Active investor optimism continues to build, signaling a possible headwind
“…some indicators have not exactly been clear for short-term traders, as other resistance levels immediately come into play after a previous level was taken out. In fact, the SPX’s 2019 close hovers just overhead at 3,230.78…Moreover, during the past couple of weeks, short-term equity option buyers have grown more and more enthusiastic, which has resulted in a caution flag being waved by me during this period.”
-Monday Morning Outlook, June 8, 2020
After the S&P 500 Index (SPX—3,271.12) marched higher from its March lows, there were several potential resistance levels that I would point out week after week. During this period, a short-term pause around these levels occurred before an explosive move higher, as historic extremes in pessimism were unwound.
Fast forward to early June, when I pointed out another technical level overhead that could pause the rally. But short-term sentiment concerns were then surfacing too, implying potential resistance levels could become more robust. At the time, the SPX’s 2019 close was just overhead. As long-time readers of this commentary are fully aware, the SPX has tended to use round percentage returns with respect to the previous year’s close or a major high/low as significant pivot or hesitation points. Coincidentally, short-term traders, as measured by the action of equity option buyers, were now displaying optimism, leaving the market vulnerable to a pause or a pullback.
The chart below displays when I made the comments that are excerpted above. As you can see, there has been a long hesitation at the round year-to-date (YTD) breakeven area, as this closing level was first tested in early June. And in 10 of the past 15 trading days, the 2019 level was touched.
Additionally, since my early-June observations, there has been more downside below 3,230 than movement above it, although bulls might point out that one difference between early June is that we are not selling off like we did then, when this important level was touched for the first time since February. But the pause at this resistance level has lasted much longer than those hesitations we saw in late March and late-April/early-May.
“…the sentiment backdrop increases correction risk, but the technical backdrop has not yet validated the timing.”
-Monday Morning Outlook, July 27, 2020
As the SPX has battled its 2019 close, the popular equity benchmark has not experienced a consequential move below short-term support areas that might unnerve equity option buyers that have helped support the rally, a topic that I discussed last week.
It might take a decent decline from current levels to spook traders. For example, the SPX’s 3,100 level is a round number that represents the early-July breakout level above a trendline connecting lower highs in June. It would likely take a move below this potential support to finally stoke fear among short-term market participants. For the upcoming week, the 3,172 area is one to focus on, as it coincides with a round 10% year-over-year (YoY) return for the index at this week’s end. Since early June, rallies have been stifled around levels that correspond to the SPX’s 10% YoY return level. Also, the SPX’s rising 40-day moving average is sitting just below at 3,162, a trendline that marked lows in June.
While not all sentiment indicators are flashing exuberance (the American Association of Individual Investors weekly survey still shows more bears than bulls), it is the action of those that are more active and putting their money where their mouth is that continues to suggest yellow flags should be waved in the short term. Note that the 10-day, equity-only buy (to open) put/call volume ratio is turning higher from extreme lows, just as it did in late June. As you can see on the chart below, this has historically preceded pullbacks – some mild, some more drastic.
Moreover, the weekly National Association of Active Investment Managers (NAAIM) survey revealed last week that the average equity exposure among respondents is 97, with 100 being “fully long” and 200 being “leveraged long.” The current reading is near the top of a range since data has been provided in 2006. That said, extremely low readings in this survey have preceded bullish action in the market, relative to high readings preceding bearish action.
Finally, a question to be raised is, “have we seen the bulk of short covering on SPX components and, if so, what kind of implications does this have?” For example, there was another decline in short interest in the latest report date mid-July. Short covering is supportive of the market, but as you can see on the graph below, total short interest on SPX components is around previous lows that have preceded builds in short interest during the past few years. The implication is that, if a build in short interest happens again from these levels, or short interest does not drop as sharply as it has during the past few weeks, what was once a tailwind could suddenly become a headwind.
However, the shorts must smell blood before they commit to lower prices. From a price action perspective, there has not been a lot of incentive to make such a commitment. There has been covering in some travel and leisure stocks that present a risk, as major uncertainty swirls around these companies as their respective stocks trade well off their highs.
The message has not changed. Respect the fact that the technical backdrop has not deteriorated even amid a loss in momentum from the March low. But be wary of short-term sentiment indicators that suggest stocks are more vulnerable than usual to a pullback. If you are an option trader, play the bullish action via calls to manage risk and leverage the possibility of a breakout from the current hesitation period. But also look for opportunities on the put side, via straddles, pairs option trades, and stocks trading into chart resistance that are also well off their highs and therefore vulnerable to the shorts increasing their bets to hedge COVID-19 and election uncertainty.
Todd Salamone is Schaeffer's V.P. of Research
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