Key Market Levels to Keep an Eye on in 2021

Traders should avoid fighting the current trend, but have a hedge in place in place to manage sentiment-based risk

Senior Vice President of Research
Jan 4, 2021 at 9:10 AM
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To begin, I wish all of our readers a Happy New Year and best wishes to you and your loved ones in the new year. As one might suspect, many have said good riddance to the pandemic-defined year of 2020. May those that succumbed to this virus and all other illnesses rest in peace. And for the rest of us, hopefully we can beat the pandemic and find joy and happiness in the coming year and years to come.

From purely an investing perspective, whether you were bullish on equities, volatility, bonds, gold, silver, or bitcoin from the start of last year though last week, you are likely saying, “Give me more of 2020!”  But if you were a dollar or oil bull, you are in the camp of “good riddance and hope 2021 is better.”

Despite the many uncertainties of 2020, ranging from U.S.- China trade relations to economic lock-downs due to COVID-19, plus, election uncertainty or the timing of a vaccine that could be rolled out safely to the public, equities and many other assets rallied strongly from March into year end. 

A huge amount of pessimism (multi-year highs in negativity among some participants) entered the market as lockdowns took hold and the economy ground to a halt at the end of the first quarter through the beginning of the second quarter. This pessimism drove stocks to their depths in March.

But as parts of the economy eventually reopened and investors discovered companies built to thrive in a “stay-at-home” environment, the record pessimism was unwound, setting stocks on a trek north through the end of 2020, with only one major hiccup along the way -- when the S&P 500 Index (SPX - 3,748.80) fell nearly 10% in September to October, as talk of a Democratic “blue wave” sweep took hold on the market. Both polls and “chatter” indicated Republicans could lose a huge number of House seats in an already Democratic majority, and possibly lose both the White House and Republican-dominated Senate majority. The latter is yet to be determined, with a key runoff election tomorrow in Georgia to determine two Senate seats.

In fact, the outcome of the runoff election could be viewed as an immediate risk because, since 1989, stocks have performed best when there is gridlock in Congress with a Democratic president. If both Democratic senators win tomorrow, there would no longer be gridlock and some may view such a scenario as less potential reward in the market.

Individual investors opened more than 10 million new brokerage accounts in 2020, JMP Securities estimates, a record. Interest isn’t fading… 2020 will be known as the year that individual investors dove into financial markets and doubled down, even in the midst of a global pandemic…”

            -The Wall Street Journal, December 31, 2020

Before the outcome of the November elections and positive news on vaccines to fight COVID-19 was unveiled just one week after the elections, the public had joined the party, helping build on the equity momentum from the March low.  Eventually, and as I reminded readers in early December (see excerpt immediately below), the sentiment backdrop had turned to  record optimism by some sentiment measures, such as the actions of equity option buyers.

For what it is worth, we saw multi-year highs in optimism among equity option buyers coming into 2018 and 2020 (highs in optimism equal a low put/call ratio in the graph below). Equites did not fare well in the first quarter of those years.

1-3 chart 1

My message remains the same as prior weeks. Do not disturb long positions, as the trend is your friend and market enthusiasts have been given no reason to panic. But with the CBOE Market Volatility Index (VIX -- 20.79) at four-month lows, you could hedge long positions in recognition of the sentiment-based risk.”

            -Monday Morning Outlook, December 7, 2020        

“…many sentiment indicators are displaying extremes in optimism that make the market vulnerable to pullbacks. On one hand, the bulls have not been truly tested to give them considerable pause or panic and unwind positions. On the other hand, multiple benchmarks are trading around psychological round numbers, which could be short-term speed bumps or peaks ahead of a decline.”

-Monday Morning Outlook, December 28, 2020

Given the sentiment backdrop, which indicates more vulnerability than usual to corrections or extended declines, but with market momentum clearly in the bull’s favor amid upbeat headlines, I recommended hedging long positions early last month given that index options were so cheap, as measured by the CBOE Market Volatility Index (VIX - 22.75).   

I find it interesting that the mid-December peak was at the VIX’s 252-day moving average. A move above this longer-term moving average in late-January 2020 hinted at major trouble ahead for stocks in February-March and another move back above this trendline in mid-October tipped off a two-week pullback in equities. At present, the VIX is not signaling major volatility in the immediate days ahead as it remains below this longer-term trendline. And as a side note, I am not seeing major VIX call buying relative to put buying, which has signaled upcoming volatility historically. This is why I recommended hedging while the VIX was extremely low relative to prior months, but not disturbing long positions.

1-3 chart 2

The SPX has grinded slightly higher since then, with the index up by about one percentage point. The VIX, meanwhile, has risen from its four-month low, even as many benchmarks have gone sideways at round psychological levels. The VIX may have to move below the 20 area to signal a lasting breakout above the SPX’s 3,700 level, although at present, bulls are putting the pressure on the few bears with four consecutive daily closes and year-end close above this round century mark. Will bears try to take back control with the turn of the calendar year?

In the meantime, the Russell 2000 Index (RUT - 1,974.86), which came into last week at the 2,000 level, closed last week below this millennium level. But it has hardly pulled back to an extent that would panic bulls, as it remains comfortably above its rising 20-day moving average. 

The 2,000 level coincides with a level that is roughly 20% above the 2019 close, but this “round, year-to-date percentage return” goes away with the turn of the calendar year. However, the 2,000-millenium level as potential resistance remains intact.

The Dow Jones Industrial Average (DJI - 30,606.48) remains above the 30,000 level, ending 2020 at an all-time closing high.  But remember it was only days before Christmas that it revisited the 30,000 mark after first touching it around Thanksgiving, implying this level is still a potential magnet in the weeks ahead.  

1-3 chart 3

Not a lot has changed from both a technical and sentiment perspective – momentum favors the bulls, and optimism, albeit justified at the moment, still makes stocks more vulnerable than usual if and when the optimists begin to unwind, as they usually rush for the exit at the same time. This amounts to not fighting the current trend, and having a hedge in place to manage sentiment-based risk.

Thank you for being a loyal reader. The Schaeffer’s team and I look forward to guiding you again from week to week in the upcoming year so that you can make decisions based on the various risks and rewards that I am observing from a sentiment, fundamental, and technical perspective.

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

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