Monday Morning Outlook: What VIX Call Volume Is Saying About Sentiment
Large- and small-cap stocks alike ended the week north of significant chart levels
by Todd Salamone 1/21/2012 10:30 AM
schaeffersresearch.com 
It was a winning week for stocks, with Wall Street recovering nicely from Standard & Poor's downgrade tour of the euro zone. Despite the agency's words of warning, France, Germany, and Spain all conducted bond auctions without a hitch last week. Meanwhile, corporate earnings were generally quite pleasant (with the glaring exception of a certain Mountain View-based Internet outfit). As a result, the major equity indexes soared past significant technical sticking points with apparent ease, and the Dow wrapped up the week at its highest level since late July... just ahead of another memorable research note from S&P, if you'll recall.
With the technical outlook improving, Todd Salamone takes a close look at the sentiment backdrop to determine whether there's enough sideline cash to keep the bullish ball rolling. Meanwhile, Rocky White makes a few surprising discoveries that might help options players determine whether they're better off rolling the dice on highly volatile small caps, or slow-and-steady blue chips. Finally, we wrap up with a preview of the major economic and earnings reports for the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: RUT and MID Rally Past Resistance
By Todd Salamone, Senior VP of Research
"...the technical backdrop continues to improve for small- and mid-cap equities, an area of the market we believe must display leadership, which has indeed been the case since late September. For example, the S&P 400 MidCap Index (MID) closed above the 900 mark for the first time since early November... But work remains to be done, as the 910 area marks a 61.8% Fibonacci retracement of last year's high and low point, in addition to its October 2011 high, while the 920-925 area lingers above, which is the site of the 2007 peak... "The Russell 2000 Index (RUT) made some significant headway this past week too, closing above the 2010 pre-'flash crash' high of 750 for the first time since late October... the RUT, like the MID, is still facing potential overhead resistance. For example, a 61.8% Fibonacci retracement of the 2011 RUT peak and trough is right at current levels, while the 2011 first-half lows linger just above, at 775... a breakout above this resistance would complete a bullish inverse 'head and shoulders' pattern on a daily chart, even though some technicians were betting on the potential for a bearish 'head and shoulders' formation to develop on a longer-term chart."
- Monday Morning Outlook, January 14, 2012
During the past few weeks, we have discussed the continually improving technical backdrop of various broad-market indexes. Last week, the storyline continued, as the S&P MidCap 400 Index (MID - 930.62) closed Friday slightly above the 930 mark, and a shade above its absolute highs in 2007. Admittedly, bulls would like to see more than a four-point move above this 1997 apex -- but they can take some comfort in the fact that there wasn't a major rejection in this area during last week's ascent, as it was the first time this level was revisited since August, when a break below it drove furious selling. Previously, 930 had acted as support in the first half of 2011. The index continues to rally sharply from its 80-month moving average, touched back in October.
Additionally, the Russell 2000 Index (RUT - 784.62) rallied above some potential areas of resistance. For example, the index climbed above its 320-day moving average, which is also the site of a 61.8% Fibonacci retracement of last year's high and low, plus the site of the pre-Lehman Brothers peak in 2008. Moreover, the RUT rallied above its 2011 first-half lows in the 675 area.
As we discussed a few weeks ago, the RUT's breakout above the neckline of an inverse "head and shoulders" formation now targets a move to the 850 area, which would push the index up to its 2011 highs. With hedge funds and active investment managers accumulating stocks, but not yet fully invested, such a target is achievable.
Meanwhile, the S&P 500 Index (SPX - 1,315.38) advanced above the 1,300 century mark for the first time since July. It is now sitting just below the 1,320 area, where it was trading immediately ahead of the financial crisis in 2008. The SPX made a brief move above this level last year, but tended to encounter resistance in the 1,340-1,350 zone.
Finally, the PowerShares QQQ Trust (QQQ - 59.77) comes into the week just below major resistance in the 60 area. As you might remember from previous commentaries, the 60 level is important, as it represents half the QQQ's March 2000 all-time high at 120. The 59-60 area has marked peaks in the QQQ since February 2011. The good news is, the exchange-traded fund (ETF) took out its 2011 peak by the slightest of margins on Friday to trade at its highest level since February 2001, as Microsoft (MSFT) and under-loved Intel (INTC) rallied on well-received earnings news, even as over-loved Google (GOOG) plummeted post-earnings.
As we mentioned last week, it appears hedge funds and institutions are shifting into accumulation mode from underweight positions, and this is when the market has tended to enjoy its best days. This activity is evidenced by the continued increase in call buying relative to put buying on CBOE Market Volatility Index (VIX - 18.28) futures, as fund managers purchase VIX calls to hedge long equity positions they are accumulating. In addition, fund managers are still purchasing a greater number of puts than calls on broad-based equity ETFs that we follow, in another sign of hedging activity.
We have noticed, however, that the ratio of call buying to put buying on VIX futures, smoothed by a 20-day moving average (first chart below), is approaching highs at which the ratio has peaked and preceded market tops. However, upon digging further, it's worth noting that the total buy-to-open option volume on VIX futures (second chart below) during the past 20 days is extremely small relative to the volume at past peaks last year. In fact, buy-to-open option volume on VIX futures is currently about half its 2011 peak, even as the call/put ratio approaches its highs. This would suggest that, while hedge fund activity has become more bullish of late, there are still a number of deep-pocketed players sitting on the sidelines.
We remain bullish amid an improving technical backdrop. Plus, there is plenty of fuel to power the market higher, as it is apparent that hedge funds are still underweight, and total short interest is considerably above year-ago levels.
Use pullbacks as buying opportunities. In addition to earnings season heating up next week, other potentially market-moving events include a meeting of European leaders regarding a possible Iran oil embargo, and the Federal Reserve's newly detailed forecast of short-term interest rates. And, in two weeks, another European summit is scheduled, as investors continue to watch the ongoing negotiations between Greece and its bondholders.
Indicator of the Week: Better to Buy Expensive Options, or Cheap?
By Rocky White, Senior Quantitative Analyst
Foreword: Option trading and stock trading is different on many levels. Stock traders gain when the stock goes up, and lose when it goes down. It's that simple. Option premium buyers not only need to pick the right direction of the stock, but the stock's move must happen in a certain amount of time (before the option expires). Furthermore, there is a premium built into options -- the implied volatility (IV) -- which tells us how much other option traders expect that stock to move. Therefore, not only do these speculators need the underlying to move in the right direction and within a certain time frame, but also by more than other option players are predicting.
So, the implied volatility of an option reflects the market's expectations for the underlying stock's price movement. Large-cap stocks that have been around a long time tend to move less than small-cap stocks, and therefore tend to have lower implied volatilities. The lower the implied volatility, the less the stock has to move for the option to make a profit. Therefore, premium buyers have a trade-off to consider when deciding which companies' options to buy. They can buy low-priced options on stocks that do not tend to make big, quick moves (but that don't have to make a big move for the option to profit), or they can buy higher-priced options on stocks that have more potential to make a big move. So, looking back at 2011, I decided to see which strategy would have paid off best.
Last year, the big caps led the way. The Dow Jones Industrial Average (DJIA) was up 5.5%, while the Russell 2000 Index (RUT) lost about 5.5%. The S&P 500 Index (SPX), meanwhile, was pretty much flat. Since the Dow is composed of 30 large-cap companies that tend to have low IVs, I assumed it would have been most profitable to buy options on these stocks. Good thing I checked the numbers, because it didn't turn out exactly as I expected.
Premium Buying in 2011: When I focus on option price comparisons for certain subsets of stocks, rather than comparing whether the stocks went up or down, I do so by comparing the returns on long straddles on the stocks. Straddles are implemented by purchasing both a call and a put at the same strike, with the intention of making a profit whether the stock goes up or down. The stock does, however, have to make a pretty decent-sized move to make up for the fact that you're buying double premium. In other words, the direction of the stock doesn't matter -- only the size of the move and the prices of the options.
For this study, I assumed that on each monthly expiration date in 2011, you purchased an at-the-money straddle on each stock which expired on the following expiration date (one month later). Then, I broke the stocks down into three equal groups, depending on their implied volatilities. The table below summarizes their returns. The low-IV stocks did have the worst performance of the bunch. Purchasing a straddle on these stocks each expiration would have netted you a loss of almost 1.23%. By contrast, buying straddles on the expensive options would have generated a gain of 1.81%.
Call Options vs. Put Options: For each of those subsets of stocks, I then looked at how it would have turned out if you had purchased a slightly in-the-money call option or a slightly in-the-money put option. Looking at the table below, you'll notice the call options had negative returns across all brackets. The low IV bracket had the least negative returns, at -5.4% -- which is not surprising, considering the Dow outperformed the small-cap RUT. However, the big profits last year would have been made by buying put options on the high IV stocks. A trader doing that would have gained an average of 13.5% on each trade.
So, though the Dow was up 5.5% last year, the stocks with low IVs would have still lost money had you purchased call options all year. However, the high IV stocks would have returned solid profits, had you bought puts all year. Surely, the majority of those profits would have come in the third quarter, when the SPX fell about 18% from late July to early August.
This Week's Key Events: Fed Meeting, Fourth-Quarter GDP in Focus
Schaeffer's Editorial Staff
Here is a brief list of some of the key events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.
Monday
- There are no major economic reports scheduled for Monday. Earnings are due out from Halliburton (HAL), VMware (VMW), Western Digital (WDC), Texas Instruments (TXN), Zions Bancorp (ZION), Kansas City Southern (KSU), and CSX Corp. (CSX).
Tuesday
- The economic calendar kicks off Tuesday with the Richmond Fed's business activity survey. Meanwhile, President Obama's State of the Union address is slated to hit the airwaves after hours. On the earnings front, we'll hear from McDonald's (MCD), Johnson & Johnson (JNJ), DuPont (DD), Travelers (TRV), Verizon Communications (VZ), Apple (AAPL), Yahoo (YHOO), Coach (COH), EMC Corp. (EMC), Harley-Davidson (HOG), and AK Steel (AKS).
Wednesday
- Pending home sales data and the regularly scheduled crude inventories report will hit the Street on Wednesday. Around midday, the Federal Open Market Committee (FOMC) will unveil its latest ruling on monetary policy, followed by a press conference with Chairman Ben Bernanke at 2:15 p.m. Eastern. There will also be plenty of earnings to digest, with quarterly results due out from Boeing (BA), United Technologies (UTX), Xerox (XRX), ConocoPhillips (COP), Delta Air Lines (DAL), US Airways (LCC), SanDisk (SNDK), and Netflix (NFLX).
Thursday
- Thursday's economic agenda heats up with reports on jobless claims, durable goods, new home sales, and the Conference Board's index of leading indicators. Slated to report earnings are 3M Company (MMM), Caterpillar (CAT), AT&T (T), Under Armour (UA), Starbucks (SBUX), JetBlue Airways (JBLU), United Continental (UAL), Juniper Networks (JNPR), and Cirrus Logic (CRUS).
Friday
- Finally, Friday's docket features the government's preliminary estimate of fourth-quarter gross domestic product (GDP), as well as the final Thomson Reuters/University of Michigan consumer sentiment figures for January. The week's onslaught of earnings concludes with reports from Procter & Gamble (PG), Honeywell (HON), Chevron (CVX), Altria (MO), Legg Mason (LM), and Newell Rubbermaid (NWL).
And now a few sectors of note...
Dissecting The Sectors
Sector Utilities
Bullish
Outlook: The positive momentum in the utility sector has dimmed lately, as this traditionally defensive group has retreated amid strength in the broader equities market. However, within the context of the longer-term uptrend in the PHLX Utility Sector Index (UTY), pullbacks like the one we're seeing now are not unusual. In fact, UTY could retreat to the $455 area -- a site of former resistance in mid-2011 -- if its 80-day moving average, located at 461.79, fails to hold up. Nevertheless, we continue to view pullbacks as buying opportunities. In addition to the sector's long-term technical outperformance, along with the appealing dividend yields of many utility stocks, there's an unwarranted amount of pessimism surrounding the group. Drilling down, 67% of stocks in the electric utility group are trading above their 200-day moving averages, but they've attracted only 43% "buy" ratings from brokerage firms. Meanwhile, the gas utility group boasts 83% of stocks trading above their 200-day moving averages -- yet these names have garnered only 38% "buy" ratings. Within the utility sector, Duke Energy (DUK) and Consolidated Edison (ED) have turned in impressive uptrends over the past year, and both securities are lingering near annual-high territory. Nevertheless, there's not a single "buy" endorsement between the two. Going forward, a round of well-deserved upgrades could draw a fresh wave of buyers to the table, helping these stocks extend their positive price action.
Sector Leisure/Retail
Bullish
Outlook: Last Thursday, Wall Street celebrated yet another positive surprise in the Labor Department's weekly unemployment report, with first-time claims for jobless benefits declining by a steeper-than-forecast margin. Additionally, consumer-level inflation remains virtually stagnant, pointing to an improving fundamental backdrop for the U.S. consumer -- and, by proxy, consumer discretionary stocks. On the charts, the SPDR S&P Retail ETF (XRT) remains a technical outperformer. XRT rallied sharply last week, notching its first weekly close above resistance at $54 since July 22. The fund is now looking to challenge its July 2011 all-time high at $56.44. For those seeking a bullish play in the retail/leisure space, we recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism. A few of our current favorites include retailers AutoZone (AZO), Advance Auto Parts (AAP), Nordstrom (JWN), and Whole Foods Market (WFM), along with restaurateurs Chipotle Mexican Grill (CMG), Domino's Pizza (DPZ), and McDonald's (MCD). With skepticism still lingering toward these consumer-dependent stocks, contrarians can continue to capitalize on situations where sentiment has yet to catch up with the bullish technical performance.
Sector Homebuilding
Bullish
Outlook: Housing data was mixed last week, as existing home sales jumped to an 11-month best, but still fell short of consensus estimates. Additionally, the SPDR S&P Homebuilders ETF (XHB) is trading near its 2011 peak, so some technical selling may have come into play. However, we would still be buyers on pullbacks. On the charts, XHB is trading solidly above its 160-week moving average, which is now turning higher. This trendline covers a roughly three-year period of time, dating back to the peak of the 2008 financial crisis. Plus, there's still plenty of negativity levied against builders, even as fundamental data continues to improve. Stocks such as Lennar (LEN), KB Home (KBH), Meritage Homes (MTH), and D.R. Horton (DHI) all sport lofty accumulations of short interest, and one brokerage house recently slapped the sector with a round of downgrades. Going forward, these names could benefit from upgrades or short-covering activity as the technical and fundamental performance continues to surpass the Street's low expectations.
Sector Financials
Bearish
Outlook: Banking stocks were a surprising pocket of strength last week, thanks to well-received earnings reports from sector heavyweights Bank of America (BAC), Morgan Stanley (MS), and Wells Fargo (WFC). From a broader standpoint, the technical backdrop has also improved. The Financial Select Sector SPDR (XLF) moved above staunch resistance at its 200-day moving average for the first time since May 2011. Moreover, the XLF's move above $14 represents a breakout above the neckline of an inverse head-and-shoulders formation, which would target a move up to $17 in this ETF. Given these developments, the risk of shorting the financial sector has increased. However, it should be noted that financials rallied into late February last year before the bottom fell out.
Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insight about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.
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