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Ride Out the Short Term for the Next Major Market Surge


The short term could be choppy, but the next major move is likely higher. Here's why.


Meanwhile, the S&P 500 Index (INDEXSP:.INX) ran into last month's highs in the 1,470 area before sellers overcame buyers on Friday, keeping the broader index about 5% below its all-time high-water mark. Finally, the CBOE Market Volatility Index (^VIX) is struggling to take out its calendar-year "half-high" in the 13.33-13.80 area, after bouncing from this level on Friday for the third time since late August.

With major benchmarks trading at or near their respective highs, price action at present suggests we could be in for some choppy action, at least until we see some resolution among the four Es looming over the marketplace at present.

Like last quarter, investors are approaching earnings season with low expectations, which increases the likelihood that lackluster reports and negative earnings growth are baked into the market. In fact, the ratio of negative pre-announcements to positive pre-announcements is near the ratio that existed in the first quarter of 2009, another sign that bad news may already be factored into stocks.

The good news for bulls is that many have missed this rally and still have little net exposure to the market, so pullbacks to previous breakout areas could be met with buyers, such as those in the hedge fund community. Signs that hedge funds have little exposure to the market are evident in the options market and in short-interest data. For example:

1. Hedging activity is relatively small among those that use exchange-traded funds (or ETFs) to hedge long positions. This is evident in the combined ratio of put buying to call buying on the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), the iShares Russell 2000 Index Fund (NYSEARCA:IWM), and the PowerShares QQQ Trust (NASDAQ:QQQ) during the past month. Our theory is, when the ratio is low, there is little equity exposure to be hedged and therefore, little put buying relative to call buying.

While such caution among fund managers can be a negative in the immediate term (since they are the market movers), it also suggests there is enough fire power to push indices through their respective resistance levels once any uncertainty is resolved. In fact, the fire power might be equivalent to that of early 2009, given how low the ratio is (see the chart below).

2. Short interest continues to rise, even on stocks that may be deemed "high quality" or defensive. For example, short interest on SPX component stocks again ticked higher in the most recent reporting period, and is barely below the peak levels of last year that preceded a major rally in equities. The current high level of short interest is indicative of the pessimism that exists, and is likely contributing to the net low exposure to equities among hedge fund managers.
No positions in stocks mentioned.
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