Where Traders Might Look to Sell an Overbought SPY

In this strongly trending market, any drawdowns could be minimal

Senior Vice President of Research
Jan 8, 2018 at 8:43 AM
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"From a seasonality perspective, there is hope for the bulls, with New Year's week having a historically bullish seasonality... [but] with [the Santa Claus rally] yet to arrive, the Fed might be labeled as the Grinch that is stealing Santa's thunder...

"[T]he levels that are a round 20% above the SPX and SPDR S&P 500 ETF Trust (SPY - 266.86) 2016 closes -- 2,686.60 and $268.23 – have been areas of resistance during the sideways action that has mostly defined the second half of December... the tech-heavy Nasdaq Composite (IXIC - 6,903.39) has toyed with the round 7,000 level since the Dec. 18 rally, but still has yet to close above this round millennium mark... in addition to the longer-term trend, the risk to the bears is the possibility of a short-covering rally."

    -- Monday Morning Outlook, January 2, 2018

As it turns out, Santa arrived after all -- albeit late and bearing fewer gifts than usual, as the time period encompassing the last five days of 2017 and first two trading days of 2018 saw the S&P 500 Index (SPX - 2,743.15) gain 1%, below its 1.7% average gain since 1928.

The action last week followed lackluster price action in the second half of December, which proved to be nothing more than a short-term consolidation. Round numbers on key equity benchmarks, such as Dow Jones Industrial Average 25,000 (DJI - 25,295.87), Nasdaq Composite 7,000 (IXIC - 7,136.56), and SPX 2,700 were taken out as the bulls celebrated the start of a new year. Sell-side analysts returned from an apparent December vacation to issue a slew of upgrades relative to downgrades.

Less obvious resistance levels were also taken out, such as the SPDR S&P 500 ETF Trust (SPY - 273.42) mid-December high just above $268, which corresponded not only to last year's round 20% gain, but also four times its 2009 low. And as it turns out, unlike the pattern I have discussed multiple times in this space about Federal Open Market Committee (FOMC) meeting day closing levels acting as resistance in the immediate days after a rate hike, it appears the Dec. 13 FOMC day close at SPY $266.75 acted as support during the pullbacks on the last trading day of 2017.

In fact, per the chart below, the SPY has only experienced one daily close below its 20-day moving average since Aug. 30. The current site of this trendline is at $267.59, which is between the mid-December FOMC day closing level ($266.75) and $268.40, or four times its March 2009 low close. This area would be a first line of defense if there is a pullback from its current overbought condition. The 2017 close of $266.86 is also in this vicinity.

I mentioned the SPY's overbought condition, but note that since early October, according to the 14-day Relative Strength Index (RSI), the SPY has been in an "overbought" condition multiple times with little to no pullbacks occurring.

spy 20-day moving average 0108

In attempting to define the next potential hesitation level from a short-term perspective, the SPY $274 level is worth watching. It is a round 10% above the August high that occurred before the first nuclear "war of words" between President Donald Trump and North Korean leader Kim Jong Un. It is also 10% above the late-September close that occurred at its 20-day moving average. In other words, there is the potential for profit-taking here among market participants that played the SPY's mid-September breakout above the August high, or the subsequent pullback to the August high in late September. A late-day rally pushed the SPY just shy of this level on Friday.

However, in a market like this, even if we're correct about this level proving to be a hesitation point, such hesitations may not last very long and come with little drawdown.  It bears repeating that there is still the large short interest on SPX component stocks that I have alluded to in recent months, which began building in February 2017 and lasted into mid-September. Many of these short SPY positions are underwater, so as resistance levels are taken out, short covering could keep momentum trades intact.

Or, if the shorts perceive sell-offs as opportunities to exit losing positions, pullbacks will continue to be kept in check. There has been mild short covering going on during the past few months, but the covering activity is nothing relative to the build that took place in earlier months.

spx short interest 0105

While high SPX component short interest amid SPX record highs is a bullish driver, a sentiment indicator that bears can cling to in the weeks ahead is in the American Association of Individual Investors (AAII) weekly survey. The percentage of bullish respondents increased last week to nearly 60% from 52%, pushing the four-week moving average of the bullish contingent to the third highest reading since 2010. In the two previous instances since 2010 that the bullish percentage spiked this high, sideways action followed, prior to an eventual sell-off.   

AAII with SPX since 2009

The AAII survey, along with the CBOE Volatility Index (VIX) Friday close at 9.22, gives bears some hope in the immediate days and/or weeks ahead. The 9.00 level has been a VIX floor since July, and another volatility pop from this level would likely be accompanied by a stock drop. After a rally like this, volatility buyers seeking perceived cheap portfolio protection could create a minor headwind in the form of put purchases. However, bears should also be aware that there could be room for a VIX move down to 8.00, which is half of 2017's closing high of 16.04.

I continue to advocate call options to play the upside in this market, as the lower dollar commitment, combined with leverage, addresses perceived risks. These uncertainties range from the company-specific earnings risks that will grip many individual equities in coming weeks, to the isolated risks associated with the VIX being at the lower boundary of its recent range, to the fact that retail market-watchers are overcome by their most bullish mentality in months.


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