What Bulls Need to Know After S&P's 50-Day Break

As trade war headlines dominated, AAII bears registered their biggest weekly gain of 2019

CMT, Senior Market Strategist
May 20, 2019 at 8:30 AM
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Markets continued to be headline-driven and pressured by the ongoing "trade war" with China this past week. The S&P 500 Index (SPX - 2,859.53) opened sharply lower to begin the week and traded down to the round 2,800 support level -- briefly eclipsing a garden-variety 5% pullback from the all-time high we put in on May 1 -- before rallying back mid-week, only to find resistance at the round 2,900 number amid more reports that trade negotiations had stalled late Friday. This volatile action has done some technical damage, as the SPX had its first weekly close below its 50-day moving average since Jan. 11.

spx 50-day moving average 0519

While this breakdown could be temporary, market participants will likely remain skeptical early next week barring any significant news, as the Nasdaq Composite (IXIC - 7,816.29) also failed at its 50-day moving average. Moreover, the Russell 2000 Index (RUT - 1,535.76) failed at the converging 50-day and 200-day moving averages, and -- possibly more importantly -- broke back below the critical support of its 80-week moving average, which it had just taken back in early April.

rut daily chart rsi 0519

On the surface, a risk-off environment certainly seems to be taking shape -- at least for the short-term, with small-caps struggling. During the majority of the sell-off, we've seen defensive sectors like utilities, healthcare, and staples significantly outperform. But when you dig down into sector performance, there's a glimmer of hope for bulls.

Amidst the selling in the first full week of May, we saw materials and energy catch a bid, and last week we saw growth sectors like technology and communication services lead the market, while defensive sectors like utilities and staples either stalled or gave back all the previous week's gains. So, while we've pulled back, there still appears to be an appetite for growth equities. This is evidenced in the S&P Growth (SPYG) vs. Value (SPYV) ratio, which indicates growth stocks are still preferred over value stocks by breaking out to new highs.

spyg-spyv ratio chart
Chart courtesy of StockCharts.com

One bearish intermarket analysis I noted this past week was that when the stock market rallied off its lows, bonds did not confirm the bullish action. Typically, we should see bonds sell off and yields rise.

spx with tnx daily chart 0519
Chart courtesy of StockCharts.com

One reason for this could be the fact that many economists are now pricing in a rate cut happening before another rate hike. While some pundits will claim another potential "goldilocks" period could be on the horizon if we continue to rally back toward the highs, we need to be mindful that it also could be signaling a deflationary environment, as we've seen some softness in economic indicators, like the ISM manufacturing index declining since September.

The Federal Open Market Committee's (FOMC) upcoming meeting minutes could provide insight into how sluggish some policymakers feel inflation data is. We'll also get durable goods orders on Thursday that will be closely watched as markets try to gauge the impact of the ongoing trade conflict with China.

"The levels discussed above will be on our radar in the immediate days ahead if stocks experience another sell-off and short volatility futures positions continue to be unwound. If the VIX moves above such levels, risks grow of an extended decline in stocks as volatility surges. Note that through Wednesday of last week, roughly 30,000 of the 180,000 net short positions in VIX futures were covered. Given the action on Thursday and early Friday, I am suspecting the 30,000 number grew into the end of the week."
-- Monday Morning Outlook, May 13, 2019

The sentiment backdrop is turning a bit more bullish. Commitments of Traders (CoT) data shows that large speculators have now covered an additional 60,600 contracts of the net short positions in Cboe Volatility Index (VIX - 15.96) futures, which means they've now covered nearly half of their record short position of just two weeks ago. As we've noted in the past, CoT large speculators are notoriously positioned on the "wrong" side of trades, and -- as we predicted in April -- they were again caught on the wrong side of the volatility trade.

cot large spec vix futures 0519

Additionally, E-mini SPX futures traders have continued to build their long position amid the market volatility, after sitting out the majority of the year. It will be interesting to see in the coming weeks, and as we head into summer, if any prolonged market volatility inspires them to reverse course.

"Global investors' equity allocations fell 6 percentage points in May and over a third of fund managers have taken out protection against sharp stock market falls in coming months, Bank of America Merrill Lynch's latest monthly survey found on Tuesday.

"The proportion of investors preparing for equity falls is the highest in the survey's history, BAML said, noting that trade war was seen as the main risk by 37% of participants, followed by a Chinese slowdown which was picked by 16%."

-- Reuters, May 15, 2019

One bullish short-term indicator this past week was a sharp reversal in the buy-to-open five-day put/call volume ratio. Typically, we see violent spikes in the ratio when a likely short-term bottom is in. Additionally, the McClellan Oscillator was oversold on both the New York Stock Exchange (NYSE) and Nasdaq.

While these short-term indicators were a great signal for last week's reversal, we'll want to see a continuation of a meaningful build in put open interest if we wish to see this market continue to make new highs, after the market ended lower for the second straight week and the "sell in May and go away" chants continue to grow louder.

Finally, according to the weekly American Association of Individual Investors (AAII) sentiment survey, participants reported the lowest bullish percentage since Dec. 19, at 29.80%. Additionally, this 13.3-percentage point drop from the previous week was the most significant decline since Dec. 12, roughly two weeks before we put in the Christmas Eve lows.

What's even more amazing is that the percentage of bearish respondents had an incredibly sharp reversal off its lows, rising by 16.1 points -- also the most significant gain since Dec. 12. On a percentage basis, that's a 69% gain, which is the biggest since a 93% gain in April 2013.

aaii bears since 2012 0519

In conclusion, markets rarely break through to new all-time highs on any significant basis immediately without some sort of consolidation. So, while this market will likely continue to be headline-driven next week, this type of action is not unexpected.

We are definitely at risk to retest the round 2,800 level on the SPX in the next week or two. However, unless we break that support level and the barely rising 200-day moving averages, we should continue to view this move as just a pullback. If the trade conflict continues to intensify, or we get some significant softening in economic data and we break those critical levels, obviously all bets are off -- but that's why we continue to suggest traders use call options for long equity exposure in this headline-driven market, to clearly define your risk while obtaining significant leverage for any potential upside.

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