Major Sector Corrections Testing Investor Nerves

Sentiment indicators are suggesting risks of a pullback are rising

Senior Vice President of Research
Jul 6, 2021 at 8:47 AM
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The first half of 2021 is behind us, and with that, a lot of excitement depending on where your investment or trading focus is. There was the boom/bust/boom of meme stocks. Bitcoin (BTC), last year’s superstar, was another hot topic, crashing 50% in April-May. Anyone that bought and held this cryptocurrency in late January and held into Friday is now underwater.

If you are in tune with financial media, you are well aware of the deep pullback in commodities, just as the inflation debate took hold. Whether it was gold, lumber, wheat, zinc or copper, corrections in the commodity market are abound. Bonds got into the act, with the iShares 20+ Year Treasury Bond ETF (TLT -- 145.04) lower by 15% in the first three months of 2021. Equity volatility, an asset class that we closely follow as measured by the Cboe Market Volatility Index (VIX -- 15.07), crashed too. From its January peak into early April, this measure retreated by more than 50%.

Coincident with the crash in equity volatility, there was new high after new high as the first half of 2021 concluded, with respect to the "boring" S&P 500 Index (SPX -- 4,352.34). While the index experienced a couple of pullbacks, they were extremely mild in comparison to what we witnessed in most other assets.

Even though the SPX stood its ground, there were sectors that were not immune to 10% corrections, testing investors nerves in the process. For example, exchange-traded funds such as the tech-heavy Invesco QQQ Trust Series (QQQ -- 358.64) and Financial Select Sector SPDR Fund (XLF -- 36.94), in addition to the Invesco Solar ETF (TAN -- 88.18), all experienced corrective moves in the first half 2021. If you are into exchange-traded funds with an international focus, you were not spared from the 10% corrections in the iShares MSCI Emerging Markets ETF (EEM -- 54.78). 

In other words, if you are on record as saying, "a correction is coming," take a bow if you were not directly referring to the SPX. We were awash in corrections and crashes in popular assets - cryptocurrencies, numerous commodities, bonds, volatility, and sub-sectors of the broader market.

As many assets struggled at some point during the first half of 2021, the SPX rallied in an orderly manner. Many of you are familiar by now with a chart that I have been posting weekly, which shows a channel that the SPX has been trading in or above since mid-November, which is when promising headlines on vaccines for Covid-19 first emerged. In fact, there were only 11 or 12 closes below this upward-sloping channel spread out in the first six months. 

After a June expiration-week selloff pushed the SPX to the bottom of this channel, the SPX has not only recovered these losses, but is off to an excellent start to the second half of 2021. In fact, the top of this channel is very much in play, as a potential resistance area between 4,375 and 4,390 to begin a shortened Independence Day week.

spxdailychart1

On April 9, the SPX broke out above potential resistance from the upper boundary of this channel. At the time, option buyers were unwinding a multi-month peak in bearishness on SPX components, as is evident by the late-March high in the SPX component 10-day buy-to-open put/call volume ratio. 

After the breakout, these short-term traders became increasingly bearish, and the SPX continued to grind higher above the channel into early May. The SPX finally broke back below the channel when option speculators suddenly turned bullish. 

This time, as the upward boundary of the SPX channel comes into play again, option buyers on SPX components are still unwinding a peak in bearish bets in late May, but the ratio is much lower than early April. The extreme low in this ratio decreases the odds of enough firepower being available to push the SPX through the upward boundary of its channel -- at least for a sustained period. 

In fact, while the direction of the ratio is bullish, the absolute level of this ratio – which is now below the 2021 low in late January – increases the risk of a short-term pullback. In late January, for example, the SPX began a decline to the lower boundary of this channel after probing the upward boundary of the channel for a few days (see circle in chart above). 

If a repeat of the late-January pullback occurs, a natural support level is the mid-June closing high at 4,255, which preceded the expiration-week selloff. This level coincided with the lower boundary of the channel at Friday’s close.

SPXMMOchart2

Momentum in the market and consecutive highs argues to stay the bullish course.  But sentiment indicators are suggesting risks of a pullback are rising. If hedging isn’t your preferred method to manage risk, another strategy to consider is selling long stock positions, and replacing them will call positions, which reduces your dollar exposure to the market. But by utilizing the leverage options provide, you are still able to capture significant dollar gains if the momentum continues to the upside, like that of April and May.

Continue reading:

Trader: Sell These 8 Stocks in 2021

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