“…the price action has not yet given reason for short-term, momentum-based participants to panic out of equities or abruptly stop doing what has worked for months. Resistance levels have generated only brief pauses in the uptrend, with minimal draw downs, resulting in little to no pain…
-Monday Morning Outlook, August 24, 2020
It took only seven trading days to do so, but the S&P 500 Index (SPX) reached the 3,400-century mark in impressive fashion last week, repeating a pattern of pausing briefly at resistance, with little to no drawdown before the next big move.
I found this interesting, as the Russell 2000 Index (RUT) continues to languish below the 1,600 mark, and remains in negative territory year-to-date. The same is true for the S&P 400 MidCap Index (MID), which has not made a serious run at the 2,000-millennium level since breaking below this level in February, and has remained in the red about 6% of the time this year.
My concluding remarks last week, excerpted above, summarize the technical aspect that I see in the market, along with the comments I have made the last few weeks in regards to the excitement we are seeing among active traders – specifically, those surveyed in the National Association of Active Investment Manager’s (NAAIM) weekly survey, the action of equity option buyers, and those engaged in shorting equities (which has become actively covering shorts, especially in SPX component names).
Equity option buyers are purchasing put options (downside bets on a stock) at a historically low rate, versus call options (upside bets on a stock). This group, along with those who typically short S&P 500 component stocks, have historically been wrongly positioned at major market declines, or periods of underperformance relative to its norm.
And while this will likely be true at the next major turning point, the fact is that the stock market has not given these traders an excuse to discontinue what they are doing -- whether that is adding equity exposure, covering short positions, or buying calls at a historic rate relative to puts.
As such, I have indicated that the market, when viewed solely through the lens of short-term trader sentiment, is vulnerable. To view sentiment in a vacuum, without paying attention to the market’s price action and its technical backdrop, however, is dangerous. Therefore, I make it a point to address potential levels of resistance at which profit taking could begin, but also point out key levels on the SPX at which a decline could make enthusiasm among active traders wane to the point of speculators souring on the market, creating a headwind for stocks.
In the chart below, we break down options volume data into equity-only, customer-only buy (to open) activity. The ability to break the information down by buy (to open) or sell (to open) volume, and volume related to closing positions, first became available in 2007. The chart only displays data since the beginning of 2019, but trust me when I say that this is currently the longest stretch that the 10-day moving average of the equity-only, buy (to open), put/call volume ratio has been below 0.40 since inception of our data.
When I look at this chart, I cannot help but think what Humphrey Neil stated in his infamous book, The Art of Contrary Thinking: “…the public is right during the trends, but wrong at both ends.”
Something that strikes me about the charts above -- the precipitous decline in the put/call ratio (first chart) driven by a huge influx of call buying (second chart) that began with “stay-at-home” orders in March, and after sports shut down completely. It is quite possible that the Robinhood-type traders (both new and experienced) emerged in a big way, using the stock market as they would a sports book, pursuing bets with potentially big payoffs. One way to do this is the options market, which remained open.
With sports slowly reopening, it should be noted that this ratio is no longer dropping significantly and is, in fact, a little higher relative to late July, when professional baseball, hockey and basketball began operating again. If a return to sports causes a slow disengagement from the stock market, particularly from those buying call options, there could be momentum traders leaving the market, thereby removing (at least partially) a tailwind that has been in place for months. For now, this group has been correct and there is little reason to bet against them. However, a question to ask right now is, “Will some of these momentum players leave the stock market for the sports book?” All this to say, the market will begin to struggle when the momentum players disappear.
“… I think it would take the SPX moving back below the 3,230-3,250 range to get the attention of short-term momentum traders, and reverse the enthusiasm on display amid these participants… bulls hope that the round 3,400 level on the SPX is as meaningless in terms of acting as resistance as 3,300 was earlier this month. This does not imply century marks like this are useless, as it took the SPX from early June into late July before finally sustaining a lengthy move above 2,200.”
-Monday Morning Outlook, August 24, 2020
Therefore, look for a change from the norm in terms of the SPX’s price action before making any major bets against the momentum. For example, former resistance levels have held on pullbacks throughout the trend, so a move back below its February high around 3,400 would wave a few cautionary flags. There is potential support, though, at the SPX’s 40-day moving average, which is currently situated at the 3,300-century mark – roughly 6% below Friday close. This moving average acted as brief resistance in mid-April, and as support in both late April and June. Plus, keep in mind that the 2020 breakeven at 3,230 poses yet another support level on a pullback, where resistance came into play in June.
Momentum players are sticking with big caps, and the SPX’s next test resides between the half-millennium mark of 3,500 and 3,550, with the round 10% year-to-date gain residing at 3,553. As long-time readers know, round-number year-to-date gains or losses can sometimes be pivot or hesitation areas. For example, in 2019, the round year-to-date 10% level on the SPX marked support during pullbacks in March and June.
If you want to hedge against a pullback to these support levels, or even a decline below these levels, you can use the CBOE Market Volatility Index (VIX) as a trigger. For example, in the fourth quarter of 2019, I advised readers to focus on the one-year (252-day) moving average for clues as to when a volatility increase may be on the horizon, as this moving average had been acting as resistance. It broke back below this trendline for the first time in six months earlier this month, per the second chart below. If the VIX gets back above this moving average on a closing basis, it may be worth hedging long positions as a “just in case,” since there is decent risk down to support levels. But if you act in anticipation of a decline, ensure you are doing that by hedging the “what has been working" type trades, versus making a major bet against the market.
Todd Salamone is Schaeffer's V.P. of Research
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