"Fear Gauge" Levels to Look Out For

Keep an eye on the SPX's -10% level in the coming weeks

Todd Salamone
Jun 1, 2020 at 9:33 AM
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Improved price action around 2,950 last week could be a cue that the SPX is on the verge of finally taking out this resistance that has been in place since late April. However, the 3,000-millennium level is 45 points, or just 1.5%, above Friday’s close. With the lower boundary of the range at 2,800, the risk-reward favors the bears from a short-term technical perspective, even though there could be slightly more upside to the round 3,000 level in the coming days or weeks, which is also the site of the SPX's widely followed 200-day moving average.”

                -Monday Morning Outlook, May 26, 2020

Well, per the first two sentences in the excerpt above, I was “half” right, or “half” wrong, depending on how you want to look at it. Indeed, the fact that the S&P 500 Index (SPX –3,044.31) had not sold off from short-term resistance at 2,950 like it had in prior instances was a cue to a breakout. However, the round 3,000 millennium level did not act as a short-term resistance level as I had identified.  That said, the jury is still out as to the sustainability of a lasting move above 3,000. 

Just as a half-century mark acted as resistance for about a month at 2,950, the next half-century mark in the 3,050 area proved to be last week’s top. The SPX moved through 3,050 intraday on Thursday but failed to close above it, as potential U.S.-China diplomatic tensions surfaced with news that China decided to override Hong Kong’s autonomy on national security. 

For bulls, after two months of trading below its 200-day moving average, the crossover should be welcome, as historical research shows crossovers after a long duration below this trendline are bullish in the near term and during the course of the next year.

Interestingly, the 3,047 level, which is the vicinity of the 3,050 half-century mark, is exactly 10% below the SPX’s 2020 closing high of 3,386 in February. In other words, there may have been a psychology among some market participants to de-risk, with the market giving them a “second chance” to exit 10% below the market’s high. After all, much uncertainty still prevails as states slowly open for business, and this is evident by the CBOE Market Volatility Index (VIX—27.51) that is still trading roughly 50-100% above its normal level compared to the past few years. In fact, as quickly as 3,000 was taken out earlier in the week, it was quickly retested on Friday, with the Friday intraday low at 2,998, before closing the week just below 3,050 at its highest close since early March.

Thursday’s intraday high was also just shy of the SPX’s round year-over-year (YoY) 10% return. Per the chart immediately below (first pane), note how that YoY 10%  level marked a peak in July 2019, as the SPX coincidentally did battle with the 3,000 level. At the end of this coming week, 3,108 on the SPX represents 10% YoY, which is coincident with the early March closing high.

As we look at the week ahead, the 3,000 level should be considered the first line of defense on a pullback, with 2,950 representing a second line of defense.

spx 200-day MA

 

“… the CBOE Market Volatility Index (VIX—28.16) declined coincident with the stock market rally last week. It is now trading just above 27.56, which is double its 2019 close and a level from which it popped two weeks ago.”

                -Monday Morning Outlook, May 26, 2020

I briefly mentioned the VIX in the discussion above and, as such, I have a follow up to my comments from last week. Despite last week’s advance, the VIX is still trading very close to the 27.56 level, even after last week’s rally, which is exactly double its 2019 close. In fact, since the VIX’s pullback to this level on May 8, it has stubbornly remained above it, even though the SPX is considerably above the May 8 close of 2,929. I am not entirely sure what to make of the VIX anchoring itself to this level. It is one of two things, which would suggest having straddle or pair trade exposure:

1. With the VIX still trading very close to the 27.56 level even after last week’s rally, it could be hinting at an upward thrust in volatility that results in short-lived breakouts above 2,950 and 3,000 or: 

2. With large speculators on VIX futures in a relatively small short position and VIX call buying picking up in recent weeks but not at an alarming level that has preceded pops. Therefore, the contrarian take is that with fewer bets on volatility continuing to move lower, the VIX remains elevated (for now).  But this sets up for the crowd to be wrong in the future. 

I get that this is another way of saying volatility is either going up or down. But it also suggests staying with the advice I gave you last week in that option pair trades and/or straddle plays could work well in the weeks and months ahead as this gets sorted out.    

If forced to take a stand on what the VIX could be hinting at, combine bullet two above with the VIX trading only slightly above its 21-day historical volatility (HV), and one might infer that hedging activity is unusually low. This would suggest that higher-than-normal cash positions are present among fund managers, implying higher-than-normal future buying power. Many, though not all, market tops or trading ranges have been preceded by VIX readings that remain high relative to SPX HV.  This could be due to higher-than-normal demand for index and exchange-traded fund puts used as portfolio protection as fund managers are overweight on stocks and carry little in cash reserves.  

Meanwhile, market troughs have occurred when the VIX was at a discount to SPX HV, which usually occurs when hedging demand drops due to cash levels in funds rising, leading to cash being put to work and equities eventually getting bid higher.

SPX HV Line-up

Another mixed signal that I am seeing is the bullish tendencies of the SPX 200-day moving average crossover with the approaching extreme in enthusiasm among equity option buyers, per the graph below. With the ratio of call buying to put buying in a decline, the bulls are in charge.  However, it is approaching levels that have spelled trouble in the past. If we see a change in the direction of this ratio coincident with a technical breakdown below support levels mentioned above, be on guard for a noticeable pullback.   

spx bto pc ratio

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

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