Stocks - How Long Can The Rebound Last?

by: Andrew Hecht

Stocks make a comeback.

A deal with Mexico could boost short-term optimism.

The Fed-induced rally.

The VIX is hanging in there.

VIXY has declined and could offer protection against a return of risk-off conditions.

Sell in May and go away did not work this year, so far. May was an ugly month, but June has brought a powerful rally in the stock market. Last week, the E-Mini S&P 500 futures contract demonstrated how strong the price action in stocks has been.

Source: CQG

As the chart highlights, the futures contract put in a bullish key reversal on the weekly chart for the week of June 3. While the price action came on only average volume, which is a cautionary sign from a technical perspective, the jury is still when it comes to the sell-in-May-and-go-away strategy. We will need to wait until the Labor Day holiday to see if taking a break for the summer with no long positions in the S&P 500 was a brilliant or stupid idea.

Meanwhile, on June 13, the VIX index was at just under the 16 level. With stocks roaring to the upside, the volatility index should be lower, but it is not. The ProShares VIX Short-Term Futures ETF product (VIXY) tends to move higher when the S&P 500 falls. The stock market was looking great on June 10, which could mean it is the perfect time to fasten our seat belts again as the market has been on a wild ride since October 2018, and it has gone nowhere fast when it comes to making a new high.

Stocks make a comeback

After hitting a low on June 3, stocks have made a comeback.

Source: CQG

As the daily chart shows, the E-Mini S&P 500 futures contract rallied from a low at 2728.75 on June 3 to the most recent peak at 2911.50 on June 11, a rise of 6.7%. The futures were just below the 2900 level on June 13. However, the price action over the recent sessions could be a sign that stocks are running into selling as they approach the highs from May 1 and last October. There seems to be congestion at the 2900 level on the futures contract. Both price momentum and relative strength on the daily chart have risen to overbought territory and while stocks made a new high on Tuesday, June 11, they closed the session closer to the lows of the day.

A deal with Mexico could boost short-term optimism

The most recent selling in the stock market came on fears that US protectionist policies were spreading from China to Mexico. The ongoing trade dispute between the US and China is over leveling the playing field when it comes to commerce. Meanwhile, the threat of tariffs on Mexico began as a ploy to increase cooperation with the United States' neighbor to the south over immigration and the flow of illegal drugs across the border. When the US and Mexico agreed to a deal that avoided the tariffs, the stock market took off on the upside. The agreement likely sparked some optimism that the summit between President Trump and Xi in Japan on June 28 and 29 could lead to a similar outcome. However, the latest reports from the Chinese state media have been that President Xi is thinking of backing out of the talks, which could lead to rising volatility as pessimism over US-China trade increases again. The situation with Mexico diverted the attention from China, but with the potential of the summit approaching, concerns will likely rise over the coming days and weeks.

The Fed-induced rally

Another factor that boosted share prices over the past days was the increased potential for rate cuts by the US Fed. President Trump has not been shy about his criticism of the central bank saying that the Fed's rate hikes have been "destructive" to both the economy and his administration's initiatives to level the playing field on trade with the Chinese. With the Fed meeting next week, the President ramped the pressure via Twitter on June 11.

Source: Twitter

The Trump administration would like to see the Fed reduce the short-term Fed Funds rate by 50 basis points to send the dollar lower and stock market higher. The most recent statements from Fed officials and the latest economic data have told the markets that the President may get his way as there is now a consensus that rates will move at least 50 basis points lower by the end of 2019. The potential for interest rate cuts added additional fuel to the stock market over the recent sessions. On Wednesday, June 12, legendary trader Paul Tudor Jones said that now is the time to buy stocks as the Fed will be cutting interest rates.

The VIX is hanging in there

As stock prices rose in early June, the VIX index declined but remained at an elevated level compared to the last time the E-Mini S&P 500 futures contract reached the 2900 level.

Source: Barchart

The chart shows that when the E-Mini reached over the 2900 level in September 2018, the VIX reached a low at 11.10. In April, when the E-Mini traded above the level once again, the low in the VIX was at 11.03. However, this time, the volatility index has remained at around the 16 level which is a sign of concern from the market and could be a signal that we are on the verge of another downside correction. With the many issues facing markets these days, including the trade dispute between the US and China, the level of the VIX makes sense. A significant move to a new high above the 2961.25 level on the E-Mini futures contract may be necessary to send the VIX back to lower levels. The VIX has moved from a high at 23.38 on May 7 to 15.74 on June 13, a drop of 32.7%. At the same time, at that level, the VIX is 42.7% higher than the April 17 low.

VIXY has declined and could offer protection against a return of risk-off conditions

While the VIX remains elevated, compared to its April low, the ProShares VIX Short-Term Futures ETF product has declined from the May high.

Source: Barchart

The chart illustrates that VIXY at $22.57 per share is 17.5% below its high, which came on May 9, and 10.4% above its low from April 23. The VIXY product underperformed the VIX on the upside and outperformed on the downside on a percentage basis from its recent high and low.

A sudden spike to the upside in the VIX if stocks fail at above the 2900 level again on the E-Mini should lead to a higher price for the short-term VIXY product. Timing is everything when it comes to VIXY, and it is only appropriate for short-term positions. When I buy this product, I employ both a price and a time stop. The fund summary for VIXY states:

The investment seeks investment results, before fees and expenses, that over time, match the performance of the S&P 500 VIX Short-Term Futures Index for a single day. The index seeks to offer exposure to market volatility through publicly traded futures markets and is designed to measure the implied volatility of the S&P 500 over 30 days in the future.

The top holdings of the ETF include:

Source: Yahoo Finance

Since VIXY holds VIX futures, it does a reasonable job replicating the price changes in the index that measures price variance in S&P 500 stocks. VIXY has net assets of $244.82 million and trades over 2.2 million shares each day on average. The expense ratio for the product is 0.87%.

It looks like the stock market could be running into selling at a familiar level, which could lead to another correction. If President Xi cancels his meeting with President Trump, or there is no progress on trade if the meeting occurs, we could see pessimism in the stock market intensify. Meanwhile, the next significant event for the stock market will be next week's Fed meeting. An interest rate cut could propel stocks higher, which would be an opportunity to buy the VIX and VIXY on a spike lower. The VIX is telling us not to be too complacent with the stock market as many issues could cause another correction in the blink of an eye.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.