Retail Investor Bear Extreme is Short-Term S&P Bull Signal

The sentiment backdrop supports more upside, but be wary of immediate risks to the rally

by Todd Salamone

Published on Jan 22, 2019 at 9:01 AM

"...the fact that the S&P 500 Index (SPX) took out its 2018 lows gives more credence to a V-rally... After moving above the February 2018 daily closing low of 2,581 on Wednesday, the SPX didn't make much headway. Profit-taking may have slowed the momentum, as the SPX climbed to the 2,586 area, a round 10% above the Christmas Eve 2018 closing low of 2,351."
-- Monday Morning Outlook, January 14, 2019

"U.S. Debates Lifting China Tariffs to Hasten Trade Deal, Calm Markets"
-- The Wall Street Journal, January 17, 2019

"China Offers a Path to Eliminate U.S. Trade Imbalance, Sources Say"
-- Bloomberg, January 18, 2019

The S&P 500 Index (SPX - 2,670.71) 2,580 area mentioned above, roughly 10% above the December closing low, proved to be a short-term hesitation point, as the index touched this level during a span of five consecutive trading days from Jan. 8 through Jan. 14. But the momentum from the late-December lows carried on last week, with the help of headlines on Thursday and Friday suggesting that significant progress is being made to relieve China-U.S. trade tensions.

As I have said before, there are multiple layers of potential resistance to overcome as the SPX digs out of its nearly 20% pullback that occurred from September into late December. But two more important levels were overtaken last week, as the round 2,600 level now sits below Friday's close. Moreover, the SPX climbed above the 2,637 level, which is 10% below its September closing high and an area of short-term lows in both October and November.

"If you're a long-term investor, and have stayed pat, you're hoping that this is 1987, 1990, 2011, or 2016, when the decline to the 160-week moving average was the end of 'it.'"
-- Monday Morning Outlook, December 24, 2018

"Cash is becoming the king as investors flee volatile stock markets. Assets in money market mutual funds have swollen to $3.066 trillion, their highest level since March 2010, driven by retail investors."
-- CNBC, January 14, 2019

"Charles Schwab Corp. reported that customers shifted assets to cash toward the end of last year, but especially in December, when volatile stock prices spooked investors."

-- The Wall Street Journal, January 16, 2019

Such technical breakthroughs are encouraging for bulls, especially after the SPX bottomed at its off-the-radar, but historically significant, 160-week moving average in late December. Could it be that retail investors were shifting money out of stocks around the time of the pullback to this trendline? Or was this massive shift the driving force behind the eventual plunge to the December lows? Regardless of when retail investors shifted from equities into money market funds, a nine-year high in money market assets now represents potential fuel to overcome the next levels of potential resistance that I'll discuss later in this commentary.

For what it's worth, there are likely a healthy number of retail investors who continue to have an unusually high amount of assets parked in these money market funds, if the American Association of Individual Investors (AAII) weekly survey is any indication. In the week ended Jan. 16, only 33% of those surveyed claimed they were bullish, while 36% claimed a bearish bias.

The chart below is a 10-week moving average of the percentages of bulls and bears in this weekly AAII survey. Our quantitative analyst, Chris Prybal, studied the historical significance of the 10-week moving average of bears moving above 40%, which last occurred in November 2012. In the 12 previous times this has happened since 1987, the four-week SPX return averaged 1.8%, with 83% of the returns positive. This compares to the SPX's average at-any-time four-week return of 0.63% and 62% positive.

aaii bearish extreme jan 2019


Last week, I talked about the possibility that hedge funds were likely moving back into the market, as SPX component short interest had not spiked very much in recent weeks. Moreover, broad-based equity exchange-traded fund (ETF) put buying relative to call buying was picking up its pace, as evidenced by an increase in the 20-day buy-to-open put/call volume ratio for the SPDR S&P 500 ETF Trust (SPY), Invesco QQQ Trust (QQQ), and iShares Russell 2000 ETF (IWM), after a long period in which this ratio was declining swiftly.

When this ratio is declining, it signals potential long equity liquidations on the part of hedge funds, as the number of broad equity-based ETF puts purchased to protect long stock positions slows. But if SPY/QQQ/IWM put demand grows, it could signal hedge funds in equity accumulation mode. This ratio continues to advance from multi-year lows, a sign that under-invested hedge funds are likely in accumulation phase -- just as the retail investor hits the panic button.

spy qqq iwm put-call ratio since 2014

"... If we look beyond January expiration, there are multiple resistance levels overhead which the SPX must overcome if it continues to make its way higher from the December lows. A major area to watch is between 2,650 (into the first week of February) and 2,690 (through this Friday), which represents potential trendline resistance when connecting the Oct. 3 peak with the Dec. 3 peak."
-- Monday Morning Outlook, January 14, 2019

With the SPX approaching an overbought condition, according to its 14-day Relative Strength Index (RSI) of 62 (at Friday's close), it comes as no surprise that more additional potential technical resistance levels are overhead.

There is the trendline that I discussed last week connecting the Oct. 3 and Dec. 3 highs, which is most concerning. It is declining daily and on Friday will be around 2,679. The 80-day moving average, which is in the vicinity of this trendline, is at 2,689. Note on the chart below that the 80-day moving average marked resistance in April and support in May and June, with moves below it in March and October 2018 signaling instability in the equity market looking out multiple weeks. If a retest of the December lows or the February lows of last year is in order, I would expect resistance in this area as the SPX moves into its first overbought condition since August-September.

spx 80-day chart 0118

But the sentiment landscape discussed above is one that suggests the SPX can continue to take out resistance levels, as it has done in the past couple of weeks. Rallies may come at a slower pace, but there is fuel on the sidelines to support further advances in the equity market. That said, the Federal Reserve saying something that market participants don't like, or headlines on trade that conflict with the well-received reports from last week, are immediate risks to the rally.

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