3 Risks to the Bullish Case This Week

Rising caution among investors bodes well longer term as the S&P eyes new-high territory

Senior Vice President of Research
Oct 28, 2019 at 8:14 AM
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"Even though the SPX failed at resistance levels last week, I still see growing potential for a breakout. First, the headwind of an options-related call ceiling disappeared last Friday with October options expiration. Additionally, looking ahead to November standard expiration, it appears the major SPY call open interest is at the 305 strike, equivalent to SPX 3,050. In other words, as it stands now, the SPY call open interest ceiling is higher.

"...[T]he sentiment backdrop appears to be on the side of the bulls, beginning with the short-covering potential amid low earnings expectations that I discussed last week. Furthermore, fund manager cash positions are above average, even with the SPX knocking on the door of a new all-time high."

-- Monday Morning Outlook, October 21, 2019

Last week, the S&P 500 Index (SPX - 3,022.55) ventured above problem levels that I have been pointing out during the past few weeks -- specifically, the round 3,000 and 3,008 levels, the latter of which is a round 20% above last year's close. Moreover, on the heels of a Friday morning headline suggesting that the U.S. and China are closer to finalizing some sections of a phase one trade deal, the SPX came within a few points of taking out its late-July all-time closing high at 3,025.

While obvious chart resistance on the SPX had emerged recently due to past failures in this area during the last few months, skepticism about a breakout has grown. This is evidenced by the actions of fund managers, who have raised cash, and the shorts, who have built positions in recent months --both of which have likely contributed to capping rallies at the psychologically important SPX 3,000 area.

Short interest data as of Oct. 15 was released Thursday evening, and we did see a small downtick on SPX component stocks, relative to the Oct. 1 data. The translation is that a headwind from a six-month build in shorting activity could be disappearing. With short interest on SPX components elevated significantly relative to the April low, and in the 96th percentile of readings in the past 12 months, short covering could give stocks the needed boost to achieve a breakout from this multi-month range in which stocks have grinded higher.

In fact, per the chart immediately below, the last time the shorts built positions coincident with stocks rising was in the first half of 2017. Short covering in the second half of 2017 helped the SPX advance 10.5% into year-end.

spx stock short interest since jan 2013

Moreover, even though it appeared pessimism among equity option buyers had peaked last week, I was surprised the 10-day moving average of the daily buy-to-open put/call volume ratio rose to 0.60 from 0.56 during the past week. This ratio is now once again at a multi-month high. From a contrarian perspective, with the SPX advancing near a new high intraday last week, the growing skepticism/caution among equity option buyers combined with the strong price action in equities has bullish implications.

equity only put call ratio for oct 27

"If the SPX pushes above its former highs, it would be a breakout from a bullish ascending triangle pattern, with the implication being a rally of almost 10% during the next four months. The biggest short-term risk is that the SPX has not yet broken out, and is therefore sitting nearer the top of its range. If you are bullish now, you're betting on a breakout -- but you do have sentiment factors supporting you."
-- Monday Morning Outlook, October 21, 2019

There are a few risks to the bull case discussed above. First, the SPX has not yet closed above previous highs of the ascending triangle pattern that I discussed last week, and it remains in the area that is 20% above the 2018 close, which is where sellers have emerged not only on stocks, but bonds and gold, as well, in 2019. If the SPX again retreats from the July high, I see potential support emerging in the 2,920 zone, which is the site of a trendline connecting various lows since early June, in addition to the under-the-radar, but significant, 160-day moving average.

spx stock chart 1027

A monetary risk arises this week, as well, with the Federal Open Market Committee (FOMC) meeting on Wednesday, Oct. 30. Fed funds futures speculators are pricing in a 93% probability of a 25-basis point cut in the fed funds rate. When the Fed cut rates at the end of July and in the middle of September, notable short-term equity sell-offs immediately followed.

Finally, with "wrong-way" Commitments of Traders (CoT) large speculators in a big net short position on Cboe Volatility Index (VIX - 12.65) futures, the risk is a VIX pop as it approaches the 12 area. This region is where the VIX bottomed prior to volatility surges and equity "mini-corrections" in April and July.

Those risks in mind, most sentiment measures remain supportive of a breakout, which means the risk-reward favors the bulls. A post-FOMC breakout from the ascending triangle would likely trigger an 8-10% rally into the first quarter of 2020, akin to the short-covering rally that occurred in the second half of 2017.

Todd Salamone is Schaeffer's Senior V.P. of Research.

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