3 Disappearing Risks for Stock Market Bulls

The blackout period for buying back shares is mostly over

Senior Vice President of Research
Nov 12, 2018 at 8:41 AM
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"[W]e prefer to see a roll-over in the equity-only, buy-to-open put/call volume ratio before declaring the risk-reward scenario is favoring the bulls. Such patience likely means you will not catch the exact bottom, but it will also keep you out of situations like last week, in which bounces prove only temporary. Coincident with a roll-over in this ratio from a relatively high level, like we're seeing now, I would like to see the VIX below 18.66 and the SPY and SPX (2,767) above $280 and 2,800, respectively."
-- Monday Morning Outlook, October 22, 2018

"Friday's Commitments of Traders report (CoT) revealed that large speculators are now net long VIX futures ... given how they have been dead wrong at extremes, it would not be a bad bet to speculate on declining volatility… beware that huge open interest on SPY put strikes below the market could exacerbate both downside or upside moves … The outcome of the midterm elections is one ‘known unknown’ on the calendar that could stoke volatile movement in either direction."
-- Monday Morning Outlook, November 5, 2018



The midterm elections yielded few surprises last week, and with the related uncertainty alleviated, stocks soared as volatility imploded. In the process, a combination of sentiment-driven and technical indicators made significant improvement for market bulls, with the S&P 500 Index (SPX - 2,781.01) moving above the 2,800 century mark briefly before a Friday setback, the Cboe Volatility Index (VIX - 17.36) moving below 18.66 -- half its 2018 closing high -- and, as I observed on Twitter the day prior to Election Day, the equity-only, buy-to-open put/call volume ratio rolled over from a relatively high level. The roll-over in this ratio implies that the pessimism that was building in October and pressuring stocks lower climaxed, an important ingredient for carving out a bottom after a sharp decline.

 "Bulls Set to Fight the Fed"
-- CNBC television headline, November 8, 2018

 "The worst of the correction could still be ahead for the market, and one chart offers evidence"
-- CNBC Trading Nation headline, November 8, 2018

 "Stock Bounce ‘Likely Running Out of Gas,’ Renaissance Macro Says"
-- Bloomberg television, November 8, 2018


Just one day after the post-midterm rally, there was anecdotal evidence -- see excerpts immediately above -- that there are still potential buyers on the sidelines that represent future buying power. In other words, while pessimism may have recently peaked, the unwinding of this fear is far from complete, and that could be supportive of equities in the weeks ahead. 

Additionally, three factors that I pointed out in late September and early October that could lead to a short-term period of weakness have been reversed: factors related to the Fed, share buybacks, and the sentiment backdrop. 

For example, last Thursday, the Federal Open Market Committee (FOMC) voted to hold the fed funds rate steady. The decision by the Fed to hold rates steady increases the likelihood of the equity market rallying over the next month, as the historical performance of the SPDR S&P 500 ETF Trust (SPY - 277.76) following a FOMC decision to hold is much more accommodating to bulls relative to its performance following a rate hike since the tightening cycle began in December 2015. If the historical pattern persists, the SPY has more than a 75% chance of advancing over the course of the next month, with an expected return of 2.61% from its Thursday close.



The sentiment backdrop ahead of last week's rate decision is also of interest and continues a pattern I have seen in 2018. That is, when stocks are most vulnerable to short-term weakness stemming from a Fed rate hike, equity option buyers have been relatively optimistic about equities, as put buying on individual stocks is relatively low in comparison to call buying. And when opportunities for short-term bulls have been brightest, this same group has been relatively negative on their outlook. 

The chart immediately below is an updated visual that appeared in the Oct. 1 commentary referenced above. The major takeaway is the relatively high reading of the equity-only, buy-to-open put/call volume ratio ahead of the FOMC decision last week to hold rates.   

SPY bto ratio Fed decisions

I would be remiss in this discussion if I did not remind you that large speculators were a rare "net long" volatility futures going into last week's huge equity rally and volatility plunge. This is a group that has been dead-wrong at major turning points in volatility. In fact, note on the graph below how they were around their largest short position on volatility just ahead of the volatility surge and market correction last month.

CoT specs VIX futures

Even though decisions by the FOMC have been widely expected by market participants throughout this tightening cycle, the post-meeting SPY performance in response to a hike vs. a decision to hold rates steady is too hard to ignore. Moreover, the pattern of option buyers being on the wrong side of post-FOMC market decisions is also hard to disregard in attempting to identify market opportunities and vulnerabilities.

 "The stock market's biggest buying force is on track to post a historic November as corporations resume a rapid pace of share buybacks after third-quarter earnings announcements. 'November is shaping up to be the strongest buyback month on record,’ J.P. Morgan quantitative strategist Marko Kolanovic wrote in a note to clients Wednesday, citing activity observed by the bank's trading desk. Investors blamed a so-called buyback blackout as a reason for the October rout in markets."
-- CNBC, November 8, 2018

Finally, the statistic above caught my eye, as it related to another vulnerability to stocks that I referenced in a late-September commentary. With close to 90% of S&P companies reporting earnings, the blackout period for buying back shares is mostly over. It is not a big secret that such activity was one supportive factor in this bull market that vanished in October, but has returned, perhaps into the December holidays, before earnings season kicks in again in mid-to-late January.

The SPY high last week was at its declining 40-day moving average, but the 200-day moving average, which caught much attention on the break below, held as support.  After Friday’s move back below $280, bulls should seek a move back above this round number and the FOMC decision-day close of $280.50, before getting aggressive to play a bullish FOMC move and sentiment unwind. 

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