How High Neutral Sentiment Impacts Stocks

The small-cap breakout above 1,600 paves the way for an eventual move to RUT 1,700

Senior Vice President of Research
May 6, 2019 at 8:20 AM
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"History suggests that a run through 2,900 and back to the September intraday high of 2,940 is imminent. Since 1950, in the 11 instances in which the SPX experienced at least a 20% decline from intraday high to intraday low, as it did in the fourth quarter, and then rallied back to within 2% of its intraday high, which occurred on Friday when the SPX closed above 2,882.09, the previous intraday high was touched on nine of those occasions within 33 calendar days."
-- Monday Morning Outlook, April 8, 2019

"While 1,600 continues to act as resistance, a bullish factor for the RUT is that it is trading above a trendline marking lower highs, suggesting a breakout above 1,600 is imminent. Moreover, unlike Invesco QQQ Trust (QQQ - 190.65) and SPX components, short interest on RUT components remains high and is a source of fuel to push the RUT above 1,600 in the coming weeks."
-- Monday Morning Outlook, April 29, 2019

The S&P 500 Index (SPX - 2,945.64) and Russell 2000 Index (RUT - 1,614.02) reached -- and even rallied above -- key levels that I've been discussing in recent weeks. In fact, the SPX made it 10 instances out of 12 in which it touched, within a 33-day time span, its previous intraday high after a 20% decline and a rally to within 2% of this intraday high. That touch of the 2,940 target level occurred on the first trading day last week, and the SPX essentially went sideways throughout the rest of the week, achieving an all-time closing high on Wednesday.

While the SPX reached its former intraday high on the first trading day of last week, it wasn't until the last day of the week that the RUT managed its first close above the 1,600 century mark since Oct. 9 (the day before it crashed back below this level after five months of trading above it). The RUT 1,600 level has been in play since late February -- but as I mentioned last week, the combination of an improving technical backdrop and massive short-covering potential on RUT components provided an ideal backdrop for a breakout above 1,600. While the RUT remains 7% below its Aug. 31 all-time closing high at 1,740, the breakout above 1,600 paves the way for a move to at least 1,700 in the coming weeks.

rut daily chart 0505

"Fed Minutes: Officials See Little Need to Change Rates This Year"
-- The Wall Street Journal, April 10, 2019

"Fed Holds Rates Steady, Says Spending, Inflation Have Slowed"
-- The Wall Street Journal, May 1, 2019

As expected, the Fed held rates steady at its policy meeting last Wednesday. In last week's Monday Morning Outlook, a table in the commentary showed that after the 25 decisions to hold rates steady since the rate-tightening cycle began in December 2015, the SPDR S&P 500 ETF Trust (SPY - 294.03) advanced over the next month on 19 of those occasions. The median return was 2.2%, with an average positive gain of 2.7%. So there is a monetary tailwind for equities, as measured by the SPY, in the month ahead -- and possibly in the months ahead.

While the iShares Russell 2000 ETF (IWM - 160.53), which is about one-tenth the value of the RUT, only rallied on 16 of the 25 occasions in the month after the Fed held rates steady, its average positive return of 4.1% is roughly 1.5 times the SPY's average positive return of 2.7%.

In addition to technical and monetary factors, another bullish factor for the IWM in the coming two weeks is the potential for short covering related to the big put open interest at the 157 strike and below. But short-term small-cap bulls should be ready to bail if the IWM falls below the 155 strike before May expiration, as delta-hedge selling could kick in as big put open interest strikes act like magnets -- in addition to technical selling from those who waited to buy the IWM until after the early April trendline breakout.

iwm open interest by strike 0505

"...JPMorgan says now is not the time to bail on the market. The reason: investors who have missed the rally are ready to buy at signs of trouble.

'When talking to clients, we don't find many truly convinced bears at this point, but rather investors who would like to add at ~5-10% lower levels and capture a return to new all-time highs,' strategists led by Marko Kolanovic wrote in a note. 'This means that (all else equal) any potential pullback is likely to be shallow.'

Another group, computer-driven funds, which have bought $250 billion of stocks during the post-Christmas rally, could add a similar amount before maxing out, they estimated. Meanwhile, money managers who pick stocks based on fundamentals have yet to raise equity holdings in any meaningful way and retail investors were net sellers, the firm's data showed."

-- Bloomberg, April 29, 2019

"Only 49% of the 148 professional money managers responding to Barron's spring 2019 Big Money poll call themselves bullish about the prospects for stocks over the next 12 months, down from 56% in our fall 2018 survey. The percentage of bulls hasn't dipped below 50% since the fall 2016 survey."
-- Barron's, April 26, 2019

Whether it is bullish price action factors related to the RUT above 1,600 or the SPX and Nasdaq Composite (IXIC - 8,163.99) closing at or around all-time highs, there isn't exactly a lot of euphoria surrounding this rally, as is evident in the excerpts above. That said, there are pockets of sentiment-based risks related to recent short-covering in SPX components and the huge build in Cboe Volatility Index (VIX - 12.87) futures short positions by large speculators in the weekly Commitments of Traders (CoT) reports. A takeaway might be neutral sentiment amid a strong market, which is exactly what we are seeing in the latest American Association of Individual Investors (AAII) weekly market survey, which showed more than 40% of respondents were neutral on the market.

We were curious what this has meant historically when neutral sentiment was this high coincident with the SPX hitting new all-time highs. Per the data in the table below, when a combination of all-time SPX highs is met with a high degree of neutral sentiment, it has been bullish. My takeaway is that market momentum related to short-covering activity will eventually move "sideline" money into equities.

spx after aaii neutral extreme

As I alluded to above, there has been a lot of short covering on SPX and Invesco QQQ Trust (QQQ - 191.11) components, and large speculators hold a record short position on VIX futures -- which I see as the biggest sentiment-based risk, as this group has been dead wrong on major volatility moves when they've been positioned at extremes (see the chart immediately below). As such, bulls should emphasize long positions, but use options to manage the heightened risk of a short-term volatility surge.

cot large speculators vix futures record net short

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