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Why All Hope Isn't Lost: A Technical Perspective

Historically, the SPX has outperformed after snapping a five-month win streak

by 8/2/2014 9:30:59 AM
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It was a tough week for the Dow Jones Industrial Average (DJI) and broader S&P 500 Index (SPX), which -- after Thursday's massive sell-off -- closed out the week at their lowest levels since late May and early June, respectively. In fact, the SPX suffered its worst weekly loss in more than two years. With the bulls licking their wounds, Todd Salamone points out key technical levels that remain intact on the major indexes, while expressing caution about the current sentiment backdrop.

  • A look at a few potential layers of technical support
  • The uncommon, yet important, moving averages on our radar
  • What to expect after the SPX snapped its monthly win streak

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

Notes from the Trading Desk: Key Technical Levels Still in Play
By Todd Salamone, Senior VP of Research

"With round numbers in play as potential speed bumps, one group that recently turned optimistic -- and has for the most part had a poor timing record -- is equity option players ...This group just reached an optimistic extreme again ... the 10-day, equity-only, buy (to open) put/call volume ratio recently hit a multi-month low of 0.44, but has turned higher to 0.49. When this ratio turns higher, as it is now, the market becomes more vulnerable than usual to a short-term pullback. But as we've said numerous times, we'd expect pullbacks to be shallow."
-Monday Morning Outlook, July 4, 2014

"The SPX just barely eked out a new all-time high on Thursday, but the 1,980-2,000 area still lingers overhead as potential resistance. The 1,950 area continues to act as the bottom of the index's recent range ...The Wilshire 5000 (W5000 - 20,907.17) and NYSE Composite Index (NYA - 10,985.81) are both trading near important round-number areas of 21,000 and 11,000, respectively. Both indexes still contend with their previous 2014 highs made in early July as well. Until we see a more significant breakout, these round-number hurdles remain in place ... While the SPX's current RSI isn't overbought, it has clearly signaled a bearish divergence."
-Monday Morning Outlook, July 26, 2014

"$DJIA clearly in YTD negative territory, following $RUT move back into red on 7/10...$MID next? 1,342.53 is YTD B/E, currently 1,359."
-@ToddSalamone on Twitter, Aug. 1, 2014

As we cautioned at the beginning of July, with overhead round numbers on multiple equity benchmarks "in play" as potential resistance, just as "wrong-way" equity option traders had turned optimistic, the market became vulnerable to weakening price action. The Russell 2000 Index (RUT - 1,114.86) has again taken the most punishment, following two corrections already this year, beginning in January and March, measuring roughly 7.5% and 10%, respectively.

As of Friday's low just above the round-number 1,100 area, the RUT had corrected 7.2% in the month of July. Meanwhile, the Dow Jones Industrial Average (DJI - 16,493.37) slipped back into the red for 2014, after closing below the 16,576 level in Thursday's trading. Elsewhere, the S&P 400 MidCap Index (MID - 1,367.20) finally broke below round-number support at 1,400. Bulls hope the MID can remain above its next major support level at 1,342, its 2013 close (Friday's low was 1,356).

Moreover, the S&P 500 Index (SPX - 1,925.15) slipped below anticipated support at the 1,950 half-century mark, with Friday's low the site of its 80-day moving average in the 1,920 area. With 10%-20% correction calls growing on the heels of another sell-off, amid a litany of negative headlines (more sanctions against Russia, Argentine debt default, Middle East tensions, financial troubles at a major bank in Portugal, and economic data suggesting the Fed could raise rates sooner than anticipated), the SPX has so far eluded the much-anticipated 10% correction, with only a 3.8% pullback from its all-time intraday high on July 24 to Friday's low.

At present, we continue to think that SPX pullbacks are likely to be moderate, no different than pullbacks we have seen during the past few months. While it was disappointing to see the 1,950 level break, we were encouraged to see the SPX's 80-day moving average hold Friday's low, a trendline that has marked previous lows from time to time during the past few years. Even if the 80-day moving average breaks, the SPX's 120-day moving average sits just below at the round 1,900 level. As you can see on the chart below, since early 2013, this trendline has marked numerous troughs, as it has coincidentally come into play around half-century and century marks. Even though the SPX broke below the more popular 50-day moving average again this week, such breaks have proven to be more bullish than bearish since 2013.

Daily Chart of SPX since April 2013 with 80-Day and 120-Day Moving Averages

Continuing our focus on uncommon, yet important moving averages, we bring your attention to the RUT's 320-day moving average -- currently situated near 1,100, a round-number area that marked the lows in February and May.

The RUT's 320-day moving average marked bottoms in July/August 2010 and November 2012, and a significant break of this moving average in 2011 led to further declines. One difference between now and 2012 is that the RUT quickly found support at its year-to-date (YTD) breakeven level of 740 after a break of this trendline in June 2012, whereas now the RUT is below its YTD breakeven mark of 1,163. Then again, one similarity at present with 2010 is that this long-term moving average coincided with the round-number 600 area in 2010, whereas 1,100 is the round number in 2014 that has been supportive.

Daily Chart of RUT since May 2010 With 320-Day Moving Average

The bottom line is that from a technical perspective, there is still potential support on the key indexes that we track.

That said, we still are not all that enthused about the short-term sentiment backdrop. For example, the equity-only, customer-only 10-day buy-to-open put/call volume ratio is only at 0.52, up from the recent low of 0.44, but still below peaks in this ratio that have ranged between 0.55 and 0.60 at major short-term bottoms. We have found that roll-overs from high levels present the best buying opportunities. A roll-over from the current level would likely lead to a rally with minimal upside, as recent highs act as resistance.

10-Day Buy-to-Open Put/Call Volume Ratio with SPX Since 2013

Another sentiment risk at present for the bulls is that after CBOE Market Volatility Index (VIX - 17.03) expiration a couple of weeks ago, total call open interest stands at 6.8 million contracts, below the pre-expiration peak levels of around 8 million contracts in May, June, and July. With VIX call volume picking up in recent days amid market weakness, and the VIX more than 50% above its recent closing low of 10.32 (implying hedgers are willing to buy portfolio insurance at any cost), a continued build in VIX call open interest could be an added headwind in the absence of an immediate rebound in equities.

If the VIX closes back below 15.48, which is 50% above its July 3 low, it would increase the probability of a short-term trading rally, as this would suggest that demand for portfolio insurance is finally deteriorating. Strong demand for portfolio insurance can be a coincidental headwind, as sellers of the insurance will likely hedge by shorting SPX futures. That said, the fact that many investors have insurance in place can also serve to keep pullbacks relatively muted, as headlines like we have seen lately will likely lessen the odds of panic sellers dominating the market. For now, however, with portfolio demand and "volatility" in favor, one cannot rule out a 20-21 VIX reading, which is double the July low.

VIX Daily Open Interest Since January 2014

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