S&P Stares Down the Rally-Killer

How to trade a continued replay of the September 2014 S&P scenario

Senior Vice President of Research
Sep 3, 2019 at 6:00 AM
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"A spokesman for China’s Commerce Ministry said Thursday that the U.S. and China remain in communication over possible talks in September and added that Beijing hopes to prioritize discussions about removing the latest tariffs announced by President Trump to prevent a further escalation of the trade war."
-- The Wall Street Journal, August 29, 2019

Last week, market participants ignored headlines pointing to a growing likelihood of a no-deal Brexit, and instead continued to be glued to U.S.-China trade talks. The first of which rallied on Monday morning on unconfirmed reports that Chinese officials had called President Trump showing interest in continuing talks, and then sharply rallied on Thursday when a spokesman for China's Commerce Ministry commented on the direction of trade talks.

"The volatility spike pushed the spot VIX above the September VIX futures contract -- a rare condition known as backwardation, and a sign of fear entering the market that typically lasts anywhere from a few days to a few weeks."
-- Monday Morning Outlook, August 26, 2019

As stocks rallied, volatility expectations, as measured by the Cboe Volatility Index (VIX - 18.98), retreated. Moreover, the VIX backwardation that I referenced last week was no longer evident; spot VIX was trading back below the September futures contract on Thursday, as heightened fears related to the previous Friday's Twitter barrage by President Donald Trump quickly subsided.

Again, it is a market that seems to be held hostage to the latest headlines related to the U.S.-China trade war, and the most we can do is note patterns that are indicative of prospects for increasing volatility (and lower stock prices) or calmer waters ahead (indicating flat to higher stock prices).

Yes, the inverted yield curve has been grabbing a lot of attention, too. This may be driven by supply-chain worries tied to growing perceptions of a long, protracted trade war. Other factors -- Brexit, for example, or political uncertainties both here and overseas -- may be impacting economic growth perceptions, and therefore interest rates based on different maturities. With the yield curve inversion such a hot topic, don't miss the in-depth discussion written by Schaeffer's Senior Quantitative Analyst Rocky White on the historical implications for stock prices after a yield curve inversion, in addition to the importance of the direction of the yield curve for determining the appropriate time to sell stocks.

"... there has been substantial short-covering by large speculators on VIX futures, per the latest Commitments of Traders (CoT) report. Large speculators were once again dead wrong ahead of this latest pop in volatility. This group remains net short, albeit not at the alarming extreme that we saw entering the month of August."
-- Monday Morning Outlook, August 26, 2019

If you have been following my commentary, whether a long-time reader or new during the past several weeks, you know that I track the action of option buyers on VIX futures via data that we purchase from the Cboe Options Exchange to get a clue as to where volatility is headed. This, in addition to the positioning of large speculators on VIX futures -- a group that has been dead wrong when at a major extreme -- per the weekly Commitments of Traders report (CoT). I commented on the latter last week.

The chart below is on my radar currently. Specifically, after the Aug. 5 volatility peak that occurred at double the VIX's 2019 closing low, there has not been a steady stream of call buying relative to put buying on VIX futures like we saw ahead of the late-July/early August volatility surge that occurred when President Trump announced the U.S. would impose 10% tariffs on an additional $300 billion in Chinese goods, setting off the latest in a long run of trade tensions.

And even as the White House indicated late last week that we are far from a trade deal, note that the buy-to-open VIX call/put volume ratio continues its descent. Also note that ahead of other major volatility surges during the past year that the ratio of VIX call buying to put buying grew notably and steadily. The current lack of intense call buying could be indicative of another notable volatility spike not being on the immediate horizon.

vix daily chart 0901

"… another question mark is whether the SPX can continue a pattern of holding its year-over-year (YoY) breakeven level. Coming into this morning's trading, the YoY breakeven is in the vicinity of the SPX's 160-day moving average, a trendline that I have referenced on Twitter and in this report as being significant recently… the rolling YoY breakeven has been supportive throughout 2019. If the SPX continues to maintain this pattern, it will have to close this month at the round 2,900 level or above."
-- Monday Morning Outlook, August 26, 2019

As for stock prices, the last week of August proved pivotal, as the S&P 500 Index (SPX - 2,926.46) not only held support at levels I have discussed here and on Twitter, but also rallied notably to maintain a pattern of finding "support" at its year-over-year breakeven level, per the bold in the excerpt above. Some attributed last week's rally to re-balancing, after a month in which stocks dropped and bonds popped higher. To the extent that this re-balancing act is over and sellers emerge this week, the SPX can drop to 2,878 at the end of this holiday-shortened week and still be at its year-over-year breakeven.

Regardless, since September 2018, the half-century 2,950 mark has been a "rally-killer" on several occasions, including this month. Bulls are hoping that this level is taken out, while bears are pinning their hopes that this continues to mark the top of the current range. Even if 2,950 is taken out, there is not a lot of upside to the key 3,000 millennium level, which marked a noticeable top in the short term.

spx daily 160-day 0901

If you are to make historical comparisons, the SPX's action last month compares remarkably to the SPX in September-October 2014. Just as the round 3,000 area was an important barrier last month, note in the chart below how the SPX's first run at 2,000 did not turn out well, either, in the short term.

In 2014, the SPX was rejected at 2,000, and a near-7% correction ensued over the next month. Ultimately, the historically significant, but unpopular, 320-day moving average marked an important bottom. And if the mid-August 2019 closing low at 2,840 marks a low, the pullback from closing high to closing low would be about 6%, with the bottom occurring at the significant, but unpopular, 160-day moving average.

spx daily 2014 0901

"A stronger dollar can have a dampening effect on growth and inflation, as well as undermine U.S. competitiveness. It eats into exporters' earnings and lends a hand to foreign producers competing with U.S. firms inside the American market."
-- The Wall Street Journal, September 26, 2014

By the way, I couldn't help but capture the above quote from The Wall Street Journal from late September 2014, when U.S. equities were in the midst of a decline from the round 2,000 level. A strong dollar fueled worries about growth and a lack of inflation, which is eerily similar to concerns on Wall Street now.

Moreover, if 2019 continues to "rhyme" with 2014, you can make a sentiment case for at least a retest, and quite possibly a breakout above 3,000, if bearish sentiment unwinds. In the American Association of Individual Investors (AAII) survey, the four-week moving average of bulls is just below 28%. For perspective, this moving average was around 24% at the 2009 low. It seems investors are reacting more to bloody headlines than equity price action, as in early 2009 we were in full-blown bear market mode.

And per the chart below, note that the 10-day, equity-only, buy-to-open put/call volume ratio recently peaked around two-year highs, and is declining. Historically, this has been a short-term buy signal.

put-call ratio with spx 0901

If you are looking for a repeat of 2014, continue to use call options in lieu of stocks in order to manage risk. One risk that I see is that volatility could still be trending higher, as the VIX remains above its 80-day moving average at 16.23, with its Friday morning low at 17.09 occurring just above its 200-day moving average. Both trendlines have marked support on "volatility pullbacks" recently (see second chart below).

vix key chart levels 0901

But betting on the VIX breaking below these trendlines is not a bad bet to make, considering the sentiment factors that are in play discussed above. And the VIX is showing a pattern reminiscent of prior peaks, with "aftershock" advances that make a lower high following the first peak.

Todd Salamone is Schaeffer's Senior V.P. of Research.

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