The SPY's current price action continues to mirror the August-October 2015 pattern, but a couple of wild-card factors could shake the bulls this week
"With the SPY approaching an overbought condition, according to its 14-day Relative Strength Index (RSI), simultaneous with potential round-number resistance at the $200 mark -- and other equity benchmarks approaching potential round-number levels, too -- a hesitation or short-term pullback to the 80-day moving average around $198 is a potential scenario in the immediate days ahead. In the absence of a strong negative catalyst that generates a pullback to this level, a decline to this area should be bought."
-- Monday Morning Outlook, March 7, 2016
The behavior of the SPDR S&P 500 ETF Trust (SPY - 202.76) in the first three months of this year continues to mirror, almost exactly, its August through October 2015 price pattern. The potential for this repeat pattern to occur first got on our radar in mid-February, and it has been a topic of discussion ever since. In last week's trading, it was the action around SPY's 80-day moving average that was reminiscent of October, with this trendline marking lows in consecutive days prior to a sharp move higher for stocks (see rectangles in the first chart below). The pullback to this trendline last week marked a nice buying opportunity, as we anticipated.
Other similarities include the fact that the price action around the SPY's 80-day moving average is occurring around the round $200 level, equivalent to roughly 2,000 on the S&P 500 Index (SPX - 2,022.19). Moreover, in both October 2015 and at present, the SPY's year-to-date (YTD) breakeven was in play ($205.54 was 2015's YTD breakeven). The SPY comes into this week sitting just below its 2015 close of $203.87.
In October, after a breakout and retest of its 80-day moving average, the SPY broke out above its YTD breakeven and rallied for another two weeks to the area of the July-August highs. If the current pattern plays out again, the SPY will revisit its November-December highs in the $208-$210 area by month's end.
The chart below is another SPY daily graph -- albeit a longer time frame than the one immediately above, and absent the 80-day moving average. This chart displays trendlines that look very similar: one drawn through lower highs from May through August 2015, and another marking lower highs from October through December. The SPY burst through the dashed May-August trendline in late October, and now faces a similar test, as it trades just below the solid trendline connecting multiple lower highs since the early-November peak. Chart technicians may view Friday's rally into this potential trendline resistance as an opportunity to sell or take profits. However, if you are betting on the current pattern that we've been discussing to continue to play out, you should resist the urge to sell into this rally right now.
As we discussed above, and despite the SPY and SPX rallying by slightly more than 10% in only a one-month time frame, we think the rally from the February lows still has strong potential to continue in the weeks ahead. Remarkably, per an observation I made on Twitter last week,
short interest on SPX components actually increased in the mid-February to early March reporting period, even as the index advanced 6% in that time frame. A sharp advance like this would normally suggest short covering, leaving the market vulnerable to downside after the shorts have covered and technical resistance comes into play.
In fact, as you can see on the graph below, short covering helped drive the double-digit percentage gain from September into early November 2015. So, while we have seen remarkable similarities in the September-November 2015 and February-present rallies, a key difference is with respect to the behavior of the shorts in the immediate days off the low.
SPX component short interest increased in last period, and is 10% above early November level
When stocks peaked in early November, short interest on SPX components was 10% below the current level. The point is that there is more short-squeeze potential now relative to early November. In fact, market participants who built up short positions around the January and February lows are losing money and may be a source of support as they cover positions to cut losses. Moreover, significant short positions were added around the August and September lows, only a portion of which were covered during the September-November rally. With the SPX now above the August-September lows, those who bet against stocks in August and September could potentially throw in the towel and provide another source of demand for stocks.
"… we are in that two-week window within standard option expiration -- Friday, March 18 -- in which the option open interest on equity and index options may influence the market's movements and exaggerate reactions to macro news more than normal. We mention this with the European Central Bank (ECB) meeting scheduled for later this week…The 205 strike could be a magnet as those who sold 205-strike calls are forced to buy more and more S&P futures if this strike comes into play …The bottom line is, with three major central bank meetings on the calendar in the next two weeks and standard March options expiration looming in that same window of time, strong directional moves are more apt to occur beginning later in the week"
-- Monday Morning Outlook, March 7, 2016
The European Central Bank (ECB), after disappointing investors in December, delivered Thursday morning before the U.S. stock market opened, adding more stimuli by
cutting rates deeper into negative territory and committing to more asset purchases. After the SPY was pushed back below the $200 mark ahead of the ECB announcement, it broke out above this level to its highest mark since early January.
Two more central bank meetings are on the agenda for this week -- the Bank of Japan and the Federal Open Market Committee (FOMC) in the U.S. As we mentioned last week, it is call open interest at strikes in the immediate vicinity of the underlying SPY that could help influence stocks this week.
Specifically, a positive reaction to these central bank meetings could result in a quick move to the 205 strike. The heavy call open interest here could generate incremental buying as those short the call options buy S&P futures to hedge their positions.
The risk to bulls, however, is a negative reaction to the Fed, as long positions associated with the call open interest are unwound, especially in a scenario in which the SPY moves back below the call-heavy 199 and 200 strike prices. In an extreme situation, a Fed disappointment could result in a move to the put-heavy 195 strike, as an unwinding of long positions associated with the calls leads to steady shorting of S&P futures as a hedge to the open puts at this strike and below.
SPY March open interest configuration
Overall, our bias is bullish. However, the risks include a Fed disappointment, as well as expiration week (and YTD breakeven) sellers magnifying the selling in the short term.
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