The Biggest Immediate Risk in an Unstable Market

"The FOMC policy statement and Fed Chair Janet Yellen's press briefing could be mid-week drivers. The removal of the word 'patient' from the FOMC statement has been anticipated by some Fed watchers. If 'patient' is removed, stocks might sell off in response, as our 'data dependent' Fed was just presented with weaker-than-expected retail sales and inflation data ... SPY comes into this week trading around the biggest put open interest strikes in the March series ... [T]he upside to this configuration is that a positive reaction to the Fed would unleash short covering related to this expiring put open interest."
-- Monday Morning Outlook, March 16, 2015

"But the internal economic projections published alongside the committee's statement and Yellen's news conference were less reassuring. Far from suggesting that better times are here to stay, they indicate that policymakers are becoming more pessimistic about the economy's prospects ... Investors and traders weren't reacting to good news about the economy. They were celebrating the rising probability that the Fed isn't about to remove the punch bowl, after all."
-- The New Yorker, March 18, 2015

The "Madness" that began last week in the college basketball world carried over into the financial markets, as the underdog Fed surprised market participants by removing the word "patient" with respect to its rate-hike outlook, while simultaneously coming across dovish in its forecasts and statement. While we believed a dovish statement was appropriate but not a given, it was how the Fed delivered its message that was surprising, removing "patient" but also maintaining the dovish tone that market participants were seeking.

The dollar experienced its biggest losses in over a year, catching many long the dollar off guard, much like those unpleasantly surprised when Georgia State and Alabama-Birmingham produced bracket-busting upsets in the second round of the NCAA Tournament. Oh yes, equity markets surged and 10-year bond yields declined back below 2.00%.

"London's FTSE 100 Closes Above 7,000 for First Time"
-- Wall Street Journal Market Alerts, March 20, 2015

Ultimately, the bulls came out on top of last week's quadruple-expiration week battle, with the S&P 500 Index (SPX - 2,108.10) surging more than 2.5% and above the round 2,100 area that marked a peak earlier this month. Other equity benchmarks rallied back above respective round-number resistance areas by last week's close, including the Nasdaq Composite (COMP - 5,026.42), which closed back above the 5,000 millennium mark. Additionally, on Friday, the COMP marched above its month-to-date high that occurred in the first week of the month.

From a technical perspective, the biggest risk to the immediate term is that multiple equity benchmarks are again trading around key round-number areas simultaneously, which was also the case earlier in the month when weakness quickly followed. In other words, we have seen markets become unstable in the early stages of overtaking a new round-number level, until they don't. With a key European benchmark overtaking a new millennium level for the first time, it will be interesting to see if anxious profit-takers take center stage in the days ahead, and whether or not this impacts world markets, particularly the U.S.

" [A]nother major index -- the U.S. Dollar Index (DXY - 100.18) -- has run up to the round $100 century mark. The strong dollar has been one of many 'fear factors' among market participants, especially as it relates to multi-national companies doing business overseas. Just as the dollar grabs headlines with its impressive rally and analysts trip all over themselves to reduce earnings estimates based on recent dollar movement, one has to ask whether this round number proves to be a major speed bump in the days and weeks ahead? ... A rejection at $100 would certainly be a surprise, as long positions in the dollar are at multi-year highs, according to the weekly Commitment of Traders (CoT) data."
-- Monday Morning Outlook, March 16, 2015

As we mentioned above, on the heels of the Fed's dovish tone last week and market participants bracing for a rate hike in the not-so-distant future, the U.S. dollar index experienced a nasty rejection at the round 100 level.

If last week marked a peak of some kind in the dollar rally, the question asked last week in this report becomes even more important: "What (if any) upside is there to the coverage the U.S. dollar is getting? In other words, might lower earnings expectations work in favor of the bulls, in terms of a lower bar to hurdle when earnings season rolls around again?" So, just as analysts scrambled to reduce earnings estimates due to a surging dollar, there is the possibility that perceived dollar headwinds are "overly" factored into earnings estimates, a potentially bullish underpinning in the months ahead.

Also, don't forget that many hedge-fund managers have moved out of U.S. stocks and into Japan and European equities. If dollar weakness continues, these same managers may move back into U.S. stocks.

Also on our radar is the CBOE Market Volatility Index (VIX - 13.02), which carved out a new 2015 intraday low on Friday, before closing back above 13.00. Previous to last week's decline and ahead of the Federal Open Market Committee (FOMC) meeting, the VIX had danced around 15.50, which is half the October 2014 high. With a new 2015 low achieved last week, our thought is the VIX has room to decline further, with an 11-plus reading a possibility in the short term. The near-term risk for equities is a short-term pop from the prior 2015 closing low.

A slow, lengthy VIX decline would be a surprise to the many strategists that have been preparing us for higher volatility. In fact, remember, it was as recently as the middle of last month when VIX futures traders were in a rare net-long position. They are now shorting volatility futures again, but the net short position is not anywhere near previous extremes. This would suggest that if the recent shorting activity in VIX futures continues, volatility is apt to remain depressed in the weeks ahead.

Various stock-market sentiment gauges support bullish price action in equities, which could depress volatility too. For example, a weekly survey of the American Association of Individual Investors (AAII) just produced its lowest bullish percentage reading since April 2013. Moreover, per the chart below, the SPX's 10-day equity-only, buy-to-open put/call volume ratio is elevated, nearer to levels that have marked major bottoms. Unwinding of this pessimism among equity option players could be supportive in the weeks ahead.

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