Are We In for Another Whipsaw Week This Week?

Why bulls could be cheering the third year of this presidential cycle

Senior Vice President of Research
Jan 10, 2015 at 8:57 AM
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It was a wild week of trading on Wall Street, with markets making big moves in both directions. Although bulls gave a valiant mid-week effort amid a brief respite in oil's rout and stimulus speculation from overseas, one particular metric in Friday's jobs report unsettled investors -- and sent the major market indexes back into the red for 2015. As Schaeffer's Senior VP of Research Todd Salamone explains, there was a "method to the madness," and offers up a number of reasons why last week's volatile price action could continue heading into January options expiration.

  • The short-term vulnerabilities facing the market
  • The under-the-radar moving average we're keeping a close eye on
  • If history is any guide, the current D.C. backdrop could bode well for bulls

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: More Evidence on the Importance of Round-Number, Half-Century, and YTD Breakeven Levels
By Todd Salamone, Senior VP of Research

"On the sentiment front, we have continued to see a lack of hedging from institutions in recent weeks. An extremely popular hedge for institutions and hedge funds are CBOE Volatility Index (VIX ) calls. The VIX 20-day buy-to-open call/put ratio is down to 1.0 -- the lowest level since April 5, 2012. In other words, there aren't a lot of people buying hedges on their portfolios right now. These low-hedging ratios could leave stocks vulnerable to headline news...

"As we enter 2015, there will be a lot of factors affecting the market. The Fed will continue to remain in focus, as investors try to glean just when exactly rates will be increased and by what amount."

- Monday Morning Outlook, Jan. 3, 2015

"$QQQ ytd b/e is $103.25- Reached this level at three hours ago and it has essentially been sideways movement since"

"$SPX YTD B/E is 2,058.90 - has stalled here for the past 1-1/2 hours"

"YTD breakeven levels on $SPY, $QQQ, $MID prove to be significant - sideways action yesterday followed by this morning's selloff"

-@ToddSalamone on Twitter, Jan. 8-9, 2015

If what lies ahead in the immediate days for the stock market is anything like we observed this past week, expect choppiness to be the order of the day. If you are a trader, this would suggest putting smaller dollars into each trade and either shortening or lengthening your time frame, whichever you prefer. Shorten your time frame to take advantage of quick, whipsaw movements. If you lengthen your time frame and put less dollars at risk, you can loosen your stops and target bigger returns, therefore reducing the risk of getting whipsawed out of trades.

From a price-level perspective, there was a method to the madness, which gives us reason to believe that more of this could lie ahead. Like last year, indexes are respecting round numbers and year-to-date (YTD) breakeven points.

For example, in just three trading days, the S&P 500 Index (SPX - 2,044.81) moved from the round-number 2,000 millennium level to its half-century mark of 2,050, which is just below the 2014 close. Long-time readers of Monday Morning Outlook are aware of the SPX's uncanny behavior around half-century levels, which tend to act as key pivot or hesitation points. Note the sideways intraday action around 2014's close that followed the "hurry up and get there" buying in the 30-minute graph below. Thursday's sideways action was promptly followed by a Friday morning sell-off.

30-Minute SPX Chart Since Friday, Jan 2 With 2015 YTD Breakeven

As a side note, we found it interesting that the SPX's low last week occurred around its 120-day moving average, a trendline that is not on the radar of many technicians, but has been important nonetheless. Note on the chart below how it has marked major short-term buying opportunities in seven of the last eight pullbacks since mid-2013. All pullbacks that have been supported by this trendline have been followed by an advance to new highs. If past is prologue, the SPX will make another run at 2,100 in the coming days.

Daily Chart of SPX Since March 2013 With 120-Day Moving Average

The below table gives you closing levels for 2014 for some major equity benchmarks that we follow, along with last week's closing lows and closing highs. The purpose of this table is to highlight the importance of round numbers and half-century marks, plus year-to-date breakeven levels that could be influential in the days, or even weeks and months, ahead.

Key Benchmarks With 2014 Closing Highs and Recent Highs and Lows

Next week is expiration for most options, although the expiration of CBOE Volatility Index (VIX - 17.55) options does not occur until Wednesday, Jan. 21 -- the week after next. The below graph is the current open interest configuration for January SPDR S&P 500 ETF Trust (SPY - 204.25) options that expire next week.

Note the enormous put open interest at the 200 strike, which acted as support last week. The furious rally from this level may have been driven, in part, by the unwinding of short positions related to this put open interest. Said another way, the further the SPY was above this strike and the closer we moved to next week's expiration, sellers of those puts that desire to be hedged were able to unload some of their short positions, as the probability decreased of these puts finishing in the money. That said, if negative news hits the market, this strike could be a magnet, as short positions would have to be re-established.

If the market advances, resistance from heavy call open interest relative to put open interest occurs at the 205 and 210 strikes, which equates to roughly SPX 2,050 -- the half-century mark that is situated just below 2015's YTD breakeven -- and 2,100, a round-number level that is just above the late-December high.

As it stands currently, SPY premium sellers would love to see a pin at 205 next Friday, as this is where the maximum number of calls and puts would expire worthless, which is the aim of a premium seller. In fact, the maximum number of call and put contracts that expired worthless occurred during the expiration of standard December options last month.

SPY Open Interest Configuration for the January Series of Options

Bigger picture, hedging activity remains well below the levels of 2014. As we mentioned last week, if market participants that are normally hedged have chosen to forego hedging but are still holding long equity positions, this leaves the market more vulnerable than normal to negative headlines, as a lack of portfolio protection puts the market at the mercy of panic sellers.

Per the chart below, courtesy of our friends at Trade-Alert, total call open interest on VIX options has declined sharply since the first 10 months of 2014. It might not be a huge surprise to contrarians that the VIX climbed to its second-highest and fourth-highest readings in a year during only a three-week period between mid-December and early January, coincident with VIX call buyers steadily leaving the building.

VIX call open interest -- sharp decline the past few months

VIX Open Interest Since December 2013

Another, albeit different, takeaway to the relatively low equity-hedging activity is that hedged players could be building cash positions or playing ball elsewhere, reducing the need for equity protection. Since the SPX hit the 2,000 level in late August, there has been a steady decrease in VIX call open interest. And, since mid-November, SPY put open interest, which is another hedging vehicle, has decreased. Could hedged players be reducing equity exposure in lieu of cash, bonds, currency, commodity, or other macro plays? If this is the case, it is a market headwind.

If indeed hedged players are reducing exposure, who or what is supporting the market? It appears the shorts have begun to throw in the towel (see the chart immediately below). If you are a bull, you want to see more of this, especially if hedged players are on the sidelines or playing elsewhere, as short covering is a supportive factor. But this supportive factor diminishes as short interest continues to decline. The good news is that short interest on SPX component names remains well above the 2011 and 2012 extreme lows, but another upturn in short interest would be ominous without hedged players looking to buy into market weakness.

Short Interest vs SPX Since January 2011

So, ideally, bulls would like to see stocks move higher coincident with a buildup in portfolio protection and still-heavy short interest levels, as this would be a sign that the deep-pocketed hedged players are accumulating equities and buying protection along the way. The recent stock market advance, however, seemed to be driven by short covering. Heavy short interest keeps pullbacks in check and supports breakouts to new highs, but we are at a lower level of short interest relative to a couple of months ago.

For now, it appears hedged money could be parking cash elsewhere and taking a "wait and see" approach, with the SPX trading in the 2,000 area, the official start of earnings season next week, and Federal Open Market Committee (FOMC) and European Central Bank (ECB) meetings scheduled for later this month.

Regardless of the motivation for low-hedging activity, we continue to advise having a hedge or short (put) exposure in place, especially with earnings season and the FOMC and ECB meetings just around the corner.

Indicator of the Week: Third Year of a Presidential Cycle
By Rocky White, Senior Quantitative Analyst

Foreword: It is pretty well-documented that the third year of a four-year presidential cycle is historically bullish. That's good news for the upcoming year, as 2015 is such a year. There are a few theories as to why this is. Maybe investor confidence is increased after midterm elections when the new Congress takes office? Another possibility is that U.S. presidents begin eyeing the next election in their third year, and promote market-friendly policies to boost their chances for re-election (or their party's chance for re-election if it's the president's second term). Of course, it's also possible that it's simply random. Whatever the reason, the consistency of positive returns over the last 60 years in the president's third year is quite impressive.

Third-Year Presidential Cycle: The table below summarizes the yearly returns on the S&P 500 Index (SPX) for each of the presidential cycle years going back to 1949. The average return in the third year of the cycle is 17.1%. That outpaces any of the other years by far. The other years all average between 6% and 7% gains. Out of 16 years, the third year of the cycle was negative only one time. That was actually just four years ago, in 2011, and the SPX was just barely negative, down 0.003% that year. The Dow Jones Industrial Average (DJIA) has actually been positive all 16 years in the third year of the cycle (the Dow gained 5.5% in 2011).

SPX by Presidential Cycle Years since 1949

The chart below emphasizes how much more bullish the third year has been compared to the others. It shows the average SPX return path for each cycle year. The third-year average returns blows away the other years right off the bat and never looks back. On average, the SPX has boasted a 15% gain in July during the third year of the cycle!

SPX Average Return Cycle by Presidential Years since 1949

The table below quantifies the first-half and second-half returns for each of the presidential cycle years. It's good news -- at least for the next six months -- that the third year is especially bullish in the first half of the year. The SPX averages a 13% return and has been positive in each of the 16 years. The second half of the year has averaged a much tamer 3.86%.

SPX Half-Year Returns by Presidential Cycle since 1949

This Week's Key Events: Alcoa Gets the Earnings Party Started
Schaeffer's Editorial Staff

Here is a brief list of some key market events scheduled for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.


  • The week begins with Alcoa's (AA) unofficial kickoff to earnings season.


  • On Tuesday, the U.S. Treasury budget data and the Labor Department's Job Openings and Labor Turnover Survey (JOLTS) are scheduled for release. CSX Corporation (CSX), DragonWave (DRWI), KB Home (KBH), and Progress Software (PRGS) will step into the earnings confessional.


  • Wednesday's packed docket includes retail sales, import and export prices, business inventories, the Energy Information Administration's (EIA) weekly stockpiles report, and the Fed's Beige Book. JPMorgan Chase (JPM) and Wells Fargo (WFC) will release their quarterly earnings data.


  • Weekly jobless claims, the producer price index (PPI), the Empire State manufacturing survey, and the Philadelphia Fed manufacturing survey come out on Thursday. Bank of America (BAC), Intel (INTC), Citigroup (C), Lennar (LEN), BlackRock (BLK), Charles Schwab (SCHW), Fastenal Company (FAST), PPG Industries (PPG), Schlumberger (SLB), and Taiwan Semiconductor (TSM) will head into the earnings spotlight.


  • Friday's economic calendar includes the consumer price index (CPI), industrial production data, and the Thomson Reuters/University of Michigan consumer sentiment index. Goldman Sachs (GS), Comerica (CMA), PNC Financial Services (PNC), Private Bancorp (PVTB), SunTrust Banks (STI) will report their earnings data.

And now a sector of note...


The consumer discretionary sector was the top-performing sector in November and December, rallying more than 6% and outperforming the broader SPX. However, as this recent column from The Wall Street Journal illustrates, pessimism remains prevalent. Despite the retail outperformance, "there is reason to believe other signs don't bode well for retail stocks" ahead of earnings season. Echoing this, of the 71 retail stocks we follow, nearly two-thirds are trading above their 80-day moving average, yet less than half of analysts offer up "buy" ratings. Plus, the average short interest-to-float ratio among these equities is 12.8%, which would take more than six sessions to cover, at average daily trading volumes. All things considered, retail stocks could be poised to run higher on potential short-covering activity and/or a round of analyst upgrades.

Meanwhile, the SPDR S&P Retail ETF (XRT) touched its all-time high of $97.15 on Thursday, and the shares are sitting atop several layers of previous resistance, including: $88, twice its 2011 lows; the round-number $90 level, roughly double its 2007 and 2010 resistance level at $45, and representing a 10% premium to XRT's mid-October closing low of $81.93; $92, roughly 20% above XRT's 2014 low; and $93, 50% above its 2013 low. Plus, the fund could find added support atop its 40-day trendline, which contained its recent dip, and it should be noted that XRT is now more than 10% higher year-over-year -- a feat that eluded XRT since mid-December.

Daily Chart of XRT since October 2014 with 40-Day Moving Average

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