Where the SPX Could Land After Last Week's Trading Frenzy

If you were not already in caution mode consider the VIX’s move as the newest emerging threat to bulls

Senior Vice President of Research
Feb 1, 2021 at 9:08 AM
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For what it is worth, we saw multi-year highs in optimism among equity option buyers coming into 2018 and 2020… Equites did not fare well in the first quarter of those years.”

          -Monday Morning Outlook, Jan. 4, 2021

“…the 10-day, equity-only, buy (to open) put/call volume ratio hit an extremely low reading of 0.32 last week for the third time since early September.  When this ratio hit 0.32 on September 2, the SPX was trading nearly 10% lower three weeks later. The ratio hit an extreme low of 0.32 again on December 17, and the SPX was flat three weeks later.”

          -Monday Morning Outlook, Jan. 25, 2021


As the S&P 500 Index (SPX—3,714.24) has grinded out for weeks, carving out all-time highs along the way, I have been warning about the growing optimism that we are seeing, whether it was among option buyers or active investment managers. In fact, with respect to options buyers, I have been signaling caution since early December, but the SPX’s momentum continued higher. 

Therefore, what occurred last week with respect to the SPX’s decline, cannot be a huge surprise, as it was only a matter of when, in terms of the broad market showing cracks in its technical backdrop, as trader optimism hit multi-year extremes. 

Admittedly, however, the surprise might be what caused the SPX to backpedal as much as it did. In other words, it was not a specifically Covid-related, stimulus-related, or a Federal Reserve headline that sparked a sell-off. 

“... a first level of potential support remains in the 3,745-3,756 area, which is the site of last year’s close… it might take a move into the red, relative to last year’s close, or a sign that momentum could finally be swinging the other way -- using the 30-day moving average as a guidepost -- for the growing bullish crowd to hit the brakes.”

          - Monday Morning Outlook, Jan. 25, 2021

In fact, the SPX broke below the first level of support that I mentioned last week, as seen in the excerpt above (I should add that it broke below a trendline connecting higher lows since mid-November, when well-received vaccine trial news began positively impacting equites).

In fact, on Friday, the SPX traded as low as the early December level, which is when I first began cautioning about the optimism creeping into the market that made equities more vulnerable than usual to pullbacks. 

Jan 31 MMO Chart 1

What was the cause of the SPX’s decline? It was attributed to a coordinated effort of a social network community that focused on buying low-dollar, small-cap, heavily shorted names. These actions squeezed hedge funds, which were heavily shorted names such as GameStop (GME), Bed Bath & Beyond (BBBY), BlackBerry (BB) and AMC Entertainment (AMC) to name just a few.

So coordinated buying generated a sell-off? Judging by the stocks that rallied and the stocks that plummeted last week, the footprint looks like forced liquidations of crowded long-short pair trades among hedge funds. It appears hedge funds were forced to raise cash by selling long positions to buy back those equites that they borrowed to sell short. For example, heavily shorted Shake Shack (SHAK) -- which hosts a market cap of less than $5 billion -- rallied strong on Wednesday. McDonalds (MCD) -- sporting a market cap of more than $150 billion -- declined that day. A scenario like this would suggest a pair trade unwind in the restaurant group.

And to those that have been reading this commentary since December, what transpired last week should not come as a major surprise either. Since this period, I have been advising that the biggest opportunities reside in the small-cap space, due to the short-covering potential relative to components of the SPX that have already benefitted from short-covering rallies as the economy slowly re-opened after lockdowns in March.

A technical theme that I heard on CNBC on Friday was that the SPX was holding its 50-day moving average, which comes into the new week and month at 3,716. With many retail investors participating in the market and this moving average being so popular, this might be a level to watch. Additionally, the round 3,700-century mark is also key looking forward, which was in play from early December into early January, as the SPX traded sideways in this area before resuming its uptrend.

The Russell 2000 Index (RUT—2,073.64), which I have been more bullish on than the SPX, was not immune to the decline last week. In fact, I find it interesting that the pullback in the RUT last week started from its closing high on Jan. 22 of 2,169, which is just seven points shy of the 2,176 level that is exactly 50% above its September closing low. However, unlike the SPX, it comes into the week still trading above its 2020 close at 1,975, but below its 20-day moving average that acted as support in early January.

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…”

- Monday Morning Outlook, Jan. 25, 2021



The surge in the CBOE Market Volatility Index (VIX— 33.09) caught my eye last week, especially after comments that I have been making in respect to recent highs in the VIX, occurring at its 252-day moving average.

Per an observation that I made on Twitter last week, the VIX pattern since December is eerily like last year’s December-January period. In fact, it was on Jan. 27 in both 2020 and 2021 that the VIX finally surged above this trendline. 

Last year, the move above the 252-day moving average eventually signaled upcoming volatility as Covid-19 concerns and then lockdowns sparked a massive decline in equities in February and March. 

Stay tuned as to what, if anything, last week’s surge above this trendline will mean for stocks in the weeks ahead. If you were not already in caution mode due to the sentiment-based risk that I have identified, consider the VIX’s move as the newest emerging threat to bulls.

If the VIX continues to advance, but the advance is muted relative to last year, consider the 41 (double the December low) and 45.50 (double the 2020 close) as potential peak levels.

I advised weeks ago to hedge the sentiment-based risk while options were cheap, as measured by the VIX. Last week is a good illustration of why. By the time there is evidence of technical damage to the market, options become more expensive, making hedging more expensive.

Lastly, if you are looking to add puts to your options portfolio, focus on the large-cap stocks.

Jan 31 MMO Chart 2

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

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