Last Friday was the lightest full session of the year, regarding volume for the S&P 500 Index (SPX – 3,899.38). This is ahead of the much-anticipated inflation data set to be released on Wednesday, which is at the forefront of market participants’ minds as we head into options expiration week. Economists and strategists have been expecting inflation growth to slow, as expectations become more difficult to beat from the previous year. Still, we’ve yet to see this come to fruition in recent reports, with the last consumer price index (CPI) reading coming in at roughly 8.6% year-over-year.
Furthermore, Federal Reserve committee members have remained steadfast in recent comments that slowing the economy to curb inflation is the priority, no matter the pain it may cause. Members speaking last week continued to call for 50- to 75- basis point rate hikes in July, as inflation pressures remain.
Additionally, widening credit spreads are a concern. One big difference I’ve noticed is the pace that the spreads are widening. In 2020, the rate was rapid, giving equities the capitulation moment they needed for a V-shaped recovery. This year’s momentum is much more aligned with the 2008-2009 and the 2014-2016 periods. Since bonds are just the inverse of yields, we can use proxy exchange-traded funds (ETFs) to see this spread action by utilizing the HYG/IEI ratio spread. As you can see in the chart, the slower the momentum, the longer it takes for the equity markets to find an ultimate bottom.
“...A move back above 3,850 in the SPX, at the very least, could drive a small rally to test the 40-day moving average, currently at the 3,948. This is where price action was capped multiple times in the early June bear rally. If price action can breach the 40-day moving average this time around, I'd expect a move back toward the upper rail of its current down trend that could push the SPX to the round 4,000-millennium level.”.”
- Monday Morning Outlook, July 5, 2022
Last week, bulls defended the SPX 3,750-level resiliently, as intraday breaks could never be held into the close. Moreover, Friday’s intraday high was just 6 points away from the 40-day moving average, which was the first bullish target we highlighted last week. Wednesday’s CPI data release will likely be the deciding factor in the near-term market direction.
If we see inflation cool, we can trade higher towards the upper rail of the downtrend and the July peak call level at the 400-strike. If inflation remains hot, a break back through 3,840 to resume the prolonged downtrend is the likely scenario. In that case, watch for a break of the SPDR S&P 500 ETF Trust (SPY – 388.67) 380-strike put, as that would open the vacuum to the large open interest 370-strike put, which had been the peak put level last week. Peak put now resides at the 350-strike, so an adverse reaction has the potential for a waterfall type of price action even if the probability is small.
The Nasdaq-100 (NDX – 12,125.69) is in a similar backdrop. Last week we saw the 40-month moving average continue to act as support, something it has done since November 2009. Furthermore, the NDX moved back above the three-year moving average and the 12,000-millennium level, after putting in a higher low. This is a critical technical step to re-establishing a bull market in the tech-heavy index.
While it’s too early to take a victory lap, since a lot can change between now and the end of July, it’s a constructive step in the right direction. When looking at the open interest configuration for the Invesco QQQ Trust (QQQ – 295.35), we see similarities, too. Peak call resides overhead at the 300-strike, which coincides with the June 9 gap down level. This could very well cap bullish price action for options expiration.
Unlike the SPY, the QQQ is already above the 40-day moving average that smothered the early June rally, and capped the upper bounds of the mid-April bear flag that led to an eventual -17% collapse over the next month. A definitive close above the 300 level and the tech-centric index could see a move to 315. The most likely scenario is we stay in a range between 280-300 for the week, but only time will tell.
“But that leaves questions that, unfortunately I cannot answer, but will certainly monitor. That question is: Does the sudden emergence of VIX call buyers mean significantly higher levels of volatility, despite the VIX near the top of this year's range? Or are the recent actions of this crowd a contrarian indicator since the call buying occurred during, versus before, a VIX spike? Stay tuned.”
- Monday Morning Outlook, June 18, 2022
The CBOE Volatility Index (VIX – 24.64) dropped below the 25 level during the modest rally, after the 30 level capped volatility the prior week. However, the VIX call/put 10-day volume ratio continued to surge throughout the week, now at 4.36. This brings back the question we contemplated the other week: Is this a contrarian indicator this time, or is this another signal that we’re on the verge of experiencing another bout of volatility?
The 25-level contained VIX spikes in mid-2021, so will it act as support? In my opinion, the deciding factor will be a break below 24. This is the level we saw break during the March bear market rally, and the level that held in early June before we saw the next leg lower in equities.
With that said, the sentiment indicators we follow are still primed for a rally. Previously, we’ve discussed that just because sentiment is ripe for a rally, it often can act differently in bear market environments. The American Association of Individual Investors (AAII) data this past week clearly shows that bulls threw in the towel, as the bull reading is in the 2nd percentile of all-time readings.
The bulls minus bears 4-week moving average has reached levels we have not seen since March 2009. However, bulls initially gave up in 2008 when, bear sterns went belly up, right before the worst of the Great Financial Crisis drawdown. Finally, our 10-day buy-to-open volume ratios for the SPX and NDX components continue decreasing leisurely. This isn’t optimal when looking at past behavior, and a more rapid descent would make me feel better about this rally.
Two very different outcomes are indeed at work here. Can the Fed engineer a softer landing, or can they spin the illusion of a soft landing long enough for a bear market rally to further develop? Or will we see that all confidence is lost in the Fed’s ability to control inflation, pushing them to become more aggressive with rate-hiking measures to stop inflation?
While I’d love to give you a concrete direction, I must continue to express caution during this modest rally until we see how markets react to the CPI data on Wednesday. So, keep your long equity exposure stops tight, and only add to long exposure with the VIX below 24. Conversely, if the 24 level holds, think about adding some hedges through VIX call options.
Matthew Timpane is a Senior Market Strategist at Schaeffer's Investment Research
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