Why the Bearish Analyst 'Hot Takes' on CBOE Are Wrong

The accompanying daily chart of Cboe Global Markets (NASDAQ:CBOE) provides a prototype illustration of the most prominent risk of "momentum investing" (even more profoundly highlighted over this past week with the implosion of the inverse volatility exchange-traded funds). Share price action can be strong over lengthy time frames -- sometimes strong enough to result in gains of 100% or more in periods measured in months (rather than in years), and even as the underlying instrument exhibits surprisingly modest volatility. But only until such "dream periods" for "buy and hold" strategies come to an end -- often very abruptly and often "overnight" in the literal sense, and (for almost all non-professional investors in these instruments) entirely "out of the blue."

And so it was with CBOE last week. The prelude, of course, was a stock in full "low volatility, persistent uptrend" mode -- an uptrend (off the low put in place in October 2016) that saw the shares post a remarkable gain of more than 120% into their January 2018 peak, as business boomed for both CBOE and for its "crown jewel" CBOE Volatility Index (VIX) trading products. And an uptrend in which pullbacks were almost laughable in magnitude (and were never remotely "scary") -- with declines invariably supported at the rising 20-day moving average, but which sometimes carried down as "low" as the 40-day (see chart).

But then came last week's inverse volatility ETF blow-ups, followed quickly by a heuristic about CBOE's business developed by analysts at two prominent brokerage firms that went like this: "Inverse volatility ETFs have blown up; volatility ETFs have been heavy users of CBOE's proprietary VIX options and futures products and have thus significantly contributed to the volume growth in these products; VIX trading for the purpose of shorting the VIX has now dried up; the reduced VIX volume from this customer base will hurt CBOE's future earnings growth; and for this reason, CBOE's earnings and share price prospects are likely to now be compromised."

Each of these analysts proceeded to downgrade CBOE on Wednesday, Feb. 7 (just two days prior to the company's scheduled report of its latest quarterly earnings). And on that "downgrade Wednesday," CBOE shares traded off by as much as 22% from the all-time high (at $138.54) achieved just six trading days before on Jan. 29.

We believe the bearish case for compromised VIX trading volume growth based on a projected absence of speculation on declining volatility is a very tenuous one. First off, the shutdown of money chasing short VIX trades could prove very temporary, as (even in the wake of Friday's 15% decline) the VIX is still trading at double its peak levels from 2017, and thereby creates an almost irresistible target for many volatility short sellers.

Second, the overwhelming concern of the analyst community over the years has been about a decline in the popularity for VIX derivatives in an ongoing "quiet" equity market, as the VIX had been considered to be almost exclusively a "fear gauge" in which interest is only activated by volatile markets in danger of crashing. And yes, the CBOE did greatly profit from the shockingly large VIX short trade that had developed in recent years -- the popularity of which (to our knowledge) not a single prominent analyst had foreseen. And so our question to our analyst friends would then be: "What is the problem here, folks? Are you still mad that you missed the huge rally in CBOE over the past year?"

Our puzzlement this past week over these bearish analyst "hot takes" is reinforced because we can't help but recall that as recently as the summer of 2016, Wall Street was seriously fretting over an entirely different chronicle widely accepted at the time as "received wisdom" -- namely, that a continuation of the extended period of extremely low market volatility will (you guessed it) begin to compromise VIX trading volume. Because, as the story went, any quickening of VIX activity must emanate from periods of market disturbances accompanied by elevated volatility. And so (with CBOE range-trading at the time in the 60s), we saw analyst downgrades in August 2016 and again in September.

But here is where it got very interesting for those of us of a technical bent. Because shortly thereafter (by October 2016), CBOE's 20-day Relative Momentum Index (RMI) had moved into climactic oversold territory (by dipping below the 30 mark) that suggested a bottom was in place. And the rest proved to be history, as CBOE shares were trading 20% higher by year-end 2016 -- and by November 2017 (a year or so later) they had doubled.

We see significant upside potential for CBOE shares here in the wake of Friday's wild post-earnings ride, and our bullish take is three-pronged. One,Wall Street again has it just about completely wrong about the factors driving the growth in VIX derivatives (and, consequently, has it wrong about the growth prospects for CBOE) -- and the power of Wall Street's negative opinion will migrate from "near-gospel" now to (once again) of little impact over time, as it is repeatedly contradicted by the facts as they develop. Two, we now have a parallel oversold condition in the 20-day RMI for CBOE to that of the fourth quarter of 2016 -- and we expect this to once again be resolved in a bullish manner. Three, as displayed on the chart, CBOE shares were ultimately supported at the key 200-day moving average, once Friday's tumultuous activity had played itself out.

Our recommended CBOE call option would reach its 200% target profit on a rally by the shares to the $125-$130 level over the prescribed holding period, a rally that looks to us to be quite feasible from a technical perspective, and further driven by an unwind of some excessively bearish sentiment that is likely based on some faulty premises.