Bond Market Could Be Signaling "Risk-Off" Conditions

The 36-month moving average could be key support for the S&P

Senior Vice President of Research
Jan 27, 2020 at 8:57 AM
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While Friday’s trading may prove pivotal as you will find later in the commentary, the beat goes on, with the S&P 500 Index (SPX - 3.295.47) notching another all-time closing high last week. Stocks hit all-time highs, trumping sentiment indicators that have been suggesting higher-than-normal vulnerability due to a short-term decline.

One area that I identified as a potential SPX hesitation point late last week on Twitter is the 3,335 zone, which is five times the 2007-2009 bear market low at 666.79. In the chart below, note that after months of monthly gains, the doubling, tripling and quadrupling of the 2009 low, marked either a short-term resistance area (2011) or long consolidations and choppiness in which sideways movement above and below these respective level, was about equal and lasted for months (2014-2015, 2018).

In the three cases that the SPX doubled, tripled and quadrupled its 2009 low, the SPX’s 36-month moving average, which equates to a three-year moving average, eventually acted as support on pullbacks and long-term consolidations. When the SPX doubled off its 2009 low in February 2011, the SPX was 22% above the 36-month moving average that was beginning its ascent higher. Similarly, the SPX is currently 22% above its rising three-year moving average, which is currently at 2,743.

Last week, the SPX stalled in the 3,335 area, which I find interesting in the context of the discussion above. However, the index remains comfortably above its short-term 30-day moving average at 3,247, a trendline that contained the mild pullback in early December. But with the SPX failure last week at five times its 2009 low, I couldn’t help but notice how sellers emerged last week after the Russell 2000 Index (RUT - 1,662.23) closed the previous week a shade above the 1,700-century mark. On an intraday basis last week, the RUT traded as high as 1,720, a level that acted as resistance in June-August 2018 as it drifted sideways ahead of the September-October pullback.

spx30day jan 26

The message in the discussion above and the chart below is that 3,335 could be a resistance area in the short term, catching both equity option buyers and large speculators on CBOE Market Volatility Index futures off guard, who are displaying a multi-year high or near high in optimism in regards to higher equities and lower volatility in the broad market.

Or, if past is prologue, and current momentum pushes the SPX above this zone, it would be expected to be followed by limited gains, with a retest of 3,335 occurring not long after the breakout.

spx 36 month jan 36

I alluded to expectations of lower broad market volatility among many market participants, as measured by the positioning of large speculators on CBOE Volatility Index (VIX - 14.56) futures. And last week, I mentioned heightened possibility of a VIX pop, with the VIX trading at historical support in the 12 area, VIX call buying relative to put buying increasing to levels that have preceded the past few pops, and historically wrong-way large speculators in an extreme net short position.

More events that can potentially contribute to an increase in volatility unfolded last week. And I am not only referring to the outbreak of a SARS-like virus in China that is creating anxiety or the beginning of the Trump impeachment opening arguments in the Senate. I am also referring to the standard expiration of January VIX options, which generates a sharp drop-off in call options. While not all standard VIX expirations are followed by a big move higher in volatility, note in the chart below, courtesy of our friends at Trade-Alert, that when VIX pops happen, it is usually soon following a big drop off in call open interest due to standard VIX expirations. April, July and November 2019 expirations are prime examples.

VIX call open interestz

“…one indicator that was not warning of a VIX pop for months is now flashing a warning... Veterans of the market know that ‘momentum begets momentum,’ ‘the trend is your friend,’ ‘you don’t fight the Fed,’ and ‘you don’t fight the tape.’… One way to reconcile all of this is simply continuing with a theme that I’ve been preaching for weeks. Use call options in lieu of buying stock outright to manage risk and ride the momentum. Call options allow you to put less dollars at risk relative to equities, while the leverage allows you to achieve the profits you are seeking. And if you do have a long equity portfolio, take advantage of cheaper index and equity benchmark exchange-traded fund (ETF) options and hedge your portfolio with puts. Or, given the heightened risk of a volatility pop, purchase calls on VIX futures options or another volatility benchmark.”

- Monday Morning Outlook, January 21, 2020

“I would have to see the VIX close above 15.50 (above its one-year moving average and the trendline connecting lower highs since August) in the upcoming week before growing more confident that a serious volatility pop or stock drop is imminent.”

- Monday Morning Outlook, January 21, 2020

The last several weeks have been all about managing risk by utilizing options while riding the momentum upward. The jury is still out as to whether or not we are on the verge of a corrective move in the market that ends the momentum game, as the SPX remains above its 30-day moving average that contained the only pullback since the October breakout.

While the VIX popped on Friday, note that it closed beneath key levels that were discussed in last week’s commentary. The jury is still out as to whether we are on the verge of the first volatility event since around July-August when the VIX doubled in a short period. But for now, volatility is still in declining mode when measuring it in the context of where it is relative to its one-year moving average and a key trendline connecting lower highs since August.

vix 252 ma jan 26

Yellow flags are waving for short-term bulls, as the SPX’s failure at 3,335 was followed by a close below the 3,300-century mark. Additionally, the RUT’s failure at 1,700 preceded a close below its year-to-date breakeven mark at 1,668.46. Finally, the Dow Jones Industrial Average’s (DJI - 28,989.73) failure at 29,000 is another factor that you can add to your list of indicators hinting at a pullback after an impressive run higher since October.

If a “risk-off” period is imminent, the bond market is sending such a signal. For example, the iShares 20+ Year Treasury Bond ETF (TLT - 142.08) broke out above a trendline connecting lower highs since August. Additionally, with large speculators short the 10-year note, which similarly experienced a breakout, an unwinding of pessimism in the bond market and optimism in the stock market sets up a period in which bonds may rally and stocks decline in the coming days or weeks.

While red flags are not waving yet with respect to a surge in volatility, I still think it is a good idea to use volatility instruments as a hedge if you are heavily tilted toward riding the momentum higher that began in October. And if you view Friday’s pullback as an opportunity to leg into equities that you expect to move higher, utilize call options in lieu of stocks as a risk-management tool.

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

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