The S&P Pattern No One's Talking About

The market's ability to 'hold up' as investors have grown more cautious suggests a favorable environment for bulls

by Todd Salamone

Published on Aug 3, 2015 at 9:06 AM
Updated on Jun 24, 2020 at 10:16 AM

"Amid a couple of obvious risks (a VIX pop from low levels and SPX trading at chart resistance), the sentiment backdrop continues to be supportive of a breakout to new highs ... An interesting scenario would be the SPX pulling back to the 2,070-2,075 area during the next couple of weeks. If this occurs, it would be a 61.8% Fibonacci retracement of the early July low and last week's high. If this area was to mark a trough, it would also set the stage for a bullish 'inverse' H&S pattern. Given that caution has reigned supreme, we have noticed that bearish H&S patterns have been more recognizable and acted upon than the bullish inverse H&S patterns."

-- Monday Morning Outlook, July 20, 2015


After the S&P 500 Index (SPX - 2,103.84) closed at 2,126 on July expiration, I mentioned a couple short-term risks that could result in a short-term pullback, with one scenario being a pullback to the 2,070-2,075 area. Just one week later, last Monday, the SPX found itself trading around this area of support, from which the index mounted a rally through the rest of the week. 

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"The fact that fewer stocks are joining the rally is a sign of investor unease, Mr. O'Rourke said. Prior market peaks -- including the 2000 top -- were accompanied by a similar pattern of a shrinking handful of large-cap stocks pulling ahead, he said."

-- The Wall Street Journal, July 22, 2015

With the SPX trading in its support zone, I observed on Twitter that my comments from a week earlier were coming into play, as a hold at the support area would set up the potential for a bullish "inverse" head-and-shoulders (H&S) pattern on the SPX. Most interesting about the potential for this bullish technical set-up to develop is that no one is talking about it. Instead, we continue to see warnings about bearish H&S tops and, most recently, warnings about weak market breadth.

Amid an environment in which caution has reigned, it isn't a big surprise to see technical warning flags receive most of the attention, as technical patterns will generally be more recognizable and accepted when a bias exists. Arguably, there has been a cautious-to-negative tone among many technicians, who continue to seek the elusive "10%" correction. Obviously, the 9.8% pullback last fall doesn't qualify -- but what if you round up, since we are only talking about roughly 4 SPX points?

That said, last week's hold at support keeps alive the possibility of the bullish inverse H&S pattern developing, per the chart above. A breakout above the "neckline" in the 2,130 area would complete the pattern, setting the SPX up to move to 2,215 over the intermediate term.

Also of interest is how round year-to-date (YTD) percentage gains continue to be crucial short-term pivot points on multiple equity benchmarks and indexes. The Nasdaq Composite (COMP - 5,128.28), for example, peaked at its 10% YTD level just after July expiration. But at last week's low, as the SPX was trading in its support zone, the iShares Russell 2000 ETF (IWM - 122.96) and Russell 2000 Index (RUT - 1,238.68) were trading at their 2014 close, or YTD breakeven points. This was also around their respective 200-day moving averages, and buyers finally stepped up.

The Google Finance graphs below present a nice picture of what we have observed. Going into this week's trading -- and from a round-number YTD percentage gain perspective -- the Dow Jones Industrial Average (DJIA - 17,689.86) is not far below its 2014 close of 17,823, which is a level to watch for clues as to whether or not a breakout in the range-bound SPX is imminent. 

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Given the range behavior being exhibited, equity benchmarks run the risk of re-testing former lows during the dog days of the seasonally weak August. If stocks pull back, we see potential support for the SPX at 2,070, while the early July lows of 17,500 on the DJIA could be supportive, with risk down to 1,485 on the S&P 400 MidCap Index (MID - 1,502.89). However, the sentiment backdrop indicates that declines will be minimal relative to the upside potential, unless negative sentiment extremes go through the roof.

We see more reward than risk, given how sentiment has changed since the onset of the trading range, which began in late February. The table below lists the readings of some of the sentiment indicators that we follow, comparing late-February numbers to current ones. Clearly, the evidence points to more buying power now, versus late February. Given that the market has "held up" as market participants have grown more cautious, we think the next major move from this range will be to the upside. A different view would prevail if the market was spinning its wheels, and evidence suggested market participants increased exposure and became more optimistic.

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Finally, as we discussed a couple of weeks ago, pessimism among option speculators reached an extreme recently, but this pessimism is now unwinding, as the buy-to-open put/call volume ratio declines from its peak. Historically, bullish market environments have occurred when this ratio declines from extreme highs, as we are witnessing now -- per the graph immediately below.

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