How Bulls Can Chase the Market Higher Moving Forward

It remains to be seen whether the VIX's surge two weeks ago is a bad omen for bulls

Senior Vice President of Research
Feb 8, 2021 at 8:39 AM
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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.”

          - Monday Morning Outlook, Feb. 1, 2021

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.”

          - Monday Morning Outlook, Feb. 1, 2021

The excerpts above are a nice starting point for this week’s commentary. After all, those stocks that benefitted from a short squeeze two weeks ago came back down to earth. Ironically, this might be viewed as a positive, as the forced selling of other equities when these stocks soared was not evident. In the table below, I listed last week’s returns for notable stocks that surged due to the major short squeeze a week prior. The short squeeze caused some fund managers to sell long positions to meet margin calls.

 MMO 206 1

With forced selling no longer in play, a “buy the dip” mentality quickly emerged, with the S&P 500 Index (SPX - 3,886.83) rallying from support at its 50-day moving average and making new highs during Thursday’s trading. While the SPX dipped into the red for 2021, it was a short-lived trip. Therefore, with the 50-day moving average sitting at 3,741, and the 2020 close at 3,756, this remains a first area of potential support if the market retreats. 

Bulls breathed a sigh of relief as the SPX moved back above the trendline connecting higher lows since mid-November. I had mentioned the break of this trendline as a sign of growing risk in the market, but this risk was removed on the first day of trading last week. In fact, if you draw a trendline connecting higher highs since mid-November, the 3,920 level marks potential resistance into this Friday’s close, with last week’s high coming just shy of the 3,900-century mark. From this vantage point, support from the trendline drawn through most of the higher lows sits at 3,787, as of this Friday’s close.

MMO 206 2

I still prefer the small-cap space. Not only is there more short-covering potential in this space -- as I have been highlighting since mid-December -- but the technical backdrop looks firmer. For example, the Russell 2000 Index (RUT - 2,233.33) never dipped below its 30-day moving average, nor did it come remotely close to moving below its 2020 close of 1,975. In fact, after the RUT's pullback the prior week started from the 2,172 level, which is a round 10% above the 2020 close, it was then taken out during Thursday’s trading.

MMO 206 3

“... 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… 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.”

          - Monday Morning Outlook, Feb. 1, 2021

When observing the CBOE Market Volatility Index (VIX - 20.87), all I can say is: What a difference one week makes. Last week, I was cautioning that the pattern playing out in the VIX was like last year’s, with respect to the VIX moving above prior resistance at its 252-day moving average. In 2020, the move above the 252-day moving average foreshadowed the massive volatility pop and stock drop that followed weeks later.

To a degree, this pattern is still repeating, as the move above the VIX’s 252-day moving average two weeks ago was followed by a move back below it last week, which occurred last year as well. But the decline back below the trendline has been much more dramatic this year, pushing the VIX down to prior lows in place since August. 

Whether the huge advance in the VIX two weeks ago is a bad omen for market bulls remains to be seen. The only certainty is that if you are interested in hedging with equity index, or exchange-traded fund options, it is much cheaper now relative to just one week ago.

MMO 206 4

While equity option buyers are still displaying peak enthusiasm as they buy a record number of call options relative to put options, we did see evidence that the decline spooked active investment managers. The current reading of 79 is down from 113 just two week ago, per the National Association of Active Investment Managers’ (NAAIM) weekly survey, with 100 representing a fully invested position, and more than 100 representing a leverage long position. From this perspective, there is money on the sidelines for these participants to chase the market higher.

If you are a bull, continue to emphasize small and mid-cap stocks. Sentiment-based risk remains, but it has been downgraded amid the market’s recovery last week, with some market participants retreating ahead of the rally.

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

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