Future Market Rallies May Be Anything But a Smooth Ride

Bears will have to feel some pain before an unwinding occurs

Senior Vice President of Research
Oct 17, 2022 at 8:54 AM
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“There are more potential technical headwinds. Friday’s gap lower was driven by a negative reaction to a stronger-than-expected September employment number…The gap created another bearish island reversal pattern…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.

            - Monday Morning Outlook, Oct. 10, 2022

After another bearish island reversal pattern, the S&P 500 Index (SPX - 3,583.07) drifted lower for three consecutive days last week. Then, on Thursday, the SPX did something for only the eighth time in more than 40 years, with the last occurrence nearly four years ago. 

After Thursday morning’s gap lower to a 52-week low on a hotter-than-expected consumer price index (CPI), the benchmark found support at the round 3,500 half-millennium mark and shot higher, forming a bullish outside day as it closed above the prior day’s high.   

This prompted me to ask Schaeffer’s own Senior Quantitative Analyst Rocky White to research the historical implications of a SPX bullish outside day on the same day it hit a 52-week low. 

The table below presents these historical implications, which are generally bullish. Note also that it isn’t a slam dunk, and that there are instances of significant drawdown within the various time frames measured. (As a side note, tune in to Rocky’s Indicator of the Week commentary on Tuesday, when he will dive into last Thursday’s bullish outside day.)

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“...be skeptical of rallies, at least until the first and second of many potential layers of resistance are taken out…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.

            - Monday Morning Outlook, Oct. 10, 2022

In fact, Friday’s action is a testament that if the market rallies in the days and weeks ahead, following the bullish outside day candle, it may be anything but a smooth ride.

Per my comments last week about technical resistance overhead, and as seen in the graph below, the intraday high on Friday was at the trendline connecting lower highs since mid-August that I highlighted last week.

With sentiment down in the dumps and at levels that typically precede V rallies, the SPX must take out that trendline of resistance before bears think about unwinding their positions. Even if this occurs, there are multiple resistance layers overhead from 3,800 to 3,950.

In other words, the current technical backdrop continues to downplay the significance of the extreme pessimism among market participants.

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As we move into standard October expiration week, delta-hedge selling risk remains due to the huge put open interest that has built up at strikes just below the current level of the SPDR S&P 500 ETF Trust (SPY – 357.63). This is in addition to overhead technical resistance dampening the SPX’s upside potential.

As I have been saying for weeks, think of these big put open interest strikes as potential magnets, particularly as we move closer to expiration, and the SPY moves below a strike with big put open interest, with other big put open interest strikes immediately below. 

The closer the SPY is to such strikes, the more risk there is. The upside is that if the SPY remains above put-heavy strikes as expiration nears, it can acts as a tailwind, as short covering eventually occurs that is related to the out-of-the-money put strikes set to expire.  

Currently, the SPY 350-strike – equivalent to SPX 3,500 – is home to the biggest put open interest in the immediate vicinity of the SPY, and could prove to be relevant again in the days ahead.

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“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.

            - Monday Morning Outlook, Oct. 10, 2022

Finally, allow me to step back and analyze the bigger picture trend for the SPX. I am doing this after reviewing interesting long-term observations in the media that may be worthwhile.

The biggest risk I see is last month’s SPX close below its 36-month moving average, which sits just above the 3,800-century mark. Per the chart below, monthly closes below this trendline have usually preceded challenging times in the months and even years to follow. Should the SPX remain below this long-term moving average, it may be worth sitting out, if you are a long-term investor.

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“...the market has now come down to another key chart threshold: the average price over past 200 weeks. That trendline halted the S&P 500’s declines in 2018 and 2016, and also marked troughs for the Dow Jones Industrial Average during those times. The long-term trendline for the S&P 500, currently sitting near 3,600, has recently become a battlefield for bulls and bears.

            - Bloomberg, Oct. 12, 2022

“At one point, the benchmark S&P 500 had given back 50% of its post-pandemic rally, triggering programmed buying.

            - Bloomberg, Oct. 13, 2022

Amid the longer-term risk I pointed out, the chart below suggests there could be some relief – if not in the long-term, then perhaps the short-term, as long-term price levels can influence short-term price action.

I created the charts below displaying what was observed in a couple of articles I read last week. I did make a slight change, though. Instead of using the 200-week moving average, I changed it to the 208-week moving average, which closely resembles a four-year moving average on a weekly time frame.

In the first chart, I find it of interest that the 50% retracement of the pandemic low and high corresponds roughly with the 208-week moving average. The charts below show the historical significance of the 208-week moving average, including bottoms in 1980, 1987 and 1990. At the same time, like the 36-month moving average, breaks of the 208-week moving average have generally preceded ugly periods for stocks.

Again, I use these tools as guideposts for making decisions, as I cannot tell you with certainty whether these levels of potential support will hold. If you are aggressive and want to put a little bit of money to work at longer-term potential support levels in the 3,500-3,570 zone, you may do so, but be intent on selling on a weekly close below 3,500 or hedging a move below this level in the coming months.

The sentiment backdrop continues to be supportive of a strong rally, but again, bears will have to feel some pain before an unwinding occurs, which is why I also urge you to keep focused on that trendline connecting lower highs since August. This trendline comes into the week at 3,695 and rounds it out at 3,636, which coincidentally is the site of the June 2022 intraday lows.

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

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