Hedge Fund Players Losing Their Incentive for Equities According to Option-Based Indicators!
March 26, 2012
It was a rocky week for stocks, as traders were preoccupied by signs of an economic slowdown in China. As a result, the S&P 500 Index (SPX) closed lower for the first time in five weeks, while the Dow Jones Industrial Average (DJIA) gave up about 1% by the time the dust settled. However the market remains north of key support levels, suggesting that stocks are simply taking a breather from their breakneck year-to-date surge. According to analysis, there could be further choppier trading ahead, as a few option-based indicators are pointing to a case of reluctance on the part of hedge fund players to participate in equities!
Round Numbers and Retracements Come Into Play
“….. technical indications are being thrown around as corrective warnings - sell signals, yet with deeper research and practical understanding on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID - 1,000.73) making its second run in as many years at the 1,000 millennium mark. Overall, this appears to be still a favorable environment for the bulls.”
- Sell Signals for the Stock Market, March 19, 2012
"Thirty-four percent of respondents to Bloomberg's monthly consumer expectations survey said the economy was improving, the largest share since January 2004. The pickup boosted the monthly expectations index to the highest in a year. Figures from the Labor Department today showed jobless claims decreased by 5,000 to 348,000 in the week ended March 17, the fewest since February 2008."
- Bloomberg, March 22, 2012
Stocks retreated slightly last week, digesting impressive year-to-date gains so far, as key benchmarks -- such as the Dow Jones Industrial Average (DJIA - 13,080.73), S&P 500 Index (SPX - 1,397.11) and the S&P 400 MidCap Index (MID - 990.93) -- simultaneously battled round-number areas. For example, the DJIA broke out above the 13,000 millennium mark in mid-March, and advanced to nearly 13,300 by expiration Friday, but pulled back to the 13,000 level in last week's trading. The 13,000 area is a 50% retracement of this month's low and high. Meanwhile, the SPX slipped back below 1,400, while the MID enters Monday's trading south of the important 1,000 millennium mark once again.
Like the DJIA, the MID's low in the 980 area this past week was at a 50% retracement of the March low and high, while the SPX's low at 1,387 was a 38.2% retracement of the calendar month peak and trough.
30-Minute Chart of SPX since March 02, 2011
As was stated last week, research on various technical indicators suggests a pause within the uptrend could be at hand, even though some technicians view the same indicators as signs of an imminent correction. The pullback over the past five days was mild, as the SPX continues to trade comfortably above last year's high at 1,370, following a breakout above this level in mid-March.
As major benchmarks trade at key century and millennium marks, one risk apparent is that a few institutional players -- especially the hedge fund players -- who had been accumulating stocks earlier this year, have now backed off -- perhaps taking a "wait and see" approach as to how the market behaves, given the numerous calls for a correction.
Evidence of Hedge Fund Departure
Evidence that some hedge fund managers are shying away from equities comes from the analysis of option activity, as put buying on major exchange-traded funds has declined, in turn driving put implied volatilities on the SPDR S&P 500 ETF Trust (SPY) lower relative to call implied volatilities (first chart below). As you can see on the second chart below, cumulative put buying at the recent peak never reached the levels of late July 2011, when hedge funds were overweight equities ahead of a 20% decline. But recent put buying on major Exchange-Traded Funds - ETFs did reach the levels of spring 2011, which preceded a 7% pullback in the SPX.
In the absence of a technical breakdown, the decrease in put buying and the plunge in out-of-the-money put implied volatilities relative to call implied volatilities are not yet alarming, but it remains on the horizon, nonetheless. If the market remains in good shape from a technical perspective, expect to see more hedge fund players actively accumulating equities, which would correspond with another increase in put buying.
A Bullish Outlook
Whatever materializes over the course of the next few weeks, the markets should remain ”bullish”, and any pullbacks should be used as opportunities to buy your favorite equities. While some hedge fund managers are backing off of equities at present, this group is far from an overweight equity position, even as the market displays strength. Moreover, retail investors are still pulling money out of equity mutual funds, driven by disbelief in an economic recovery. Retail investors still represent enormous buying power, despite the market's surge from the 2009 lows and, more recently, the October 2011 trough.
The SPX Resistance
Resistance for the SPX is in the 1,440-1,450 area, its target after the inverse "head and shoulders" breakout above 1,360. The 1,450 area was also the site of a peak in May 2008. Support lies in the 1,360 areas, site of its 40-day moving average and area of the 2011 high. It is of importance to note, some traders are keying on the 14-day moving average, which has supported multiple pullbacks since the middle of January, with the exception being the early March decline. The rising 14-day moving average on the SPX is currently sitting at 1,386.40, which corresponds with the 38.2% Fibonacci retracement level referred to earlier.
'Fibonacci Retracement’ is a term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going higher). The Fibonacci retracement is the potential retracement of a financial asset's original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction.
These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.
Fibonacci retracement is a very popular tool used by many technical traders to help identify strategic places for transactions to be placed, target prices or stop losses. The notion of retracement is used in many indicators such as Tirone levels, Gartley patterns, Elliott Wave theory and more. After a significant price movement up or down, the new support and resistance levels are often at or near these lines.
Daily Chart of SPX since February 2011 With 14-Day and 40-Day oving Averages
Conclusion - Investment Thoughts
With the hedge fund creating some concern, other groups are certainly providing opportunities. Homebuilders and the retail/restaurant group are a consideration for an investment portfolio, where price action is strong amid skepticism. Financials are another area to be aware of as there is evidence that these stocks are rallying on good news, and holding their own on bad news. For example, Bank of America (BAC) rallied 2.6% on Friday amid a brokerage house downgrade, while Morgan Stanley (MS) surged almost 4% on a broker upgrade.
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