When to Expect a Market Volatility Pop

Notable fund managers have recently sounded an alarm for poor risk-reward

Senior Vice President of Research
Jun 22, 2020 at 8:53 AM
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“…the SPX’s 2019 close hovers just overhead at 3,230.78, along with the round 3,200. One constant in this space from week to week is potential overhead resistance on the SPX, but the delta is higher levels of resistance,.. For what it is worth, this is the first time that the SPX’s 14-day Relative Strength Index (RSI) has moved into overbought territory since mid-January…”

- Monday Morning Outlook, June 8, 2020

After advancing without pause from mid-May through the first week of June, the S&P 500 Index (SPX -- 3,097.74) finally ran into a level of resistance. More specifically, the 2019 close in the 3,230-area marked what has so far been a two-week high for the SPX. As I alluded to two weeks ago, the 3,230 was another one of several potential resistance levels still lurking -- even as the SPX overcame lower levels of resistance while clawing its way out of the March selloff. One factor evident two weeks ago, but not evident prior to that, was that the SPX was overbought, according to its 14-day Relative Strength Index (RSI), a condition not evident as it took on prior resistance levels.

MMO Chart 1 June22

As the SPX continues to languish in negative territory this year, it has quickly become apparent, that the round 10,000 millennium level on both the Nasdaq Composite Index (IXIC -- 9,946.12) and Nasdaq 100 Index (NDX -- 10,008.64) has acted as barrier for these tech-laden indices.

As the NDX represents larger-cap technology names, some of which have fueled this rally, I find it interesting that the 9,632 level is double its March 2000 peak, which the index struggled to surpass in 2015 and parts of 2016. This area acted as resistance in February and a dip below it earlier this month was immediately met with buyers. In fact, the 9,606 level is a round 10% above the 2019 close. While the 10,000 mark has put at least a temporary delay in this index’s momentum higher, a close below 9,600 could spark even greater selling in larger-cap tech names.

MMO Chart 2 June22

Moreover, the small-cap Russell 2000 Index (RUT -- 1,418.63) simultaneously failed at the round 1,500 area, which is in the vicinity of its 200-day and 320-day moving averages. Additionally, the 1,500 level is approximately 50% above the March closing low, a tempting place to take money off the table when anchoring to the March valley.

Another area of resistance came into play last week, with the 1,450 half-century mark -- a long-time support level in 2019 -- rebelling a rally attempt early in the week. If the RUT moves below the round 1,400 level (a site of a trendline connecting lows since March), small-caps are at increasing risk of a move down to perhaps 1,250 -- a 50% retracement of the March low and June high.

MMO Chart 3 June22

With key benchmarks failing at resistance levels, Federal governors, including Chairman Powell, did not give investors a lot to get excited about last week. In a nutshell, the message from the Fed is more stimulus is needed, as they see much risk in the economy bouncing back, in direct opposition with investment bank Morgan Stanley, which doubled down on its expectation for a V-shaped recovery in the economy.

What’s more, an uptick in COVID-19 cases in China and several U.S. states became a hot topic for the media last week. In response, the comments from Fed governors were not a major surprise, very much in-line with what analysts expected. However, the stock market was not as pleasant in its response. This may have to do with speculators that have driven stocks higher, especially equity option buyers, who are positioned for only surprisingly good news and vulnerable to anything less, per my comments on Twitter late last week.

“Nearly 80 percent of fund managers shepherding a combined $600bn of assets think that stocks are too expensive, the highest shares in records going back to 1998, according to a monthly survey released by Bank of America on Tuesday.”

-Financial Times, June 17, 2020

Equity option buyers were buying equity puts (downside bets on a stock) at the lowest rate relative to calls (upside bets on an equity) in years, but now this ratio is turning higher, as I mentioned above. This change in the direction of the ratio could be signaling that those that drove the rally are slowly souring on the market. If the market loses support from short-term traders such as equity option buyers, and other market participants continue to seek lower valuations and/or more certainty with respect to the impact of COVID-19 in the second half, it could be a long summer for bulls. When this ratio turned higher from an extremely low ratio in January, a month later, stocks cratered.

In fact, our buy (to open) option data goes back to 2013. In instances where this ratio turned at least 0.05 higher from a historically low level of 0.50 or below, the market experienced average returns two weeks out, but experienced negative returns on average one month and three months from the signal. Note however, that the market still grinded higher a majority of the time after the six signals we've had since 2013, but with moderate average returns, this would suggest that significant pullback risk is higher than normal one month and three months after the signal.

Right now, the 10-day, equity-only, buy (to open) put/call volume ratio is only 0.038 above its recent low. But with the ratio trending higher, we could be on the verge of a signal, so I am summarizing the study below.

MMO Chart 4 June22

With money market assets ballooning from about $3.5 trillion at the end of last year to the current $4.6 trillion, the highest amount on record, there is cash on the sidelines. Many notable fund managers have recently sounded alarm bells on the poor risk-reward in the stock market, and the Fed has painted a picture of a tough road that lies ahead due to the damage to the economy by the ongoing pandemic. To the extent expectations are being set by Fed governors, the good news is there are low hurdles ahead with respect to the economy and earnings. And the intermediate to longer-term danger for bears is that $4.6 trillion that has already made its way to the sidelines, looking for an opportunity to get back into the game.

Long-term investors should stay the bullish course, while short-term traders should brace for higher-than-normal odds of a noticeable pullback during the summer months as uncertainty still prevails with the pandemic, resistance has come into play for multiple benchmarks and short-term trader optimism leaves them more vulnerable than usual to negative news.

Finally, standard June expiration Cboe Market Volatility Index (VIX -- 35.12) futures options expired on Wednesday of last week. As I have noted before, volatility pops have been known to occur just after a plethora of call open interest disappears. With Friday’s VIX low at its 20-day moving average -- a trendline that provided resistance from early April through late May -- Friday’s low could be indicative of another pop into at least the 40-42 zone in the upcoming days.

MMO Chart 5 June22


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