“Hedge funds brace for second stock market plunge…Managers say asset prices have become too detached from bleak fundamentals”
- Financial Times, June 3, 2020
“Even vocal optimists are now skeptical of the never-ending stock rally”
- Bloomberg, June 3, 2020
“… the VIX is still trading very close to the 27.56 level, even after last week’s rally, which is exactly double its 2019 close…I am not entirely sure what to make of the VIX anchoring itself to this level….
If forced to take a stand on what the VIX could be hinting at…. with the VIX trading only slightly above its 21-day historical volatility (HV), and one might infer that hedging activity is unusually low. This would suggest that higher-than-normal cash positions are present among fund managers, implying higher-than-normal future buying power. Many, though not all, market tops or trading ranges have been preceded by VIX readings that remain high relative to SPX HV.”
- Monday Morning Outlook, June 1, 2020
Last week was another winner for bulls, as the S&P 500 Index (SPX -- 3,193.93) continues to take out one resistance level after another. Friday’s rally was the clincher, on the heels of an employment number that showed a gain in May payrolls,
even though consensus forecasts expected another round of massive job losses.
The headline news and price action on Friday reminded me of comments I made last Monday, implying that there must be higher-than-normal buying power among those that typically hedge long positions. This buying power was unleashed last week, leaving
many scratching their heads in disbelief. Volatility expectations, as measured by the CBOE Market Volatility Index (VIX -- 24.52), which finally made a noticeable move below 27.58 -- or double its 2019 close -- after anchoring to this level since
early May, even as stocks rallied.
Moreover, Friday’s employment number reminded me of the potential contrarian implications of headlines that I saw in the Financial Times and Bloomberg earlier in the week, which I excerpted above. After Friday’s employment number was released,
I found myself asking, “Is the market detached from fundamentals, or is it that under-invested fund managers are detached from fundamentals?” The employment number surely hinted at the potential for a V-type economic recovery, even
though fund managers are reducing risk due to concerns about a second wave of infections, doubts that consumers will come back quickly, or the recent protests and the flare-up in U.S.-China tensions.
The underlying reasons for these doubts are legitimate, but the fact is that the SPX keeps taking out resistance level after resistance level, as fund managers sit on heavy cash levels looking for another selloff. Perhaps some of this cash was put
to work last week.
Admittedly, some indicators have not exactly been clear for short-term traders, as other resistance levels immediately come into play after a previous level was taken out. In fact, the SPX’s 2019 close hovers just overhead at 3,230.78, along
with the round 3,200. One constant in this space from week to week is potential overhead resistance on the SPX, but the delta is higher levels of resistance, as the SPX has been slowed only briefly in these areas, before making explosive moves
higher on the breakouts. For what it is worth, this is the first time that the SPX’s 14-day Relative Strength Index (RSI) has moved into overbought territory since mid-January, which preceded only a minor short-term pullback.
Moreover, during the past couple of weeks, short-term equity option buyers have grown more and more enthusiastic, which has resulted in a caution flag being waved by me during this period. But the current momentum off the trough is why I advised option
strategies such as straddles, which give you both call and put exposure to play the momentum, while also hedging as short-term optimism enters the market. The call legs of these straddles have likely performed very well amid the strong advance
in equities.
For longer-term investors, you have benefited from the rebound, as the SPX never broke longer-term moving averages on a monthly closing basis that have historically marked major market bottoms, as I discussed in mid-March.
“Another mixed signal that I am seeing is the bullish tendencies of the SPX 200-day moving average crossover with the approaching extreme in enthusiasm among equity option buyers, per the graph below. With the ratio of call buying to put buying in a decline, the bulls are in charge. However, it is approaching levels that have spelled trouble in the past. If we see a change in the direction of this ratio coincident with a technical breakdown below support levels mentioned above, be on guard for a noticeable pullback.“
- Monday Morning Outlook, June 1, 2020
As I referenced last week, we are closely monitoring the sentiment among equity option buyers. The number of calls (upside bets) that they are purchasing relative to puts (downside bets) is now at the level of late-February/early-March, when
the SPX was in a topping process. The ratio is still declining amid multi-month highs on the SPX, but it is now at levels that have preceded tops. If this ratio begins to turn higher amid the SPX no longer shaking off perceived negative
news, or not responding favorably to positive developments, you should then be on guard for a noticeable pullback.
That said, with the VIX now below 27.56, we are not seeing anything that has typically tipped us off to an upcoming volatility surge that occurs coincident with sharply declining stocks. For example, large speculators on VIX futures, who are
historically poor volatility timers, are usually in an extreme net short position ahead of volatility spikes. While this group is net short, the net position is not anything close to an extreme that waves red flags.
Moreover, VIX option buyers, who have been smart money in the past, are not purchasing calls at an alarming rate relative to puts, which we saw ahead of the market top earlier this year (see the two charts pasted at the end of this commentary).
Todd Salamone is Schaeffer's Senior V.P. of Research