Written by Jim Welsh
Macro Tides Weekly Technical Review 04 September 2020
After posting an intra-day low of 3355 on August 20 the S&P 500 rallied to 3588 on September 2, a gain of 233 points in just 9 trading days. This gain was subsequently erased in just 8 market hours as the S&P 500 fell to 3350 on September 4. Much of this gain was not due to improving economic activity but instead was driven by a boom in call option buying. This discussion is intended to explain how this developed, if you’re first thought is, “How is that possible?”
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This boom in option trading is also why the S&P 500 fell so quickly, after Apple and the other major Mega cap stocks began to reverse lower on September 2 and then lost 5% on September 3.
When the economy was shut down in March and April, there was a surge in new accounts at Schwab, ETrade, and other brokerage firms.
Millennials and others stuck at home, had time on their hands, had just received at $1200 check from the government, and decided to invest in the stock market. Millennials as a group were already using Amazon to do much of their shopping and their Apple phone to make payments.
The problem they and other investors faced was that the price of Amazon’s and Apple’s stock was expensive, so they searched Google to learn about trading options.
A call option gives an investor the option to buy a stock at a future time and price, but requires a small amount of money compared to the actual price of the stock. After opening their account and learning about buying call options, this new wave of investors began trading and the amount of day trading soaring by fivefold.
After soaring 35% in July from June, the value of the call options purchased exceeded the dollar amount of the actual stocks being traded on exchanges.
Option traders have increased their focus on individual stock options that expire in less than two weeks, even though there are options that extend many months into the future. The volume of call options with less than 2 weeks to expiration more than doubled in July from June.
Options that expire in less than 2 weeks represented 75% of total option volume in July and was likely higher in August. The amount of net call buying (call volume minus put volume) as a percent of total NYSE volume averaged a little over 2.0% from 2001 through 2017. After picking up in 2018 it has soared to almost 12% of NYSE volume.
The monthly average (22 day average) of option volumes on all the exchanges held steady from 2007 thorugh 2019 but has exploded by 60% in 2020.
The concentration of call buying pushed the Put/Call ratio to its lowest level since 2000 indicating a high level of bullishness.
The connection between the big increase in call buying and the run up in the big Mega cap stocks, and other companies that have thrived during the Pandemic is straight forward. When an investors buys a call option, the dealer who sells the call option is effectively short the stock. To hedge the option position the dealer will buy the stock or use strategies to hedge the risk. As call option volume soared in recent months it created a demand in the underlying shares, which lifted those stock prices and increased the value of the call option purchased by the investor.
The quick profits that accrued to the new option traders paved the way for an increase in more speculation and more call option buying. This demand feedback loop accelerated in recent weeks and caused the Nasdaq 100 and the S&P 500 to ramp higher, even though most stocks continued to seriously lag behind.
As individual stock volatility spiked higher dealers were inclined to hedge the rising level of individual stock volatility by buying the volatility index (VIX). Normally, the VIX declines as the S&P 500 trends higher. It is unusual for the S&P 500 and the VIX to rise simultaneously. During the past decade the VIX rose on only 10 days when the S&P 500 was up by 1.0% or more. On Wednesday (8-26) and Thursday (8-27), the VIX was more than 5% higher each day, with the S&P 500 up both of those days. Since the VIX usually falls as the S&P 500 goes up, it is rare for the S&P 500 to record a new all time high with the VIX being above 20.
On September 2 the S&P 500 made a new all time and the VIX was the highest it has ever been.
On September 1 I discussed the correlation between the S&P 500 and the VIX in a piece mailed to clients entitled ‘One Way Street”, which included the chart below on the right:
“In recent days the VIX has been trending higher with the S&P 500 and the correlation between the VIX and the S&P 500 has reached levels that in the past were followed by decline a few weeks later or within a week. In the four prior instances there was a fundamental trigger for the decline. In February 2018 it was an employment report that caused the S&P 500 to fall -11.8% in 10 trading days and in the fourth quarter of 2018 it was concern about Fed policy 2 that led to a -20% drop. In May of 2019 as trade tensions with China bubbled over the S&P fell -7.6%. In 2020 the S&P 500 plunged -35.0% in a month.”
In the August 31 WTR entitled ‘Moving To The Exit’ I reviewed an email that was sent on August 26:
“When the S&P 500 was trading at 3472 on August 26 I sent an email with this message:
“The Nasdaq 100 is up 1.8%, S&P 500 up .83%, the equal weight S&P 500 is lower by -.22%, and the Russell is down 0.44%. The black trend line connecting the January 2018 high with the February peak comes in just above 3500 near 3525. Should be a good place to sell.”
With the email I included a chart of the S&P 500 highlighting the trend line connecting the high in January 2018 with the February 2020 peak.
The S&P 500 jumped above the trend line for less than an hour on September 2 and quickly reversed. As noted in the August 31 WTR:
“The S&P 500 traded up to 3514 on August 31 and could push a bit higher in the next two weeks. From a risk to reward perspective the S&P 500’s upside potential seems limited, while the downside could allow it to fall at least 10% sometime in the fourth quarter. The initial level of support is between 3350 – 3400 and will likely support any short term correction.”
The S&P 500 lost 238 points after falling from 3588 to 3350. A 61.8% retracement would bring the S&P 500 up to 3497. The S&P 500 is not expected to break out above the trend line which is near 3540. The S&P 500 found support on September 4 at 3350 as suggested in the August 31 WTR:
“If Congress does pass the next stimulus bill the S&P 500 may touch the trend line connecting the January 2018 and February 2020 near 3550. The odds of a top will increase if the S&P 500 closes below either 3350 or the low of any short term drop in the next week.”
The decline to 3350 and subsequent bounce off 3350 reinforces the importance of that level of support. The expectation is that the S&P 500 will break below 3350 and fall to near 3200 (blue trend line). Ultimately, the S&P 500 has the potential of falling to 2950 – 3000 in November. There is a chance that the results of the election will not be clear on November 4.
Bullish sentiment is widespread and the employment report has reinvigorated the expectation that a rotation to cyclical and value stocks is imminent. The rebound in the market today was led by cyclical stocks, which have lagged badly. Treasury yields jumped with the 10-year rising 0.099% to 0.721% and the 30-year rising to 1.47% after an increase of 0.129%. The increase in Treasury yields caused the yield curve to widen, so bank stocks were strong. An increase in spreads helps banks but, as noted in the September Macro Tides, banks have increased lending standards, which suggests the volume of loans won’t grow much:
“In the second quarter banks significantly increased lending standards for every type of credit. A whopping 71.2% of banks increased lending standards for Commercial loans for large and median sized firms and 70% for small companies. Lending standards for consumer loans were also ramped up with 71.7% of the banks raising standards on credit cards and 55.4% for auto loans. While the Federal Reserve and Treasury are trying to push more money into the economy, banks are pulling back on credit availability.”
Banks make more money when they make loans and their profit margin on existing loans doesn’t increase as spreads widen. The Nasdaq 100 bounced 4.3% off its intra-day low after losing -10.4% in 8 hours.
Whether the S&P 500 falls to 3220 or 3000 may be determined by the extent cyclical stocks hold up as the market undergoes a deeper correction.
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