Beware the Consensus Storyline on Earnings Season

VIX fell last week, but the risk of rising volatility still lingers

Senior Vice President of Research
Apr 16, 2018 at 7:30 AM
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"Multiple resistance levels now lie overhead, which reduces the appeal of stocks at this moment. For example, there is the SPX 2,650 level that gave it trouble last week on rally attempts, and the year-to-date breakeven level at 2,673 that acted as support in early March but could now act as resistance on rallies."
-- Monday Morning Outlook, March 26, 2018

"...we have come full circle to where we were two weeks ago, with the SPX entering this week's trading just above a major support area... Expect more of the same -- headlines generating sharp daily movements, but solid support and resistance levels above and below keeping a volatile range environment intact."
-- Monday Morning Outlook, April 9, 2018

As I mentioned a week ago in this space, the S&P 500 Index (SPX - 2,656.30) and the SPDR S&P 500 ETF Trust (SPY - 265.15) once again entered the week just above a major support area, setting the stage for a potential rally. But last week's rally was far from a high-probability trade, as the SPX entered the final trading week of March around the same level -- a week that finished flat.

If indeed headlines again drove the price action in this volatile trading range that has now lasted since March 21, when the Fed last raised rates, bulls can thank Chinese President Xi Jinping and U.S. President Donald Trump. Their trade war rhetoric that weighed on the market has turned to trade deal rhetoric, setting in motion a positive bias for stocks. However, technical resistance, along with the State Department's claim on Friday that Syrian President Bashar al-Assad used chemical weapons in a recent attack, put a lid on the rally.

While last week had a positive tone, there is work to be done from a technical perspective. Just as there is major support in the SPX zone between 2,550-2,600 as described last week, there is major resistance in the 2,650-2,700 zone, which is where we enter this week's trading.

For the SPY, these support and resistance levels correspond with $255-$260 and $265-$270. Resistance is in the form of the following:

  1. The SPX and SPY 2017 year-end closes of 2,673 and $266.86, respectively (long-time readers know the importance of prior-year closes).
  2. The SPX 2,700 and SPY $270 levels mark the mid-March "Fed day" closes, when the Federal Open Market Committee (FOMC) raised rates. During the current rate-tightening cycle that began in December 2015, these Fed-day closing levels tend to act as resistance in the weeks following rate hikes.
  3. The SPY 265 and 270 strikes (equivalent to SPX 2,650 and 2,700) are home to huge put and call open interest in the April options series that expires this week. In the absence of any major market-moving headlines, buying and selling of S&P futures related to the big open interest at these strikes will tend to produce sideways movement around these respective strike prices, much like we saw last week around the SPY $265 level.

spx ytd with 200-dma

spy april open interest by strike 0413

If you are looking to the Cboe Volatility Index (VIX - 17.41) for clues, bulls still run the risk of volatility rising and thus putting a lid on stock rallies. While the VIX declined last week, it closed Friday at a key area around 18. With 18.30 representing double this year's closing low and 18.66 one-half this year's high close -- and the 80-day moving average just below these levels, at 16.91 -- bulls would like to see a significant move below this area.

Additionally, the decline in index option premiums may invite index put buyers to purchase portfolio insurance as we move into the heart of earnings season, and amid geopolitical uncertainty. A rush to purchase portfolio insurance would create a short-term market headwind as the SPX battles resistance.

From a longer-term point of view, I still find it encouraging for stock market bulls that the historically "wrong way" large speculators in the weekly Commitments of Traders (CoT) report have a record net long position on VIX futures. Given this group's poor track record, VIX upside should be limited as long as they have an extreme net long position. I expect the area just above 25, half this year's intraday high, to continue to act as resistance.

vix ytd with 80-dma

"Can a Strong Earnings Season Halt the Stock Market Slide?"
-- The Wall Street Journal, April 3, 2018

"A cool 80 percent of S&P 500 gains have come during earnings seasons since 2013. Over that period, stocks had a perfect streak of rising whenever results were being reported... the streak ended in February with the most spectacular equity meltdown since 2011 was a reminder that the foundation isn't invincible... Strategists from JPMorgan and Deutsche Bank have expressed confidence, citing everything from a weaker dollar to stronger global growth and buybacks as reasons S&P 500 earnings will surpass estimates by as much as 5 percent."
-- Bloomberg, April 12, 2018

Speaking of earnings season, something that has grabbed my attention when listening to a long line of guests on financial television during the past few weeks is the near-consensus opinion that earnings will drag stocks out of their recent funk. The thinking in this group is that investors will get back to focusing more on company-specific fundamentals, and less on the macro issues that have been holding the market back.

The excerpts above do a good job of capturing this sentiment -- but as a contrarian, I am reluctant to buy into the consensus here. Friday's poor earnings reactions out of the bank sector may be enough to convince you not to buy into this consensus thinking, either.

And for what it's worth, for many of the earnings-induced win streaks described in the Bloomberg piece, there was skepticism going into those earnings seasons, as many doubted that top-line growth or cost-cutting efforts could be sustained. This isn't to say that the market won't rally, but I think macro headlines will continue to impact the day-to-day swings. And these headlines are difficult to predict.

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