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Escalating Optimism and What It Could Mean for March Is the market due for a short-term breather? by Todd Salamone 3/2/2013 9:25:21 AM

Despite the "sequester" standoff in Washington, D.C., the major market indexes edged higher for the second week in row, as Congressional gridlock seems to be par for the proverbial course. And speaking of more of the same, Todd Salamone examines the similarities between the current quarter and a year ago, and explains why the current sentiment backdrop could point to short-term speed bumps. In the same vein, Rocky White tries to gauge what to expect in March, and what escalating optimism could mean for an historically bullish month.

The next hurdle for the SPX
The key level to watch for the market's "fear barometer"
What the past two months could tell us about the future

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Potential Short-Term Warning Signs?
By Todd Salamone, Senior V.P. of Research



"The momentum, short-covering potential, round numbers, and a recent surge in buying from institutional players -- evident by record-setting CBOE Market Volatility Index (VIX - 13.02) call buying -- are at the top of the radar for us. On one hand, should the market track higher on the heels of continued short covering, it wouldn't be a major surprise. On the other hand, it wouldn't be a huge surprise if the market stalls or experiences a pullback of note from round-number resistance."

-[url=]Monday Morning Outlook[/url], February 9, 2013



"SPY 5% out-of-the-money (OOTM) put implied volatility is high relative to OOTM call implied volatility ... An option pricing disparity like this has preceded a volatile trading range or correction since 2011 ... a break below the 30-day moving average and 1,500 would likely spell looming turbulence, given the short-term sentiment backdrop has swung toward optimism and a technical breakdown could drive recent buyers out of the market."

-[url=]Monday Morning Outlook[/url], February 23, 2013



"Yesterday's VIX close was more than 50% above recent VIX low of 12.32 ... 50% above prior low capped multiple advances last year"

-SchaeffersResearch.com, February 26, 2013



"Dow 14k again... 12 of 18 trading days have seen 14,000 mark touched since Feb. 1, and only four of 17 closes above 14k"

-[url=]@ToddSalamone on Twitter[/url], February 27, 2013

During the past few weeks, we have emphasized the fact that short-term optimism was fueling a market rally, but as multiple benchmarks approach round-number levels -- particularly 14,000 on the Dow Jones Industrial Average (DJIA - 14,089.66) and 1,500 on the S&P 500 Index (SPX - 1,518.20) -- the market could be due for a pause or pullback.

In impressive fashion, the market has grinded higher, nonetheless, but in a very choppy fashion, with historical volatility on the SPX rising from its Jan. 31 low of 5.54 to its current reading of 12.85. In fact, the SPX just experienced its first notable pullback of the year, a near 3% decline from Feb. 19 to Feb. 25, as European worries began festering again. So far, the sell-off has been short-lived, as an impressive rebound occurred, even ahead of the March 1 automatic spending cuts that are expected to trim gross domestic product (GDP) forecasts.

If the February action in the Dow is indicative of what is on deck in the coming weeks, you can expect a range-bound market. Since first hitting 14,000 on Feb. 1, the Dow has touched the round-number 14,000 level in 13 of 20 trading sessions, as of Friday.



Another theme we have been discussing is how the price action in the first quarter of this year has practically followed the same script from last year's first quarter: a low-volatility uptrend fueled by short covering. In both instances, the SPX found support at uncommon moving averages, such as the 15- and 30-day trendlines. In fact, in late February/early March 2012, the SPX experienced a 2% pullback, somewhat of the magnitude of the pullback we just experienced.

This past week, the SPX closed below its 30-day moving average, which could be an early warning sign of an impending decline. As you can see on the SPX's 2012 chart below, in April, the SPX experienced a significant close below both its 30-day moving average and the round-number 1,400 level, and quickly bounced back during the next three weeks. It took out 1,400, but never exceeded the prior 2012 highs. A correction soon followed.



Similarly, per the 2013 daily chart below, the SPX has quickly bounced back from last week's close below its 30-day moving average and the round-number 1,500 mark. In fact, the SPX has cleared 1,500, but has not yet cleared its 2013 highs. That said, a move above 1,530.94 by the SPX would break the pattern we witnessed in 2012, and likely lead to a continuation move higher. However, if the SPX penetrates below last week's trough at 1,485 -- which happens to be the site of its 40-day moving average -- this could signal more downside if the 2013 market continues to behave in similar fashion to last year's.



The CBOE Market Volatility Index (VIX - 15.36) peak last week is also on our radar. As we observed on Twitter, there were multiple peaks last year in the area that was 50% above the prior low. While this is not a hard-and-fast rule for all VIX advances, of course, the explanation behind this tendency could be "anchoring" that takes place after such pops. In other words, those looking to purchase portfolio insurance might view index put options as too expensive, as conscientious buyers anchor to the percentage increase in portfolio insurance from a previous low. Or, those making bets on higher volatility via the purchase of VIX calls or futures might back off, as they view the 50% volatility pop as "running its course."

If this thinking is prevalent after such VIX pops, the purchase of index put options and volatility futures and call options may suddenly dissipate, removing a coincidental market headwind. With the VIX immediately reversing back below the 50% marker above its 2013 nadir, bulls should be encouraged.

As we look ahead to next week, the VIX is trading in an area that is a 50% retracement of last week's high and the 2013 low. Bulls should be encouraged by the potential downside back to the 2013 low, but be on guard if the VIX experiences another sharp advance through the 50%- above-2013-low area.

The short term is still a toss-up in terms of direction, as traders remain trigger-happy to buy pullbacks and the SPX is still on sound technical footing. But short-term sentiment measures are around levels that have historically preceded trading ranges or pullbacks, as small-caps have noticeably underperformed on the recent snap-back rally, and the S&P 400 MidCap Index (MID - 1,098.15) is back below 1,100. The market tends to be strongest when leadership is coming from the small- and mid-cap groups.

The intermediate-to-longer-term outlook continues to look rosy for bulls, as some skeptics continue to be sidelined by a low VIX, low volume, and retail inflows into equity funds in 2013. Our response to these concerns: Fears of low volume have been voiced since the market bottom in 2009, low volatility can persist for years, and recent inflows into equity funds are peanuts relative to the outflows in prior years.