7 S&P Levels to Watch in 2017

Post-election optimism could leave stocks vulnerable to another January decline

Senior Vice President of Research
Jan 3, 2017 at 8:45 AM
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"The $225 level coincides with S&P 500 Index (SPX - 2,259.53) 2,250, a half-century mark -- and such half-century marks have historically acted as magnets during trading range behavior and/or key pivot areas after a big advance or pullback. The importance of these half-century levels could be due to the heavy open interest that tends to build up on SPX ... Coincidentally, the $225 level on the SPY is also around its 2016 10% YTD return level ... I point this out as the -10% YTD area marked an important SPY bottom in February ... [I]t is worth pointing out why it could be a hesitation area in the immediate term."
    -- Monday Morning Outlook, December 12, 2016


For the past few weeks, with the key 20,000 millennium mark on the Dow Jones Industrial Average (DJIA - 19,762.60) hovering just overhead, the S&P 500 Index (SPX - 2,238.83) trading around a half-century mark (2,250) -- 10% above the 2015 close -- the Russell 2000 Index (RUT - 1,357.13) and S&P MidCap 400 Index (MID - 1,660.58) trading 20% above their respective 2015 closes, and the Nasdaq Composite (COMP - 5,383.11) closing in on a level 10% above last year's close, it was evident that equities were at risk of hitting a massive speed bump after an impressive post-election rally. Such levels likely provoke profit-taking among those looking to cash in profits before year-end, balancing out the late-comers chasing highs or those covering bearish short positions. 



Moreover, as we mentioned last week, another asset -- equity volatility -- hinted that stocks were further vulnerable to trading-range action or a pullback in the near term, as equities typically move inverse with volatility. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV - 46.75), which is linked to short-term CBOE Volatility Index (VIX - 14.04) futures, rallied to the round $50 area, which marked major peaks in June and August 2015. As the name indicates, XIV is an inverse exchange-traded note (ETN) -- so if volatility increases, the ETN will decrease. Indeed, volatility increased last week, as the XIV failed to take out the $50 level, which is also an area that represents double the 2015 close.   

Since mid-December, around the time that the Federal Reserve raised interest rates, equities have indeed been in a holding pattern around the levels that we have identified as significant. Last week, in fact, equities declined slightly and were unable to close 2016 above the various round numbers or round-number year-to-date percent returns that we've been discussing the past few weeks.   


Two weeks ago, we observed that a weekly newsletter advisor survey indicated levels of optimism that have historically preceded market weakness. In last week's report, we suggested the extreme contango in volatility futures prices could be viewed as evidence of excessive short-term optimism. Now, another sentiment measure in the options market is flashing short-term caution: The 10-day moving average of equity-only buy-to-open put volume relative to buy-to-open call volume just troughed at a level in which equities have run into short-term weakness. 

Per the chart immediately below, when this ratio hits an extreme low and turns higher (as it is doing now), traders should prepare themselves for upcoming equity weakness. While the current ratio is low looking back over two years, such levels have typically preceded only moderate pullbacks.  

Above said, it should be emphasized that the recent lows in this ratio are nowhere near the extreme lows that preceded bear markets. In other words, while we are seeing optimism that leaves the market vulnerable to a short-term pullback, it isn't the extreme in optimism that has preceded prolonged, bear-market behavior, such as that in 2007 when the low was at 0.40, or readings in the 0.30s ahead of a sizeable corrective pullback in 2011. 




With equities around all-time highs, the pre-election caution that existed has given way to short-term optimism, increasing the risk that January 2017 is a repeat of January 2014, January 2015, and January 2016, when the SPX declined 3.6%, 3.1%, and 5.1%, respectively.  

If a pullback occurs, note that the SPX's 50-day moving average is currently just below the round 2,200 area, which is also the vicinity of the August and September highs and 20% above the 2016 closing low of 1,829. A pullback of this magnitude is 3.4% from the December closing high, similar in magnitude to the declines experienced in January 2014 and 2015. As we said last week, the Dow could see a retest of the 19,000 mark, which would be ironic after the recent Dow 20,000 "Alert." The Dow's 50-day moving average is in the 19K vicinity, too.

From a longer-term perspective, we still like the prospect of equities reaching new heights and outpacing strategists' estimates for year-end 2017. While short covering has been evident in recent weeks, note on the chart below that SPX component short interest remains significantly above the 2011-2014 levels, after peaking at a multi-year high in early 2016. This might reflect continued trepidation/caution among hedge fund managers, participants very capable of driving stocks higher if they become more positive.


Bigger picture, here are seven key SPX levels to watch as 2017 unfolds:

1,950 - Current site of trendline that connects 2009, 2011, and 2016 lows. It will move higher as time passes. Also, a half-century mark, which tends to mark peaks and valleys during advances and declines.

2,015 - Roughly 10% below 2016's close and just above 2,000 millennium mark.

2,035-2,050 - 2,035 is the current site of the uptrending 36-month (3-year) moving average; marked two troughs on a monthly closing basis since the bull market began in 2009. This long-term moving average has proven significant since at least 1988. Plus, 2,050 is a half-century mark that will eventually become site of the 36-month moving average.

2,135-2,150 - Site of 2015 highs and double the 2011 low.

2,238.83 - SPX 2016 close. Year-to-date breakeven levels have proven pivotal on pullbacks or rallies, therefore this could be a level of significance in the months to come.

2,356-2,365 - 2,356 is the average strategist forecast for 2017, per a Dec. 23 Bloomberg articleCoincidentally, 2,365, just 9 points above this average, is 50% above the 2007 SPX peak and a potential "profit-taking" zone for those that bought the breakout above this peak in May 2013.  

2,465-2,500 - 2,465 is roughly 10% above 2016's close, with 2,500 marking a big, round-number level where a lot of call and put open interest is likely to accumulate if we move higher this year.

We at Schaeffer's Investment Research wish you and your families a healthy and profitable 2017!  Thank you for being a loyal reader.

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