How to Approach This Choppy Market Now

"From a shorter-term perspective, the SPX is trading in a volatile, choppy range. Throughout January, in fact, a defined area of resistance was at the Dec. 31, 2014 close of 2,059 ... Support has been in the round number 2,000 region ... A concern for the bulls is that the SPX has spent more time in the 2,000 area, which is the bottom of the range. The risk is that buyers at this level eventually disappear, which would likely set up a test of the 10-month moving average in the 1,985 region..."

"...a review of several Commitment of Traders (CoT) reports reveals low levels of VIX, SPX and E-mini futures open interest, coincident with multi-year high levels of open interest in euro, gold, oil and copper futures contracts. This is still more evidence that suggests some hedge funds, particularly macro funds, are exiting positions in U.S. equities in favor of other assets, such as commodities and currencies."
-- Monday Morning Outlook, February 2, 2015

The technical scenario that we presented in our Feb. 2 report played out last week with respect to the S&P 500 Index (SPX - 2,055.47) breaking below the 2,000 level, setting up an intraday decline to the lowest levels of 2015. However, longer-term support came into play in the 1,985 region -- around the index's 10-month moving average -- from which a furious rally began, proving once again the significance of this trendline.

The SPX behavior that we are observing looks very similar to the beginning of the year -- a decline to the vicinity of a key round-number area and long-term moving average, followed by a sharp rally to its year-to-date breakeven point at 2,058.90 -- a volatile, choppy range. Moreover, the importance of half-century marks on the SPX (a topic we have discussed in prior reports) remains a theme, with the index for the most part stalling in this area since it was first touched in November. Bigger picture, however, the bulls are happy to see the SPX continue in a low-volatility uptrend amid volatile headlines, with support from its 10-month moving average.

In a week's time, we have moved from the SPX trading just above potential support from the round-number 2,000 area and its 10-month moving average to the SPX trading back in the vicinity of the half-century 2,050 zone and its 2014 close at 2,058.90, an area that marked peaks in early and late January. Coincidentally, as the SPX hits resistance, the Russell 2000 (RUT - 1,205.46) and the S&P MidCap 400 Index (MID - 1,476.89) are trading around round-number century marks at 1,200 and 1,500, respectively.

The MID quietly achieved new all-time highs last week, but has never touched 1,500, which we suspect will act as resistance. The 1,500 century mark is 50% above the 1,000 level that capped multiple rallies in 2011 and 2012, so those who bought the 1,000 breakout will likely reduce exposure at a 50% gain.

Meanwhile, the RUT has failed to sustain a move through 1,200 since it first touched this level in March 2014. The 1,200 level is roughly triple the 2008-2009 lows in the vicinity of 400, and looks very much like the resistance that took hold on the MID at 1,000 a few years ago.

Last week, the CBOE Volatility Index (VIX - 17.29) peaked at 22.81, right below two key levels, in our view -- 23.28, which is 50% above its 2015 low, and 23.64, representing double the late-2014 low. That said, the VIX has not moved below 15.50, its late-January low, which is also half the 2014 peak. Thus, it is too soon to declare that the higher volatility that we are witnessing in 2015 is over.

Speaking of the VIX, a theme we have discussed the past few weeks has been the extremely low call open interest. While VIX call volume picked up a little this past week, our theory has been that hedge funds that use VIX calls as portfolio protection have reduced equity exposure, and thus do not need as many VIX calls to protect their equity portfolio. We went on to suggest that these same funds may be viewing opportunities elsewhere – such as bonds, currencies, and commodities. An article in The Wall Street Journal on Friday morning, entitled "Computer-Driven, Automatic Trading Strategies Score Big," [subscription required] supports this theory:

"Hedge-fund managers who employ complicated, automatic-trading strategies made millions off the wild swings in currency and commodity markets in recent weeks, investors said."

"In many cases, they ramped up bets on the momentum against the euro and reaped a huge win when the Swiss National Bank removed its currency peg, pushing the euro down deeper. They also have capitalized on what was until recently a consistent plunge in oil prices without worrying about when they would hit a bottom. The volatility is a rare treat for automated traders, who make their livings jumping on markets moving out of sync but have been stymied by the placid markets since the crisis and years long march higher for U.S. stocks and other related assets."

The implication for the stock market is that a powerful segment of market participants is not as actively engaged in the equities market, reducing liquidity and resulting in higher volatility. Therefore, the market may face stronger headwinds relative to last year, especially when resistance areas are approached. This is not to say that this is the end of the bull market, as the latest pullback proved that there are still willing buyers -- whether this is in the form of corporate buybacks, retail inflows, short covering, or traders playing the range. In fact, from a bigger-picture perspective, equities have remained remarkably resilient amid a plunge in oil prices, plus Fed and overseas uncertainty, particularly in Europe and China. So for this reason, we advise longer-term investors to remain long, but still have those portfolio hedges in place.

Our short-term sentiment indicators are giving mixed signals at the moment, with the buy-to-open equity put/call ratio moving lower from a relatively high level, which historically has bullish implications. However, weekly data from the National Association of Active Investment Managers (NAAIM) survey shows managers reducing equity exposure from a relatively high level, which is a potential headwind.

Therefore, short-term traders should have both long and short exposure, looking to add short exposure nearer the top of the range, and continue to either lengthen or shorten your typical time frames amid this choppy, volatile range.

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