It was a disappointing January for bulls. In fact, for only the third time since 1979, the Russell 2000 Index (RUT - 1,165.39) did not experience a single daily close above the previous year's close for the entire month. The only two other times this occurred was in 2005, when the RUT went on to rally 7% into year-end 2005, and in 2008, when the RUT lost an additional 26% into year-end 2008.
(In January 2008, the RUT was in far worse technical condition than 2005, with the index closing below its 40-month moving average in January 2008. Today's technical backdrop is more like that of 2005.)
The January Barometer suggests that as January goes, so goes the rest of the year. Rocky White, our Senior Quantitative Analyst, discussed this subject in detail last week in a study he ran on the Dow Jones Industrial Average (DJIA - 17,164.95).
As a reminder, with the DJIA finishing with a negative return in January, historical data suggests that the probability decreases that the rest of the year will be positive relative to years when the month of January is positive. That said, despite a negative January, it is still slightly better than a coin flip that the rest of the year finishes positive, according to Rocky's research (summarized in the table immediately below). Therefore, bulls should not necessarily throw in the proverbial white towel just because January was negative -- but at the same time, the risk of a double-digit decline through year-end has increased.
Lost amid the "bearish" tone when negative Januaries occur is this: In the years in which the February-December period produced positive returns after a negative January, the average return was 13.5% -- just slightly less than the 14.1% mean return when January is positive. So, it might "bear" repeating what Rocky suggested last week, which is that the January Barometer indicator does not give one a statistical edge over a "buy and hold" strategy.
The January Barometer indicates roughly a 50/50 chance of a double-digit decline from now until year-end, and understandably, this may not sit well with most of you. But, with the S&P 500 Index (SPX - 1,994.99) still displaying a nice uptrend with support from its 10-month moving average, as well as the "coin flip" odds of a double-digit February-December advance, according to this indicator, we currently advise not disturbing long positions.
That said, the SPX is sitting just above a critical level that, if broken, could lead to additional weakness in the days ahead. If the 10-month moving average is breached, we could see a move down to at least 1,900, or the August 2014 low.
S&P 500: Uncertainty abounds, but there's still a low-volatility uptrend with potential support in the 1,985 area if the round-number 2,000 level is broken
From a shorter-term perspective, the SPX is trading in a volatile, choppy range. Throughout January, in fact, a defined area of resistance was at the Dec. 31, 2014 close of 2,059, which is the top horizontal line in the chart below. Support has been in the round number 2,000 region, represented by the bottom horizontal line. The 30-minute chart, which goes back to the first trading day of January, paints this picture clearly.
A concern for the bulls is that the SPX has spent more time in the 2,000 area, which is the bottom of the range. The risk is that buyers at this level eventually disappear, which would likely set up a test of the 10-month moving average in the 1,985 region, as discussed above.
"It is not a bad idea to be hedged or at least make preparations to hedge when necessary, as one risk to the market is a break of support potentially causing panic selling among unhedged longs and/or a sudden demand for portfolio protection, which could coincidentally push indexes lower than expected."
"We don't have a definitive reason as to why VIX call open interest and SPY put open interest have plunged in recent months. Another theory could be hedge funds have chosen to play in other areas -- currencies, commodities, emerging markets, bonds, for example."
-- Monday Morning Outlook, January 24, 2015
Still on our radar is the low level of CBOE Volatility Index (VIX - 20.97) call activity and open interest, especially with the VIX closing above 20 in January and up nearly 15% year-to-date.
Moreover, a review of several Commitment of Traders (CoT) reports reveals low levels of VIX, SPX and E-mini futures open interest, coincident with multi-year high levels of open interest in euro, gold, oil and copper futures contracts. This is still more evidence that suggests some hedge funds, particularly macro funds, are exiting positions in U.S. equities in favor of other assets, such as commodities and currencies. If this trend continues, it will be a major market headwind -- especially in the absence of short-covering activity, which helped drive the market higher late last year.
Total open interest on light, sweet oil futures and gold futures at multi-year highs
Bulls would prefer to see higher stocks coincident with hedging activity as a sign that hedge funds are in equity accumulation mode. With short interest increasing on SPX and PowerShares QQQ Trust (QQQ - 101.10) components in the most recent report, an ongoing short-interest build is an additional risk if the deep-pocketed players continue moving into other assets, as we suspect is occurring at present.
If the VIX rises above the January high of 23.43, a move to 31.00 could very well be in the cards. Last month's VIX high is in the vicinity that marks a 50% advance from the mid-January VIX low of 15.52. If the January high is taken out, the 31.00 area represents double the January low and is the site of the 2014 peak. Therefore, as we've been saying for the past few weeks, owning VIX calls is not a bad idea if you have long exposure at risk, especially at a time when VIX calls are relatively unpopular.
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