"...equities have performed better in the short term when the Fed holds rates steady versus hiking rates during this tightening cycle. Therefore, with support continuing to hold on pullbacks and negative sentiment representing future buying power, the current environment favors the bulls."
-- Monday Morning Outlook, May 7, 2018
Major U.S. equity benchmarks rallied last week, supporting a theme that I have pointed out for months regarding bullish tendencies following Federal Open Market Committee (FOMC) decisions to hold rates steady, which occurred on May 2. Not so welcoming to market participants have been FOMC decisions to raise rates, which last occurred on March 21. The SPDR S&P 500 ETF Trust (SPY - 272.85) followed script, with lackluster price action following that March rate hike -- until the early May meeting acted as a "green light" for bulls.
The only exception to this theme was in December-February, when investors put more weight on tax cuts than the Fed’s decision to raise rates in December. But payback soon followed, as the January high was nearly coincident with the Fed holding rates steady. Therefore, Fed actions seem to be more important than speculation about what it does next, or unrelated headlines that either shake investors' nerves or stoke enthusiasm in between meetings.
The rally last week drove equity benchmarks through resistance levels, some of which are obvious, such as the SPY trendline connecting a series of lower highs since late January, which formed the basis for the "triangle" formation you have likely heard or read about. Not so obvious was the SPY’s close above $270.43, which hadn't occurred since the March 21 decision to raise interest rates, despite an April 18 intraday challenge. That marked the beginning of a steady slide into the May meeting.
On the heels of the Fed holding rates steady earlier this month, the latest move above SPY $270.43 is likely to have staying power. Admittedly, I do have some unease with the amount of press surrounding the triangle breakout. But this uneasiness is offset by the negativity that had built up ahead of the breakout, in addition to the timing with respect to it occurring on the heels of the Fed holding rates steady. The negativity represents buying power that is necessary to fuel stocks higher.
To give you a better perspective on this increased caution among market participants, below are some of the key sentiment facts that you have seen in this weekly commentary during the past month. During this time frame, the SPY made little to no directional movement from week to week, and experienced a couple tests of this year’s lows, as investors worried about the economy slowing and peak earnings:
"I still find it encouraging for stock market bulls that the historically ‘wrong way’ large speculators in the weekly Commitments of Traders (CoT) report have a record net long position on VIX futures."
-- Monday Morning Outlook, April 16, 2018
"Fund managers' allocation to stocks is at an 18-month low and many believe the market has peaked or will peak this year, according to the latest Bank of America Fund Manager Survey ... The allocation to global technology shares also fell sharply -- to a five-year low, according to the Bank of America Merrill Lynch Fund managers' monthly survey."
-- CNBC, April 17, 2018
"…one theme that caught my eye last week were the comparisons to the sentiment backdrop at present relative to the time around the November 2016 election, when the market was struggling with election-related uncertainty and negative sentiment was building ... [O]ther sentiment indicators that we follow are also echoing the November 2016 time period, from newsletter advisor sentiment in the weekly Investors Intelligence survey to SPX component short interest, which is declining from 18-month highs."
-- Monday Morning Outlook, April 23, 2018
"Call it the running of the bears. With equities almost three months removed from the last record, Americans have grown less optimistic that the market will bounce back. For the first time since Donald Trump’s shock election in November 2016, a majority of consumers expect stocks to be lower 12 months from now, according to the latest sentiment reading from the Conference Board."
-- Bloomberg, April 24, 2018
"Investors are dumping U.S. stock funds at one of the fastest paces in a decade as rising market turbulence erodes confidence in the nine-year-old bull market. U.S. equity mutual funds and exchange-traded funds recorded $2.4 billion in outflows for the week ended April 18, according to the Investment Company Institute. That followed $41 billion in outflows from these funds in February -- the biggest monthly exodus since January 2008, ICI data show. Overall, investors have yanked $67 billion out of these stock funds since the start of February."
-- The Wall Street Journal, April 26, 2018
One scenario is the SPY rallying into mid-June and testing the mid-March highs at $280. Circle June 12 and June 13 on your calendar, with June 12 marking the date that President Donald Trump will meet with North Korean leader Kim Jong Un. But as much press as this meeting will receive, the meeting that could have heavier market implications is the Federal Open Market Committee (FOMC) gathering on June 13.
Currently, fed funds futures players are factoring in a 100% probability of a rate hike on June 13. If the market rallies into this meeting, I could see a scenario in which the sentiment landscape is not nearly as negative relative to that which preceded the May 2 FOMC meeting. In other words, market participants could become more comfortable with stocks on the eve of a June rate hike, which has tended to precede weakness in stocks the following month.
"...as expiration nears and the SPY remains above both $250 and $260, one might expect a slow, gradual unwinding of short S&P futures positions related to these big put strikes. Time is on the side of the bulls as long as the SPY remains above $260 in the weeks ahead."
-- Monday Morning Outlook, May 7, 2018
If a pullback occurs this expiration week, bulls want to see support on the SPY come into play between $266.86 -- its 2017 close -- and the $270.43 level discussed above. Open interest in the options market, however, remains a source of potential buying power, albeit slightly different from what we may have witnessed last week.
For example, last week’s strength may have been helped along by the unwinding of short positions related to heavy put open interest at strikes immediately below the market. As the SPY moved further above these heavy put strikes, the delta -- or sensitivity of these options to SPY movement -- decreased and, as such, many of the short S&P futures positions associated with this put open interest were likely covered. Now, the SPY is in an area of heavy call open interest at the 272 and 275 strikes, and this open interest was mostly buy-to-open volume. So, there is the possibility that the 275 strike acts as a magnet, as sellers of the calls are forced to buy S&P futures to maintain a neutral position in a process called delta-hedge buying.
The risk this week is the SPY trading below the 272 and 275 strikes. In this instance, the longer it remains below these strikes, the more apt that long S&P futures positions at 272 and 275 are unwound, creating a modest headwind.
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Editor's note: This article was updated to correct SPY's March 21 closing level to $270.43.