Stay the Bullish Course Until This VIX Pattern is Broken

Short interest could be supportive of stocks, too

Senior Vice President of Research
Jan 6, 2020 at 8:39 AM
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The first two trading days of 2020 did not lack market-moving macro catalysts. The new year and new decade got off to a roaring start, as U.S. equities rallied in response to China's central bank reducing the reserve ratio for commercial banks by 50 basis points. The S&P 500 Index (SPX - 3,234.85) advanced nearly 1% to kick off 2020 on the news, closing at an all-time high. Likewise, leadership in the technology group continued, with the Nasdaq Composite (IXIC - 9,020.77) notching another all-time high, closing comfortably above the 9,000-millennium mark.

But overnight headlines ahead of Friday's trading worked to undue a portion of the gains from the first trading day of the year. Additionally, oil prices jumped and safe havens, such as gold and bonds, rallied after it was reported that the U.S. killed an influential Iranian military leader. A potential escalation of the conflict caused one Fed official to mention the event as adding to recession risks, while others feared it could stir up inflation.

The latter headline caused only a mild sell-off, however, as the SPX reversed off its morning lows, which occurred around the December 2019 close at 3,230.78. As long-term readers of Monday Morning Outlook are fully aware, this is not the first time that a year-to-date breakeven area acted as support or resistance on a widely followed benchmark or asset. 

As we begin the year, we’ll closely watch 2019 closing levels on key benchmarks, as noted in the below table.

2019 us stock market closing levels

"Not everyone is fading this rally, so there are risks from a sentiment perspective. The first is one that I highlighted last week, with the 10-day, all-equity, buy (to open) put/call volume ratio at a multi-year low. However, it is not yet turning higher. In most cases, a turn higher in this ratio from a low level precedes a notable pullback in equities. It would likely take a negative catalyst to reverse the current optimistic mindset of equity option buyers."
-- Monday Morning Outlook, December 30, 2019

With the 10-day, all-equity, buy (to open) put/call volume ratio at its lowest level since June 2014, the immediate risk to bulls is the euphoric sentiment among short-term traders, as measured by the option activity on individual equity options. I said in the previous week that if a negative catalyst arises at a time that this ratio is extremely low, it could set into motion the unwind of the optimistic views among traders, resulting in an equity market sell-off.

equity options buyers jan 4

"If the SPX drops noticeably in the beginning of 2020, I look for the 3,150 area to be a first area of potential support, site of its 30-day moving average that caught the early December pullback and the November high."
-- Monday Morning Outlook, December 30, 2019

A negative catalyst came into play on Friday, which resulted in some selling. However, the selling was contained, as the SPX remained above its 2019 close, the round 3,200 century mark, and comfortably above its 30-day moving average that marked the low in December. As I mentioned last week, this moving average is the first line of defense if a noticeable pullback occurs.

With the SPX trending higher on the heels of the Fed's third rate cut in late-October 2019 and Chairman Jerome Powell's suggestion that a rate hike is likely to not occur until he sees a persistence of inflation, investors may be viewing the Fed as a friendly backstop to prevent a serious increase in recession risks.  

spx daily chart jan 4

"…the VIX has found 'support' at 12, but stocks have rallied even with this floor in place. While large speculators have covered some short positions in VIX futures, they are still at an extreme and thus vulnerable to a sharp spike in volatility futures that occurs with decline in stocks… Bulls hope that if there is another VIX spike in the immediate horizon, the trendline marking lower highs since the August peak holds -- which is currently at 16.78, but declining daily."
-- Monday Morning Outlook, December 30, 2019

Turning to the Cboe Volatility Index (VIX - 14.02), Friday's intraday high at 16.20 was interesting, as it was just below the trendline marking lower highs that I discussed last week. This would suggest that volatility is still declining, which is a plus for bulls.

vix daily chart jan 4

A topic that I have brought up in recent weeks is short interest on SPX components being at multi-month highs, with no visible signs of covering since the breakout above the summer's highs in early November. With that said, if the shorts are finally in covering mode, this could be supportive of stocks and thus contain volatility spikes. 

But keep in mind that there is still an extreme short position in volatility futures, which is another risk to the short-term bull case. If there is a sign that the current downtrend in volatility is broken, be prepared for at least an SPX pullback to the 3,150-3,170 area. 

In the meantime, the "glass half-full" angle is that there is room for a VIX decline to the 12 area, that would likely be coincident with new highs, as equities continue to plow ahead despite a visible and obvious VIX floor in place for several months. Stay the short-term bullish course until this pattern is broken.

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

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