“… many sentiment indicators we track are displaying levels of optimism that have historically made stocks vulnerable to pullbacks. Or, at best, vulnerable to a period of underperformance.…if you are looking for an area that the SPX might have to move below before risk grows of an unwind of the growing enthusiasm we are seeing at present, I think the 3,550-3,580 area is a good starting point…Do not disturb long positions, as the trend is your friend and market enthusiasts have been given no reason to panic. But with the CBOE Market Volatility Index (VIX -- 20.79) at four-month lows, you could hedge long positions in recognition of the sentiment-based risk.”
- Monday Morning Outlook, Dec. 7, 2020
The excerpt I led with last week is again my lead, as I think this best describes not only the sentiment backdrop, but what it might take from a technical perspective to generate an unwinding of the growing optimism on display among investors and short-term traders.
As stocks have grinded somewhat higher during the past two weeks, optimism has also increased. The positive sentiment has not only been documented here, but on social platforms and other media outlets. Sentiment-based measures, such as the equity-only, buy (to open) put/call ratio, are at extremes that suggest the market is more vulnerable than usual to negative headlines, while positive headlines are less apt to produce the sharp rallies consistent in a low-expectation environment.
Even though stocks have edged higher during the past couple of weeks, so too have volatility expectations, as measured by the CBOE Market Volatility Index (VIX – 21.57). In other words, hedging costs are only slightly higher than two weeks ago, thanks to a steep retreat from a reading of 23.61 in the last 30 minutes of trading on Friday.
That said, the VIX remains above the 20 area and the half-high of its October closing peak of 40.28, even as the SPX carved out a new all-time closing high last week. Why might the VIX be stubbornly holding above its 20 area amid this rally and its 30-day historical volatility at 11.50? One reason could be the important run-off election in Georgia that is in two weeks, which could potentially shift the make-up of the currently Republican-controlled Senate.
Certainly, the extremes in bullishness among traders and investors should be on your radar. In fact, per the chart below, our 10-day, equity-only, buy (to open) put/call volume ratio, which we calculate using data from three options exchanges, just touched the level of the Aug. 31 - Sept. 2 period, which was then a multi-year low before the ratio headed higher. The multi-year low reading preceded a three-week pullback of more than eight percent in the S&P 500 Index (SPX – 3,709.41).
“The U.K. has been plunged into chaos after the government revealed a new strain of the coronavirus is "out of control." Authorities effectively locked down the southeast of the country including London, restricting travel into and out of the region. Most European countries have banned flights and ships to Great Britain. Given freight travel bans, there is a risk of delays to essential food supplies in the days before Christmas. A WHO official said it could take more than a week to find out how the new strain responds to vaccines.”
- Bloomberg, Dec. 21, 2020
“Dr. Scott Gottlieb says there is no evidence that new UK strain of COVID-19 will evade vaccines, but it is possible vaccines will need to be updated in future years; good news is MRNA vaccines can be updated very easily”
- Briefing, Dec. 21, 2020
As it stands now, this ratio has not yet turned higher, nor have equities retreated to the extent that would spark an unwind of the optimism on display. However, amid the news related to a new virus strain, S&P futures are indicated about two percent lower, which could be the catalyst that unravels the optimism, especially if the technical levels I have referenced these past weeks are broken to the downside.
We are also seeing optimism among active investment managers, as shown in the weekly National Association of Active Investment Managers (NAAIM) exposure survey. In fact, the four-week moving average of weekly exposure readings has moved above 100, which means these managers are fully invested with a tiny bit of leverage. Per the chart below, this is an extreme reading when looking back five years. But one would have to see evidence of this group reducing exposure as technical support levels break down on key equity benchmarks before acting on this optimism. If this group remains bullish amid a continued flow of positive headlines, an unwind of this growing enthusiasm could be delayed. The latest positive for stock market participants was the Fed announcing that it continues to expect interest rates to remain low for the next couple of years as they continue to buy Treasury bonds.
The latest positive for stock market participants was the Fed announcing that it continues to expect interest rates to remain low for the next couple of years as they buy Treasury bonds and hint that another stimulus is on the way. But will this be enough to overcome the latest uncertainties with respect to a new strain of the virus?
I do find it interesting that extremes in optimism are flashing as multiple equity benchmarks and exchange-traded funds (ETF’s) are trading around psychological round numbers.
For example, the Dow Jones Industrial Average (DJI -- 30,179.05) hit 30,000 on November 24. While it is above this level, it has been mostly sideways action since late November. Similarly, the S&P 500 Index has been going sideways since early December, after first touching the 3,700-century mark.
The recently outperforming Russell 2000 (RUT – 1,969.98), which I highlighted last week as having much more short-covering potential among its components relative to SPX components, is making a charge at the 2,000-millennium level for the first time ever. With 1,982 representing double its March closing low and 2,001 the site of its round 20-percent year-to-date gain, this index is susceptible to a huge speed bump as profit taking creates potential resistance.
So how do you play this environment? Strong momentum higher on the heels of positive vaccine news and a friendly Fed, but new uncertainties with respect to whether the recently approved vaccines for Covid-19 will fight the new strain?
First, options can be used in lieu of stocks to reduce dollars at risk but allow leverage to work for you in the event you are playing stocks to the upside that might rally on this morning’s headlines, such as the Teladoc (TDOC) or Zoom Video (ZM).
You may also find straddles or strangles as a worthwhile strategy, which involves the simultaneous purchase of a call and put option on the same underlying method. The put gives you insurance in recognition of the sentiment-based risk and new uncertainty with the virus, while the call gives you exposure to the momentum higher with minimal drawdown that has (so far) transpired since the elections and vaccine news.
Todd Salamone is Schaeffer's Senior V.P. of Research
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