"…traders -- specifically, equity option buyers -- have suddenly soured on the market... this group was buying equity put options relative to call options at a rate similar to that which marked the bottom of the February and March correction. By the end of the week, this ratio climbed to its highest level since August 2017.
"...But you have to be careful with sentiment indicators, as extremes can become more extreme. Therefore, we prefer to see a roll-over in the equity-only, buy-to-open put/call volume ratio before declaring the risk-reward scenario is favoring the bulls. Such patience likely means you will not catch the exact bottom, but it will also keep you out of situations like last week, in which bounces prove only temporary."
-- Monday Morning Outlook, October 22, 2018
The advice from last week when assessing the current sentiment backdrop proved to be on target. Major equity benchmarks broke support levels, and high levels of fear grew, as measured by the action in the equity options market. Per the chart below, the 10-day, equity-only, buy-to-open put/call volume ratio continued its sharp advance, after bottoming ahead of the late-September Federal Open Market Committee (FOMC) meeting, when the Fed raised rates. As I said last week, while such levels of fear have previously marked bottoms, visible evidence that growing caution has peaked offers a better risk-reward scenario for those looking for an entry point on long positions.
"Certain prices, such as recent highs and lows and variations on the 50-day and 200-day moving averages, take on a symbolic importance to the market. Depending on market trends, those price levels can either establish a floor that supports falling prices, or impose a ceiling that resists a rally.
"That's why it was an ominous sign when prices for S&P 500 E-mini futures contracts tumbled decisively below key support levels Wednesday... traders use them as stop-loss signals, which is why selling often accelerates after an important technical level is breached. That's what happened two weeks ago, and again on Wednesday."
-- The Wall Street Journal, October 26, 2018
On Friday, the SPDR S&P 500 ETF Trust (SPY - 265.33) reached "official" correction territory on the heels of disappointing earnings results from FAANG names Amazon (AMZN) and Alphabet (GOOGL). It took out the $264.22 level, one of several potential "lines in the sand" support levels that I posted on Twitter on Wednesday and Thursday. The SPY's 10% retreat from the September high took 26 days to happen, whereas in January and February this dubious feat took only nine days to play out. One difference is that whereas the SPY held support at the popular 200-day moving average during the February/March correction, it moved sharply below this trendline in the current correction, and even moved below its 320-day moving average, which held during the 2014 corrective phase.
But, as you can see below, during the past several years, breaches of the 200-day moving average have marked lows or near lows more so than being predictive of bear market action. I said in an internal email on Friday morning:
"At some point, maybe now, this 200-day breach will signal bearish activity to come. But there have been many 'false negatives' along the way too in which the break of this trendline occurred around major lows."
The 10-year daily chart of the continuous S&P 500 E-mini futures contract (Esc1) that Friday's article in The Wall Street Journal was referring to gives you a visual to my internal email observation. While the article is correct that the 200-day moving average can provide support -- breaks of which can often lead to accelerated selling -- what it failed to mention is that such accelerated selling has marked bottoms or near-bottoms during the past 10 years.
That said, there is often a volatile, choppy phase that equity markets endure in the following weeks and months after a break of this trendline. Whether the current breach signals a bear-market phase remains to be seen. My message is to be careful about the longer-term implications of the 200-day moving average breakdown last week that is being discussed.
As long-time readers are aware, I like to keep unpopular but significant moving averages on my radar, whether this be from a longer-term or short-term perspective. Since the article I referenced from The Wall Street Journal focused on S&P 500 E-mini futures, I will stick to that chart.
One moving average that I have used is the 80-week moving average, pictured in the graph below. It is off the radar of many, if not most, market participants. However, it has had an uncanny knack for signaling poor future price action on breakdowns, while also marking support during various market drawdowns.
Again, it can be dangerous to continually draw lines in the sand, but it's also hard to ignore how this longer-term moving average marked bottoms during this bull market in 2010, 2012, 2014, and 2016 (a pattern that has occurred every two years, in fact). In fact, it was the site of Friday's low around 2,640.
Before reacting to last week's 200-day moving average breakdown, it might be wiser to focus on the 80-week moving average before concluding that there is longer-term technical damage to the stock market. And even though it is a longer-term moving average, it could provide both short-term and long-term buying opportunities.
Per the SPY open interest graph below, I noticed on Friday that accelerated intraday selling hit the market when the SPY broke below the 265 strike. Open interest at this strike is huge, totaling about 300,000 contracts, and sellers of those puts likely sold S&P 500 futures on this "strike breakdown." Had this occurred closer to standard November expiration week, even heavier selling of S&P futures may have resulted.
Heavy put open interest through November expiration is stacked down to the 255 strike. Therefore, if a combination of the SPY's 80-week moving average at $264 (also a round 10% below last month's high), peak put open interest at the 265 strike, and the SPY's year-to-date breakeven at $267 do not hold, this strike could act as a magnet as we move closer to November expiration. This would imply another 100-120 points of S&P 500 Index (SPX - 2,658.69) short-term risk through the third week of November.
The broad market comes into the week once again around a potential support area, but there is risk in drawing more lines in the sand after other areas of support were breached. Trader sentiment is negative and at levels that have coincided with major bottoms, but this fear is growing and has not shown it has climaxed. If you are betting on a rebound, use call options in lieu of stock, as you can put less money at risk with call options relative to owning stock, and the leverage will give you a meaningful return on your investment if you are correct.
For bulls, last week's Cboe Volatility Index (VIX - 24.16) close below 25.15, half this year's intraday high at 50.30, is somewhat encouraging. However, that is offset by the discouraging mid-October low in the 17-18 area that marks last year's high, double this year's closing low, and half the 2018 closing high.
Large speculators in VIX futures, per the weekly Commitments of Traders (CoT) report, are very close to moving into a net long position. As I have said numerous times, this group has been dead wrong with respect to major volatility moves. They are now net short only 10,000-plus contracts, after being net short 140,000 contracts prior to equities declining and the VIX spiking this month. Note in the 5-year chart below that whenever this group has moved into a net long position, which they are close to doing, it is not only rare, but it comes at peaks in volatility. The action in the CoT report is one of the stronger cases one can make about volatility being at or very near a peak.
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