The Next S&P 500 Level That Bulls Should Look Out For

AAII sentiment could provide a silver lining, however

Todd Salamone
Aug 10, 2020 at 8:59 AM
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“…there has been a long hesitation at the round year-to-date (YTD) breakeven area, as this level was first tested in early June. And in 10 of the past 15 trading days, the 2019 closing level was touched.”

            -Monday Morning Outlook, August 3, 2020

After a two-month struggle, the Standard & Poor’s 500 Index (SPX) again vindicated the bulls, as the index finally made a convincing move above the 3,230 level, which represents last year’s close. Coincidentally, volatility expectations as measured by the CBOE Market Volatility Index (VIX) achieved a multi-month low, finally breaking below the 24-level following a two-week battle with this important area, which is double this year’s low. 

While the VIX’s move below 24 does not necessarily mean risk in the market has significantly dropped, it might suggest that the SPX’s drawn-out attempt to move back into positive territory in 2020 is likely to be sustained for at least a few weeks. Bulls will look for early June's former level of resistance to now act as support in the event of a pullback.

But as you have heard many times before during the past few months, it seems that each time the SPX takes out a resistance level, no matter how long it took to do so, there is a level (or levels) lurking just overhead that could present the next hesitation or pivot area, as market participants reassess market exposure.

In this case, with the SPX already through the round 3,300 level, the two levels overhead that I am focusing on now are 3,356 and 3,386. The former is 50% above the March 23 year-to-date closing low of 2,237.40, implying that any market participants anchoring to the 2020 closing low may view this level as an opportune time to lighten exposure. Meanwhile, 3,386.15 represents the SPX’s closing high six months ago, on February 19.

8-8chart 1

Many domestic equity mutual fund investors used the rally to the SPX’s year-to-date breakeven level to de-risk, perhaps taking satisfaction in recouping the money they had entering 2020, before the COVID-19 pandemic and government actions to contain its spread caused both the economy and stocks to experience historic plunges. In fact, a story published last week by Investment Company Institute (ICI) displayed a table showing that domestic equity mutual fund outflows totaled $36.7 billion in June, which was nearly 50% more than the outflows in the prior month. These outflows proved to be a headwind for stocks, as the SPX moved into its year-to-date 2020 breakeven point.

July inflow/outflow data has not yet been published, so it will be interesting to see if domestic mutual fund investors dramatically reduced their selling relative to June. If so, this would explain why the SPX performed better in July relative to June, even though it hovered around its year-to-date breakeven for weeks, before finally starting a convincing breakout last week. June, for what it is worth, was responsible for 19% of the January through June total outflows of $192.3 billion. 

8-8chart2

I made this point about mutual fund outflows because it is quite possible that fund investors will again view a SPX rally that gets to 50% above the 2020 closing low, or a rally back to February’s all-time high, as a psychological “second chance” opportunity to reduce exposure, especially since the unknowns that blindsided so quickly and dramatically in February are still fresh on their collective minds. Plus, another major unknown lies just around the corner -- the November election -- which may give them the excuse they are looking for, if given a second chance. 

If domestic equity fund investors view the levels I pointed out as selling opportunities, like I am hypothesizing, we could see a mild pullback on par with that of June, pushing the SPX to its 40-day moving average, which is currently at 3,182.  But if equity option buyers and active investment managers sour on stocks simultaneously, selling could be more pronounced. These two groups of market participants remained bullish as fund investors turned more cautious in June, thereby giving the market support.

8-8chart3

There is good news on the sentiment front, and it is a topic that I regrettably have not addressed, at least directly. That is, the $192 billion that moved out of domestic equity funds in the first half of 2020 represents future buying power. In fact, there may be a connection between the American Association of Individual Investors (AAII) weekly survey and the actions of these investors. The bearish sentiment in this survey has reflected the action of domestic equity fund investors, who have been a headwind this year, even during the rally off the March low. In last week’s survey, only 23% of respondents were bullish, while 47% responded as bears.  As such, the $192 billion withdrawn from domestic equity mutual funds may grow.

But there will likely be a point they move off the sidelines and back into equities. It is the timing that is uncertain, especially as the trend in this group through June’s data is reducing equity exposure. They may be looking for COVID-19 and/or election uncertainties to alleviate. Or, there is the “fear of missing out” reaction to market strength that could move this group off the sides. Quite possibly, the SPX’s move into positive territory in 2020 could be the trigger for a “fear of missing out” type trade. Others may be anchoring to this impressive rally that they missed and looking for a pullback to enter, which would be supportive of the market on pullbacks.

The sentiment backdrop remains a risk that I think is worth repeating. But as I discussed last week, I am not advocating fighting the tape, as bulls are being vindicated and have been given no reason to panic. If you are playing purely options, you can continue to play the sentiment risk and strong technical backdrop via straddles and pairs options trades, where the call exposure gives you exposure to the momentum higher, and the put exposure gives you exposure to the sentiment-based risks. Or, if you are playing long equities only, you can manage the sentiment risk by selling the stock and buying in-the-money and/or longer-term calls that give you exposure to the upside with less dollars at risk.

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

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