“I am watching two other levels of interest, one of which is obvious, the other of which is not. First, the September lows occurred at 4,300…and could be an area where buyers step in to halt the slide. Just below 4,300 is the 4,289 level, which is the level that coincides with a round 10% below 2021’s close. Long-time readers of this commentary know the historical importance of round year-to-date levels as hesitation or pivot points. But like other troughs, I think a bull would like to see a day or two of heavy selling in the morning, followed by a rally and close near or at the high.”
- Monday Morning Outlook, January 24, 2022
Per the excerpt above discussing the S&P 500 Index (SPX – 4,431.85), and not long after this commentary was posted on our website, the index found itself testing the critical levels I highlighted. After the standard Friday, Jan. 21 expiration close at 4,398, the following Monday was met with follow-through selling. In fact, the SPX traded below 4,300 and 4,289, areas that mark the early October 2021 bottom, and a round 10% below last year’s close, respectively.
As I have said multiple times, it is the close that matters most, but the intraday movement below these levels were of concern before the late-afternoon reversal that eventually came. “Bewildered” was a term that I noticed being used to describe last Monday’s reversal to close back above support levels I identified. Moreover, Monday’s candle – heavy selling in the morning, followed by a rally and close at its high of the day – was something I mentioned bulls wanted to see before dipping their toes back into the water.
The 4,289-4,300 area would go on to mark support throughout the balance of the week, as the SPX chopped in a volatile range between the support levels discussed above, and its highs between 4,420 and 4,440. This included Wednesday’s action, when the highs occurred around 4,440, before Federal Reserve Chairman Jerome Powell’s “hawkish” press conference, following the release of the Federal Open Market Committee’s (FOMC) statement. After Powell’s comments, the SPX found itself barely above 4,300 at the close.
“Turning away from anecdotal evidence of potential extreme fears among traders and investors, which are fundamental to a market-bottoming process, let’s turn to a few quantified indicators, starting with those in the options market… extremes in fear are welcome, but there has to be evidence that such fear has climaxed, which is a major uncertainty at present… The 10-day average of the equity-only, buy (to open) put/call volume ratio on SPX components is at an extreme too, but the direction of this ratio continues to be the biggest risk for bulls.”
- Monday Morning Outlook, January 24, 2022
As the SPX held support, we began seeing evidence of extremes in pessimism being more profound than what I pointed out last week. This was a risk I identified beforehand – fears we are seeing at present becoming deeper and wider spread.
For example, look at the absolute and the direction of the 10-day, buy-to-open put/call volume ratio on SPX components in the graph below. This ratio continued higher last week, despite coming into the week at range highs going back to mid-2020. The risk to bulls is that this ratio eventually revisits the early 2020 high at 0.90, or moves to a higher level above that extreme.
The high point in this ratio occurred in early 2020, coincident with a sharp equity market selloff when the economy essentially shut down to stop the spread of Covid-19. Whereas the Federal Reserve eventually calmed markets by utilizing tools to help support the economy, the Fed is now unwinding that stimulus, which is driving markets lower.
Plus, check out the 10-day, buy-to-open put/call volume ratio on Nasdaq-100 Index (NDX – 14,454.61) components in the graph below. This is a group that has incurred the brunt of the damage as interest rates have turned higher, due to hints from the Fed of multiple hikes this year.
“Officials still think the broad direction of short-term interest rates will be higher in 2019, according to recent interviews and public statements. But as they push up their benchmark, they are becoming less sure how fast they will need to act or how far they will need to go, and they want to assess how the economy is holding up under moves they have already made.”
- The Wall Street Journal, December 6, 2018
The good news for bulls is that the NDX component, buy-to-open put/call volume ratio is at two climactic highs that occurred in December 2018 and March 2020, both of which marked notable bottoms in the NDX.
For what it is worth, similarly to the present environment, Fed uncertainty was a driving force behind the December 2018 selloff, as the Fed was talking about further fund hikes into 2019, amid a growing trade dispute with China that was creating economic uncertainty. For a bottom in stocks to be achieved at present, investors must determine if the economy is in position to take on rate hikes or not.
Like the SPX, the NDX is holding at a potentially important level, the round 14,000-millennium mark. Not only is this a big round psychological level, but it is double its 2020 closing low. Unlike 2018 and 2020, the climactic readings in option-buyer pessimism on NDX components occurred when the NDX was probing its 36-month, or three-year moving average. The NDX comes into this week far above this long-term trendline.
I think, at minimum, NDX bulls can deem it safe to get back into the water if signs emerge that option buyer pessimism on NDX components has indeed climaxed and/or the index climbs back above its October closing low at 14,472. Aggressive speculators can make bullish bets now, with negative sentiment on NDX components at levels that preceded two prior major bottoms and 14,000 holding. But keep a short leash if using stocks when determining a stop-loss, or use call options in lieu of long stock plays to limit your dollars at risk, if you make such a bet.
If both the NDX and SPX hold support levels, a powerful rally could happen, with other negative sentiment extremes emerging. The National Association of Active Investment Managers' (NAAIM) weekly survey reading came in at 53, with 100 being fully invested, zero implying 100% cash or fully market neutral, and -100 being fully short. For what it is worth, this reading was 103 in late November, implying slightly leveraged long.
Finally, the four-week moving average of the bulls minus bear ratio in the weekly American Association of Individual Investors (AAII) is either at or approaching levels at which past bottoms have occurred during the past 10 years. When it dips below zero, as it has now, it means there has been more bearish respondents than bullish on average over the past four weeks. A cautionary note is that this reading can stay low or continue lower, implying respondents may have to get to a point where they feel they are missing out on a rally.
Finally, two short observations to conclude this commentary. First, total short interest on SPX component names is at multi-year lows, and far below the levels that coincided with bottoms in 2018 and 2020. Thus, short covering will not have the bullish impact it has had in the past on some underlying equities in this index. In fact, the long-term risk to bulls is the shorts returning in a big way, creating a long-term headwinds after years of mostly covering activity that has been supportive. That said, bulls would gladly welcome more covering activity.
Second, last week’s peak in the CBOE Volatility Index (VIX – 27.66) occurred in the vicinity of double its 2021 close, and double this year’s closing low, which happened in early January. A close above these levels would create a risk for bulls of an eventual peak in the 45 area, which is triple the October closing low. A close below 25.30 and 25.71 – the latter representing the September closing high, and the former being 50% above the 2021 close – would suggest lower volatility and higher stock prices in the weeks ahead.
Todd Salamone is Schaeffer's Senior V.P. of Research
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