“After finding resistance at five times the 2009 low, a level I cautioned Twitter followers about on Jan. 24…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.”
-Monday Morning Outlook, January 27, 2020
As the S&P 500 Index (SPX—2,954.22) approached the 3,335 area in late January -- an area five times its 2009 low -- I cautioned readers about the growing risk of a long-term choppy period around this level and/or a sharp pullback. The caution was based on a combination of factors, including extremes in optimism based on a sentiment reading we track closely and the historical price action since 2009. Specifically related to the latter clue, in instances when the SPX doubled, tripled and quadrupled the 2009 low, either a sharp pullback immediately occurred or a lengthy consolidation period.
What we know now is that the caution was well-timed, as the SPX's violent decline of 12.4% during the past seven trading days. The media has proclaimed the events of the past several days to be the fastest corrective move from closing high ever. However, a sharp move of similar magnitude and duration occurred in December 2018, when the SPX was already rolling over from its October peak. With a rate hike imminent in mid-December 2018, the SPX tumbled 11.3% in seven trading days from December 13 through December 24. An impressive “V-rally” began immediately after Christmas Day that year.
The most recent action in the SPX closely mirrors that of February-August 2011, when the SPX hit the 1,335 area, double its 2009 low. After four months of battling this area, with small moves above and 1,370 marking the high in May of that year, a retest of 1,335 was quickly followed by a plunge to its 36-month moving average, a long-term trendline that has marked support on pullbacks in the months following a doubling, tripling or quadrupling of the 2009 low.
Per the chart immediately below, note that while the SPX is slightly above the 3,335 area, quintuple its 2009 low, a quick retest of 3,335 was immediately followed by a plunge, driven by growing coronavirus fears. The correction began just one day after a Goldman Sachs warning that a 10% correction was in the offing due to investors not pricing in potential negative impacts of the epidemic.
If the past is any indication of what the future might hold, long-term bulls should be happy, as the risk to reward has improved significantly from a technical perspective. In other words, with the 36-month moving average sitting at 2,775, it is just 100 points below Friday’s intraday low, implying downside risk has diminished sharply as a result of last week’s plunge. Risk of a move to 2,775 increases if the SPX closes below the 2,900-2,910 area, with the round -10% year-to-date loss level at 2,907 and 2,900 being a round century mark, levels it broke intraday on Friday, but closed above.
Shorter-term market participants should be cognizant that if this long-term moving average eventually marks a bottom. And, if this happens quickly, there is still sizablerisk of about 200 SPX points to the downside, even after the plunge we experienced in only a seven-day period.
The SPX’s 36-month moving average is ascending rapidly, implying the risk decreases from month to month if the SPX stabilizes. Again, the major assumption is that this trendline marks another bottom at some point. A decisive move below this trendline would likely indicate we are in for a rough few years.
“…One area you could reduce risk, however, is in big-cap technology names. I mention this sector specifically following a cover story in the Feb. 22-28 issue of The Economist entitled, ‘Big tech’s $2 trn bull run.’ You could reduce risk by the purchase of puts on the Invesco QQQ Trust Series (QQQ), for example.”
-Monday Morning Outlook, February 24, 2020
“This week, shares of tech companies within the S&P 500 are some of the biggest losers.”
-The Wall Street Journal, February 28,2020
Sticking to equities for now, one area I suggested reducing risk last week was big-cap technology names. If you bought puts on the Invesco QQQ Trust Series (QQQ-- 205.80) as a hedge or even a speculative play, this proved to be a solid move, with the QQQ declining 10% last week and implied volatilities on QQQ options soaring.
One week can change an outlook, so beware of a bounce. The low at $198+ is the site of its 200-day moving average, which is situated just below the round 200-century mark. Additionally, to the extent options played a part in the sharpness of the decline, the last significant put open interest in options expiring through standard March expiration resides at the 200 strike. In other words, this strike may have acted as a giant magnet, as delta-hedging selling whereby sellers of the puts are forced to sell the Nasdaq-100 Index (NDX-- 8,461.84) futures short as the 200-strike puts become more sensitive to the QQQ decline. To the extend this played a part in the selloff, such hedging activity that is a massive headwind has mostly disappeared.
Additionally, the CBOE NASDAQ 100 Volatility Index (VXN-- 43.13) touched its highest level in five years on Friday when it traded at 46.92, its 2015 peak. Bears run the risk of another peak in NASDAQ volatility, with the VXN trading just below 50.67, which is exactly three times its 2019 close of 16.89.
In fact, if you are a premium seller and anticipate the QQQ is at or near a bottom, you can use the sharp decline and huge increase in implied volatilities last week on QQQ options to sell short-term, out-of-the-money QQQ put options. Focus on short-term options, however, as this is where the options are super expensive, per the table immediately below, captured late Friday.
“During the last two weeks, I have discussed the heightened probability that we could be on the verge of a volatility pop of some magnitude.…the VIX technical pattern that stands out to me at present is similar to the early May through first half of July 2019 action… in which a trendline connecting lower highs (similar to August-January) was taken out and retested before the VIX doubled in a matter of days. A repeat of this pattern in terms of the VIX doubling from the retest level of the August-January trendline would target a VIX move to the 30 area, or a round 150% above the floor at 12.“
- Monday Morning Outlook, February 3, 2020
How could I not end this commentary without a discussion of the CBOE Market Volatility Index (VIX--40.11), which soared to the round 50 level last week. Loyal readers of this weekly commentary should not have been shocked that the VIX popped, but the size of the pop admittedly took me by surprise, as I was expecting the possibility of a move to the 30 level if the 18 area was taken out.
I found the VIX’s weekly close at 40.11 interesting, as the 45-47 area is triple the level at which it broke out above a trendline connecting lower highs from August through early January, with 47 marking highs in 2010, 2011 and 2015. With the VIX trading in this area from which it has peaked on multiple occasions, it would suggest bargain hunting in anticipation of lower volatility and at least a short-term rally.
Moreover, and perhaps bulls' most friendly indicator this week, is a chart that shows a massive capitulation of Large Speculators on CBOE Market Volatility Index futures traders. On January 21, with the SPX closing in on 3,335 resistance, large speculators were net short 170,000 volatility futures contracts. Last week, this number was net short 77,000 contracts, with this number being cut in half from the week prior.
This group has been dead wrong at major turning points in volatility for years, and they were caught in a huge short position just ahead of this latest volatility pop. When volatility turns lower, they will either be net long or in a very small net short position ahead of the downturn in volatility.
I cannot wait for this coming Tuesday when Friday's data comes out, as this group could be net long, given the continued move higher in volatility as the week progressed last week. And as you can see on the chart below, when Large Speculators on VIX futures are net long, major peaks in volatility occur. The implication is that a volatility peak is near, if not here.
Todd Salamone is Schaeffer's Senior V.P. of Research
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