What Needs to Happen for SPY to Rally This Week

Both SPY and SPX are docked below resistance, while the Dow and Russell 2000 Index are trading near round-number milestones

Senior Vice President of Research
May 15, 2017 at 8:35 AM
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"...[T]he FOMC policy decision may be the most relevant headline impacting stocks, as Fed Chair Janet Yellen and company juggle the unpleasant task of normalizing rates in an environment filled with uncertainties..."
    -- Monday Morning Outlook, May 8, 2017

"If it feels like Federal Reserve members are speaking more, that's because they are. Federal Open Market Committee participants have consistently delivered more speeches each year since the mid-1990s... committee participants are on pace to give a record-high 14 speeches per member, versus four in 1996."
    -- CNBC.com, May 9, 2017

"The Federal Reserve must be 'very vigilant against falling behind' on needed interest-rate hikes, said Cleveland Federal Reserve President Loretta Mester on Monday. 'If we delay too long in taking the next normalization step... we could risk a recession,' Mester said in a speech to the Chicago Council on Global Affairs."
    -- MarketWatch, May 8, 2017

"'Along with a gradual reduction in the level of the balance sheet, it would still be reasonable to have three rate increases over the remainder of this year, assuming the economy evolves like my forecast envisions,' [Boston Fed President Eric Rosengren] said."
    -- Bloomberg, May 10, 2017

"'The one lingering difficulty, I would say, and it's an important one, is that inflation pressures are still under-running our 2 percent objective in the U.S.' [Chicago Fed President Charles] Evans said Friday during a moderated discussion at an event in Dublin. 'At the moment, I think the downside risks still predominate.'"
    -- Bloomberg, May 12, 2017

While the firing of FBI Director James Comey dominated headlines last week, investors focused on the speeches of several Fed officials. As central bankers offered their respective views on the economy and monetary policy, both a dove (Evans) and a hawk (Rosengren) gave support for a gradual wind-down of the Fed's bloated balance sheet.

Other Fed officials who spoke last week included Philadelphia Fed President Patrick Harker, who said he expects two more hikes this year, and New York Fed President William Dudley, who said balance sheet normalization will occur if the economy continues to grow as expected. The tilt toward a hawkish tone is a continuation of what investors perceived as a higher probability of a June rate hike after the release of the Fed's policy statement on May 3, when the Fed held rates steady but indicated that the weakness of the first quarter is likely temporary.

The SPDR S&P 500 ETF Trust (SPY - 238.98), which is roughly one-tenth the value of the S&P 500 Index (SPX - 2,390.90), retrenched slightly amid the Fed speak last week -- and as government inflation data beat expectations and retail sales missed expectations (a combination that likely gave buyers pause). But sellers were not abundant either, as many of the Fed comments were hedged as being data-dependent.

The SPY did end the week above its May 3 close of $238.48. With the 20-day moving average, which served as resistance from March 3 through April 19, sitting at $237.72, we view the area between $237.72 and $238.48 as potential support in the coming week.

"The pattern we've noticed in recent months is resistance coming into play in the weeks immediately following a Fed rate hike (mid-December 2016 and mid-March this year)... On Feb. 1, the Fed met but did not raise rates, and the SPX rallied soon after."
    -- Monday Morning Outlook, May 8, 2017

As I discussed last week, after the Dec. 14 and March 15 rate hikes, the SPY found resistance at its closing levels of those dates into the next Federal Open Market Committee (FOMC) meeting. As it stands now, the SPY has ended above its May 3 close for seven consecutive days, which should be an encouraging sign for bulls. Moreover, for most of last week, the SPY closed above $238.95 -- its closing price as of March 15, the date of the last rate hike. The jury is out as to whether the SPY (and SPX) can mount a significant rally, as stocks did in February after the Fed held rates steady.

"...[T]raders may view the SPX and SPY as having little upside from a chart perspective, with SPX 2,395.96 and SPY 239.78 representing the March 1 closing highs -- plus, the round SPX 2,400 mark looms just overhead, too... The 2,400 level on the SPX coincides with the SPY 240 strike, which is home to more than 400,000 call contracts in the standard May expiration series...  If the SPY $240 level is taken out, large open interest accumulations at the 241 and 242 call strikes represent magnets too, setting up the potential for a move to $242 (or SPX 2,420) by May options expiration. But the longer SPY remains below $240... the more vulnerable it is to the unwinding of long positions related to the out-of-the-money call strikes."
    -- Monday Morning Outlook, May 8, 2017

We enter this week in familiar territory. The SPY and SPX are docked just below key resistance levels discussed in last week's commentary, on the heels of recording all-time closing highs last Wednesday. Both failed, however, to close above round-number resistance from $240 and 2,400, respectively -- and, by week's end, found themselves back below the March 1 closing levels.

spy daily price chart with 20 day moving average

I have noted in the past that round numbers tend to take on more significance when notable benchmarks are approaching these levels simultaneously, which is the case at present. The Russell 2000 Index (RUT - 1,382.77) has been fighting 1,400 since mid-February, and the Dow Jones Industrial Average (DJIA - 20,896.61) has toyed with 21,000 at various times since early March.

djia daily price chart ytd 21000

The SPY 240 level is reinforced by the "call wall" at the round 240 strike as we move into expiration week. The longer the SPY is below 240, the more vulnerable it is to headwinds into Friday's expiration, as long positions associated with the calls at the 240 through 242 strikes are steadily unwound. But, if the SPY manages to rally above 240 -- especially early in the week -- the 241 and 242 strikes would likely act as magnets, as sellers of the calls are forced to buy S&P futures to hedge. Chart technicians focused on a breakout would likely help this process along, resulting in a sharp rally.

In analyzing the open interest configuration, it's another expiration week where selling is not likely to be compounded by heavy put open interest at strikes below the current market. Long-time readers are keenly aware of how big put open interest strikes below the market can act as magnets, particularly in the week before or during expiration week. In fact, open interest at the SPY 238 and 239 strikes is minimal, and about equal on the put and call side (which is interesting, from the perspective that this aligns with the support levels we discussed earlier).

That said, selling related to heavy put strikes becomes a risk if the SPY breaches $235. With Fed speaking engagements light relative to last week, stocks may remain in a tight holding pattern.

spy may expiration open interest by strike

The positioning of large speculators on CBOE Volatility Index (VIX - 10.40) futures is back on my radar, as this "wrong way" group of market participants is again nearing an extreme short position. This group was most recently caught flat-footed when volatility spiked in March and stocks retreated almost 3%. My concern with the positioning of these speculators grows if the VIX moves back above the 11.25-11.50 area, which is one-half the November pre-election high.

Moreover, May VIX futures call options expire on Wednesday, which means those using calls to hedge a volatility short position will soon be unhedged. That means they're more apt to cover short volatility positions on negative news, or will be forced to replace volatility hedges, which puts a floor on volatility.

cot vix futures net short lg spec

Equity options remain very cheap, and thus call options present an excellent way to leverage the longer-term uptrend in the market in lieu of stock positions that tie up more capital. And put options are a cheap way to hedge long stock positions, with the SPY at resistance and the risk of a volatility pop higher than normal again.

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