for portfolio protection via SPX puts is likely a sign that buyers are not ready to step in and buy the dip.

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