This Could Be the Start of Another Short-Term Sell-Off

Corrective moves have occurred as option buyer sentiment has soured

"[A] current risk to equity investors is this year's pattern of taking profits when key asset benchmarks reach levels that correspond to a 20% profit for 2019. If this pattern repeats, you will see a rotation out of stocks, and into bonds and gold ... On the sentiment front, one thing that has changed significantly from last week is the level of the 10-day, equity-only, buy-to-open put/call volume ratio. This ratio has declined and is now close to levels that have marked previous tops for the equity market during the past year... the risk now is a subsequent turn higher in this ratio from extreme lows, as it is usually a catalyst that suddenly changes the mindset of equity option buyers."
-- Monday Morning Outlook, September 16, 2019

As I review comments from two weeks ago, a rotation occurred, from stocks into bonds, as the S&P 500 Index (SPX - 2,961.79) has pulled back from its Friday, Sept. 13, close at 3,007.39, which was just 1 point below the level that is 20% above its 2018 close. During this period, gold has been roughly flat, but bonds rallied, as measured by the iShares 20+ Year Treasury Bond ETF (TLT - 142.73), which closed that same Friday at $136.54, just above its 80-day moving average.

Up until last Friday morning, the SPX pullback had been minimal, as its rising 20-day moving average provided support most of last week, even as more political uncertainty arose with respect to House Majority Leader Nancy Pelosi announcing a formal impeachment inquiry against President Donald Trump. But, after a couple of weeks of perceived positive news on U.S.-China trade, a Friday headline suggested that the Trump administration is weighing limits on U.S. investors' holdings of Chinese-listed companies, causing stocks to sell off on the news.

As the new uncertainties surfaced, the risks I discussed two weeks ago from a sentiment perspective became more of reality. In other words, we could be in the beginning of a short-term sell-off again, as unwinding enthusiasm for stocks that was coincident with the SPX's brief move above the 3,000 level has apparently peaked.

For example, note in the graph below how equity option buyers are buying more puts relative to calls, as the 10-day equity-only, buy-to-open put/call volume ratio has bottomed and turned higher. Corrective moves have occurred as option-buyer sentiment moves from one of enthusiasm (a low ratio) to increasing caution (a rising ratio).

Friday saw an intraday breakdown below the 2,950 half-century mark, which marks the September lows, the early May high, and the vicinity of its 80-day moving average. But 2,950 held on a closing basis -- a positive for bulls heading into this week's trading. With the impeachment and trade risk headlines emerging Friday, an SPX technical breakdown below 2,950 could spur more put buying on individual equities and the broad market, and coincidentally pressure stocks ahead of the mid-October meeting with Chinese leaders.

"[T]he 10-day equity-only put/call volume ratio keeps plunging, and last week reached a low of 0.447, which was the lowest reading since June 2018. But what caught my attention was how the Cboe Volatility Index (VIX - 15.32) responded after previous falls in the ratio. Over the next month, the VIX was positive 56% of the time and, on average, returned +13.6%. Over the next two months, the VIX was positive 67% of the time, and returned, on average, +15.8% ... Commitments of Traders (CoT) data confirms that large speculators continue to increase their net short position in VIX futures, and these investors have notoriously been on the wrong side of the trade."
-- Monday Morning Outlook, September 23, 2019

Another risk that emerged briefly on Friday was the Cboe Volatility index (VIX - 17.22) moving intraday above the 18 level, which I have discussed multiple times in this weekly commentary as being important because it represents one-half December 2018's closing high. The VIX decline below 18 in late January confirmed that the SPX's advance from the December trough was firmly in place, while resistance at VIX 18 in early February and March further hinted that the rally was not in any danger of ending amid mild pullbacks. However, moves above 18 in early May and early August hinted of trouble immediately ahead.

A VIX breakout above 18.00 coincident with the SPX closing below 2,950 could set up a retest of the August lows in the 2,850 area. A worst-case scenario for bulls would be the SPX again retesting its year-over-year breakeven level, which has been the theme of many pullbacks during 2019. The October 2018 closing low was at 2,641, which came near the end of that month.

But for now, the bulls have the upper hand, with the VIX entering the week below 18.00 and below a trendline connecting lower highs since the early August peak. With the SPX rallying from its August range high and 80-day moving average on Friday, a move above a short-term trendline connecting lower highs since Sept. 19 would set up another run at the 3,000 area that has put a lid on rallies since July.

Todd Salamone is Schaeffer's Senior V.P. of Research.

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