"An IWM put purchase should be considered in the context of having long exposure. As we have been saying for weeks, the sentiment backdrop warrants long exposure, as the negative sentiment extreme we observed in late September and earlier this month appears to have climaxed. Historically, after such a climax in negativity, a powerful sustained rally becomes a strong possibility."
-- Monday Morning Outlook, October 26, 2015
If you have been reading our column, you are aware of the striking similarities of this year's stock market to 2011's, and how October 2015 was almost a carbon copy of October 2011. Along with this observation, we cautioned that if the pattern continues into November, another correction would be on the immediate horizon. However, the market is now showing signs of diverging slightly from 2011. For example, whereas the S&P 500 Index's (SPX – 2,099.20) advance above the prior year's close in October 2011 lasted only a few days and preceded a significant pullback into late November, this year's Oct. 23 move above the 2014 close of 2,058.90 has held for a couple of weeks so far.
Moreover, two weeks ago, in the context of a generally bullish outlook tempered by the risk of 2011's November corrective pattern emerging, we recommended the purchase of iShares Russell 2000 ETF (IWM – 119.22) put options as a hedge to bullish exposure. At the time, the Russell 2000 Index (RUT – 1,199.74) was struggling to overtake resistance at 1,165, and 30-day implied volatility on IWM options was at 17%, half the 2015 peak. We saw risk in a pop in IWM implied volatility from this half-high, which could be coincident with a pullback in the small-cap space.
Since then, the prospects for small caps have improved, with the RUT moving above resistance at 1,165, and 30-day implied volatility on IWM at 16% as of Friday's close. As we mentioned two weeks ago, after the CBOE Volatility Index (VIX – 14.33) fell below its 2015 half-high in early October, an impressive rally followed.
The two sentiment-based charts that follow should be enough to keep bulls excited and bears nervous. In both cases, there is evidence of multi-year extremes in pessimism that climaxed several weeks ago. And, as we said in the Oct. 26 commentary, "Historically, after such a climax in negativity, a powerful sustained rally becomes a strong possibility."
National Association of Active Investment Managers Survey (NAAIM)
The NAAIM survey, discussed last week, is catching our eye, particularly the now-visible turn higher in the 10-week moving average, suggesting investment managers are increasing exposure after months of reducing market exposure. In March, for example, this moving average began moving lower from high average stock exposure levels, and the trendline continued lower until only recently. It was difficult for stocks to advance as active investment managers steadily reduced market exposure. In fact, the rollover from high exposure levels began around the time that the Dow Jones Industrial Average (DJIA – 17,910.33) was probing the 18,000 millennium level for the first time ever and the Nasdaq Composite (COMP – 5,147.12) was revisiting 5,000, last seen 15 years ago.
With these benchmarks again trading around the round numbers of 18,000 and 5,000, the current trend of increasing exposure is supportive of a sustained breakout above these millennium levels -- unlike the failures around these levels earlier this year, when this group began a lengthy process of reducing market exposure.
10-Day, Equity-Only, Buy-to-Open Put/Call Volume Ratio
With put buying on equities equivalent to a downside speculative bet and call buying equivalent to an upside bet, you can see on the chart below that pessimism among options speculators recently peaked at levels last seen during the financial crisis in 2008-2009. This ratio is now sliding lower, indicative of a climax in negativity that had been building among options participants since June. Yes, there could be a surprise event (likely not the Fed) that could be the driving force that alters its current direction -- but as it stands currently, bulls have to be encouraged by the fact that short-term headwinds are giving way to short-term tailwinds as caution eases.
"But instead of celebrating, many money managers are fretting … stocks could be in for more trouble later this year… some have cut stock holdings and built cash reserves in case of trouble."
-- The Wall Street Journal, October 25, 2015
"Despite stocks sitting only a percent from their record, concerns remain under the hood. Market breadth is one of them. Since April, breadth has been weakening to near a two-and-a-half year low, according to Jack Ablin, chief investment officer at BMO Private Bank. He measures it by comparing returns of the S&P 500 equal-weighted index to that of the cap-weighted index, which he said have lagged by more than four percentage points since the beginning of the year."
-- The Wall Street Journal, November 5, 2015
Although extremes in pessimism are fading relative to what we witnessed in late September, there is still a fair amount of caution, per the excerpts above. Concerns range from valuations, earnings potential amid a strong dollar/weak oil, and the Federal Reserve tightening policy (Chair Janet Yellen maintained last week that a hike in December remains a "live possibility" before Friday's better-than expected payroll and wage growth numbers). Other concerns include slowing world economies and -- from a technical perspective -- market internals, or breadth.
I'll address a couple of these concerns. First, with regard to the Fed, the implied odds of a rate hike rose on Friday to roughly 70% from the previous day's 58%. And one month ago, when the SPX was around 1,980, the implied odds of a rate hike were only 5%. The point is, a rate hike by year-end is mostly baked into the market, and investors are accepting this, as economic growth is welcome.
Breadth is another concern I'll address, as some are worried about the divergent action of the large cap indexes trading around all-time highs as small-cap relative strength wanes, which was also evident ahead of the past two bear markets.
Above said, since the bull market began in early 2009, there have been various bouts of weakening small-cap relative strength as the market rallied, as seen in the circled areas on the below chart. While weakening relative strength during market rallies in 2000 and 2007 was observed (see red rectangles), note that small-cap relative strength weakness lasted for years preceding the market peak in 2000. For what it is worth, the SPX nearly tripled over this period. The bottom line is -- lagging small caps may be present at key market tops, but this indicator has also produced its share of false signals along the way (click chart to enlarge).
Moreover, it can be argued that at present, SPX internals are stronger than 2011, when a rally from the October lows persisted into early the following year and for the years to come, with only minor corrections along the way.
For example, one measure of breadth is the number of stocks in an index making new 52-week highs. Per the chart immediately below, and as I observed on Twitter last week, the percentage of SPX components making new 52-week highs in the past 10 days is higher now relative to 2011 and 2012. Given the mean-reverting market tendency, this measure may be "too high" from a near-term perspective, suggesting the numerous stocks making 52-week highs might be vulnerable to shallow pullbacks to former levels of resistance in the coming days. We would view such pullbacks as buying opportunities, however.
With multiple indexes battling round numbers that defined the highs earlier this year, but year-to-date breakeven levels acting as support, a consolidation of last month's gains could be in store for the near term. But sentiment-based indicators are currently suggesting that a rally through chart and round-number resistance levels is a growing possibility in the weeks and months ahead.
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