Was That a Breakout for Stocks?

Recent seasonality is on the side of stock market bulls

CMT, Senior Market Strategist
Jul 16, 2018 at 8:37 AM
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"Now, SPX 2,786 and SPY $278.92, which represent the respective closes prior to the June 13 rate hike, reside immediately above Friday's closing levels. The June pre-Fed high was just below the mid-March peak, so this area overhead could be a short-term barrier if follow-through buying from last week continues up to this level."
-- Monday Morning Outlook, July 9, 2018

Bulls started out strong this past week, with earnings on the horizon, positive data coming out of China, and recently breaking short-term resistance during the previous holiday-shortened week. The S&P 500 Index (SPX - 2,801.31) and SPDR S&P 500 ETF Trust (SPY - 279.59) went on to challenge the SPY June 13 highs that coincided with the Fed rate hike last month.

However, bulls failed to break out above resistance on their first attempt, pulling back when the Trump administration threatened tariffs on another $200 billion in Chinese goods, right when the major indices were all nearing round-number resistance levels. The mainstream financial media also found it interesting that the S&P 500 was near 2,800, which is the area of resistance preventing the index from making a run at new all-time highs. In addition, the Nasdaq Composite (IXIC - 7,825.98) and the Russell 2000 Index (RUT - 1,687.08) were near all-time-high resistance levels, which temporarily derailed a breakout of the 2018 range.

The tariff news sucked some of the optimism out of the stock market, causing it to pull back, but the knee-jerk reaction was short-lived. Markets quickly shook off the pessimism and again made a run to break through those June 13 resistance levels. Although the market technically broke above the highs of the resistance, is this a breakout?  The SPY broke above the prior high by just a few cents, and with the lack of volume it shows there wasn't high conviction by market participants going into the weekend. 

SPY daily chart MMO july 16

 

"This current reversal from an optimistic sentiment extreme might also be construed as a win for the bulls, because it has done very little damage to the equity market so far. Earlier this year, as I mentioned last week, the ratio turned higher from a similarly optimistic extreme, and equities corrected. That said, if the shift from optimism to pessimism continues in the days ahead, it will continue to be a headwind for equities. But it is also safe to say that from a sentiment perspective, the risk to bulls has decreased relative to three weeks ago, when there was a lot more short-term optimism to wash out."
-- Monday Morning Outlook, July 9, 2018

To carry on from last week, the 10-day, equity-only, buy-to-open put/call volume ratio still rose even during last week's rally. Increasing pessimism indeed could derail this rally, especially without seeing the SPY break through the June 13 Fed-day highs of $279.48 with strong conviction. 

BTO pc ratio and SPX

Market breadth is also negatively diverging now. Only 62.4% of stocks are above the 200-day moving average, compared to 66.2% last month at this time. However, this pessimism could also be the fuel on the fire that we need to test the all-time highs. Because as we all know, markets like to climb walls of worry. 

In contrast to the prior sentiment indicators, the American Association of Individual Investors (AAII) sentiment index surged last week by 15.2 percentage points, which was the largest one-week increase since the week after the presidential election in November 2016. This is bit of a divergence amongst sentiment indicators highlights why the market couldn’t break out with high conviction.

Over the last month we also saw sector rotation away from technology, financials, and consumer discretionary stocks, into more defensive sectors such as staples, utilities, and REITs. But, in the last few days, we've seen sector rotation happen once again back into technology and financials, with consumer discretionary trailing, but all starting to rebound. We'll want to see continued follow-through in this sector rotation if the market is going to continue to rally here.

"This current reversal from an optimistic sentiment extreme might also be construed as a win for the bulls, because it has done very little damage to the equity market so far. Earlier this year, as I mentioned last week, the ratio turned higher from a similarly optimistic extreme, and equities corrected. That said, if the shift from optimism to pessimism continues in the days ahead, it will continue to be a headwind for equities. But it is also safe to say that from a sentiment perspective, the risk to bulls has decreased relative to three weeks ago, when there was a lot more short-term optimism to wash out."
-- Monday Morning Outlook, June 11, 2018

As we mentioned back in June, the month after Fed hikes, the SPY has had a median return of negative 0.42%. This played into our short-term outlook for the last four weeks, but that timeframe is now behind us. According to Reuters data, market participants are currently pricing in a 2.6% chance that the Fed will raise rates on Aug. 1. This could be a potentially bullish catalyst for markets, especially if we are close to testing all-time highs, because the SPY median return after the Fed holds rates is 1.77%. 

SPY after Fed decisions

When looking forward to this week, the S&P will get a chance to show conviction or fall back in the range it's been stuck in since breaking out of the triangle on May 10. The good news if you're a bull is that over the last 10 years, July has seen the second-best monthly return for the SPX, at an average of 2.23% -- next to only March, which has generated a gain of 2.51%, on average. This July, the S&P 500 has already returned 3.05%, putting us on pace for the third-best July return over the last decade. Historically over the past 10 years, when July starts out this strong, the month tends to finish strong before going into the summer doldrums of August.

Bulls also have the tailwind because most economic indicators are still trending in a positive direction, which helped hold the S&P 500 Index range of 2,700 to 2,800. Next week, we also get a slew of data, including the Fed's Beige Book, retail sales, exports, industrial production, manufacturing output, and more. With all this economic data and earnings season in full force, it should make for an exciting week and could cause some volatility. 

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