How This S&P Volatility Reading Could Play Into a Pullback

The SPX 20-day historical volatility, combined with excessive optimism, could spark a correction

CMT, Senior Market Strategist
Jan 13, 2020 at 8:34 AM
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To say the market has been resilient in the first full week of trading during the new year is an understatement. In the face of mounting geopolitical tensions, the S&P 500 Index (SPX - 3,265.35) has managed to remain in positive territory for the year and continue its melt-up from the holidays, despite escalating events between the U.S. and Iran. This leaves many market participants wondering if the market can maintain its current record-setting pace amid new uncertainties as we head into expiration week, earnings season, and the expected signing of the "phase one" trade deal between the U.S. and China.

SPX yield jan 13x

From a fundamental perspective, valuations are once again stretched with many financial pundits pointing to the S&P 500 forward 12-month price/sales ratio at 2.2 and S&P 500 EV/EBTIDA ratio hovering around 14x, which are levels last seen in January 2018 and are largely perpetrated by the unprecedented easy money policies set by central bankers globally, while corporate profits have been in a steady decline since 2014. I don’t disagree that these extremes aren’t scary, as many other strategists on the Street have stated, but I think it needs to be put into context from a cross-asset perspective as well.  When you look at it on a relative basis from the yield on S&P 500 earnings and the yield from bonds (we use the U.S. 10-year Treasury as a proxy), stocks aren’t that expensive on a relative basis.

Moreover, earnings are expected to start flat-to-negative on a year-over-year basis, but we expect to see earnings improvement throughout the year. So, while it would be constructive for valuations to consolidate, and these levels present some near-term risks, we're likely still in a yield-seeking environment for the foreseeable future. The only caveat that I see which could change this perspective is if we get a more balanced global recovery, which appears possible as we’ve seen positive data coming out of Europe. This could eventually force the hands of central bankers to start once again tightening and ending the yield-seeking behavior cycle that is driving investors into equities, but this likely wouldn’t be a negative headwind until later this year or early 2021. 

E-Mini SPX Futures

Now from a technical perspective, the market still looks very bullish, and it has paid handsomely not to fight the trend or the Fed, but cracks are emerging with some divergences starting to appear on daily charts, and we need to keep in mind there are still many short-term risks. First, the S&P 500 pulled back last week around 3,288, which is the 161.78% Fibonacci extension level from the September 2018 high, and December 2018 low when using weekly closing candles.

E-mini SPX 9 Month

Additionally, the weekly Relative Strength Index (RSI) level sits in overbought territory at 75.55, and at a level we have not seen since January 2018. As I previously mentioned, we’re starting to see some divergences on daily charts, and most notably in RSI, where we peaked in late December. This behavior can remain for a while before it eventually rolls over to weekly indicators, but it’s important to remember divergences aren’t the best timing indicator and a better warning flag to simply be cautious when allocating new capital.

SPI OI Config

When looking at the SPDR 500 Trust (SPY – 325.71) open interest (OI) configuration for expiration next week, we see a wall of calls at the 330 strike that coincides with the Fibonacci extension we mentioned above that is likely to act as major resistance. Looking for possible support, we find that the peak put is down at the 320 strike, which leads us to believe that we’ll likely be range-bound next week, barring any unexpected catalysts. Looking further out into February and March, the 330-call strike could remain a barrier from an OI perspective, while we have some stacked put levels below with peak put at the round 300-strike.

SPY OI Thru March

Equity Options Buyers

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.

-- Monday Morning Outlook, January 6, 2020

Sentiment has remained at extreme levels for over a month now while the market continued to rally. As we’ve mentioned the past few weeks, a risk to equity buyers is the 10-day, all-equity, buy (to open) put/call volume ratio, which recently broke below the 2019 and 2018 lows, and now at 0.44 is its lowest level since June 2014. It also may finally be putting in a floor, as it has remained near 0.45 for one month now, and any negative catalyst could signal a sharp upward reversal from here that typically leads to pullbacks in the market.

SPX IVs jan 13

Furthermore, the SPX 20-day historical volatility is sub-7%, while SPX implied volatility is 13%, representing a wider-than-usual spread that typically widens as we near inflection points. While this by no means in itself indicates an immediate correction – as we’ve seen this spread remain wider than usual for long periods like the 2017 melt-up -- when it is combined with extreme levels in the 10-day, all-equity, buy (to open) put/call volume ratio, we have the right conditions that can create a pullback or correction to unwind the euphoric behavior**.

If we were to get a pullback, it is most likely another buyable dip, as we have multiple support levels just below from the OI perspective, and two other technical areas that have caught my attention. First, the 310 strike coincides with the S&P 500 breakout level and the 26-week moving average/6-month moving average, which has held since Q1 2019. Second is the round 300 strike that coincides with a rising 160-day moving average that has also held since the March 2019 lows.

For the last two weeks, 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

However, we’ll likely need a negative catalyst to get the ball rolling, as we’ve discussed over the past few weeks. The CBOE Volatility Index (VIX -- 12.56) is still firmly entrenched in a downtrend, as it was rejected once again at the trendline and sent back to the support level in the 12’s.  

So, the market firmly is in a bullish trend in which market participants should not fight until we get a negative catalyst. But, with all these factors we’ve covered, more conservative market participants might want to look towards options as a stock replacement strategy to reduce capital at risk or look to add some cheap short-term protective to puts to their portfolio for insurance at these levels in case we get a pullback. 

**This paragraph has been updated to better explain the role current historical volatility levels could play in the market going forward.

Matthew Timpane is Schaeffer's Senior Market Strategist.

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