Late last month, I observed both on Twitter and in this space the potential significance of the 3,335 level on the S&P 500 Index (SPX -- 3,337.75). After meeting resistance in this area in late January and again in early February, the SPX broke through this level, eventually pushing toward the round 3,400 level in the middle of last week. However, by Friday, on the heels of a two-day decline attributed to coronavirus fears, the SPX found itself trading at the 3,335 level once again. The pullback from just below 3,400 -- which is less than 2% above the 3,335 zone and the revisit of 3,335 -- affirms the significance of this level.
“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.”
-Monday Morning Outlook, January 21, 2020
When we witnessed a surge in volatility -- as measured by the CBOE Market Volatility Index (VIX -- 17.08) coincident with a drop in the SPX from the 3,335 area in late-January -- the SPX decline was only about three percent, while the VIX quickly fell, back below 18 after a one day close above this level. After finally receiving short interest data as of the end of January, the mild drop in stocks amid volatility quickly retreating can be partially attributed to the actions of the shorts.
In other words, after months of holding the largest short position on SPX component stocks since mid-2018, stocks rallied late last year and into the new year, causing the shorts to finally begin throwing in the towel -- perhaps dampening the selloff. I would not be surprised if this covering continued in the days after Jan. 31 cut-off date that the exchanges used to report short positions. Feb. 15 data will be released next week.
I share this observation not only to report on what occurred, but also highlight the implication, which is that there is a little less ammunition for bulls related to short covering now relative to one month ago.
If you are short volatility futures, like many are as evident by the net position of large speculators in the weekly Commitment of Traders (CoT) report, you are still running the risk of another volatility spike.
After a brief move below its 252-day moving average and a trendline connecting lower highs since August, the VIX found support at its 2019 close at 13.78, and popped to the 18 area. The spike occurred immediately after standard January VIX futures options expired, exactly when we are most at risk of a volatility increase, because call open interest interest drops significantly. To the extent that some of the expired calls were hedges to a long equity portfolio or a short volatility futures position, negative headlines are more likely to spur actions to manage risk, which drives volatility higher.
That said, and as I have noted multiple times, the 18 level on the VIX is very important, as it is half its 2018 closing high -- an area in which spikes have peaked in recent months. If the VIX moves above 18, I would expect a move to at least 25, maybe 30. Finally, the VIX action still reminds me of May-August with respect to the breakout above a trendline connecting lower highs.
A VIX close or two below its YTD breakeven level of 13.78 would make me feel better that lower volatility is here to stay in the weeks ahead.
With the SPX 3,335 area still in play as a “problem area”, the equity-only buy (to open) put/call volume ratio is at low levels once again (a sign of optimism among equity option speculators that is usually evident at short-term tops). And volatility -- as measured by the VIX -- threatens to move higher. One area you could reduce risk, however, is in big-cap technology names.
I mention this sector specifically following a cover story in the Feb. 22-28 issue of The Economist entitled, “Big tech’s $2 trn bull run.” You could reduce risk by the purchase of puts on the Invesco QQQ Trust Series (QQQ), for example.
Admittedly, this cover has stirred conversation on social media, with the potential contrarian-related implication of a top in big-cap technology names the takeaway. That said, while technology has been a leading sector, it is not (yet) broken in terms of technicals and calling tops is extremely hard, which is why this cover isn’t necessarily a call to action to sell everything.
In fact, I found the following excerpt in a Bloomberg column last week very fitting, with respect to tying The Economist cover story to a top in technology stocks.
“It's always easy to spot the signs of the top in retrospect. The absurd AOL-Time Warner deal was one obviously crazy example of exuberance. But if the internet bubble had burst earlier, maybe the top would have been considered TheGlobe.com IPO, and the founder's plastic pants. In the Big Short, the peak of the housing bubble was demonstrated when a stripper talked about her real-estate flipping. But if the housing market had tanked earlier, then maybe people would have pointed to the launch in 2003 of a popular reality TV show hosted by a real estate celebrity as the sign it was all going to collapse.. The lesson is it can always get crazier.”
-Bloomberg, February 20, 2020
That said, I specifically pointed this cover and this sector out due to a couple other reasons. First, Bank of America Merrill Lynch hedge fund analysis found that hedge funds are still heavily invested in the technology group, but they have been selling for three months.
Moreover, per the chart below, note that the QQQ Trust (QQQ - 230.27) is approaching the $240 level. This level strikes me as important because it is double the $120 level, which marked the technology top in March 2000 and served as a resistance point from August-December 2016.
Those that bought the breakout double their money at $240 and therefore this could be an area at which sellers emerge, whether it be for “profit-taking” or “de-risking” purposes. If $240 is proves significant in terms of resistance, this could be be yet another “Ah-Ha” technical reason when looking back and calling the top in retrospect.
Is a technology top near? Perhaps. However, the trend is too hard to fade at the moment but a hedge to a portfolio of big-cap technology names makes sense for those looking to manage risk.
Todd Salamone is Schaeffer's Senior V.P. of Research
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