"The S&P 500 is on one of its longest streaks without a 1% daily move in the past five decades, highlighting how the latest leg of the stock-market rally has been a gradual climb rather than a euphoric surge. The broad equity gauge hasn’t moved 1% or more in either direction since mid-October, its sixth-longest streak since the end of 1969 and third-longest since the end of 1995…many analysts are wary that the eventual return of volatility could fuel an unwind of wagers on riskier investments and spark a market downturn."
-- The Wall Street Journal, January 16, 2020
The price action being described above is another way of saying that stocks have been engaged in a multi-month advance, with very little drawdown. The rally has resulted in new high after new high, leaving investors and traders looking for a pullback little or no opportunity to enter the market. In fact, since November, the S&P 500 Index (SPX - 3,329.62) has spent many days and weeks in or near overbought territory, according to its 14-day Relative Strength Index (RSI), an indicator that will give false sell signals in trending environments like we are experiencing now.
As such, SPX historical volatility has plummeted into single digits. Moreover, volatility expectations, as measured by the CBOE Volatility Index (VIX - 12.10), remain depressed. The VIX, for example, has closed below its rolling (and declining) 252-day moving average every day since Oct. 11, albeit there have been five intraday moves above this trendline, which is currently situated at 15.03. I used a 252-day moving average because there are typically 252 trading days in a year.
For months, we have been on a heightened volatility spike alert, with historically wrong-way positioned large speculators that play volatility futures in an extreme short position, and multiple tests of the 12 area -- which is one-half the 2019 closing high, and an obvious floor -- since early 2019. But sharp VIX advances that usually coincide with equity declines haven’t materialized.
However, one indicator that was not warning of a VIX pop for months is now flashing a warning. In fact, the chart below caught my eye last week, and thus I feel prudent to include it in this week’s commentary.
With the VIX trading around its floor once again, and large speculators on VIX futures in covering mode but still in a big net short position, there has been a notable drop-off in put buying on VIX options, resulting in a huge increase in the 20-day cumulative buy (to open) call/put volume ratio. This caught my eye because, as you can see in the chart immediately below, the last two times this call/put volume ratio was at five or higher, the VIX experienced a notable pop immediately or within one month of the ratio reaching such an extreme.
In other words, the action on VIX options has been smart money, and with bets on a drop in volatility futures decreasing sharply in recent weeks, volatility futures could be at risk of either stabilizing around current levels or advancing. Bulls would prefer the former.
Per the second chart below -- which looks back three years -- it is mostly the same story. In other words, a high level of call buying on VIX options relative to put buying precedes volatility pops. A notable exception was October 2017, when a short-covering rally helped keep heightened risk of a volatility pop in check.
Per the latest report from the exchanges as of late December, short interest on SPX components remained at multi-month highs, so bulls can hang their hats on the potential that short covering could again reduce the heightened risk of a “volatility pop, stocks drop” risk that we are seeing with respect to the VIX trading at a historical floor, large speculators on VIX futures extremely short, and a high buy (to open) call/put volume ratio on VIX options.
Referring back to the VIX chart above, I would have to see the VIX close above 15.50 (above its one-year moving average and the trendline connecting lower highs since August) in the upcoming week before growing more confident that a serious volatility pop or stock drop is imminent.
There is another sentiment indicator in the options market that is flashing a signal that the market is vulnerable. For example, equity option buyers have historically been caught off-guard prior to V-rallies or corrective market environments. Right now, this group’s optimism is at a multi-year high, as the buy (to open) put/call volume ratio is low (puts are downside bets on an equity, while calls are upside bets).
"The RUT's descending triangle breakout two weeks ago targets a 7.5% move higher during the next four months to the round 1,700 level. With some technicians voicing concerns about few stocks participating in the rally, a 7.5% jump might take many by surprise."
-- Monday Morning Outlook, November 18, 2019
Turning to the equity benchmarks, the Russell 2000 Index (RUT - 1,699.64) enters the week at the 1,700-century mark, my target when the RUT broke out in mid-November. It is trading just below its all-time closing high of 1,740 in 2018. So, from a purely chart perspective, the risk-reward on small caps is not nearly as attractive as it was in November.
However, the SPX is at all-time highs and moved through the 3,300 century mark last week. I was intrigued by this move, as 3,300 is 10% above the round 3,000-millennium mark and profit-taking could have been a temptation among those that bought the breakout above 3,000 in late October.
Veterans of the market know that “momentum begets momentum,” “the trend is your friend,” “you don’t fight the Fed,” and “you don’t fight the tape”. As of now, if you cash in on this rally or move too heavily on the opposite side of the current price action, you are ignoring these phrases.
In other words, heightened risk of a pullback or correction does not mean a pullback is imminent, although a “known, unknown” is on the immediate horizon. President Donald Trump’s impeachment trial begins this week. It appears the market is anticipating that he is acquitted before his State of the Union address in February. However, a trial that lasts longer than expected, or an outcome that results in the President being removed from office would likely spook the market.
One way to reconcile all of this is simply continuing with a theme that I’ve been preaching for weeks. Use call options in lieu of buying stock outright to manage risk and ride the momentum. Call options allow you to put less dollars at risk relative to equities, while the leverage allows you to achieve the profits you are seeking. And if you do have a long equity portfolio, take advantage of cheaper index and equity benchmark exchange-traded fund (ETF) options and hedge your portfolio with puts. Or, given the heightened risk of a volatility pop, purchase calls on VIX futures options or another volatility benchmark.
Todd Salamone is Schaeffer's Senior V.P. of Research
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