VIX Decline Closes the Volatility Gap - Stock Pullback Likely
2011 Stock Peaks to be Conquered!
February 19, 2012
By the time markets closed on Friday last week, the Dow Jones Industrial Average (DJIA) and Nasdaq Composite (COMP) both rallied their way to new multi-year highs.
However, several other equity benchmarks -- including the S&P 500 Index (SPX) -- finished the week just shy of their 2011 highs. While a retreat from these potential resistance levels is possible, it is important to note that any previous stock pullback in 2012 has proven to be buying opportunities. (And, as an added bonus, portfolio protection became a lot cheaper last week.)
“It has become quite evident that optimism has been creeping into the market, right as the S&P 500 Index (SPX) and the S&P 400 MidCap Index (MID) approached their 2011 resistance levels in the 1,350 area and the 1,000 millennium mark, respectively. With key equity indexes lingering near resistance, these bullish headlines suggest we could be ripe for a pullback -- or, at the very least, continued choppiness in the days ahead..... With portfolio insurance relatively expensive -- and thus unattractive for some hedge fund managers looking to put cash to work -- and the SPX and MID trading just below former resistance, the near-term price action may not be as rosy as the past several weeks. But pullbacks should continue to be viewed as buying opportunities, as considerable cash remains on the sidelines."
- VIX Premiums High Cost – A Deterrent to Potential Buyers!, February 13, 2012
During the past couple of weeks, there has been the possibility of a choppy phase, or pullback, and of course that any such pullbacks present buying opportunities. This short-term caution was driven by major indexes and exchange-traded funds (ETFs) trading just under significant resistance levels, with the exception being the PowerShares QQQ Trust (QQQ - 63.43).
Coincident with this move up into potential resistance, it has been observed that some anecdotal optimism has entered the market -- but also warned that optimism within the context of strong price action is not as meaningful as optimism amid weak price action. Moreover, portfolio protection was becoming more expensive relative to actual volatility, which was thought that it might slow down the accumulation of equities among hedged players.
As you can see on the 30-minute graph of the S&P 500 Index (SPX - 1,361.23) below, which dates back to Jan. 9, a pullback of note has not occurred, with the biggest drawdown being the 2.5% decline in the last week of January (circled). And up until Thursday's impressive advance, the SPX had indeed chopped around between 1,340 and 1,355 throughout the first half of this month. But overall, it has been an ”uptrend in 2012”, rewarding investors with a time frame of more than a few days, who have held long positions through the late-January "mini-pullback" and the choppy phase in the first half of this month.
30-Minute Chart of SPX since January 09, 2012
Heading into the long Presidents Day weekend, the SPX was trading just 2.38 points below the 2011 closing high of 1,363.61 and 9.35 points below its 2011 intraday high of 1,370.58. These are levels many chart technicians will be keeping an eye on, as they could represent another speed bump - a stock pullback! Also of note, per the chart below, is the fact that the SPX enters the week just 1.3% above its one-year return, as the lows of this past week were contained around its one-year breakeven level. But as we move into the holiday week, this one-year breakeven will move lower due to the stock pullback that occurred last year, with 1,306 representing the SPX's one-year breakeven return as of Feb. 24.
Daily Chart of SPX since February, 2011
Meanwhile, the Russell 2000 Index (RUT - 828.68) is within striking distance of last year's highs in the 860 area, while the S&P 400 MidCap Index (MID - 984.60) is just below the all-important 1,000 millennium level, which marked its peak last year.
It is obvious that the slightest stock pullback has represented buying opportunities going back to mid-December, and it is believed that it is the result of hedge fund managers, who were underweight coming into this year, putting cash into equities.
While they took a brief pause a few weeks ago, the analysis of options data suggests that they are back in equity-accumulation mode, despite the expensive portfolio insurance that was discussed last week as a possible deterrent to hedged buyers. As a side note, portfolio insurance became cheaper this past week, as SPX historical volatility was flat, while the CBOE Market Volatility Index (VIX - 17.78) decreased 14%, closing the gap between implied and historical volatility on the SPX.
Evidence of this accumulation is seen in the advance in the 20-day combined buy-to-open put/call volume ratio on the SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 Index (IWM), and PowerShares QQQ Trust (QQQ). A slight roll-over in this ratio preceded the minor stock pullback in late January, but the ratio has turned higher once again. Continue to pay close attention to this indicator, as fund managers can change their views instantly!
A point of note -- hedge fund managers will buy ETF puts to hedge long positions they are accumulating. Given hedge funds are a driving force in this market, it has been found that when put buying picks up in major ETFs, the market has enjoyed its best days since the 2009 bottom.
Keep close eyes on the decline in VIX futures call buying, though, per the chart below! Hedge fund managers can use VIX calls as another method to hedge long equity positions, and the rate of call buying has declined significantly. This could quickly reverse with a stock pullback, but it appears that not as many hedge fund managers are in accumulation phase relative to the beginning of the year, though enough hedge funds remain bullish to keep the overall trend intact.
With the plunge in the VIX this past week, now is a good time to replace portfolio insurance that expired last week. The outlook remains ”bullish”, although the SPX has speed bumps just overhead which may represent a stock pullback. Use ”pullbacks as buying opportunities” and maintain long stocks that are working for you.
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