Avoiding Pessimism as a Contrarian Entry Point

The 30% SPX drop since mid-February sparked an influx of pessimism among some participants

Senior Vice President of Research
Mar 23, 2020 at 9:14 AM
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“… breakdowns below the 36-month moving average led to a move down to (at least) its 80-month moving average, where it sometimes finds support (these moving averages playing “role reversal” in 2011, as a break of the 80-month moving average preceded a move to support at its 36-month moving average). 

In other instances, the 80-month moving average fails to hold, which leads to further and considerable downside. Currently, the 80-month moving average is at 2,355, which is 13.1% below Friday’s close. So if you are “frozen” and still holding a sizable equity position, one approach to consider, using history as a guide, is slightly reducing your equity exposure as long as the SPX is below its 36-month moving average (currently situated at 2,766). Aggressively reduce your equity exposure if the 80-month moving average fails to hold amid further equity weakness.’

            -Monday Morning Outlook, March 16, 2020

In last week’s commentary, I presented three monthly graphs of the S&P 500 Index (SPX -- 2,304.92). These took snapshots of various 12-13 year periods, which gave readers a historical perspective of the importance of long-term moving averages that we follow, specifically the 36-month and 80-month.

While these trendlines are not something that you will read about in a technical analysis book, the charts showed the significance of these moving averages in terms of acting as support or resistance levels, or buy and sell signals when the trendlines are crossed.

In fact, as I warned readers last week, after the SPX’s 36-month moving average acted as support on a monthly closing basis on multiple occasions since 2011, a mid-March close below this trendline signaled a potential move down to its 80-month moving average. The SPX was 13.1% above the 80-month moving average going into last Monday’s trading, and by mid-week, that trendline was indeed tested. In fact, on an intraday basis, the moving average was violated, but there was not a daily close below this long-term trendline on Wednesday and Thursday. Preferably, we like to use monthly closes to evaluate price relative to these moving averages, although this is admittedly hard to do with volatility around record levels and six more trading days left in the month.

Last Wednesday’s low was very interesting, as it occurred just above the level when President Trump took office in January 2017. Furthermore, the SPX broke below its December 2018 closing low at 2,353.35 in mid-week action, but ultimately closed above this much watched level before giving way to it at the close on Friday. Coincidentally, the December 2018 closing low and the current site of the SPX’s 80-month moving average are currently situated around the same level. Moreover, the SPX’s 10-year, 100% return, before dividends, is at 2,338 at the close of the quarter and month, per the chart immediately below.

MMO1 March 23

If the day-to-day volatility is too much for you to stomach, consider using Friday’s close below the key levels I identified above in legging out some equity exposure. The intent is that a monthly close below the 80-month moving average would trigger more drastic change in reducing equity exposure, using historical implications of a technical breakdown like this as a guide to manage increasing risk.

Even though last week brought stimulus efforts and Fed actions as companies draw on credit lines with the economy on pause to stem the spread of the coronavirus, uncertainty as to exactly how long Americans and the rest of the world must hunker down persists. As such, questions remain whether the Fed’s actions and the stimulus efforts being discussed will be enough. The uncertainty has led to massive stock liquidation and record volatility, with the CBOE Market Volatility Index (VIX -- 66.04) experiencing a record closing high last week at 82.69, exactly 500% above the 2019 close.   

The option activity I saw on the SPDR S&P 500 ETF Trust (SPY -- 228.80) late last week was intriguing. While I don’t think it represents the consensus, someone is looking to make money if the SPY trades below 25 by June expiration. This would represent about a 90% decline, suggesting we could bet that the economy as we know it is about to implode. It sparked my interest because I noticed that when new analyst targets are revealed in reaction to price action, it usually marks a key bottom or trough. In this case, after a major decline in stocks since mid-February, someone is making an extreme bet in reaction to the price action. Might such activity be indicative of a bottom? It is certainly worth noting.

The 30% decline in the SPX since mid-February has obviously sparked an influx of pessimism among some market participants on par with major bottoms or near bottoms.  But I caution against using this pessimism as a contrarian entry point unless there is an improvement in the technical backdrop – a starting point might be the SPX moving back above its 36-month moving average. 

And it is not an accident that I emphasized the word “some” when referring to market participants’ pessimism extremes or near extremes in the paragraph above. For bulls, one disappointment from a contrarian perspective is the inflows and outflows this month in major exchange-traded funds (ETFs) that invest in equities, bonds, gold, and the U.S. dollar. 

The table below is the result of a query I did on ETF.com that shows inflows and outflows of major ETFs since the end of February. ETF participants are moving into equity funds amid the bloodbath in stocks, and moving out of bonds, which have outperformed equities significantly in March and year to date. Inflows have been minimal in the dollar fund relative to equity funds, even as the dollar has ripped higher this month. This analysis would suggest doing the opposite of what the ETF players are doing in these specific assets, since price action is not supportive of their behavior.

MMO 2 March 23

The pause in economic activity will obviously negatively impact the economy, but to what extent no one knows, especially without knowledge of how different states will act in order to contain the coronavirus and how long containment actions last. On Friday, California and New York -- hot spots for the coronavirus spread -- moved to “stay at home” orders. Then, rumors surfaced on Friday afternoon that Illinois will be the next to do this, and sellers emerged as the perception of a domino-effect of other states following California and New York is moving closer to reality.

Nonetheless, below gives a glimpse of what to expect in the immediate week ahead when jobless claims are revealed, and a worst-case scenario for the current quarter.  These data points do not necessarily reflect consensus opinion, but give a glimpse of how expectations are plunging as some companies remove earnings guidance due to an environment where uncertainty reigns.

 “The one number that everyone is hanging on at the moment is jobless claims, with yesterday’s print showing a 70,000 increase, and Goldman Sachs Group Inc. warning that it could surge to a record 2.25 million for this week, with that data published next Thursday.”

            -Bloomberg News, March 20, 2020      

Second quarter GDP could fall 14% in worst-case scenario

            -Bloomberg TV, March 20, 2020

“… after months of holding the largest short position on SPX component stocks since mid-2018, stocks rallied late last year and into the new year, causing the shorts to finally begin throwing in the towel -- perhaps dampening the selloff… I share this observation not only to report on what occurred, but also highlight the implication, which is that there is a little less ammunition for bulls related to short covering now relative to one month ago.”

            -Monday Morning Outlook, February 24, 2020

With the SPX below its 80-month moving average (albeit not a monthly close), various Fed actions and other stimuli failing to convince investors, a red flag is waving. ETF flows suggesting a “buy the dip” mentality has not been supportive either. 

I suggest reducing your equity exposure until the technical environment improves and we see a roll-over in the pessimism that continues to build outside the ETF world. And finally, one has to assume that the shorts will build positions again, after standing pat throughout the rally into January and then bailing in early February. If the shorts smell more blood, this is yet another equity market vulnerability facing the market as they re-emerge.

I don’t want to end on too sour of a note, but not just because I am looking for a silver-lining. It is possible that the late-day Friday selloff was driven by delta hedging that pushed the SPY to the put-heavy 230 strike late in the day, where put open interest was heavy (see second graph below). 

The 230 strike could have acted as a magnet, as S&P futures were sold more and more heavily as this strike came more into play. If this is the case, stocks should “un-do” Friday’s losses rather quickly (by the end of this month), which is one reason not to fully bail, as Friday’s technical breakdown could have been everything to do with options expiration and the coming March 31 quarterly expiration.

MMO 3 March 23

MMO 4 March 23

“The Federal Reserve announced a major expansion of lending programs that are designed to unclog credit markets that seized up last week, expanding its facilities to include certain types of corporate and municipal debt. The rate-setting Federal Open Market Committee said the purchases of Treasury and mortgage securities that it approved one week ago are essentially unlimited, and the central bank said it would buy $375 billion in Treasury securities and $250 billion in mortgage securities this week.”

The Wall Street Journal, March 23, 2020

Finally, the Fed announced some more actions this morning that turned S&P futures green, after they were limit down following the defeat of a stimulus package in Congress. With the Fed continuing to step up amid a stimulus package on the horizon, such actions could push the SPX back above the 80-month moving average by month end. Therefore, if you can take on such risk and exercise patience, it may be worthwhile to see how the rest of the month plays out before making a noteworthy reduction in your equity portfolio.

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

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