What Happens When Hedge Funds Are Net Long Volatility?

Mid-cap stocks are vulnerable to short-term headwinds, but watch for a breakout by June

Senior Vice President of Research
Feb 16, 2015 at 7:57 AM
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"...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. And the cost of the hedge may prove to be very small in the context of the potential rally that we could witness if hedge funds begin increasing their leverage once again."
-- Monday Morning Outlook, January 24, 2015

For the first time in 2015, the S&P 500 Index (SPX - 2,096.99) experienced two consecutive closes above 2,058.90, its 2014 close. As we have pointed out in past discussions, this level has been worth keeping an eye on -- up until last week, a close at or just above this year-to-date (YTD) breakeven level was immediately met with selling. In fact, notching that second consecutive daily close in the green for 2015 wasn't an easy task for the SPX, as an intraday pullback from its highs was supported right at this YTD breakeven.

30-Minute Chart of SPX since Feb. 9, 2015

After this SPX breakout above its 2014 close, many indexes -- including the SPX -- now face another potential short-term hurdle from round-number levels, including 18,000 on the Dow Jones Industrial Average (DJIA - 18,019.35). However, the most notable is the S&P MidCap 400 Index (MID - 1,502.78), which is an area of the market that we recommend (mid-cap stocks). In fact, several weeks ago, we discussed the implications of a breakout above 1,450, which is the neckline of a bullish inverse "head and shoulders" pattern. The target remains a move to the 1,630 area by the end of June.

From a short-term perspective, however, note that the round 1,500 level is now in play for MID. Longtime readers of this column might remember how the 1,000 millennium mark acted as resistance for several months during 2011 and 2012. With the MID now at a round-number level that's also 50% above a major breakout area, it would be natural for profit taking to act as a headwind. The MID might be especially vulnerable to headwinds with other indexes nearing key round-number levels, too.

Weekly Chart of MID since February 2010

While on the round-number discussion -- quickly turning to another asset class -- note that the CBOE 10-Year Treasury Note Yield (TNX - 20.21) is bumping up against the round-number 20 level (equivalent to a 2% yield on 10-year Treasury notes). If 2% acts as a cap on yields, bonds will rally, and stocks would likely weaken. In early 2013, TNX moved back up to 20 (2%) from 15 (1.5%). It closed just barely above this level for a few weeks before yields plummeted back below 2% in March.

Weekly Chart of TNX since April 2012

Turning back to equities, not to be forgotten is the Russell 2000 Index (RUT - 1,223.13), as it moved above the round 1,200 level and its YTD breakeven mark at 1,204.70. But there is work to be done, as its all-time closing high occurred in late December at 1,219.11, and the index comes into the shortened trading week around this potential resistance. Small-cap investors would like to see the RUT finally make a noticeable break above the 1,200-1,220 area, which has turned back all rallies since March 2014.

Daily Chart of RUT since February 2014

"Turmoil in Europe and an unprecedented decline in oil are complicating the guessing game around Federal Reserve rate increases, says Peter Cecchini at Cantor Fitzgerald LP...

'Investors are getting increasingly nervous about a potential selloff,' Bill Merz, a strategist on the derivatives and structured products team at U.S. Bank Wealth Management, said by phone...

Hedge funds and other large speculators have pared positions that profit should the VIX decline, increasing the balance of those betting on a higher VIX to the most since at least 2004...

'The fact you've got all these uncertainties makes you feel like there's better risk-reward to be net-long volatility than net short,' Justin Golden, a partner at Lake Hill Capital Management LLC in New York, said by phone Feb. 10."

-- Bloomberg, February 12, 2015

There has been a lot discussion in recent days about large speculators, which are usually hedge funds, moving into a net long position on CBOE Volatility Index (VIX - 14.69) futures. The Bloomberg excerpt may capture the drivers behind this, which appear to be fear and uncertainty. If this fear/uncertainty is being accurately portrayed, it would further support the notion that the drop-off in VIX futures call open interest -- which has been written about extensively in this space during the past few weeks -- could be driven by hedge funds reducing long equity exposure. During this period, the market has remained relatively resilient -- which is why we have suggested not disturbing long positions, but also maintaining a portfolio hedge in the event that continued unwinding of long equity exposure did technical damage to the market (which, thus far, has not been the case).

Something we haven't discussed, but which the excerpt from the Bloomberg article would imply, is that reducing long equity exposure might take place in the form of reversing short VIX futures positions that were put on in anticipation of lower volatility and higher stock prices. To the extent that hedge funds use VIX calls to hedge against a short VIX futures position or a long equity portfolio, it would make sense that VIX call open interest experiences a coincident drop.

Why is the fact that large speculators are net long, according to the Commitment of Traders (CoT) report, making a lot of noise? As you can see on the chart below, since the financial crisis, it has been a rare event for these investors to be net long, or looking for higher volatility. In fact, since 2011, it has happened on only three occasions, which is admittedly a small sample size.

CoT Net VIX Futures Positions (Large Speculators) since February 2010

However, our curiosity got the best of us, as to what both the SPX and the VIX did following instances when large speculators moved into a net long position. In the few instances that this has happened, volatility headed lower or rose modestly over the next two months, while stock prices (as measured by the SPX) soared. In two of the three instances, the SPX was higher and the VIX headed lower during the ensuing two-week and one-month periods, as well. Fortunately for bulls, the SPX's price action following the Jan. 20 "signal" looks more like the two-week period that followed the March 2011 and October 2014 signals, which produced healthy SPX returns. Specifically, the SPX rallied 1% in the two weeks following the recent Jan. 20 signal, and also rallied in the two weeks following the March 2011 and October 2014 signals.

SPX and VIX Returns Following Previous Net Long Situations

In fact, those betting on volatility (as measured by the VIX) to move lower were happy to see the VIX close below 15.53, which is half its October 2014 intraday high of 31.06. The VIX's end-of-January closing low was 15.52, ahead of a nearly 50% pop into the first week of February.

The bottom line is that from a historical perspective, if large speculators move into a long position on VIX futures, it is far from a slam dunk that volatility will head higher and stocks lower. Therefore, we advise that investors continue not to disturb long positions. Traders should continue to be open to opportunities on both sides of the market, especially if you are short-term oriented, as one cannot rule out another retest of the SPX 2,050-2,060 area.

Read more:

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