Why the SPX's Next Rally Could Be Short Lived

Short-term sentiment and a pickup in VIX put volume indicate short-term bursts higher

Senior Vice President of Research
May 1, 2022 at 7:18 PM
facebook twitter linkedin


A bounce in a bear market, or a recovery in the continuation of a bull market?... Fortunately, as market participants assessing risk and reward, we don’t necessarily have to make a bold projection, but instead use price action to guide us in our decision-making process…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 two weeks ago.”

Monday Morning Outlook, March 28, 2022 

The events of last week in terms of equity price action were unfortunate for stock market bulls. But if you were following this commentary during the past month, you were likely not shocked by what transpired, or at the very least, acted as the market first began unraveling with the prior week’s S&P 500 Index’s (SPX – 4,131.93) move below 4,375.

As I said in late March, history has shown that vicious rallies do occur in the context of bear markets and, as such, the mid-March breakout above a trendline connecting lower highs was an uncertainty to its sustainability.

Admittedly, the SPX has not officially entered a bear market by the popular measure of a 20% retreat from its peak. Nor has it entered bear market mode by our measure, which is a monthly close below a long-term trendline, such as the 20- or 24-month moving averages.

But the fact that the SPX hasn’t achieved a new high in months, in addition to the Fed pivoting to a more hawkish strategy to combat inflationary pressures that have persisted longer than many have anticipated, and the SPX’s break below a long-term channel connecting higher highs and higher lows late last year, has certainly increased the possibility of a prolonged period of lower stock prices, as investors adjust to higher interest rates, and possibly slower economic growth.

Two graphs stuck out to me in the past week. The first suggests heightened risk of higher volatility and lower stock prices in the near future. VIX futures options buyers are again purchasing calls relative to puts at a rate that has historically preceded trouble for equities in the past year.”

Monday Morning Outlook, April 4, 2022 

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 (the SPX’s) 63-day historical volatility and roughly half this year’s intraday high.”

Monday Morning Outlook, April 11, 2022

Moreover, CBOE Volatility Index (VIX – 33.40) futures option buyers, who have had a solid track record the past few years in forecasting volatility expectations for equities, were hinting that volatility was heading higher, potentially putting the SPX’s mid-March breakout in jeopardy of being a fake-out move to the upside.

These option buyers were again prescient with respect to their timing, with the VIX surging into the 30 area as the SPX closed back below the 4,375 level on April 22, which was the site of the mid-March breakout above the top rail of a channel connecting lower lows and highs.

The close below 4,375 was followed by an immediate retest of the February and March lows in the 4,150 area, which was coincidentally the site of the SPX’s year-over-year breakeven level. But a bounce from this support area failed to materialize into anything substantial, as sellers rudely greeted the move back to the 4,300-century mark, which had previously marked lows in October and January. In fact, the SPX closed out the month of April trading in negative territory year-over-year for the first time since May 2020.

Amid the carnage, the Nasdaq-100 Index (NDX – 12,854.80) closed at its 2022 lows and was driven south of the 13,000-millennium mark. Moreover, for the first time since December 2018, it experienced a monthly close below its 24-month moving average, which qualifies this index being in a bear market by our definition. It is also 22% below its November closing high, meeting the consensus definition of bear market. The Russell 2000 Index (RUT –1,864.10) closed at its 2022 lows too, and is trading at levels not seen since December 2020, as it stands down more than 17% year-over-year, and well below its 24-month moving average.

MMO 0501 1

We enter this week’s trading and a new month just below the lower boundary of a volatile range since January between 4,150 and 4,600, and at the top rail of a bearish channel in play from November into mid-March. Short-term sentiment measures and a pickup in VIX put volume indicate we could see more short-term bursts higher, though moves above resistance levels that I am about to discuss may prove fleeting.

Bulls beware, particularly long-term bulls, that unless the SPX moves back above 4,375 in the weeks ahead, rallies may be short lived, perhaps even weaker in magnitude than the bullish action from mid-to-late March.  As such, they should be used to lighten up on bullish positions or to hedge long positions, if you haven’t done so already.

Not only does 4,375 represent the level from which the SPX broke out above a channel connecting lower lows and lower highs from January through February, note that a new trendline connecting lower highs from late-March into mid-April has developed. In mid-May, this trendline will be sitting at 4,375, and at the beginning of June, this trendline will be sitting at 4,300. As such, a move north of 4,375 can only happen if the 4,300-century mark is taken out, which not only proved to be resistance into this week, but could also be a formidable resistance level a month from now if retested again.

If one uses the 20-month moving average as a demarcation between bull and bear markets, the SPX’s monthly close 14 points below this trendline officially puts the index in a bear market. It is 14% below its closing high, implying most market analysts will not declare it in a bear market, and a longer-term monthly chart would suggest it is not in bear market mode.

The SPX is well above its 24-month moving average at the 4,000-millennium level. As you can see, this long-term moving average has supported the SPX on multiple occasions. But you should also note that when the SPX breaks below its 24-month trendline, the 36-month moving average, currently situated at 3,650, has come into play and/or a trendline connecting higher lows since the 2007-2009 bear market trough.

As I did in late March, I am making these observations so that you can continue to assess risk-reward in the coming weeks.

MMO 0501 2

While the SPX may not be in a bear market by traditional measures, a concern I have is sentiment indicators recently behaving as if in a bear market. For example, during the bear markets in 2000-2003 and 2007-2009, equity put/call volume ratios tended to trough in the 0.50-0.55 zone, as opposed to the 0.30-0.35 during bull market phases.

Note in the chart immediately below how the 10-day, buy-to-open put/call volume ratio on SPX components recently troughed in a zone that is more typical of a bear market than a bull market.

The extreme high in this ratio suggests we could be on the verge of another bounce higher. But a sustained period of unwinding of this growing fear will only occur if the SPX takes out the resistance levels discussed.

If the SPX cannot do this, no one will have fears of missing out on a rally and/or the shorts may grow bold again and use the technical weakness to build short positions. Per the second graph below, this is not exactly a highly shorted market, implying short covering is not likely to be supportive. Moreover, if the shorts begin smelling blood, they may begin building positions, and this would be a headwind.

MMO 0501 3

MMO 0501 4

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

Continue Reading:

 

Stop leaving money on the table with the same old broken options trading approach...

There is no options strategy that more perfectly capitalizes during earnings season better than this simple call and put buying strategy. Perfect for aggressive traders looking to recover their suffering portfolios so far in 2022. With the simplest possible options strategy, Schaeffer's team with 100+ years of options trading excellence, target 200% gains on every single trade. So many trades are being beaten down by the market, but don't be one of them! Don't waste another second... join us right now before the next trade is released! 

 
Schaeffer's Daily Bulletin Offer
 


 


 
Special Offers from Schaeffer's Trading Partners