Reading the Fed as Market Reverses Expiration Week Losses

A hedge of long positions to protect against surprises could be appropriate

Senior Vice President of Research
Jun 28, 2021 at 9:02 AM
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If buyers surface, the first area of potential resistance is between 4,193 and 4,212, or the lower boundary of its channel. The second area of resistance is between the early May closing high at 4,232, and last week’s closing high at 4,255. For what it is worth, Thursday and Friday’s candles look very similar to May 11 and May 12, which is the last time the SPX closed below the lower boundary of its channel.

          - Monday Morning Outlook, June 21, 2021

After another false alarm with respect to a technical breakdown, the S&P 500 Index (SPX - 4,280.70) quickly reversed losses following expiration and a week-long selloff that was in response to the Federal Open Market Committee (FOMC) meeting. In fact, as I alluded to last week, the channel breakdown occurred in the context of late-week candles that looked very similar to May 11 and 12, which preceded a rally after a false alarm breakdown that same month.

With the SPX quickly back in a bullish channel that has been in place since mid-November, while also carving out new all-time highs, bulls remain firmly in control. In the options market, the ratio of buy-to-open put volume to buy-to-open call volume continues to drift lower to extreme levels, as both momentum and mild pullbacks continue to attract equity speculators.

The bearish ‘tri-star’ doji pattern that emerged on the SPX in April is something that continues to stand out …It took the index six to eight weeks to fully recover from similar bearish patterns in January and February. Bulls have a glimmer of hope that we are closer to the backend of bearish ramifications of this multi-candle sell signal, as this latest ‘tri-star’ doji bearish pattern surfaced nearly two months ago. Coincidentally, Friday’s pullback was in the vicinity of those late-April SPX closes.”

          - Monday Morning Outlook, June 21, 2021

In a week’s time, the SPX was teetering on a deteriorating technical backdrop, then rallied to take out various potential resistance levels, most notably its early May, all-time closing high. As I said a few weeks ago, if the SPX spends most of its time within the upward channel that began to take shape at the same time positive Covid-19 headlines were emerging, it would be considered a win for bulls, since support and resistance levels that make up this channel move higher with each passing day.

Looking ahead to the week that will entail the last day of the second quarter, as well as the beginning of the third quarter, the bottom of the channel begins the week at 4,215. By Friday, it will be coincidentally at 4,232, which is the site of its May all-time high, which was just taken out last week. As such, the area between these levels defines the first area of support. 

MMO 627 1

It will take a much larger drop in the SPX to create a serious unwinding of the growing optimism we are seeing among retail traders and equity option buyers. For example, the area between 4,056 – six times the SPX’s 2009 closing low – and 4,100 is significant. The latter is a round number and site of the breakout above the upper boundary of the channel in early April. The former is a level I continue to monitor because, since the 2009 closing low, levels that were two to five times that low have marked long hesitation points, or notable corrective moves.  

However, 4,056 has been different in that we have not seen a hesitation around this area, nor a corrective move from that point. In fact, after the breakout above the 4,056 level in early April, this point acted as support in both late April and early May.

The SPX is about 4.5% above the area between 4,056 and 4,100. With the Cboe Volatility Index (VIX – 15.62) coming into a new week and quarter around 15 – which was its reading ahead of the early 2020 Covid-19 sharp selloff, and a level from which it has bounced in recent months – a hedge of long positions to protect against mid-summer and/or late-summer surprises could be appropriate. 

If the SPX is trading below 4,056-4,100 in the weeks ahead, portfolio insurance will be a lot more expensive than at present. Therefore, it is better to buy portfolio insurance when few anticipate needing it, versus when many are falling over each other to buy it.

MMO 627 2

New York Fed President John Williams told Bloomberg Television on Tuesday that liftoff is ‘still way off in the future’ and the central bank isn’t close to tapering bond buying. The following day, Atlanta Fed president Raphael Bostic said the taper decision may come in the next few months and he expects the Fed to first hike rates in late 2022. Chair Jerome Powell himself weighed in, telling Congress that the central bank will wait for ‘actual evidence of actual inflation’ before lifting rates.

          - Bloomberg, June 25, 2021

Finally, as the summer progresses, investors will be looking for clues as to exactly what the implications of the FOMC meeting were two weeks ago. In other words, were they hawkish as first perceived, driving a shift into bonds and out of commodity-related and financial stocks? Or were they dovish, as Federal Reserve Chairman Jerome Powell and New York Fed President John Williams conveyed last week, reversing the course of financials and commodity stocks last week?  

It is best to refrain from jumping to conclusions about what Fed governors are saying in the media and look to voices that matter. For example, per the excerpt from Bloomberg above, Powell and Williams are FOMC voters this year and into 2023, if they remain in their respective positions. For that reason, their words may carry more weight than Atlanta Fed President Raphael Bostic's, who is a voter on the FOMC this year, but will not be a voter again until 2024.

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