"With the Thanksgiving holiday last week, Schaeffer's Senior Quantitative Analyst Rocky White looked back at the market's performance in the week after Thanksgiving. He broke the historical returns down based on how the SPX performed during Thanksgiving week ... based on this study, one could argue the risk-reward this week favors the bears. Bulls, however, should stay the course, and use pullbacks as buying opportunities."
- Monday Morning Outlook, November 28, 2016
Last Monday, in a commentary entitled, "
Why The Risk-Reward Favors Bears This Week," I presented several observations regarding potential resistance levels for multiple equity benchmarks, ranging from 19,000 for the Dow Jones Industrial Average (DJIA - 19,170.42) to 2,200 on the S&P 500 Index (SPX - 2,191.95) to a pair of significant price points for the Russell 2000 Index (RUT - 1,314.25). The small cap-focused RUT faced potential resistance from the 1,350 half-century mark and also 1,370, which is four times the 2009 low of 342.60.
Additionally, after assessing that the Thanksgiving week resulted in a 1.4% rally for the SPX -- and looking back at how the week after Thanksgiving has played out historically after advances of this magnitude (the table we presented last week is reproduced immediately below) -- my conclusion was that the risk-reward likely favored the bears. Sure enough, the SPX declined back below 2,200 -- nearly 1% -- and RUT pulled back as well.
The Dow, however, managed to finish last Friday north of its Thanksgiving-week close on the strength of
news-driven financial and energy stocks, albeit only by about 20 points. One thing that stands out, and which I failed to mention last week, is not only 19,000 looming as a potential re-test area, but the round 10% year-to-date (YTD) return level hovering around current levels. With the DJIA closing last year at 17,425, the level that represents a 10% gain is 19,168.
In the chart below, the top pane represents the daily YTD gain for the Dow since the start of 2016, with the dashed lines at -10% YTD and +10% YTD. Note the significance of the -10% YTD level as a support area at the January and February lows, and even the significance of the breakeven level (solid horizontal line) in May and June. Therefore, there is the possibility that +10% YTD on the Dow becomes significant in the days ahead as resistance, especially with the SPX trading back below the round 2,200 level.
But given the powerful post-election rally, even if there is a DJIA 250-300-point pullback, the index would still be above its 20-day moving average, as displayed in the chart's second pane. In fact, with the exception of the Nasdaq Composite (COMP - 5,255.65), most major equity benchmarks are significantly above their 20-day moving averages, implying it would take a major move lower to do severe technical damage. A short-term consolidation to work off overbought levels would not be a surprise, while a Dow move through its +10% YTD level while in an overbought condition would be impressive.
Round-number levels could still give investors pause in the weeks ahead. Moreover, yesterday's Italian referendum and the looming Federal Open Market Committee (FOMC) meeting next week could give potential buyers further pause.
But the good news for bulls is that in both cases, perceived bad news is expected. For example, a vote against Italy Prime Minister Matteo Renzi's proposed changes to its legislative branch was expected, leaving investors to ponder further European political uncertainty if he resigns. Remember, back in June, no one was expecting uncertainty to materialize with the "Brexit" vote. Moreover, the expectations for a rate hike this month are nearly 100% when looking at Fed funds futures, indicating a potential rate hike is likely baked into the market.
Volatility expectations, as measured by the CBOE Volatility Index (VIX - 14.12), crept higher last week ahead of the weekend referendum in Italy. It is interesting that the VIX closed around a level that we have focused on since August -- the 14.07 level, which is half its 2016 closing high. Volatility peaks in July and August occurred around this area, whereas significant moves through 14.07 were
warning signs of explosive volatility ahead.
Finally, we are in that two-week window in which the market could be influenced by the positioning of option players on exchange-traded fund (ETF) and index options. As usual, our focus is on SPDR S&P 500 ETF (SPY - 219.68) options to identify key levels.
The chart below combines weekly 12/9 expiration SPY options with standard 12/16 expiration options. Compared to many instances when we do this analysis, what stands out is that there is not a lot of put open interest immediately below the market, effectively reducing the odds of a decline that is exaggerated by delta hedging (
where big put open interest strikes can act as "magnets"). Even if a decline occurs, the 215 strike could act as a potential magnet -- but that also represents a potential stopping point, as put open interest is modest below that strike.
Coincidentally, SPY's 50-day moving average is situated just above this heavy put strike, which corresponds to the half-century 2,150 level on the SPX. Moreover, the $215 mark was supportive in August on a minor pullback, and acted as resistance in the weeks preceding the election.
The risk, however, is the unwinding of long positions related to overhead calls, particularly at the 220 through 222 strikes. If SPY remains below these strikes, a steady liquidation of long positions related to this call open interest could occur -- but again, we don't find the potential headwind from this activity as unusually large, given that we are not talking about open interest levels above 200,000 or 300,000 contracts.
The upside to these calls is that if SPY moves through the call-heavy 220 strike again, strikes up to 225 are stacked with fairly heavy call open interest and could act as small magnets. The SPY 225 level coincides with SPX 2,250, and half-century marks have proven pivotal in recent years. If you are a bull, the 225 level is a potential target if we continue the post-election rally into Christmas, following last week's slight decline.
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