Traders should remain cautious until Fed-day resistance is taken out
"Ironically, short-term market participants have turned positive on stocks just ahead of this Wednesday's FOMC meeting... note that stocks have struggled in the month after a rate hike during the current tightening cycle -- with a notable exception being December 2017, when tax cuts 'Trumped' Fed policy."
-- Monday Morning Outlook, June 11, 2018
"Fed Raises Rates, Sets Stage for Two More Increases in 2018"
-- The Wall Street Journal, June 13, 2018
"U.S. Stocks Slide as Trade Tensions Heat Up"
-- The Wall Street Journal, June 15, 2018
The event that I have been talking about for weeks finally arrived last Wednesday, when the Federal Open Market Committee (FOMC) raised interest rates. Sure, there were other notable headlines discussed in financial publications and on TV -- most notably, what has been deemed by President Donald Trump as a successful summit with North Korean leader Kim Jong-Un, and new tariffs that the U.S. slapped on $50 billion in Chinese goods.
If past is prologue, it was the Fed's action last Wednesday that could have a negative impact on the stock market in the short term. Loyal readers are now fully aware that during the current rate-tightening cycle, equities -- as measured by the SPDR S&P 500 ETF Trust (SPY - 277.13) -- underperform or even experience a drawdown in the month following a rate hike, while showing a tendency to rally and produce respectable returns when the Fed holds steady.
The good news, from a longer-term perspective, is that the stock market has taken the six previous rate hikes in stride despite the short-term hiccups, with the SPY sporting a 35% return (excluding dividends) from the first rate hike on Dec. 15, 2015 to the seventh rate increase last Wednesday.
In the instances where SPY has entered a choppy trading-range period in the immediate aftermath of a rate hike, resistance usually emerges around the site of SPY's closing prices on the day prior to or the day of the Fed outcome. A perfect example is the mid-April rally that stalled just above SPY $270, which is where the SPY was trading at the time of the March rate hike.
Therefore, you can expect potential resistance on the SPY over the next four weeks in the area between $278.03 and $278.92 -- its closing levels from last Wednesday and Tuesday, respectively. This range also encompasses the March 2018 closing high of $278.87 that occurred about two weeks before the March rate increase.
Note that the SPY went ex-dividend on Friday, and thus on a chart, it is trading further below resistance relative to the S&P 500 Index (SPX – 2,779.66), which is above its FOMC day close of 2,775.63 and slightly below 2,786.85, which is where it closed on the evening before last week’s rate hike.
If indeed the rate hike last week heralds lackluster price action in equities in the near term, I find it interesting that many market participants have grown relatively comfortable with stocks, implying further vulnerability. Last week, for example, I displayed a graph showing equity options traders are buying puts (downside bets) at a relatively low rate relative to calls (upside bets).
Moreover, the weekly National Association of Active Investment Managers (NAAIM) index just pushed above 100 for the first time since January, implying that this group is fully invested and moving into a leveraged long position. In previous instances during the past couple of years when this index was above 100, it has typically preceded sideways movement or a pullback in stocks.
There is hope for the bulls in the weeks ahead, and it runs counter to the usual contrarian way we view market sentiment. Specifically, in the most recent weekly American Association of Individual Investors (AAII) survey, the bullish percentage minus the bearish percentage is 23 (the percentage of bulls was 44.8% -- a four-month high -- and the percentage of bears was 21.7%). I was curious to see how this current AAII sentiment reading stacked up just ahead of rate hikes in the current tightening cycle.
The table below displays the date of each rate hike, the bulls-minus-bears percentage point difference, and SPX returns one month after the rate hike. Surprisingly, sentiment among this group has been correctly aligned with the eventual short-term market direction -- with the lone exception occurring ahead of the March rate hike, when this group was net bullish ahead of a 1.4% SPX pullback in the month following the rate increase.
This data set might help you to keep an open mind after this latest rate hike, as weak price action in the weeks ahead is not a 100% guarantee. However, it is best to await a close above the expected $278.03-$278.92 "Fed rate-hike resistance" as your clue that a rally is in the cards. If you are using the SPX as your benchmark, the key levels are 2,786.85 (Tuesday pre-Fed close) and 2,775.63 (Wednesday post-Fed close).
For now, with sentiment optimistic, and the SPX below its pre-rate hike closing level, we suggest you remain apprehensive about the bullish bias among option speculators, active investment managers, and retail-level investors.
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