"Extreme short positions among large speculators on VIX futures usually precede volatility pops. And we have noticed that if a volatility pop occurs, it is usually after the expiration of millions of VIX call options... to the extent that there is an extreme VIX futures short position among large speculators, some of which are no longer hedged, the risk of a volatility pop has increased... note how SPX large speculators are in an extreme net short position, too -- which is counterintuitive... Piecing this together, the best conclusion is that stocks do not have the same magnitude of downside risk at the moment relative to the upside volatility risk."
-- Monday Morning Outlook, January 23, 2017
"Round numbers on three equity benchmarks are now in play: SPX 2,300; S&P MidCap 400 Index (MID - 1,696.67) 1,700; and Dow 20,000... The jury is out as to whether last week's breakout can sustain itself, and whether the Dow can hold above 20,000 in the immediate days ahead. SPX 2,300 immediately reared its ugly head in last week's trading, potentially signaling the DJIA's vulnerability to move back below 20,000 in the not-so-distant future..."
-- Monday Morning Outlook, January 30, 2017
"Fear Index Soars…VIX +16%"
-- CNBC television headline, January 30, 2017
Equities were driven by multiple factors last week, including: 1) earnings and economic reports; 2) new presidential administration policies; and 3) the first Federal Open Market Committee (FOMC) meeting since Donald Trump took office.
Stocks began the week lower, with technology companies leading the decline, after President Trump and his administration temporarily banned travel from seven Muslim-majority countries. Concerns arose among investors and tech CEOs that such restrictions could hamper their efforts to recruit top talent to their firms.
As such, the Dow Jones Industrial Average (DJIA - 20,071.46) retreated below 20,000 much faster than the time it took to overtake this millennium level. The S&P MidCap 400 Index (MID - 1,706.64) fell back below its December high in a continued retreat from 1,700, and the S&P 500 Index (SPX - 2,297.42) fell further south of the 2,300 level, after this round number acted as a barrier in the prior week's trading. In fact, coincidentally -- or perhaps not -- the SPX found itself trading in the vicinity of its Dec. 13 close right around the time of last Wednesday's FOMC interest rate decision, in which the committee left rates alone and reiterated that it is looking to raise rates gradually.
Meanwhile, the tech-laden Nasdaq Composite (COMP - 5,666.76) filled in a gap area from the Jan. 24 close to the Jan. 25 open. In all cases, however, equity benchmarks "bent" very little before rallying back to or near the prior week's highs. The end-of-week rally occurred on news that President Trump was getting ready to sign an executive order to roll back Dodd-Frank regulations, sparking leadership out of financial stocks on the day the president was scheduled to meet with CEOs of major financial firms.
Volatility, as measured by the CBOE Volatility Index (VIX - 10.97), rose sharply, but immediately retracted. From its Friday, Jan. 27 close to its pre-Fed peak on Tuesday, the VIX rose 23%. If this is the VIX spike that I've been warning about, it was small by historical standards. Nonetheless, the action is somewhat consistent with my comments from two weeks ago that we are at risk of a volatility pop amid only a mild stock drop. In this case, the SPX's pullback from an all-time high was contained at its 20-day moving average, which it has not closed below in 2017.
Moreover, last week's action was very consistent with my concluding comment two weeks ago when I said, "...there is not a major 'known (event), unknown (outcome)' like Brexit or the U.S. election on the calendar. But many market participants will be intensely in tune with the president's actions in his first 100 days in office."
While nothing has been "set in stone" as to policy changes, the administration (through executive orders) has signaled where it wants to go on matters such as immigration, relieving regulatory burdens, seeking fairer trade, and dismantling the Affordable Care Act (ACA) and the Dodd-Frank Wall Street Reform and Consumer Protection Act. These matters, along with potential tax reform, will continue to make headlines and move stocks in the days, weeks, and months ahead.
Despite a plethora of headlines out of Washington, D.C., key equity benchmarks begin this week around the same levels as they did last week. In other words, the DJIA, SPX, and MID are not out of the woods in terms of taking out round-number resistance levels comfortably. In fact, there has been a strong tendency for the SPX to revert to the 2,270-2,275 area, site of its past two closes ahead of FOMC decision days.
Finally, we are in that two-week window preceding standard options expiration in which equity action is more vulnerable than usual to the influence of options open interest that has built up on indexes and exchange-traded funds (ETFs), such as the SPDR S&P 500 ETF Trust (SPY - 229.34).
With that said, we are paying close attention to the SPY 230 and 232 call strikes. Our data indicates this open interest was primarily accumulated by option buyers, so there is the potential that the 232 strike -- equivalent to SPX 2,320 -- acts as a magnet if there is a catalyst to push SPY through the call-heavy 230 strike. More often the case, however, is that the SPY fails to move through call-heavy strikes, and this would suggest limited upside reward in the short term.
If the latter scenario occurs, the longer the SPY remains below the 230 strike, the more likely it will encounter a slight headwind risk from the gradual liquidation of long S&P futures positions tied to the call open interest overhead.
In the event of a negative catalyst that pushes stocks lower, heavy put open interest resides at the 220, 222, and 225 strikes. In other words, a move below the 225 strike would put the SPY at risk of a move down to the 222 strike, or SPX 2,220.
The takeaway is that one should pay attention to these strike prices with significant call and put open interest, as the open interest is quite large in options that are getting set to expire in the coming days. These strikes could act like magnets, especially during a time in which the market may be more sensitive than usual on a day-to-day basis, with respect to headlines coming out of Washington.
I continue to recommend allocating dollars to gold and bonds, in light of the uncertain environment -- and with some market participants more enthusiastic about stocks now relative to a couple of months ago, which may undermine the potential short-term reward. Gold looks especially interesting, given its favorable seasonality through the end of the month, the strong 2017 price action, and the fact that many have given up on the precious metal, as I discussed last week.
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