http://www.schaeffersresearch.com/commentary/observations.aspx?ID=103840&obspage=1
What the Trading Desk Is Expecting: Bulls Continue to Show Strength
By Todd Salamone, Senior Vice President of Research
During the past few weeks, we have highlighted several longer-term resistance levels capping the S&P 500 Index (SPX) and evidence, via our options analysis, that hedge fund managers had mostly returned to the sidelines after a period of accumulation from late August into early November.
Our conclusion has been that while ample sideline money is a necessary condition to support a continued bullish market environment, a continued absence of hedge fund accumulation could be an inhibitor to an upside breakout, as the market is left to the mercy of the high-frequency traders and their mean-reverting activities. Therefore, the risk of a trading range similar to the end of 2009 was viewed as a growing possibility.
The SPX comes into the new week trading around the April and November 2010 peaks. After closing the month of November below the 1,200 century mark and its 80-month moving average, it has quickly rallied above these resistance areas. As we enter the traditionally strong December month, the possibility of a sustained upside breakout has increased for the following reasons.
- The 20-day combined buy-to-open put/call volume ratio on the SPDR S&P 500 ETF Trust (SPY), PowerShares QQQ Trust (QQQQ) and iShares Russell 2000 Index Fund (IWM) has turned higher, driven mostly by a dramatic increase in put buying on IWM. The ratios on SPY and QQQQ are no longer sharply declining, but haven't yet risen as sharply as the IWM's. An increase in put buying is usually coincidental with hedge fund accumulation, suggesting strong hands are in accumulation phase again, key to continued market strength.
IWM has pushed above its April 2010 peak. In early March, the IWM broke out above its January highs, but the Nasdaq Composite and SPX did not break out above their respective highs until one week and two weeks later, respectively. Small-cap leadership may signal an imminent breakout in larger-cap indexes.
Reactions to recent headlines indicate bull market conditions persist. Last week, for example, we stated that the recent price action in the U.S. market – indifferent, at best –might be considered a win for the bulls. That is, stocks showed relative resilience despite a constant stream of negative headlines that could have easily driven stocks below support levels – namely the re-emergence of the European sovereign debt crisis, the growing possibility of a Chinese rate hike, hostilities between North and South Korea, charges of insider trading brought against some hedge funds, and Friday's extremely disappointing employment report. The market bent, but certainly did not break amid these headlines.
Our "VIX Premium" indicator, which compares the CBOE Market Volatility Index (VIX – 17.88) to the SPX's actual volatility (15.96), is indicating lower volatility ahead, which is usually coincidental with higher stock prices. Per the chart below, note that during the past couple of years, when the VIX is trading at significant premium to SPX historical volatility (significant as defined by the VIX trading at a level that is double its actual volatility), it is a precursor to higher volatility and a market pullback. On the other hand, when the VIX is at a relatively small premium to actual SPX volatility, lower volatility has followed amid a rising SPX. In early November, this indicator correctly forecasted higher volatility and an SPX decline, as the VIX traded 140% above SPX historical volatility. The "VIX premium" has since eroded substantially, as you can see below.
The "Black Friday" indicator, discussed by Senior Quantitative Analyst, Rocky White, in last week'sMonday Morning Outlook. Rocky studied the performance of the SPX in the week after Black Friday. He found that when the market rallied in the week following Black Friday, there is a historical tendency for the market to experience a stronger-than-normal rally into year-end, compared to instances when the market experienced negative returns in the week following Black Friday. Last week, the SPX rallied, a positive omen for the rest of the year.
