Does Europe Still Present a Panic Situation?
The VIX, the Fear Gauge, Now Has Room to Move Lower!
April 30, 2012
Stocks ended solidly higher last week, as traders effectively brushed off a Spanish debt downgrade, a disappointing unemployment report, a slimmer-than-forecast GDP rise.... and of course, the collapse of the Dutch government. While any one of these headlines, trying to invoke fear into the investor, might have sparked a selling spree in the not-so-distant past, this article breaks down a few notable data points that help to explain the market's growing resilience. But while Europe may finally be priced in -- at least, for now – it is important to note several looming technical levels that could keep a lid on stocks going forward and helping abate fear.
Headlines Promoting Fear
"A number of hedge funds bought Spanish CDS at the start of the month, say industry insiders, helping drive up the price to more than 500 basis points earlier this week from below 350 basis points in February... While funds have kept positions relatively small on concerns over lower liquidity in some credit markets and a fast-changing political environment, managers are generally still short stocks -- betting on falling prices -- looking at sectors such as banks... Most hedge funds are still bearish on the euro zone's debt crisis."
- Reuters, April 27, 2012
Last week it was quite evident that the resilience of the U.S. stock market amid headlines related to European sovereign debt issues, which have been surfacing on and off again since early 2011. It becomes apparent that this resilience was that hedge funds -- who have pretty much dictated the direction of the market, given that retail investors continue to flee domestic equity funds -- already had a relatively low allocation to U.S. equities, substantially removing potential selling pressure in the market.
As can be ascertained from a Reuter’s article on Friday, excerpted above, hedge funds are making bets against Spanish debt through the purchase of illiquid credit default swaps (CDS). So, the market participants that have the power to drive the U.S. market one way or the other have been seeking bearish opportunities overseas, which may explain why the panic selling related to Europe is now not evident, that prevailed throughout last year. It appears funds are positioned for a negative environment in Europe, reducing the element of surprise as it relates to the U.S. market. In fact, amid a downgrade of Spanish debt and domestic GDP data that came in weaker-than-expected, both U.S. stocks and equities in Spain managed to rally on Friday.
Fear Effecting the Major Indexes
“Going forward, some other definite positives we're seeing, off-setting the bullish risk dilemma, include a few clues that big money could be getting back into stocks here. As has been mentioned on numerous occasions over the past months, it is very probable that activity on CBOE Market Volatility Index (VIX) futures and major equity-based ETFs is hedging-related. In other words, this activity could suggest institutions are in the process of making either bearish or bullish bets. Back in March, this option activity was a cause for concern, but now we're seeing signs that deep-pocketed players are putting their cash back to work……the VIX is also seeing a rebound in call buying. As the chart below shows, when the VIX's 20-day buy-to-open Put/Call Ratio has turned higher from similar lows, it can be a very bullish signal for the overall market.”
-Bullish Risk – Investor Anxiety Spikes, April 16, 2012
In fact, just as the S&P 500 Index ((SPX - 1,403.36) was hitting lows in the 1,360-1,370 area a couple of weeks ago, it was observed that underweight hedge funds were dipping their toes back into the stock market, as evidenced by increased call buying, as discussed in the excerpt above, on CBOE Market Volatility Index (VIX - 16.32) futures and an uptick in put buying on equity-based Exchange-Traded Fund (ETFs), such as the SPDR S&P 500 ETF (SPY), iShares Russell 2000 Index (IWM), and PowerShares QQQ Trust (QQQ). It's encouraging for the bulls that such funds have ample cash to deploy to the market on pullbacks, and option activity that, with continuous observance, suggests that some hedge funds are again accumulating stocks, and using options on the VIX and major equity ETFs to hedge.
Fear in the Marketplace
One thing that is particularly intriguing, particularly if you are a contrarian, is the amount of fear that has come into the marketplace, in what has so far proven to be a mild short-term pullback within the context of impressive price action during the past several months.
For example, this past week, has shown that there is a weariness, or in some cases even fear, of the retail investing crowd which is evident in their attitude, suggesting a healthy disregard for equity investments. Recent data from Investment Company Institute (ICI) domestic equity fund flows , the American Association of Individual Investors (AAII) retail sentiment survey, and Bankrate.com's Financial Security Index points to the fact that investors have had enough, and refuse to be "burned again."
The ICI is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $13.3 trillion and serve more than 90 million shareholders. The institute's analysis of recent domestic equity fund flow data illustrates that every month over the past year; investors withdrew money from domestic equity funds -- to the tune of $177 billion in net outflows!
The AAII sentiment survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market in the short term. Individuals are polled from the AAII website on a weekly basis. This indicator can be used as a tool to measure crowd sentiment based upon retail investors. The AAII weekly sentiment survey revealed that there are more bears than bulls, with only 27.6% of individual investors taking a bullish stance, as 37.4% claimed to have a bearish view. The bullish percentage is the lowest in 2012, and is also the lowest reading since September 2011, when the SPX was carving out a major bottom in the 1,100-1,150 zone.
In order to better quantify the fear by analyzing what traders are doing, as opposed to thinking, the bearish surge in the AAII survey is confirmed in the equity options market. Per the chart below, check out the spike in the 10-day customer-only, equity-only buy-to-open put/call volume ratio. As you can see, equity put option buying has reached its highest point since last fall, and is at a level that not only marked a bottom during the May 2010 flash crash, but also preceded the SPX's breakout above 1,350.
A recent article entitled Americans Reject Stock Market Investments pointed out that 76% of investors "are saying 'no' to equities," while "only 18% say they are more inclined to invest in the stock market with interest rates as low as they are."
Fear in the Week Ahead
As we head into this week's trading, the following indexes are above important round-number century or millennium levels:
1. Dow Jones Industrial Average (DJIA - 13,228.31) - above 13,000
2. Nasdaq Composite (COMP - 3,069.20) - above 3,000
3. Russell 2000 Index (RUT - 825.47) - above 800
4. S&P 500 Index (SPX - 1,403.36) - above 1,400
Conclusion to Fear Investing
But work remains, as the Dow's high on Friday was the site of the April 2 closing peak, and the RUT is perched just below its February and March highs in the 830-840 area. Moreover, the S&P MidCap 400 Index (MID - 999.40) comes into the week below the important 1,000 millennium level, and the Dow Jones Transportation Average (.TRAN - 5,267.39) remains below 5,500, which has marked peaks since 2007.
While technical speed bumps remain in place, there is encouragement from the sentiment backdrop, as there is sideline money and short-covering potential to push major benchmarks through resistance.
Furthermore, the last time the SPX was trading in the 1,400 area, the VIX was bottoming around 14.00. With the VIX at 16.36 coming into this week's trading, a bull could argue it has more room to fall before another period of short-term weakness -- in fact, the next major low in the VIX could occur around 11.50, which would be half the recent peak.
”Success is simple. Do what's right, the right way, at the right time.”
”Success is simple. Do what's right, the right way, at the right time.”
Option Tip for your Success!
Options traders are not successful because they win.
Options traders win because they are successful.