Investor Caution for Stock Market Bulls
The VIX to Remain Elevated in the Week Ahead!
The SPX Suffering Onset of History!
by Ian Harvey
September 03, 2012
Stocks extended their winning streak to three straight months in August, with Friday's speech from Fed Chairman Ben Bernanke fueling hopes for another round of quantitative easing. However, it is important to realize that there is still a great deal of evidence that caution remains prevalent on Wall Street, and light trading and more central-bank fodder could determine stocks' post-holiday trajectory.
Risks for Stock Market Bulls
"The National Association of Active Investment Managers (NAAIM) sentiment survey measures the overall equity exposure of active money managers who are either long or short the stock market... this past week's reading of 82.89 is the most elevated since April 20, 2011... Overall, when active managers have elevated exposure (NAAIM number is greater than 80, one signal per month) the returns for the S&P 500 Index (SPX) are below average, compared to at-any-time returns since 2006."
- Sentiment in the Past Week, September 01, 2012
"...because of various unusual headwinds slowing the recovery, the economy needs more policy support than usual at this stage of the cycle; and the need to compensate for limits to policy accommodation resulting from the lower bound on rates."
- Fed Chairman Ben Bernanke, August 31, 2012
“Looking at the steepness of the VIX futures curve -- whereby longer-dated VIX futures are significantly higher than the cash VIX. It can be noted that when the steepening occurs, we get warnings about a selloff ahead. But, in checking our historical VIX futures data (which goes back to 2004), it is evident that a steep curve is not a sell signal.”
- “The CBOE Market Volatility Index (VIX), widely considered the best gauge of fear in the stock market, ended its four-session rise, and inched 0.4 point, or 2%, lower on Friday. On the week, the market's fear gauge surged 15.1%....."
When looking at the latest survey from the National Association of Active Investment Managers (NAAIM), as excerpted above, there appears to be certain risk to the stock-market bulls. The study of the table below provides implications, as based on the historical returns over several timeframes, suggesting that the market is vulnerable to pullbacks after optimism among this group is revealed in the survey.
Therefore, the NAAIM survey shows there is certainly a risk for stock market bulls that is worth noting, from a sentiment perspective. However, this does not mean that it is necessarily a certainty that the market will follow in the path of its historical returns after such a high reading.
In fact, after observing the current CBOE Market Volatility Index (VIX - 17.47) and S&P 500 Index (SPX - 1,406.58) relationship, whereby the VIX is trading almost three times higher than realized volatility, it can be found that a similar relationship existed in late December 2010, when the VIX was trading at 17.75 and SPX realized volatility was around 6.0. During that period almost two years ago, the SPX continued to rally into mid-February before finally correcting. This stands out because fund managers surveyed were extremely bullish in December 2010, but this translated into one of the few "sell" signals that did not work. In fact, there was evidence in Exchange-Traded Funds (ETFs) option activity in late 2010/early 2011 that hedge-fund managers were increasing their exposure to stocks, and evidence is being sought to see if this is again re-occurring, as discussed last week in the article “Hedge Fund Managers Becoming More Bullish”.
It is quite possible that we are in the same environment as late 2010, with the exception of seasonality factors, which works against the stock market bulls at present, but worked in their favor in late 2010.
Stock Market Bulls and Protection
It is quite obvious that the protection trade is alive and well, and the existence of this caution continues to provide a base for the market. The other outstanding base, or floor for the market, is Fed Chairman Ben Bernanke, who again left the door open for a third round of Quantitative Easing -- QE3 -- at a central bankers' meeting in Jackson Hole, Wyo., on Friday.
The caution among investors is evident in: the steepening slope of the VIX futures curve, the bullish implications of which were discussed two weeks ago; a VIX reading that is almost triple that of SPX realized volatility; a large short position on SPX component stocks, per the graph below; and a hedge-fund community that is underweight U.S. equities (albeit there is evidence that this exposure is being increased).
With the 'European Central Bank - ECB' meeting scheduled for the week ahead, and a Fed meeting scheduled in the second week of September, it would not be a major surprise to see the VIX elevated during the upcoming weeks, as investors, especially stock market bulls, remain on-guard with respect to a seasonally weak period and the "known unknowns" on the calendar. And even though many traders return after the Labor Day weekend, volume could be light early in the week ahead, just before the ECB meeting on Sept. 6.
SPX and Direction
The 1,420 area on the SPX continues to loom overhead as resistance, but a move above this level would likely spur more short covering, clearing a path to 1,500.
A possibility is that the currently bearish NAAIM indicator proves to be accurate, and the elevated VIX turns out to be smart, as historical volatility sharply advances after events unfold during the next two weeks. If this occurs, a potential level of support on a pullback is in the 1,350 level, which is around last year's high and site of heavy put open interest. Such large open interest put strikes, often driven by investors purchasing portfolio protection, can sometimes act like a magnet during periods of market weakness, as sellers of the puts sell equity futures to maintain a neutral position.
The best advice at present is to be open to both scenarios: a modest correction if ECB leaders disappoint investors, particularly stock market bulls, or a surprising assault on SPX 1,500 driven by more central bank support that spurs the shorts into covering.