There's No Way to Time the Biggest Risk to Stocks Right Now

Bullish stock market momentum has stalled, but the Fed provides a couple of silver linings

Senior Vice President of Research
Apr 1, 2019 at 8:31 AM
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The first quarter of 2019 is in the books. The S&P 500 Index (SPX - 2,834.40) logged an impressive 13% advance, following a lousy fourth quarter that saw the index lose 14%. In case you missed Schaeffer's Senior Quantitative Analyst Rocky White's Indicator of the Week commentary last Wednesday, he discussed the historical implications of "bounceback" quarters like we saw in the first quarter. The sample size is small, as one would expect, but the expected future returns are big, per the table below. For more details and perspective on this, you can click on the embedded link.

spx bounceback quarter returns 0331

"...U.S. investors added a net of $14.2 billion into domestic stock funds over the last two weeks, the most over a two-week span since the net $17.4 billion invested in late January 2018. Domestic stock funds have brought in a net of $715 million over the 11 full weeks of the year to date... World stock funds, meanwhile, continued a five-week streak of shedding assets, dropping a net of $3.6 billion last week... For the year to date, world stock funds have brought in a net of $4.4 billion... Bond funds overall added a net of $10.6 billion in assets last week, continuing a streak of positive inflows over every full week of 2019. Since the start of January, bond funds have garnered a net of $104.1 billion."
-- Reuters, March 27, 2019

Despite a robust start to 2019, there is hardly enthusiasm for the rally in U.S. stocks, based on fund flows data. Per the bold text (mine) in the Reuters excerpt immediately above, net inflows into domestic stock funds tallied less than $1 billion in the first 11 weeks of 2019. Investors favored world stock funds, but were most enamored with bond funds, as inflows into domestic stock funds were less than 1% of the year-to-date $104 billion of inflows into bond funds. This data reflects that a slowdown in U.S. growth and earnings is expected -- which bulls should embrace, as lower expectations translate into lower odds for negative surprises down the road.

Moreover, if growth and earnings come in higher than expected, cash could come back into U.S. stocks, building on the historical returns that have followed "bounceback quarters" as we move into the rest of 2019.

Most of the SPX's gains came in the first two months of the year, with the SPX hitting a speed bump in the 2,800-2,820 area in late February. While inflows into stock funds began picking up two weeks ago, there is evidence that deeper-pocketed market participants have reduced exposure in recent weeks.

For example, the combined buy-to-open put/call volume ratio on the three major U.S. equity exchange-traded funds -- the SPDR S&P 500 ETF Trust (SPY), Invesco QQQ Trust (QQQ), and iShares Russell 2000 ETF (IWM) -- is rolling lower, in a sign that the hedging activity that usually coincides with hedge funds accumulating equities is waning.

spy-qqq-iwm put-call ratio 0331

Furthermore, survey data from the National Association of Active Investment Managers (NAAIM) shows active managers reducing their exposure to stocks.

naaim sentiment survey 0331

"...the SPX's 2,800 level is on the radar of many chartists as a potential resistance area -- a level that is now very much in view. This is an important level, as it is a round number and the site of the past highs as I mentioned last week. But if indeed a short-term top or a hesitation in the upside momentum occurs, I would find it interesting if it occurred at 2,820 -- a level that is a round 20% above the December closing low, and not on the radar of many as a potential hesitation point."
-- Monday Morning Outlook, February 25, 2019

The SPX's hourly chart below is a nice visual of the major sideways action that has been present for more than a month. I brought up the possibility of profit-taking or a decrease in potential buyers in late February, as significant selling emerged around the 2,800 level multiple times in 2018 and, as such, this was a key level on the radar of many technicians. Also, with the 2,820 level situated 20% above the December 2018 closing low, such round-number percentages above a major pivot point would likely inspire profit taking or give potential buyers pause.

spy hourly chart 0331

The bad news for bulls is that the January-February momentum has stalled, but there are silver linings worth discussing.

First, the early March pullback from the 2,800-2,820 area was not nearly as vicious as the declines that ranged from 6% to 16% in only a few weeks in 2018. These sell-offs occurred in the context of the Fed raising rates and anticipating more hikes in 2019, as growth worries and macro uncertainties were front-and-center on investors' minds.

In contrast, the present sideways action in the 2,800-2,820 range occurs in the context of the same growth and macro uncertainties, but the Fed has held rates steady twice this year, and changed their outlook to no rate hikes this year. In other words, a "Fed tailwind" is balancing a growing consensus that earnings and economic growth are poised to slow, and has created more stability at current SPX levels relative to last year.

Moreover, the winds favor bulls in the month following decisions to hold interest rates steady, as the Federal Open Market Committee (FOMC) did on March 20. The table below displays the SPY action in the calendar month following a rate hike versus a rate hold since the tightening cycle began in December 2015. Since the March 20 decision, the SPY had closed above the pre-FOMC decision day close of $282.40 only once, prior to Friday's close above this level.

spy returns after fed days 0331

The biggest risk to the bull case continues to be the positioning of wrong-way Cboe Volatility Index (VIX - 13.71) futures players, who are nearing an extreme in the short volatility trade, per the latest Commitments of Traders (CoT) data. Unfortunately, the timing of this vulnerability -- a VIX spike coincident with a market pullback -- is uncertain. In 2017, the short volatility trade was in place for several months before the VIX eventually exploded higher, while the short volatility futures trade was popular for just two months ahead of the fourth-quarter explosion higher in volatility.

I continue to focus on the 18 level on the VIX as significant, as it is one-half December's closing high. In fact, this level marked two peaks last month. If the VIX moves above 18, there is a heightened chance of stocks suffering a short-term setback as the current short volatility trade is unwound.

cot large specs net short vix futures 0331

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