Powell-Fueled Rally Could Spark Powerful Unwinding

A near two-year extreme in the weekly AAII sentiment survey should give bulls hope

by Todd Salamone

Published on Dec 3, 2018 at 8:21 AM
Updated on Dec 3, 2018 at 8:21 AM

"The SPX closed below its 80-week moving average on Friday, currently situated at 2,660... Unless the SPX immediately recovers from this technical breakdown before the end of the month, risks have grown substantially for weakness over the next few months, or even a transition into a bear-market environment... In June 2012 and June 2016, the SPX experienced weekly closes below its 80-week moving average but recovered quickly, generating only a single data point below this trendline. The SPX will have to do the same if there is any hope for this heightened pessimism to unwind on the heels of the Fed's decision to hold rates steady earlier this month."
-- Monday Morning Outlook, November 26, 2018

On the heels of Fed Chair Jerome Powell doing a "180" with respect to his early October remarks about interest rates being a "long way" from neutral, the S&P 500 Index (SPX - 2,760.16) rallied strongly last week. Whereas stocks failed to respond to the Federal Open Market Committee (FOMC) holding rates steady in early October and instead focused on the chairman's interest rate outlook on the way to a 10% correction, the equities market responded favorably to another -- and much different -- outlook from Powell, who said Wednesday the Fed's benchmark rate is "just below" neutral.

In response, the SPX swiftly advanced back above its 80-week moving average, potentially repeating the scenarios of June 2012 and June 2016 that I discussed last week -- in which the SPX rallied for weeks before another correction occurred, but the bottom was in on those short technical breakdowns.

spx 80-week 1130

"If last week's SPX dip below its 80-week moving average proves only temporary, a bounce from this longer-term trendline -- which is just above a half-century mark on the SPX -- must be confirmed by a move above the round 2,800 century mark and the Nov. 8 Federal Open Market Committee (FOMC) meeting day closing level of 2,806. If the SPX fails to take over these levels... rallies should be viewed as simply bounces in the context of longer-term weakness."
-- Monday Morning Outlook, November 26, 2018

Despite last week's rally, equities are still locked in an area that is pivotal for bulls and bears alike. In other words, the bulls are not out of the woods, but the bears have to be somewhat disappointed in last week's advance. For example, SPX resistance resided just overhead in Friday's trading, ahead of the G-20 meeting on Saturday evening between President Donald Trump and China's President Xi Jinping, where all eyes were on trade talks.

SPX resistance is in the form of a trendline drawn through the early October high -- one day prior to Powell's "long way" remarks on rates -- through the mid-November high. Additionally, just as the SPX rallied from the vicinity of the 2,650 half-century mark, it comes into this week around the 2,750 half-century mark -- which could act as resistance, just as 2,650 acted as support. These half-century levels tend to have significance as big options open interest tends to build at round-number strikes on SPX options and the related SPDR S&P 500 ETF Trust (SPY - 275.65) options (SPY 265 strike would be equivalent to the SPY 2,650 strike).

Whereas the SPY 265 strike is put-heavy and the SPY 275 strike is call-heavy, amid an environment over the past couple of weeks of negative and positive headlines with regard to the Fed and trade talks with China, it is not a huge surprise to see the put-heavy strike defended and the call-heavy strike posing as resistance.

Moreover, the SPX's 200-day moving average resides overhead around 2,760. After a significant breach of this trendline in October, rallies back above it have been sold quickly, following a historical script of choppy price action when this popular trendline is violated. Volatile, choppy action is what the market has given participants since the initial plunge that followed Powell's early October outlook on rates.

On the sentiment front, the plunge in technology stocks rattled investors. Whereas total short interest on SPX component stocks has showed little change since the beginning of the recent market correction, short interest on components of the Invesco QQQ Trust Series (QQQ - 169.37) surged, but declined slightly during the period from late-October to mid-November.

qqq component short interest 1130

The plunge in high-profile tech stocks struck fear in equity option buyers, as the 10-day, equity-only, buy-to-open put/call volume ratio last week hit its highest level since the November 2016 elections. The bulls should find it encouraging that this ratio is rolling over from an extreme, although the risk is that the last roll-over proved only temporary. But if this fear continues to unwind, equities have the potential to take out the technical resistance mentioned above.

equity put-call ratio 1130

If you are a risk-taker, I think you bet on an imminent market rally, at least through the mid-December FOMC meeting, and maybe until the end of the year. This bet hinges on volatility moving lower in the coming weeks, as the historically wrong-way large speculators on Cboe Volatility Index (VIX - 18.07) futures remain in a rare net long position, per the latest Commitments of Traders (CoT) report that was released on Friday.

vix cot net long 1130

Another sentiment note that gives bulls hope comes from the American Association of Individual Investors (AAII) weekly survey. We smooth the weekly bullish and bearish percentage readings, since they can be volatile from one week to the next. Of note is that the 10-week moving average of bears outnumbered the 10-week moving average of bulls for the first time since early 2017, as you can see on the accompanying chart. When this occurs during the aftermath of a decline, it has generally been bullish for stocks, as "buy the dip" is a mentality this group has not adopted.

aaii 10-week ma 1130

With the SPX at a pivotal juncture from a technical perspective, the VIX around 18.65 -- half its 2018 closing high, and an area from which it has found support the past two weeks -- another FOMC meeting scheduled for mid-December in which a rate hike is expected, and a sentiment backdrop that could lead to a powerful short-term rally, continue to be open to opportunities on both sides of the market. And as a guest said on CNBC last week, and with which I couldn't agree with more: Use options as a tool to play opportunities that you see, as they provide leverage and allow you to put limited dollars at risk during this continued period of heightened uncertainty.

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