Levels of Resistance to Watch As Stocks Rebound

The worst might not be over for stocks just yet

Senior Vice President of Research
Apr 13, 2020 at 8:42 AM
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A double-dose of positive headlines put the bulls in control last week, sending stocks higher and volatility expectations, as measured by the Cboe Market Volatility Index (VIX -- 43.27), lower. First, there were indications that coronavirus outbreaks were leveling off, with the number of cases and deaths coming in below expectations according to various models. Plus, on Friday morning, the Fed made itself harder to fight, as it announced various programs to provide an additional $2.3 trillion in loans to support small to mid-sized businesses as well as state and local governments.

There was a decent amount of technical damage suffered by the stock market amid the coronavirus-related uncertainty --  the virtual shut down of the economy to manage its spread, and the millions of jobs lost either temporarily or permanently as a result.   Therefore, as stocks climb from the depths of last month’s low, on the heels of aggressive Fed and stimulus actions, there are various important levels of potential resistance for investors to navigate. The same principal applies to the VIX, which usually moves inverse to stocks, as it declines from last month’s high, as there are multiple potential support levels it must break below. 

For example, the VIX’s 50 area marked peaks on multiple occasions since the late 1990's, with the one previous exception to last month being since October and November 2008. When the 50 area was taken out in 2008 and last month, it signaled more damage to come. Bulls hope that last week’s move back below the 50 area last week signals that the worst is over, or at least near over. 

However, there is more to be done if you are using the VIX as a tool for what may lie ahead. As I alluded to on Twitter Thursday morning, the VIX has moved down to a level that is roughly half last month’s high, which is also three times the 2019 close. Might those that view a "50% off portfolio protection sale" drive index and exchange-traded fund (ETF) put buyers who desire portfolio protection?    

April 10 MMO Chart 1

Note on the chart below that in December 2008, the VIX pulled back and leveled off in the 40 area for months, as the 40 area marked one-half its October and November 2008 closing highs. As it languished around 40, the S&P 500 Index (SPX -- 2,789.82) traded sideways before its final descent into its March low.

April 10 MMO Chart 2

The SPX made a bold move higher during the holiday-shortened week, taking out a few potential resistance levels. But others linger just above these levels. The below long-term monthly SPX graph is one that you are surely familiar with if you have read this commentary during the past few weeks. Standing out to me, after last month’s close above the historically significant 80-month moving average, is the rally back above the 2,664 level, which is four times the 2009 close and a level that was in “in play” for six consecutive months before the rally continued. Just 20 points above 2,664 is 2,684, which is 20% above last month’s closing low, which to some market observers ends a brief bear market environment.  

April 10 MMO Chart 3

But as you can also see on the graph, the SPX ended the week right around its 36-month moving average -- a trendline that has proven significant historically, as it has provided support on numerous pullbacks through the years, but has signaled more selling on the horizon after breakdowns. This trendline is currently at 2,773, while immediately above resides the 2,800-century mark, which is also in the vicinity of a 50% retracement of this year’s closing high and low.  As I alluded to on Twitter on Thursday morning, 2,800 has served as resistance in the past, namely the fourth quarter of 2018, which many bulls would like to forget.

A decisive April month-end close below the VIX’s half March 2020 closing high and a monthly SPX close above its 36-month moving average would give me more confidence that indeed a bottom has already been reached and a sustained V-rally is underway.  

“…the equity-only, 10-day buy (to open) put/call volume ratio has rolled over from a multi-year peak. Roll-overs from high levels are good times to enter the stock market. But with that said, note that there have been brief roll-overs in the past that were short-lived before another influx of put buying generated another high. The action in this ratio currently is encouraging and supports holding current long exposure, but the jury is still out as to whether the unwinding of this pessimism will continue.”

-Monday Morning Outlook, March 30, 2020

At the end of March, one indicator that was looking bullish for the short term was in the action of equity option buyers, as a recent multi-year high was achieved in the ratio of equity puts purchased (to open) – a downside bet – versus equity calls purchased (to open) – an upside bet. After a multi-year high in the ratio, it began to roll over, suggesting mounting pessimism had peaked, but appeared to be in the process of unwinding, as the ratio was headed lower. As I suggested two weeks ago, this action in the ratio usually marks a solid buying opportunity. Since I made this observation, a tradeable rally has occurred, with the SPX up 6% during this period.  

But I left open how long the unwind of this pessimism would continue. In this case, it didn’t seem to be very long, as the ratio is headed higher again, which means some are viewing the advance as an opportunity to either hedge a long position with puts, or speculate on weakness ahead. If this sentiment is representative of other investors, it could be indicative of short-term market participants looking for an exit point as opposed to buying into the current strength. As such, resistance levels referenced above should be monitored closely in the days ahead, especially if coincidental headwinds occur as a result of more sophisticated investors using the collapse in volatility as an opportune time to hedge long exposure in lieu of adding long exposure.

That being said, with expectations for a second-quarter gross domestic product (GDP) number that collapses by at least a double-digit percentage (I have seen a few banks out with predictions of a 25 to 30%  decline) and uncertainty as to exactly how long government officials will aggressively use mitigation policies to contain a virus that knows no time nor borders, and for which a vaccine or treatment has not been developed, it appears many fund managers have addressed this uncertainty by selling first and asking questions later. 

Not only was the massive selling that we witnessed last month evidence of this, but another clue is in the pricing of call and put options on the SPDR S&P 500 ETF (SPY -- 278.20).  For example, in the graph below, note that ahead of the decline, put implied volatilities on strikes 5% below the current SPY price were more than double that of call implied volatilities on strikes 5% above the SPY’s value. To the extent puts were driven higher in part by demand for portfolio protection, the higher demand drove out-of-the money puts higher relative to calls. 

April 10 MMO Chart 4

Now, this ratio is at a multi-year low, which has historically meant market-nice buying opportunities. The low “skew” is perhaps a clue that put protection is not as heavily in demand because funds are holding much higher-than-normal cash levels and have little incentive to protect a large equity position. If this is the case, risk is limited relative to the potential reward, as the cash will eventually be put back to work and fund managers will likely have portfolios strongly tilted toward “risk adverse.”

If you are a short-term trader, keep in mind that resistance levels reside just overhead, and if the VIX behaves like late 2008-2009, it could be indicative of choppy waters ahead and one more scary decline. If you are a long-term investor, your equity allocations should be a bit lower than normal after the breach of its 36-month moving average. At the same time, you should not be strongly defensive after the last month’s rebound closed above its 80-month moving average, which remains an encouraging sign, especially if I am correct in that most fund managers moved into a hugely defensive position in just a matter of weeks.

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

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