How Hedge Funds Could Drive S&P Gains

A VIX close below 18.03 could indicate lower volatility ahead

by Todd Salamone

Published on Jan 14, 2019 at 8:23 AM

"If you're a long-term investor, and have stayed pat, you're hoping that this is 1987, 1990, 2011, or 2016, when the decline to the 160-week moving average was the end of ‘it.’"
-- Monday Morning Outlook, December 24, 2018

"[T]he early 2018 lows around SPX 2,580 that, when breached in December, saw the proverbial bottom fall out, represent yet another resistance level that must be taken out before a ‘V’ bottom can be taken seriously or considered sustainable. Plus, those early 2018 lows are situated a round 10% above the December closing low -- which is another reason 2,580 takes on importance from a short-term perspective, as a profit-taking mentality is likely to surface among short-term traders."
-- Monday Morning Outlook, January 7, 2019

Bulls were treated to another round of buying last week, as Fed Chairman Jerome Powell and other Fed governors reiterated that they can be patient with respect to evaluating data and raising rates. In fact, based on my comments from last week, the fact that the S&P 500 Index (SPX - 2,596.26) took out its 2018 lows gives more credence to a V-rally.  

That said, after moving above the February 2018 daily closing low of 2,581 on Wednesday, the SPX didn't make much headway. Profit-taking may have slowed the momentum, as the SPX climbed to the 2,586 area, a round 10% above the Christmas Eve 2018 closing low of 2,351. The good news for bulls is that the SPX has now closed five consecutive days above its closes on Dec. 18-19, when the Federal Open Market Committee met and raised rates. Typically, if a pullback occurs immediately after a rate increase, such Fed-day closing levels will act as short-term resistance. Therefore, the area between 2,506-2,546 remains a first line of defense for bulls in the short term.

The rally has continued following an important weekly close for longer-term investors above the SPX's 160-week moving average in late December, after a beginning-of-the-week break of this trendline on Christmas Eve. The low on Christmas Eve occurred at the SPX's 200-week moving average, which is another trendline we'll focus on if the lows are retested in the coming weeks or months. We noticed that this trendline marked the exact lows in 1987, February 2016, and December 2018, making it worthwhile to have on your radar, particularly during periods of market distress like December. Just as the 160-week moving average is approximately a three-year moving average that we have focused on for weekly closes, the 200-week moving average is a round-number moving average that approximates a four-year moving average.

 

MMO spx one-year weekly

SPX round-number resistance at 2,600 now resides just overhead, and this could take on more importance this week, with standard January options due to expire. Because of this, we turn to the SPDR S&P 500 ETF Trust (SPY - 258.98) January open interest configuration, where there is a huge amount of put and call open interest at the 260 strike, which is equivalent to SPX 2,600. Buying and selling related to this open interest could create a speed bump through Friday's expiration, much like the week-long speed bump that occurred around the 250 strike from the end of December into the first week of January. 

A delta-hedge sell-off, like we saw in December, is unlikely, given how far out of the money the major put strike open interest below the SPY's Friday’s close is coming into expiration week. 

MMO SPY jan oi

And if we look beyond January expiration, there are multiple resistance levels overhead with which the SPX must overcome if it continues to make its way higher from the December lows. A major area to watch is between 2,650 (into the first week of February) and 2,690 (through this Friday), which represents potential trendline resistance when connecting the Oct. 3 peak with the Dec. 3 peak (you can see this trendline on the SPX chart above). Levels connected with this trendline move lower as time passes, which is why I gave a wide range to monitor beginning with this week into early February. For what it is worth, when looking at a similar trendline during the January-March 2018 correction that connected the mid-January and mid-March highs, a continuation of this trendline was at 2,350 in late December, when the SPX bottomed.

"Bulls would like to see the VIX get below 18.30, which is double the 2018 closing low and roughly half last month's intraday high."
-- Monday Morning Outlook, January 7, 2019

The Cboe Volatility Index (VIX - 18.19) action could give us a clue as to whether the next move will be a retest of the low or a continuation rally from the December bottom. The VIX comes into the week situated between half its December closing high at 18.03, but below half its 2018 closing high at 18.66 and double its 2018 closing low at 18.44. In other words, this area between 18.03 and 18.66 is significant relative to important closing highs and lows since January 2018. A daily close below 18.03 could indicate lower volatility ahead, combined with further strength in equities.   

Unfortunately, with the government shutdown, the net positions of VIX futures large speculators has not been reported by the Commodity Futures Trading Commission (CTFC). As of the last report date, Dec. 18, this group, which is usually wrong at major turning points in volatility, was in a rare net long position. This favors the bulls, especially after the SPX's bounce from long-term moving average support around the time of the position update.

MMO daily VIX chart

"The shorts could create a headwind for equities as they try to build on last week's rally. Short interest data as of Dec. 15 was released last week and again, to my surprise, there was not a noticeable build-up of short positions on SPX component names, which I found unusual in the context of what has transpired since September. A concern for bulls is that the shorts could be looking for more ideal entry points, and thus use rallies to initiate new positions."
-- Monday Morning Outlook, December 31, 2018

Finally, I’ll leave you with what appears to be potentially good news for bulls. As the market rallied from the Christmas Eve closing low, it looks like shorts indeed built up positions, but it was not a very big buildup, according to short interest data as of Jan. 1, 2019, that we compiled on SPX components. The fact the SPX rallied during this build is also encouraging, as it is indicative of money coming off the sidelines that was able to overcome the shorting activity, and many of the freshly added shorts are now in a losing position, which might generate covering.

MMO SPX short interest

Above said, there is still a risk to bulls that the shorts are looking for higher levels to unleash their fury, and these could be at levels that I discussed above. But it appears that the group that might be most prone to building a short position, the hedge funds, may be looking to build long positions instead. For example, look at the chart below that quantifies buy-to-open put and call volume on major exchange-traded funds (ETFs), such as the SPY, iShares Russell 2000 ETF (IWM - 143.68), and tech-laden Invesco QQQ Trust Series (QQQ - 160.69). 

Since some hedge funds use these ETFs as hedging vehicles, the buy-to-open put/call volume ratio tends to decline because they are either liquidating long positions (buying fewer puts as a hedge) or buying more calls relative to puts as they build short positions. The ratio rolled over prior to the most recent setback, as put buying plunged (indicative of hedge funds liquidating long positions). 

The ratio recently bottomed at a multi-year low and is now ticking higher, due to put demand growing again. When the buy-to-open put/call volume ratio was this low in early 2014 and began moving higher, it was a major buying opportunity, as the hedge funds were likely in accumulation mode, building long positions from a historically low exposure level. All indications are these funds have very low stock exposure, and continued accumulation from this crowd could drive the SPX through resistance.

In other words, instead of short covering driving a continued "V" rally, it might be hedge-fund cash moving off the sidelines. There is no way to predict where this volume ratio is headed, but if it continues to rise amid a rising SPX, this would be good news for bulls.

MMO jan 13 pc ratio

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