Did Last Week's Rally Bring Stability to Wall Street?

Be skeptical of rallies after last week’s market action

Senior Vice President of Research
Oct 10, 2022 at 9:07 AM
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“... potential support levels have been breached during the selloff, including the June lows being taken out, which is not a huge surprise during delta-hedge selling…If delta-hedge selling was a major culprit in the magnitude of the equity market’s decline in a short duration, like June, I would expect that stocks find stability in the immediate days ahead…If the market does not stabilize quickly with the expiration-related selling, this should be considered a major red flag for bulls. It could suggest that momentum sellers could do even more damage to the market in the weeks ahead.

            -Monday Morning Outlook, Oct. 3, 2022

In reviewing my comments from last week, one might ask if the action in the stock market qualifies as finding stability. On one hand, the equity market did as I expected, as it rallied strongly in the immediate aftermath of September’s quarterly expiration. This is normally the case after a component of selling in the days or weeks prior.

The Federal Open Market Committee (FOMC) hiked the Fed funds rate by another 75 basis points on Sept. 21, and strongly hinted the job of fighting inflation was far from over. From that close through the last day of September – which coincided with quarterly expiration of options – the S&P 500 Index (SPX – 3,639.66) continued to sell off sharply. But by last Tuesday’s close, the SPX impressively wiped out all losses since the FOMC decision close.

From that vantage point, the market stabilized, as the SPX easily moved back above its June lows in that ferocious two-day rally, and closed the week at those lows, implying a close above the prior weeks'. However, one could argue the SPX is clearly not out of the woods, and that the finish was ugly, which is a potential destabilizing factor. 

For example, there were plenty of sellers viewing the two-day advance back to the FOMC decision close as their second chance to unload equities. Additionally, a trendline connecting lower highs since the mid-August peak marked intraday highs on Wednesday and Thursday, implying this technical hurdle should continue to be monitored in the days ahead (this trendline begins the upcoming week at 3,760 and closes the week at 3,700).

“... last Monday morning’s gap lower produced another bearish technical omen known as a bearish ‘island reversal’ pattern, in which the Aug. 10 gap higher was followed by the Aug. 22 gap lower.

            -Monday Morning Outlook, Aug. 28, 2022

There are more potential technical headwinds. Friday’s gap lower was driven by a negative reaction to a stronger-than-expected September employment number, decreasing hopes among some that a Fed pivot to a looser monetary policy may come sooner rather than later.  

The gap created another bearish island reversal pattern, which occurs when a jump higher is followed by a large drop lower, and the gap higher is not filled in the intervening days. This is the third time a bearish island reversal has occurred on the SPX since Aug. 22. It’s worth noting that price action in the immediate days after such a pattern has been far from pretty from a bulls’ perspective.

MM0 1009 1

With only two weeks left until October standard expiration, delta-hedge risk is already back after Friday’s sharp selloff. As you can see on the SPDR S&P 500 ETF Trust (SPY – 362.79) open interest configuration graph below, significant put open interest resides at the 360-strike, and there is also even heavier put open interest at the 350-strike, equivalent to SPX 3,500.

The bigger the put open interest, the higher its magnetic effect during periods of market weakness. With the SPY’s close, there is not a lot of room for error if you are a bull. And overnight risk is big, with inflation data due out Wednesday and Thursday morning before the opening bell.

MMO1009 2

There might be glimmer of hope for bulls if market participants view inflation data positively, given short-term sentiment data is at levels from which V-rallies have emerged. But again, after watching last week’s action, be skeptical of rallies, at least until the first and second of many potential layers of resistance are taken out. Right now, bears are not being pressed into unwinding bearish bets, and those sitting on the sidelines are not yet being pressed into committing money to the market.

The first level of SPX resistance is at the trendline connecting lower highs since August. Another layer of resistance is last week’s highs in the 3,780 area, with other potential resistance areas annotated on the SPX chart above. If you have a longer-term horizon, continue to stay hedged or be mostly in cash, as the SPX remains below its 36-month moving average at 3,808, after the close below it last month and unsuccessful bid to cross back above it last week. If you are short-term, be open to all possibilities, with multiple market-moving “known, unknowns” on the calendar, such as inflation data and retail sales.

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

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