Why Bulls Should Brace for a Potential VIX Pop
Longer term, a shift in the AAII sentiment survey could be a boon for stocks
by Todd Salamone 8/11/2012 10:34:43 AM
The buzzword of the week was "stimulus," with expectations for additional policy accommodation pushing stocks higher around the globe. By the time the dust settled on Friday, in fact, the major equity indexes were planted north of some significant round-number milestones.
As we head into August expiration week, Todd Salamone recommends keeping a close eye on those notoriously stubborn round numbers -- particularly since there are now a handful of technical indicators to provide cause for short-term concern, including the presence of possible options-related headwinds for the Spiders.
Meanwhile, Rocky White commemorates the end of an historically epic bearish streak in the weekly AAII survey. After crunching the numbers, Rocky explains what contrarians can expect from a shift in the sentiment tides. Finally, we wrap up with a preview of the major earnings and economic reports for the week ahead, along with a few sectors to watch.
Notes from the Trading Desk: After Five Weeks of Gains, Four Short-Term Risks for Bulls
By Todd Salamone, Senior VP of Research
"The options fear gauge on Wednesday was currently hovering around 16, at the lower end of its range since June as the S&P was within striking distance of the 1,422 multiyear high set in April. 'Now is a good time to buy downside puts on the S&P 500 index because they can increase in value if the market falls and if volatility moves up,' said WhatsTrading.com options strategist Frederic Ruffy."
- Reuters, August 8, 2012 In last week's commentary, we listed some bigger-picture reasons why the equity market's risk/reward equation favors the bulls. To summarize: In the context of strong price action this year, the sentiment backdrop is one of caution and fear among most market participants -- a sentiment environment that would suggest the S&P 500 Index (SPX - 1,405.87) is down double digits for the year, instead of the reality of being up double digits in 2012. From a contrarian perspective, this dichotomy between price action and sentiment is bullish.
With this in mind, there are a few notes of caution, from a technical perspective, that short-term traders should be aware of as we enter August expiration week. On the heels of five consecutive weeks of SPX gains, it's worth noting:
- The SPX, Russell 2000 Index (RUT - 801.55) and Nasdaq Composite (COMP - 3,020.86) are simultaneously trading around key round-number levels that mark potential resistance. Since these indexes traded above their respective round-number levels this past week, they have gone sideways as very short-term realized volatility has imploded. The caution for bulls would be realized volatility spiking if these round numbers indeed act as resistance. Plus, the SPX's high close on Friday last week was nearly flat with its early-May closing peak, and only about 13 points below the 2012 calendar-year closing high.
- In addition to the SPDR S&P 500 ETF (SPY - 140.84) entering the week near potential call-related resistance at the round 140 strike (see the SPY open-interest configuration chart immediately below), there are a few sector-related exchange-traded funds (ETFs) -- such as the SPDR S&P Retail ETF (XRT - 60.10) and Financial Select Sector SPDR Fund (XLF - 14.94) -- trading just below heavy call open interest, such as the round 60 and 15 strikes, respectively.
- The CBOE Market Volatility Index (VIX - 14.74) is trading just below 15, a level from which it has popped several times during the past two years. Moreover, the CBOE Russell 2000 Volatility Index (RVX - 19.99) has experienced only one other weekly close below the 20 level since August 2007, and the RVX comes into next week trading right at this support area.
In fact, per the table below the accompanying VIX chart, SPX returns over a five-day period since 1990 have been negative, on average, after the VIX breaks below 15. But note that breaches of the 15 level mean very little beyond Day 5.
Market participants seeking portfolio protection -- or looking to replace expiring portfolio protection -- may view the VIX pullback as an opportune time to hedge. An increase in VIX call buying or index/ETF put buying would be a coincidental headwind for the market, as sellers of portfolio insurance short SPX futures to hedge their risk.
- Active investment managers have above-average exposure to the market, according to the most recent National Association of Active Investment Managers (NAAIM) survey -- similar to that of April, which preceded a correction.
The NAAIM risk would be of bigger concern to us if confirmed by other sentiment indicators that we follow. For example, short interest at present is a lot higher than the April period, suggesting demand from short covering is stronger. Furthermore, equity option buyers were purchasing more than two calls for every put in April, which marked a one-year high at the time. At present, 1.5 equity calls are being purchased for every one equity put, which is around three-year lows.
There are technical risks for the market in the near term, but if a pullback this week indeed occurs, it should be viewed as a buying opportunity. Short interest is declining from the kind of highs last seen in September 2011, when short covering drove an impressive rally that lasted into March of this year. Few expect a repeat of the September-March rally -- which is exactly why we like the upside probabilities into year end, even though there are technical speed bumps overhead.
Indicator of the Week: The AAII Streak Ends
By Rocky White, Senior Quantitative Analyst
Foreword: One of the sentiment indicators we follow is the weekly survey conducted by the American Association of Individual Investors (AAII). In this poll, the AAII asks its membership where the market is heading in the next six months. Prior to last week's report, the bears had outnumbered the bulls in this survey for 13 straight weeks. The poll can be very volatile, so it's quite extraordinary that it stayed bearish for about three straight months. This week, let's take a look at what has happened in the past following similarly lengthy streaks of bearishness in the weekly AAII roundup.
When the Streak Ends: I alluded to the fact that it's quite rare to see such long streaks of bearishness. We have data on the poll since 1987, and this is just the sixth time that the bears have outnumbered the bulls for 13 straight weeks. Below is a table showing other streaks of at least 13 weeks of bears outpacing the bulls, along with the S&P 500 Index (SPX) returns over different time frames out to about six months (26 weeks). In the summary, you'll see the average of the returns after an occurrence as compared to the typical SPX returns over those time frames. Checking out the data, the returns after one of these signals outperforms what the market typically does -- especially at the 8-week and 13-week time frames (approximately two and three months, respectively).
As contrarians, we expect this almost-unprecedented bearishness to have bullish implications. If the poll is indicating that investors are moving from a bearish outlook to a bullish outlook, then it may be quite a buying opportunity. That's because the 13 weeks of bearishness is a sign that investors may have been keeping money on the sidelines -- and if they're turning bullish, that money could now begin flowing into the market to drive stocks higher. Make sure you're in this market before the rest of the crowd moves in.
Finally, below are a couple of SPX charts marking the signal dates in the table above.
This Week's Key Events: Inflation Data, Retail Earnings On Tap
Schaeffer's Editorial Staff
Here is a brief list of some of the key market events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.
Monday
- There are no major economic reports due out on Monday. On the earnings front, we'll hear from AuRico Gold (AUQ), Groupon (GRPN), InterOil (IOC), Sky-mobi (MOBI), Sysco (SYY), and Transcept Pharmaceuticals (TSPT).
Tuesday
- The economic calendar comes to life on Tuesday with the release of the producer price index (PPI), retail sales, and business inventories. Earnings are due out from Home Depot (HD), Dick's Sporting Goods (DKS), Estee Lauder (EL), JDS Uniphase (JDSU), Michael Kors (KORS), Myriad Genetics (MYGN), Pan American Silver (PAAS), Saks (SKS), and TJX Companies (TJX).
Wednesday
- The Empire State manufacturing index hits the Street on Wednesday, along with the consumer price index (CPI), industrial production and capacity utilization, and the National Association of Home Builders (NAHB) housing market index. Quarterly results are expected from Cisco Systems (CSCO), Abercrombie & Fitch (ANF), Agilent Technologies (A), Applied Materials (AMAT), Deere & Co. (DE), NetApp (NTAP), Staples (SPLS), and Target (TGT).
Thursday
- There's no shortage of market-moving potential on Thursday, as investors will have a chance to respond to weekly jobless claims, the Philadelphia Fed's manufacturing index, and housing starts. Wal-Mart Stores (WMT), Aeropostale (ARO), Brocade Communications Systems (BRCD), Dollar Tree (DLTR), GameStop (GME), Marvell Technology Group (MRVL), Ross Stores (ROST), and Sears Holdings (SHLD) are slated to report earnings.
Friday
- The mid-August Thomson Reuters/University of Michigan consumer sentiment index will be released on Friday, as will the Conference Board's index of leading economic indicators. We'll also hear the latest quarterly earnings from Foot Locker (FL) and J.M. Smucker (SJM).
And now a few sectors of note...
Dissecting The Sectors
| | Sector | Leisure/Retail
Bullish |
Outlook: Despite three straight months of waning consumer spending, the SPDR S&P Retail ETF (XRT) has held relatively steady from a price-action perspective, implying that expectations for retailers are already low. In fact, we've noticed a pattern of slight dips on poor macroeconomic news, and large advances on encouraging macro developments -- pointing to an appealing risk/reward set-up for this group. On the earnings front, Macy's (M) and Dillard's (DDS) both moved higher last week on the heels of their quarterly reports. With a flood of retailers set to unveil their own financial results this week, there could be more upside surprises in store. Technically speaking, XRT continues to trend above support in the $56 area, home to its July 2011 peak, and has bounced back above its rising 80-day and 160-day moving averages. However, the ETF is still struggling to find a reliable foothold above the $60 level, which represents quadruple its November 2008 low. The August 60 strike is also home to heavy call open interest, so this speed bump could remain intact through front-month expiration. Contrarian traders should continue to target scenarios where outperforming retail stocks remain underappreciated by the crowd. For example, a number of consumer-discretionary notables -- including Under Armour (UA), Wal-Mart Stores (WMT), Home Depot (HD), Sherwin-Williams (SHW), and O'Reilly Automotive (ORLY) -- have seen more put buying than call buying during the past month, suggesting the bullish bandwagon is far from crowded. As the skeptics continue to capitulate, these under-loved outperformers could enjoy contrarian boosts.
| | Sector | Homebuilding
Bullish |
Outlook: The housing sector continues to see positive developments in 2012, as record-low mortgage rates have reignited interest in the real-estate market. The good news continued to roll in last week, when separate reports from CoreLogic and Freddie Mac showed home prices rising by the biggest percentage in at least seven years. Meanwhile, J.P. Morgan doled out upgrades for Beazer Homes (BZH), KB Home (KBH), and PulteGroup (PHM), which sparked sector-wide strength on Thursday. In fact, the SPDR S&P Homebuilders ETF (XHB) marked the occasion by rising to a new year-to-date high, and clambering above the crucial $22 level in the process. This area, which roughly coincides with half the ETF's 2006 inception price of $44, had previously served as resistance since last March -- so this breakout is encouraging for bulls. Some of our preferred names in the group include PHM, D.R. Horton (DHI), Toll Brothers (TOL), Lennar (LEN), and Meritage Homes (MTH), due to a combination of solid price action and lingering skepticism from Wall Street. Going forward, all of these technically strong stocks stand to benefit from short-covering support or additional analyst upgrades. That said, we continue to watch support for XHB in the $19-$20 area -- which corresponds with the site of the ETF's 2011 high and its 160-day moving average, currently docked near $20.38. Meanwhile, the 80-day moving average (around $20.95) can possibly contain any short-term pullbacks, and heavy out-of-the-money put open interest at the August 20 and 21 strikes could reinforce the support in this area, as well. During the near term, a move below this region would be a point of concern. Investors may therefore wish to hedge any long positions on homebuilding names with XHB puts. Meanwhile, another homebuilding ETF we monitor is the iShares Dow Jones U.S. Home Construction Index Fund (ITB), which recently pulled back to around $16 and bounced off support from its 40-day moving average. This level coincides with the fund's April 2010 peak, and is also double the October 2011 low. The $17.80-$18 region is also another area to keep an eye on, as it represents a 50% year-to-date gain for the ITB.
| | Sector | Big-Cap Banks
Bearish |
Outlook: Amid ongoing regulatory and macroeconomic concerns at home and abroad, large-cap banks remain unimpressive. The Financial Select Sector SPDR Fund (XLF) is trading at the top of a month-long trading range just below $15, which has previously played a significant role as both support and resistance. Options traders are heavily targeting this price point, with the August and September 15 strikes hosting peak call open interest for their respective series. This suggests the fund could be thwarted by options-related resistance during the coming weeks. On the other hand, XLF remains above its 320-day moving average, and short-term traders should be cautious of potential structural support from heavy put open interest at the 14 strike. Drilling down to sector components, Citigroup (C), JPMorgan Chase (JPM), and Goldman Sachs (GS) have gained little-to-no ground since reporting earnings, even while some short sellers have taken their leave. This suggests some of the weaker bearish hands have hit the exits, while the more confident bears are digging their heels in for a long stay. Meanwhile, Bank of America (BAC) and Morgan Stanley (MS) were punished outright after earnings, with the shorts finding little motivation to abandon their winning bets. And speaking of earnings, the nation's five largest banks -- C, BAC, GS, JPM, and MS -- recorded their weakest first-half revenue figures in four years, according to Bloomberg. Nevertheless, laggards such as C, JPM, MS, and Wells Fargo (WFC) are still sporting a preponderance of "buy" ratings from analysts, so a round of downgrades could apply further pressure to these struggling securities as they try to break free of their recent funk. |
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