The market is jumpy based on several variables … what we can learn by watching how Wall Street traders are positioning themselves … what technical indicators are telling us
We’re “just about there.”
So said House Speaker Nancy Pelosi yesterday, referring to the likelihood of agreeing on a new stimulus deal:
If we were not making progress, I wouldn’t spend five seconds in these conversations …
This is not anything other than I think a serious attempt. I do believe that both sides want to reach an agreement.
Wall Street rallied on the comments, turning yesterday morning’s losses into gains.
As our technical experts, John Jagerson and Wade Hansen, wrote in their latest Strategic Trader update, Wall Street traders are hopeful — hedging themselves, but hopeful nonetheless.
What exactly are John and Wade seeing that’s giving them this perspective?
From John and Wade:
If you want to know what traders are thinking, you have to look at where they are putting their money.
So, where are traders putting their money?
Traders are taking their money out of Treasurys, putting it into equities and then hedging their equity positions.
Today, with the market sensitive to the passing of a stimulus bill, the outcome of the upcoming election, and any developments on the pandemic front, let’s see what signals the pros are looking at to help them with short-term market direction.
***What we can learn from U.S. Treasury yields
For newer Digest readers, John and Wade are the analysts behind Strategic Trader.
In their service, they combine options, insightful fundamental and technical analysis, and market history to trade the markets, whether they’re up, down, or sideways.
In their update from Wednesday, they began their market analysis by looking at what Treasury yields are indicating about the market — specifically, how Wall Street traders feel about stocks.
You can tell traders are starting to take money out of U.S. Treasurys because Treasury yields are starting to rise.
You see, Treasury prices and Treasury yields have an inverse correlation. When Treasury prices rise, Treasury yields fall. Conversely, when Treasury prices fall, Treasury yields rise.
When we see Treasury yields rising, we know that traders are selling Treasurys — which pushes the price of Treasurys lower as demand decreases.
Looking at the chart of the CBOE 10-Year Treasury Note Yield Index (TNX) in Fig. 1, you can see that the TNX has climbed to 0.81%, its highest level since early June.
Fig. 1 — Daily Chart of the CBOE 10-Year Treasury Note Yield Index (TNX) — Chart Source: TradingView
John and Wade then tackle the question of why traders are getting out of Treasurys.
In short, the answer boils down to fear of inflation.
When traders believe inflation is going to rise, they require a higher yield on their investments to compensate them for the threat of that rising inflation. That’s because higher inflation diminishes the future spending power of bond profits.
John and Wade point toward early June to see what this looks like on a historical basis:
Treasury yields spiked because the May employment numbers were shockingly good …
This was great news for the U.S. economy because more people were going to have more spending money in their pockets. At the same time, more spending money in the economy meant there was a risk of higher levels of inflation in the future.
This increase in perceived inflation risk caused traders to push the TNX up to a high of 0.96% on June 5.
John and Wade tell us that the TNX today is showing us that traders are pushing yields higher once again as they worry about inflation — this time courtesy of a new government stimulus package.
After all, more stimulus means more dollars, which has a devaluing impact on those dollars.
***So, what are traders doing with the money freed up from Treasury sales?
Putting it into stocks.
John and Wade tell us that much of the money that is coming out of the Treasury market is finding its way into the equity market:
Even after some profit-taking in September, the S&P 500 (SPX) is still within 4% of its all-time high (see Fig. 2).
Fig. 2 — Daily Chart of the S&P 500 (SPX) — Chart Source: TradingView
The fact that the S&P 500 is consolidating within the up-trending channel it has been in for the past six months shows traders are still confident in the future of the index.
***Despite this confidence, traders are hedging themselves
We can see this by looking at the VIX versus the VIX3M.
When measuring trader sentiment, most investors tend to focus on the CBOE S&P 500 Volatility Index — the VIX. It’s a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days.
But we can also look beyond 30 days. When traders want a longer-term outlook, they can reference the CBOE S&P 500 3-Month Volatility Index — VIX3M.
As its name suggest, it’s a measurement of the anticipated volatility being priced into S&P 500 options for a three-month time frame.
Here’s John and Wade for more:
Because these volatility indexes measure the magnitude of the price movement traders believe the S&P 500 may make during the measured time frame, the value of the VIX3M is usually higher than the value of the VIX.
After all, if you give the market three months to make a move — like the VIX3M measures — instead of just one month — like the VIX measures — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short term than in the long term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.
To examine this relationship, John and Wade created a relative-strength chart of the indexes that divides the value of the VIX by the value of the VIX3M.
Most times, this chart will have a value less than “1.” That’s because the value of the VIX is usually less than the value of the VIX3M.
But during times of fear and market volatility, this reading will be greater than “1” because traders are more fearful about the next 30 days than three months out.
Where are we now?
Back to John and Wade:
According to Fig. 3, the VIX/VIX3M briefly crossed above one (Wednesday) morning.
Fig. 3 — VIX/VIX3M Daily Relative Strength Chart — Chart Source: TradingView
The VIX/VIX3M crossing above one tells us that traders believe short-term risk is high — even though their longer-term outlook is still bullish — and they are willing to pay to protect the long-equity positions in their portfolios.
***What are they buying to hedge their portfolios?
Many are buying put options.
From a very general perspective, a put option gains value as an associated, underlying asset falls in value. So, if stocks drop, a put option on those stocks will generally rise.
The opposite of this is a call option. Broadly speaking, a call option gains value when an associated, underlying asset rises in the market.
One way to see whether puts or calls has the advantage with Wall Street is by examining the Put-to-Call Ratio.
This is exactly what it sounds like. We look at the number of puts being bought, relative to the numbers of calls.
A ratio greater than 0.7 means that equity traders are buying more puts than calls (the baseline isn’t “1” as you might expect because there are usually more call-buyers than put-buyers). That means they’re taking a protective stance.
As I write Friday morning, the latest total Put-to-Call Ratio is 0.80.
This illustrates John’s and Wade’s takeaway that, despite overall bullishness, Wall Street is hedging its bets.
Bottom-line — there’s still plenty of strength behind this market, but Wall Street traders are signaling that we should prepare for shorter-term bumpiness.
Here’s the final word from John and Wade:
We think traders on Wall Street are being reasonable in their approach, and we plan to ride the bullish uptrend until there is a compelling reason to change our strategy.
Have a good evening,