“One area that I identified as a potential SPX hesitation point late last week on Twitter is the 3,335 zone, which is five times the 2007-2009 bear market low at 666.79…In the three cases that the SPX doubled, tripled and quadrupled its 2009 low, the SPX’s 36-month moving average, which equates to a three-year moving average, eventually acted as support on pullbacks and long-term consolidations. When the SPX doubled off its 2009 low in February 2011, the SPX was 22% above the 36-month moving average that was beginning its ascent higher. Similarly, the SPX is currently 22% above its rising three-year moving average, which is currently at 2,743… if past is prologue, and current momentum pushes the SPX above this zone, it would be expected to be followed by limited gains, with a retest of 3,335 occurring not long after the breakout…The message is that 3,335 could be a resistance area in the short term, catching both equity option buyers and large speculators on CBOE Market Volatility Index futures off guard, who are displaying a multi-year high or near high in optimism… If a “risk-off” period is imminent, the bond market is sending such a signal.… I still think it is a good idea to use volatility instruments as a hedge if you are heavily tilted toward riding the momentum higher that began in October.”
-Monday Morning Outlook, January 27, 2020
In late January, on the heels of an impressive rally off the October low that fueled a multi-year high in optimism among some market participants, I cautioned readers about the S&P 500 Index (SPX -- 2,711.02) approaching a potential hesitation area at five times its 2009 low. Specifically, that this could lead to giant pullback or long-term consolidation period based on historical patterns since the 2009 bottom.
The SPX proceeded to rally about 1% in the following weeks, before gapping back below the important 3,335 zone on Feb. 24. The gap lower driven by growing coronavirus concerns proved to be the first shot fired in the historic decline.
Admittedly, both the speed and magnitude of the current decline exceeded my expectations. But the caution that I spelled out in late-January proved worthwhile, especially in my concluding comments in regards to using volatility instruments to hedge long positions, which has paid off handsomely, with both the CBOE Market Volatility Index (VIX -- 57.83) and VIX futures soaring in recent weeks.
So, where do we go from here? If you did not insulate your portfolio through hedging, the speed and duration of the decline has you frozen and indecisive. No one can predict the future, but I am a firm believer in using history as a guide to help make decisions based on identifying risk relative to potential reward. Back in January, for example, I identified reward as minimal for the SPX, with risk roughly 20% below.
If you are holding equities, what does the risk-reward scenario look like now? Or better yet, how can you manage the risk-reward situation going forward? It is difficult, as there is a myriad of uncertainty with respect to exactly what we are dealing with in terms of the coronavirus, which is why volatility -- as measured by the VIX -- is currently through the roof, suggesting a huge rally or still significant downside, pending more clarity.
So investors might be thinking, “I don’t want to sell the low” but at the same time, “I don’t want to experience further damage in my portfolio.”
So how can one manage the “unknown?” Below, I paste a series of long-term monthly charts on the SPX that covers various periods from 1959 to present-day, that could present a map for decision making. In each of the charts, I included the SPX’s 36-month moving average, which is equivalent to a three-year moving average. Additionally, I included the SPX 80-month moving average, a trendline that we have followed for years.
The charts give you a nice visual as to why we track these respective moving averages, especially during times like this. The big picture perspective that these charts deliver give you an excellent visual as to the historical importance of these trendlines in acting as support and resistance, with crosses above or below providing attractive buy and sell signals.
The first thing that stands out to me when reviewing these charts is how significant the 36-month moving average has been in terms of containing pullbacks during the past 60 years, including three separate occasions in 2011-2018, before last week’s breakdown (the jury is out as to whether or not the SPX experiences a monthly close below it). But certainly, this breakdown should put long-term bulls on guard, as it may signal additional weakness in the months, or even years, to come.
Note how breakdowns below the 36-month moving average led to a move down to (at least) its 80-month moving average, where it sometimes finds support (these moving averages playing “role reversal” in 2011, as a break of the 80-month moving average preceded a move to support at its 36-month moving average).
In other instances, the 80-month moving average fails to hold, which leads to further and considerable downside. Currently, the 80-month moving average is at 2,355, which is 13.1% below Friday’s close. So if you are “frozen” and still holding a sizable equity position, one approach to consider, using history as a guide, is slightly reducing your equity exposure as long as the SPX is below its 36-month moving average (currently situated at 2,766). Aggressively reduce your equity exposure if the 80-month moving average fails to hold amid further equity weakness.
We prefer to focus on monthly closes when making decisions with respect to these trendlines, but unfortunately if future volatility in the next couple of weeks is anything like the last couple of weeks, a premature decision may have to be made, using your best judgment with the information available.
Not surprisingly, quantified sentiment measures that we track at the very least, if a tradeable bottom is a risk to short-term bears. For example, remember how equity option buyers were at a multi-year extreme in optimism about six weeks ago, thus warnings of market vulnerability from a contrarian perspective? Per the chart below, this segment of the market is now buying equity puts relative to calls near the levels of late 2016 and 2018, when major buying opportunities emerged after sharp pullback. That said, this ratio is rising sharply as negative sentiment grows. Therefore, a roll-over in this ratio concurrent with the SPX trading above last week’s low would give me more confidence that a retest of the 36-month moving average at 2,752 is in store.
Another sentiment chart that I haven’t discussed very often but caught my eye last week was the positioning of active investment managers, per the National Association of Active Investment Managers (NAAIM) weekly survey. There was panic in this group, with the weekly equity positioning reading plummeting to a multi-year low. In fact, the graph looks much like the SPX, suggesting this group may have done much of the selling in a “sell first, evaluate outcome later” mentality.
The last time their exposure to equities was this low was September/October 2015, when the SPX was in a long trading range that began in the 2,000-millennium area, triple its 2009 low. And just like the present, the SPX experienced an intra-month break of its 36-month moving average that was resolved by two monthly closes above it. The difference between 2015 and the present is the 36-month moving average was tested as a result of a grueling near two-year trading range, whereas a sharp downturn in stocks this month put this longer-term trendline in play.
Finally to the VIX, which hit a multi-year high last week. While this is encouraging as stocks will usually trough with VIX highs, I find it interesting that in Thursday’s trading, the net result of options trading saw three times more call adds than put adds on SPDR S&P 500 ETF Trust (SPY -- 269.32) options, and twice as many call adds relative to put adds on SPX options. These open interest adjustments aren’t exactly a sign of capitulation. But at the same time, to the degree that these options are used to hedge long positions, one must consider that if you have less to protect as a result of selling stock or your portfolio being reduced in size, then demand for puts will decrease too.
Regardless, historically, when you buy stocks with the VIX at these levels, you come out ahead one year later. But beware that when the VIX hit its all-time high in October 2008, the SPX did experience further downside in the months following, even as the VIX declined coincidentally. Usually, however, a peak in volatility often coincides with a rally in equities.
For March expiration of VIX options that settle on Wednesday morning, there is more put open interest than call open interest, a very unusual situation. But given this asset is mean-reverting historically and trading around historical highs, it may not come as a surprise that calls are liquidated and puts are added as a volatility decline is anticipated.
And remember, VIX option speculators loaded up on calls relative to puts by an unusually high ratio of five calls bought to every put purchased in late January, correctly anticipating a pop in volatility. Now, put buying is on par with call buying, which is unusual too.
But just as most VIX call open interest tends to expire worthless because VIX call buyers focus on far out-of-the-money strikes, don’t be surprised if a majority of the put open interest expires worthless too. This would suggest that if the March futures contract (/VXc1) declines early this week, it may not get below the 50.00, where there is heavy put open interest at this strike and strikes below it.
While we are living in a world where there a virus spreading around the world and lethal to humans, necessary precautions are being taken that is going to impact the economy and we are seeing this play out in the stock market, bond market, and daily life. But there is not a standard from country to country, and state to state on how to deal with the virus, which is also contributing to the unknowns.
No one has answers for the immediate future amid little clarity on the situation, so I would be a fool to tell you where stocks are headed. But I think the road map that I gave you is one to potentially follow in order to take emotions and guess work out of the game.
Finally, if you are looking to hedge via put options on equity index or exchange-traded funds, keep in mind that hedging via put purchases is super expensive relative to late-January. Debit spreads may be a way to go versus buying a put option only. But keep in mind that a debit spread’s maximum value is maxed out by the difference in the spreads, implying you don’t have unlimited protection. But it is one way to reduce hedging costs.
Todd Salamone is Schaeffer's Senior V.P. of Research
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