The Bullish Nasdaq Pattern No One Has Noticed

Between underwater short sellers and traders who have missed out on the stock market rally, there's still potential fuel in the SPX's tank

by Todd Salamone

Published on Jul 18, 2016 at 9:25 AM
Updated on Jul 18, 2016 at 9:29 AM

"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, Feb. 16, 2016

"… with SPY 10% below its 2015 high, we are seeing equity option speculator sentiment that resembles what we saw when the SPY was nearing 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."
-- Monday Morning Outlook, Feb. 22, 2016


"While the charts say limited reward versus risk, the sentiment backdrop paints a different story, one that suggests more reward in the market than the charts are currently implying… a potential tailwind could be found in short covering related to the expiring put open interest."
-- Monday Morning Outlook, July 5, 2016

The S&P 500 Index (SPX - 2,161.74) finally broke out to new all-time highs last week, perhaps helped along by short covering related to July expiration. The breakout came after multiple benchmarks were trading at potential round-number resistance (see the June 30 tweet above). Market breadth was impressive, too, as a multitude of stocks participated. For example, the 10-day average of SPX percentage advancers skyrocketed to 73%, territory not seen since late July 2009 -- four months after the 2007-2009 bear market trough.

After seeing the breadth statistic comparison to 2009, I could not help but think back to February of this year, five months ago, when the market was trading just 10% below its May 2015 high. Per the excerpt above, we were observing negative sentiment extremes on par with 2009. In other words, the SPX's breakout to new all-time highs amid impressive breadth occurred just five months after investors were behaving as if we were in a bear market, with no end in sight. Moreover, this breakout -- as we detailed last week -- surprised many investors, including the retail crowd, sell-side research firms, and fund managers. 

In the context of a market more in corrective territory versus a bear market environment, our view of February's negative sentiment extreme was bullish. Yes, the negative sentiment has been slow to unwind, and there have been minor stumbles along the way, but the SPX is now about 19% higher relative to its February low. Given the number of investors who have missed out and/or are currently underweight equities -- in the U.S. market, in particular -- there is an increasing likelihood that multiple new highs are in the cards over the course of the next several months.

From a longer-term perspective, what is the potential reward in this market, considering there is potential fuel from a combination of short covering and sideline money from retail investors and fund managers who have missed out?  Turn to the charts for that answer -- a subject I covered on Twitter last week:



Per the tweets above, we will turn to a couple of benchmarks that have been noticeable underperformers during this long lull in stocks. Below, I feature a chart of one of those benchmarks, the Nasdaq Composite (COMP - 5,029.58). Notice the bullish inverse "head and shoulders" formation that no one is discussing on social media. As a side note to this observation, there are numerous analysts on social media who are usually quick to point out a bearish "head and shoulders" formation, perhaps because it is easier to see due to a prevailing cautious viewpoint toward stocks during the past several years.

The circles in the chart below represent the head and the shoulders. The neckline is a trendline connecting lower highs since the July 2015 high. This neckline is currently situated around the round 5,000 millennium level, with the head sitting considerably south, around 4,250. With the difference between the head and neckline representing 750 points, and this pattern taking roughly a year to develop, one could target a 15% advance to 5,750 in the next 12 months.

comp head and shoulders july 15




From a short-term perspective, there are levels that could act as resistance on several benchmarks that we track. The iShares Russell 2000 ETF (IWM - 119.70) is bumping up against a round number that equates to roughly 1,200 on the Russell 2000 Index (RUT - 1,205.31). It also happens to be double the five-year low that occurred in 2011.

The SPDR S&P 500 ETF Trust (SPY - 215.83) is trading just above $214.86, which is double its own five-year low. This level equates to roughly 2,150 on the SPX. Half-century marks have been notorious for acting as major pivot points and marking sideways movement in the past.

Finally, as you can see on the chart below, the COMP has run into a speed bump of its own, as the 12-month rolling breakeven return has acted as resistance on rallies since March. Through mid-August, the area between 5,020-5,170 represents its rolling 12-month breakeven. Therefore, pay attention to the COMP's year-ago close during the next few weeks.

comp rolling return july 15


Another short-term risk: With CBOE Volatility Index (VIX - 12.94) options expiring this week, and with the VIX and short-term VIX futures trading around their calendar-year lows, demand for portfolio protection via VIX calls, VIX futures, or volatility-based exchange-traded notes could create a small market headwind in the days ahead.

august vix futures july 15b


The perception of cheap portfolio protection is heightened by the fact that the VIX reading was sitting 35% below the SPX historical volatility reading of 20 late last week. As Schaeffer's Quantitative Analyst Chris Prybal pointed out, the bad news is that when this occurred in the past, it was a short-term sell signal. The good news is that there have been few instances when this has occurred, per the table below, making the "signal" a lot less robust. And, in 2007, when the sell signal did not work, the SPX was above its 200-day moving average, as it is now. In other instances, the SPX was below its 200-day moving average.

vix returns july 15

Don't be surprised to see a consolidation or a modest pullback in the days ahead. That said, the risk-reward continues to favor the bulls when looking out over the course of the next year.


Read more:

Indicator of the Week: What the S&P's Hard-Won Record High Means for Stocks

The Week Ahead: Blue Chips Highlight Busy Earnings Schedule

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