I $SPY With My Little Eye, Lower Highs

by Dan June 30, 2016 3:10 pm • Commentary• Trade Ideas

It seems like a lifetime ago but on Friday the S&P 500 (SPX) was in an all out free-fall in the aftermath of the UK Brexit vote, closing down 3.6%.  I had some fairly specific commentary (MorningWord 6/27/16: How’s That Working Out For You? Being Clever?) about large cap U.S. stocks on Monday morning, expecting follow through, but fully acknowledging the potential for a sharp bounce:

Maybe there is some tape-bomb that causes a short squeeze back to 2100 in the SPX. But as some focus turns to U.S. corporate earnings, U.S. multi-nationals aren’t going to get the same mulligan they got during Q2 results. Q3 guidance is going to be atrocious with all that’s happening, and the lofty $120 S&P 500 earnings estimate for 2016 will be nothing short of wishful thinking.

As I said on Friday the worst case scenarios in the near term following Brexit were not likely to rock U.S. markets or our economy:

The likelihood of financial contagion spreading to the U.S. is not that high if some European banks have their equity wiped out. It won’t be pretty, but not really contagion. But emerging market banks are another story altogether. And that feedback loop would bring a second wave of volatility to the U.S.. In other words, de-coupling is nonsense.

I have been nothing if not consistent (some would call stubborn) that the path of least resistance for the SPX is no longer higher, and there have been some notable technical developments in the last 18 months that embolden my view that the next major move in the SPX will be lower:

The two lower lows in the SPX since the May 15th high is significant, but more so was the February low, the first lower low in the SPX since the start of the bull market in March 2009 that has yielded 200% plus gains.  There is a clear technical change in place from the years of QE induced gains for the SPX:

SPX since Jan 2014 from Bloomberg

SPX since Jan 2014 from Bloomberg

Monday, the SPX closed at the nice round number of 2000, down a whopping 5% from Thursday’s pre-Brexit vote result’s close. On Tuesday morning (MorningWord 6/28/16: Eyes Wide Shut) I had the following to say about the world’s largest equity index’s 2 day decline, its relative strength to almost every other equity market the world over and how it may trade if Fed policy becomes more dovish:

If the Fed is forced to get (more) unconventional, it’s not good for the SPX. While the SPX has shown tremendous relative strength to most major global equity markets over the last year, remember that a large component is that others have already gone negative on interest rates. Trillions of dollars of sovereign debt now a have negative yield (Europe & Japan). And although no one knows the what’s a correlation or a causation, we do know that their equity markets act the worst, both down 25% from their 52 week highs.

Despite the perceived relative strength in the SPX, its inability to make a new high since its all time highs in May 2015 suggests the path of least resistance is no longer higher. Lower rates here in the U.S. could spell new 52 week lows for the SPX in the back half of the year. Yesterday’s close at key technical support puts a target on 2000, and what lies beneath is an air-pocket to 1900. Watch that level closely:

From Bloomberg

From Bloomberg

No matter how you look at the SPX, it’s a crowded trade. And whether it’s a less than constructive technical set-up, a confused FOMC, or something from overseas, it’s already hinted at its vulnerabilities for those with their eyes wide open.

So we failed below the prior lows, where I would have expected us to, bounced at a level that the world saw as support and are now very likely to flll in the entire Brexit decline.

So what I am going to say next is not going to surprise you, but 2100 (give or take a percent or so) feels like a good short entry or a spot to slap on some large cap equity protection in the SPY, the etf that tracks the SPX.

Short dated option prices have declined hard in the SPY, with 30 day at the money implied volatility back in the low teens, down from 20.50% on Friday, but still up a few points from its early June 2016 lows.

From Bloomberg
From Bloomberg

So here is where I am now on the SPX (using the SPY).  I think the rally is rejected soon. I think 2000 has a massive near term target on it. I think there is an air-pocket back towards the $185 level where the Index made closing bottoms very near in August, September January & February:

From Bloomberg
From Bloomberg

Those are the levels I want to target, as I see a strong likelihood of a re-tracement at some point this summer.

SO what’s the Trade?  

*Trade: SPY ($209.15) Buy Sept 210 / 185 put spread for $5

-Buy 1 SPY Sept 210 put for $6.25

-Sell 1 SPY Sept 185 put at $1.25

Break-Even on Sept Expiration:

Profits: of up to $20 between $205 and $185 with max gain of $20 below $185

Losses: up to $5 between $205 and $210, with max loss above $201.

Rationale: This trade risks 2.4% of the underlying etf price, offers nearly 10% protection with a break-even down 2% from current levels.  The trade is nearly $1 in the money, which helps offset some decay over the course of the summer.