Sentiment Ratio Signaling Lower Volatility Ahead

We could be in the early innings of an unwinding of Fed-induced fear

Senior Vice President of Research
Feb 7, 2022 at 8:51 AM
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Whether you follow earnings reports at the company-specific level, or those that make up the Federal Reserve, last week was action packed. Amazon.com (AMZN) and Snap (SNAP) were among the headliners with impressive earnings reactions. But the reports that surprised the crowds came from Spotify Technology (SPOT) and Meta Platforms (FB) -- formerly known as Facebook -- as their shares plummeted in response to their respective earnings reports.

Before these earnings reactions on Thursday and Friday, a few Fed governors walked back the hawkish takeaways from Federal Reserve Chairman Jerome Powell’s press conference the week prior, following the Federal Open Market Committee (FOMC) meeting.

For example, ahead of the FOMC decision, Fed funds futures were implying less than a 40% probability of five or more rate hikes by the end of 2022. Immediately following the meeting and Powell’s comments, the implied probability of five or more rate hikes shot up to more than 60%. But early last week, a few regional governors went on record to reiterate their anticipation that three to four rate hikes would be needed this year.

 “I am watching two other levels of interest, one of which is obvious, the other of which is not. First, the September lows occurred at 4,300…and could be an area where buyers step in to halt the slide. Just below 4,300 is the 4,289 level, which is the level that coincides with a round 10% below 2021’s close. Long-time readers of this commentary know the historical importance of round year-to-date levels as hesitation or pivot points. But like other troughs, I think a bull would like to see a day or two of heavy selling in the morning, followed by a rally and close near or at the high.”

     - Monday Morning Outlook, January 24, 2022

Over at JPMorgan Chase & Co., strategists led by Marko Kolanovic observed a similar deterioration in liquidity, and noted that options dealers who buy or sell stocks to hedge their derivatives holdings are now in a ‘negative gamma’ position that requires them lean into existing market trends in a big wayAs long as S&P 500 remains below ~4600, gamma is negative with dealers buying on strength and selling on weakness,” Kolanovic wrote in a note. ‘This would amplify market moves, especially in the current low market liquidity/depth environment.’”

            - Bloomberg, January 31, 2022

I used the excerpts above because in the aftermath of the Fed decision, the less hawkish tones from other Fed governors, and the hit or miss earnings reactions, the S&P 500 Index (SPX — 4,500.53) troughed and peaked around significant levels. I found the peak around 4,600 on Tuesday especially interesting. With Wednesday’s close just below this century mark and underwhelming earnings from FB, a massive rejection at the 4,600-century mark occurred as dealer buying had likely peaked.

Going into the week ahead, a first level of support for the SPX continues to be in the vicinity of the round 4,300 level, which defines the September 2021 low that is roughly 10% below last year’s close. Plus, the 260-day moving average, which represents roughly a one-year average (52 weeks x 5 trading days = 260), is at 4,630. Note in the graph below that while this moving average was breached two weeks ago, there was never a close below it.

Potential resistance in the week ahead between 4,525 and 4,600. The 4,600 level is where the peak of dealer buying related to options open interest diminishes, and is the site of last week’s high. Plus, bulls must contend with former resistance (August 2021 closing high) and support (intraday mid-December low) at 4,536. Moreover, a trendline connecting lower highs since this year’s early-January peak lies at 4,570 today, and ends the week at 4,525.

Finally, the 80-day moving average, which marked a major low in March 2021 and multiple short-term lows in November through January, is worth monitoring as it sits at 4,616. 

SPX 260-Day MMO

With the 10-day average of the SPX component buy-to-open, put/call volume ratio showing signs of peaking at the highest level in nearly two years, betting on a breakout above resistance is not a bad play. This is because we could be in the early innings of an unwinding of Fed-induced fear.

Fed rate hikes and higher interest rates elsewhere are not necessarily a bad thing, if indeed warranted. The jury is still out as to whether or not the Fed will manage a return to normalcy. For now, a long bias is recommended if the SPX remains above 4,300, and amid what appears to be the early stages of an unwinding of negativity in the market.

SPX BTO pc ratio

“…NDX bulls can deem it safe to get back into the water if signs emerge that option buyer pessimism on NDX components has indeed climaxed and/or the index climbs back above its October closing low at 14,472. Aggressive speculators can make bullish bets now, with negative sentiment on NDX components at levels that preceded two prior major bottoms and 14,000 holding. But keep a short leash if using stocks when determining a stop-loss or use call options in lieu of long stock plays to limit your dollars at risk, if you make such a bet.”

            - Monday Morning Outlook, January 24, 2022

Likewise, the 10-day Nasdaq 100 Index's (NDX — 14,694.35) component put/call open interest ratio appears to be finally rolling over, after hitting similar climactic highs seen in December 2018 and March 2020, both of which marked major troughs. Thanks to the FB earnings reaction that dragged many tech stocks lower, the NDX declined back below the 15,000-millennium level.

However, Thursday and Friday’s lows occurred at the 14,472 level, or October's closing low, which I mentioned could be significant last week. Should the NDX stabilize, or V-bottom like it did in December 2018 and March 2020, this would support the SPX breakout discussed above.

10day ndx pc ratio

“…last week’s peak in the CBOE Volatility Index (VIX – 27.66) occurred in the vicinity of double its 2021 close and double this year’s closing low…A close below 25.30 and 25.71 – the latter representing the September closing high, and the former being 50% above the 2021 close – would suggest lower volatility and higher stock prices in the weeks ahead.”

            - Monday Morning Outlook, January 31, 2022

With climactic sentiment apparently unwinding, and key indices such as the NDX and SPX holding above support levels, emphasize long positions. However, resistance levels linger above, so keep a tight leash if using equites, or use call options in lieu of equities to minimize dollars at risk, while leveraging the potential for upside movement in the weeks ahead.

Moreover, the Cboe Volatility Index (VIX — 23.22) closing below the 25.30 and 25.71 area last week, with VIX futures option buyers emphasizing puts over calls in the last few days, are signs of lower volatility ahead. Prior to the latest VIX spike, and prior to other spikes, option buyers have bought more calls than puts at a ratio of 2:1 in a 10-day period.

VIX cp ratio

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

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