For Stocks, History May Not Repeat Itself, but It Does Rhyme

Tracing connections between last week's SPX selloff and past pullbacks

Senior Vice President of Research
Apr 11, 2022 at 9:25 AM
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“… the 10-day buy (to open) call/put volume ratio on VIX futures is approaching the November 2021 levels that preceded a 4% pullback from the early-November high to the early-December low, which was then followed by choppiness into the Christmas holiday…a 4% pullback from last week’s closing high at 4,631 would push the SPX down to 4,446, above the 4,377 level that I highlighted last week as important to bulls.”

          -Monday Morning Outlook, April 4, 2022

It is of paramount importance to get inflation down … Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017--19. The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee's Summary of Economic Projections.”

           -Lael Brainard, Fed Governor, April 5, 2022

It’s hard to know how much the U.S. Federal Reserve will need to do to get inflation under control. But one thing is certain: To be effective, it’ll have to inflict more losses on stock and bond investors than it has so far.”

          -Bill Dudley, former New York Fed President, April 6, 2022

A quote from Mark Twain, “History doesn’t repeat itself, but it does rhyme,” is a familiar piece of wisdom that stock market investors use when confronted with taking a “this time is different” approach.

Twain’s piece of wisdom came to light as the S&P 500 Index (SPX – 4,488.28) sold off last week following a one-two punch of comments from a current Fed governor and a past Fed president. The decline followed several days in which a noticeably large number of Cboe Volatility Index (VIX – 21.16) futures call contracts were purchased (to open) relative to puts purchased (to open), which has historically been a red flag for short-term stock bulls, beginning days or weeks after such options activity.

In this instance, and as I cautioned readers last week, the ratio of VIX calls relative to puts purchased (to open) was approaching that of early November, which preceded a 4% pullback over the next month, though the majority of that decline didn’t occur until two weeks after the signal. This time, a selloff took hold immediately, with the SPX’s lows in the 4,450 area on Wednesday and Thursday, and in the immediate vicinity of the 4,446 level that I mentioned in the April 4 commentary, which is being 4% below the recent closing high of 4,631.

If last week’s lows prove to be a trough for the time being, history indeed rhymed, as the magnitude of the decline was like that of November-December. But unlike the early November VIX futures option-buying sell signals, the duration of the 4% decline was about half of the early November to early December period.

Amid the SPX’s pullback, there was hardly technical damage. In fact, its upward-sloping 20-day moving average contained the lows. This moving average is also a 50% retracement of the January closing high and March closing low. Additionally, the SPX didn’t come close to breaking below the 4,377 level, which marked the site of the breakout above the top rail of the bearish November through mid-March channel.

mmo chart 1 apr 10


It might be that market participants have moved from concerns that the economy was not in a place to handle rate hikes, to a new belief that rate hikes are needed and welcomed.”

            -Monday Morning Outlook, March 21, 2022

The minor damage to stocks amid hawkish Fed events last week (multiple presidents and governors with comments along the lines of Brainard’s and the release of the Federal Open Market Committee (FOMC) minutes from the last meeting) leaves me to consider again an observation I made in the March 21 commentary, excerpted above.

That is, investors may be more comfortable with the hawkish Fed posture relative to five months ago, when the Fed cautioned that its long dovish posture was about to change. The November warning from the Fed was the start of a multi-month period from November into mid-March in which the SPX made an orderly series of lower highs and lower lows.  

But consider the following:

  1. The SPX is still well above its March 15 close of 4,262, which preceded the March 16 rate hike. In fact, a breakout above the top rail of the channel described above, and as seen in the chart, occurred just one day after the Fed’s rate hike.
  2. Since March 1, the much-followed 10-year Treasury Yield Index (TNX – 27.13) has risen from about 1.70% to 2.70%, or 100 basis points in a little more than a month. The SPX is up about 4.5% over that period. Taking this observation one step further, since the TNX’s early-August 2021 low at 1.17% to its current yield -- a 153 basis point rise in eight months -- the SPX is still slightly above the 4,423 early August close.
  3. During the past month, rate hike expectations into year end by Fed funds futures traders, as seen on the Chicago Mercantile Exchange’s (CME) web site, have risen substantially. One month ago, these traders assigned a zero-percent probability of a Fed funds rate of 2.50% to 2.75% by year end. As of Friday, this group assigned a probability of 80% that the Fed funds rate would be at least 2.50% to 2.75% at the end of December. The SPX is up nearly 8% over this one-month period.

In evaluating the path of interest rates, expectations on the Fed’s actions into year end, and SPX price action, it appears that market participants have become more concerned with inflation stunting economic growth and are viewing the Fed’s hawkishness as not only necessary but welcomed.

Moreover, the index’s price action has occurred as words like “recession,” “hard landing,” and “stagflation” have taken greater hold in financial news outlets, implying some investors may be hedging or preparing for such scenarios to unfold, which lowers expectations and keeps the wall of worry that stocks typically need to advance intact.

From a short-term technical perspective, the SPX remains situated in the middle of what could be resistance levels overhead and strong support levels below.

Resistance overhead begins with the close ahead of last week’s gap lower at 4,525. Another layer of potential resistance resides at last month’s closing high in the 4,630 area. If these levels are taken out, the 4,700-century mark could be contentious, as this marks the close before the sustained move below the bottom rail of a bullish channel from late 2020 into November 2021. Above that, the 4,765 level represents the 2021 close, and is yet another potential barrier.

“…if following the historical script and applying to the present, the SPX’s 4,375 level should be your ‘uncle’ point to take action to lighten up on bullish positions you may have initiated coincident with the SPX breakout… If you want to give a little more room, or lighten up even further if the SPX declines, the round 4,300-century mark is another point to focus on, as this represents September and January support.”

  -Monday Morning Outlook, March 28, 2022 

Many guests on CNBC are expecting at least a retest of the lows, and some are expecting worse. Risks of a bear market or a move below prior lows is heightened if support levels discussed above are broken.

The historical script I discussed in the excerpt above referred to the action in the SPX following strong rallies within two previous multi-year bear market environments. In other words, breakouts above bearish channel lines occurred in the 2000-2003 and 2007-2009 bear markets but were followed by moves back below the breakout level. Such moves back below the breakout level preceded declines to lower lows.

I cannot say with 100% certainty if the lows for the year are in place. If the SPX moves below the support area described above, shorts would likely be emboldened again. Amid low historical short interest on SPX components, a massive headwind would present itself if the shorts get bolder following a technical breakdown.

If you want to hedge against a bearish scenario with index or exchange-traded fund (ETF) options, now is the time, with the CBOE Market Volatility Index trading in line with 63-day historical volatility and roughly half this year’s intraday high.

Finally, I will leave you with another historical fact regarding rate-hiking cycles. It may not repeat exactly, but if it rhymes, bulls remain in a good place.

An analysis of 12 rate hike cycles overall by Truist Advisory Services found the S&P 500's posted a total return at an average annualized rate of 9.4% during the length of such cycles, showing positive returns in 11 of those periods.”

          -Reuters, March 16, 2022 

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

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