What the Stock Market Might Be Telling Us

Put exposure via pairs options trades or straddles is still a sound approach to playing upside momentum

Senior Vice President of Research
Jul 6, 2020 at 8:54 AM
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"If the SPX breaks its first line of support in the 2,985-3,000 zone on a closing basis, this might be enough to give short-term speculators the nerve to increase downside bets, creating a headwind for stocks in the process. If, however, last week’s lows prove to be a short-term trough, I would expect a rally back to last week’s high in the 3,230 area, followed by a volatile summer trading range that washes out the optimism among short-term traders at present."

Monday Morning Outlook, June 15, 2020

In mid-June, I observed that the S&P 500 Index (SPX -- 3,130.01) was at a critical level of potential support following a sharp pullback from a multi-month high. The index was trading just above the psychologically important 3,000-millennium area, the late-April/early-May resistance, and the potential trendline support connecting the early-April low and mid-May trough. 

It was crunch time for bulls, as enthusiasm among equity option buyers was at a multi-year high, leaving the market vulnerable to a corrective mode if technical support levels began to break down amid negative news flow.

As you can see in the chart below, the SPX held on to that first line of support that I highlighted three weeks ago. But what you cannot see in this chart are headlines that are scaring people, as is evident by the recently released weekly American Association of Individual Investors (AAII) survey, which showed only 22% of respondents as bullish and 46% as bearish (bears more than twice the bulls). Not only are individual investors concerned, but so too are active investment managers, per the National Association of Active Investment Manager’s (NAAIM), which showed an exposure index of only 71.4 late last week, versus the 91.8 reading at the beginning of June.

MMO Chart 1 July 5

Specifically, as Matthew Timpane highlighted in last week’s report, a second wave of new daily COVID-19 cases has swelled in recent weeks, as states reopen. With more states experiencing a new daily case count that is above their seven-day average, some have delayed or rolled-back re-openings. Many are also speculating that lockdowns like the ones we experienced in March and April will be back, crushing the economy once again. However, stocks have not bought into this way of thinking. 

What might the market be telling us? Perhaps the recent upswing in cases and threat of shutdowns will inspire more accountability in terms of following guidelines to slow the spread (such as wearing a mask). Or perhaps a vaccine and/or medication to relieve symptoms of the novel coronavirus will come sooner rather than later.

Regardless of the "why?," equity markets have not reacted as negatively as some have expected, supporting the notion that price matters more than headlines. While the price action amid the headlines is a perceived win for some bulls, don’t get lost in the fact that the SPX has remained locked in a range between 3,000 and 3,150 since mid-June, and we are entering the second week of July at the top of this range. If the SPX breaks out to the upside, remember that its 2019 close remains overhead at 3,230, and this marked last month’s peak.

"…. Moreover, the Nasdaq-100 Index (NDX – 9,849.36) failed near the round 10,000 millennium level for the second week in a row, which coincidentally, is also at the top of the price channel that started way back in 2011. "

            - Monday Morning Outlook, June 29, 2020

Big-cap technology stocks, as measured by the Nasdaq-100 Index (NDX -- 10,341.892), broke out above the 10,000 level and new highs last week. The 10,000 level has been a magnet since early June, so the question remains whether a sustained move above 10,000 is about to take hold after last week’s new high. With this year’s low around the 7,000 level, note that this index is less than 100 points away from the 10,500 mark, which is a round 50% above the March low. If we see a pullback, the first line of support is between 9,700 and 9,800, which are round century mark numbers in the vicinity of the February peak and the 30-day moving average, respectively.

MMO Chart 2 July 5

While 10,000 may be most of the range, I find it fascinating, when reviewing the NDX’s price action this year, that it has respected round year-to-date (YTD) percentage gains and losses at major and short-term pivot points. The chart below gives you a visual on what I am seeing.

For example, in February, the level that corresponds to a YTD 10% gain in the NDX marked the peak ahead of a sharp downturn. The trough in this downturn occurred at a level that corresponded with a 20% year-to-date loss in the NDX. As the NDX climbed its way from its low point, the -10% YTD level acted as short-term resistance. At the mid-June low, the price point that corresponds to +10% YTD acted as support. 

Now, the 10,479 level lurks just above, which corresponds with a round +20 percent YTD gain. And this level is in the vicinity of the 10,500 area that I discussed above, or 50% above the low. If the NDX continues to advance in the immediate days ahead, I would not be surprised if there is a hesitation in the 10,480-10,500 area. 

MMO Chart 3 July 5

With individual investors and active investment managers displaying caution in recent surveys, this represents future demand that could help the market continue to leave investors scratching their heads and ask, "why is it trading higher?" 

But the one sentiment indicator that still leaves the market vulnerable, and has for weeks, is the action of equity option buyers. The ratio of put buying to call buying is still historically low, indicating a lack of fear among these participants who tend to be wrongly positioned at major market turns.    

Also, the CBOE Market Volatility Index (VIX -- 27.68) broke below its 20-day moving average, which I had been keying on as a potential hint that a volatility pop could be on the way. The close below this trendline on the last trading day of June hinted at big equity buying to start July and the second half of 2020. However, Friday’s VIX close at 27.68 is just above 27.38, or double the February closing low that occurred before the VIX hit an 80+ reading in a matter of weeks. Bulls would like to see the VIX eventually get below the June low in the 24 area, which is double this year’s low. 

Therefore, put exposure via pairs options trades or straddles is still a sound approach to playing the upside momentum and the vulnerability on display in this indicator. Or, offsetting some of your call exposure on momentum names in technology with directional speculative put purchases on underperforming names that have bounced in recent weeks, such as those in the energy group, is another reasonable strategy worth considering.

MMO Chart 4 July 5

MMO Chart 5 July 5

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

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