Q2 STOCKS TO BUY

The Short-Term Trendline SPY Needs to Take Out

With sentiment still at a very negative extreme, bulls might be encouraged by indexes sitting atop round-number support

Senior Vice President of Research
Feb 22, 2016 at 9:53 AM
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"The SPY's price action looks similar to the September period … From a sentiment perspective, a relatively shallow decline from January's close would make sense, as there is not as much optimism to wash out."

-- Monday Morning Outlook, February 8, 2016

"With gold and bonds trading at potential resistance, the SPY experiencing a nasty decline to potential chart and options-related support the week prior to this week's standard February expiration, and perceived positive catalysts at the end of the week -- a trading rally is an increasing likelihood … [S]hort-term market sentiment is suggesting an extreme in fear that has marked bottoms in the past, leaving bears vulnerable to sharp, short-covering rallies. For example, the 10-day, all-equity, buy-to-open put/call volume ratio reached a multi-year high late last week, nearing the levels that marked the bottom of the bear market during the financial crisis and surpassing the level reached last fall."

-- Monday Morning Outlook, February 16, 2016


Indeed, bulls were presented with a significant rally last week, with the SPDR S&P 500 ETF Trust (SPY - 192.00) racking up strong rallies on Tuesday and Wednesday, following an impressive advance the prior Friday. In fact, SPY put together three consecutive days of 1.5% gains or better in the Friday-through-Wednesday period (Monday was a holiday). 

Moreover, as we observed the past couple of weeks, the price action in January/February continues to look very similar to that of August/September last year, when September marked a major short-term bottom. For example, SPY's 40-day moving average acted as resistance going into an eventual short-term double-bottom in September 2015 -- and this trendline acted as resistance again late last week, after another potential double-bottom occurred.

One difference between now and September is that expiration week this month experienced a strong advance, whereas last September's expiration week was a disaster for bulls. But if the broader similarities continue, and bulls can push SPY above resistance from its 40-day moving average, a potential target is $207 -- which is where it peaked just ahead of the sharp sell-off that began in late December. Note that SPY was unable to move above the $210 area in October and November last year, which was its level just ahead of the sharp August downturn.  

160222MMO1




As you can see immediately below, going back to SPY's inception in 1993, it has been a rare occurrence for the exchange-traded fund (ETF) to experience three consecutive daily rallies of 1.5% or more. Albeit a small sample size of only three occurrences, the good news for bulls is that bullish price action followed, per the table immediately below. 
 

160222MMO2

If you tune into the dates of the three previous signals, one occurred just months before the top in a bear market, another occurred in the middle of a correction, and the last signal occurred at the end of a correction within a bull market. The jury is still out as to whether we are in the middle of a bear market or at the end of a corrective phase within an ongoing bull market -- which is why we continue to advise longer-term investors to reduce equity allocations via avoiding the underperforming small-cap space, while keeping a portion of your capital in the larger-cap names.

Per the chart below, SPY has not yet experienced a monthly close below its 36-month (three-year) moving average, suggesting a glimmer of hope for bulls that we are in a bottoming-out phase.

160222MMO3


Going into this week’s trading, per the tweet above, multiple indexes are simultaneously trading just above round-number levels. With sentiment still at a very negative extreme, which we will discuss below, bulls might find it encouraging that we enter this week above support from these round numbers.


But with this market, there seems to always be a "however."  So beware: The Russell 2000 Index (RUT - 1,010.01) and Nasdaq Composite (COMP - 4,504.43) are sitting below levels that represent 10% year-to-date declines -- 1,022 and 4,506, respectively. Therefore, this is an area where bears may attempt to use this rally to press their positions. As such, bulls would like to see the RUT and COMP above these levels.

"Fund managers' cash in February rose to the highest level since 2001, higher than at any time during the 2008-09 bear market[.] This is bullish for equities ... Allocations to US equities remain at an 8 year low..."

-- 'The Fat Pitch' blog, summarizing the BofA-Merrill Lynch global fund manager survey, February 16, 2016




As we said earlier, sentiment is at a very negative extreme, so a logical question is, "Will the bears grow even bolder?" Price action hasn't been stellar over the past several months, so there is that risk. At the same time, equity option buyers are buying the most puts relative to calls since 2008 and 2009, when the S&P 500 Index (SPX - 1,917.78) was 18% off its high (early 2008) and roughly 50% off its high (early 2009). 

Now, with SPY 10% below its 2015 high, we are seeing equity option speculator sentiment that resembles what we saw when the SPY was nearing a bear-market conditions in 2008, and what we witnessed at the bear-market bottom in 2009. We are only 10% below the May highs, so our instinct is to interpret this as pessimism that is well understood, relative to the barrage of negative headlines -- but perhaps far too much, relative to price action. So, the current high reading should have bullish implications.  

160222MMO4

But admittedly, a big question mark looms, as a reading like this in early 2008 preceded a noticeable plunge in equites into early 2009. And as we said a few weeks ago, if we enter a recession, it is far from being factored into the market, and thus we continue to manage this uncertainty and risk by reducing equity allocations via avoiding small caps. And while you're at it, avoid Europe, which is a favorite among many fund managers, as Europe is likely to have trouble if the U.S. experiences a recession.    

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