SPX, VIX Signposts for Reducing Bullish Exposure

VIX call buying has been at elevated levels

Senior Vice President of Research
Feb 21, 2023 at 9:03 AM
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“… the SPX area that is a round 10% above its late-December closing low and a 50% retracement of the January 2022 all-time high and October 2022 low in the 4,150-4,160 range continued to act as resistance. This area, by the way, also marked a major short-term peak in June 2022. After various Fed officials indicated the inflation fight is not over throughout the week, the SPX closed lower, due to a combination of technical and monetary factors.”

-Monday Morning Outlook, February 13, 2023

For the second week in a row that stocks finished lower, the S&P 500 Index (SPX--4,079.09) is heading into a holiday-shortened week in the vicinity of its January close at 4,077, which was its close prior to the last rate hike. Friday’s action saw the SPX dip 30 points below this level, but a late rally saw the SPX claw its way back and finish a couple of points above last months’ close.

Per the excerpt above, the same factors came into play last week as the week prior. Early last week, the SPX again met resistance at the area discussed in that excerpt.

Moreover, following data on consumer and producer prices for January that came in above expectations, with stronger-than-expected retail sales data coming in-between those reports, several Fed officials reiterated that there is more to do in terms of rate increases, sending rate expectations higher once again and stock prices lower.  

For example, going into last week, fed funds futures traders assigned only a 38% probability that the Federal Open Market Committee would increase rates by 50-basis points following the June meeting. Now, this group is assigning slightly more than a coin flip chance of two rate hikes after that June meeting.

Fed funds futures raised probability of higher fed funds futures rate after June FOMC meeting, per data from www.CMEGroup

*Now = Friday afternoon, February 17

MMO Feb20

Even though stocks declined for the second consecutive week, there has been little technical damage. While the SPX moved below the popular 20-day moving average, which I displayed on the chart last week, note that the less popular but arguably more important 30-day moving average, which has acted as support/resistance on multiple occasions since June, was in the vicinity of Friday’s low. Note that crosses above and below this moving average have marked buy and sell signals in this timeframe. For now, it remains an advantage to bulls.

If the SPX cross below the upward-sloping 30-day moving average at 4,043, it is possible that the 3,970 level gets tested, which is the site of the January breakout above the trendline that connected all major lower highs last year. A close below this level would be a signal to reduce long exposure as risk of a steeper slide in equities would be heightened.

mmo feb20 chart 2

An additional risk that I see for bulls in the upcoming week is with respect to recent Cboe Market Volatility Index (VIX--20.53) action…the VIX advanced above a trendline connecting lower highs since the December peak. This could be hinting at a couple of things: 1) a correction on the horizon and/or 2) the path for bulls will not be as smooth in February as we saw in January. This is in context of VIX futures option buyers purchasing calls relative to puts at a rate of five to one. Historically, these option buyers have been smart money, but since November, their call buying bias has not played out correctly.,, risks to the bull case increase if the VIX gets significantly above its 2022 close at 21.67.”

-Monday Morning Outlook, February 13, 2023

“‘I’m very negative right now on equities,’ said Eric Johnston, the head of equity derivatives at Cantor Fitzgerald, who predicted the recent S&P 500 rally but now expects a slump…Mr. Johnston now thinks the S&P 500 will eventually fall below its 2022 low, a drop of more than 10 % from current levels. Strategists at Morgan Stanley and JPMorgan Chase are also among those bracing for a fall.”

-The New York Times, “Why a Strong Economy Is Making Stock Investors Jittery,” February 17, 2023

Recent economic indicators show that the Fed’s mission to bring down inflation is ‘very much unaccomplished,’ Hartnett wrote. He expects the S&P 500 to slump to 3,800 points by March 8 — a decline of more than 7% from Thursday’s close — after the benchmark failed to break through a ceiling of 4,200 points.”

-Bloomberg, February 17, 2023 (Michael Hartnett is Bank of America Strategist)

Why Inflation Will Be Hard To Bring Down

-The Economist magazine cover, February 18, 2023

Continue to monitor action in the Cboe Market Volatility Index (VIX--21.23), as VIX futures buyers, per the chart below, are still buying calls at a high rate relative to puts. Historically, these option buyers have been correct about future VIX action, but they have been heavy buyers of VIX futures calls for weeks, with nothing materializing.

I don’t know exactly who is buying the calls, but per the excerpts from the New York Times and Bloomberg articles, various strategists are sounding the alarms, which is getting the attention of financial publications. The contrarian instinct in me suggests going against such calls, at least at present and until technical indicators suggest these forecasts have betters odds of coming to fruition.

This week’s call volume on VIX futures was especially notable on Tuesday through Thursday, as call volume between 50,000 and 110,000 contracts crossed at the May 50 and July 60 strikes during those three days, amid economic data that supported what Fed officials have been warning us about for months about their projected path for interest rates.

mmo feb20 chart 3

If the VIX closes above last year’s close, I think it would be worth growing more cautious about a continued rise in volatility that is concurrent with lower stock prices. It would be worthwhile, on a VIX close decisively above its 2022 close, to hedge long positions, even if the SPX has not broken below major support, such as the 3,970 level discussed above.

Using history as a guide, I think risk grows of the VIX getting up to at least the 27 area, or 50% above this year’s closing low, if it moves above its 2022 close. A move into the 32 area would also be a possibility, which is 50% above last year’s close. As such, it would be worthwhile to hedge this possibility while the VIX is in the low 20’s.

 mmo feb20 chart 4

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

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