Why a Risk-On Phase Could Be Imminent

S&P 500 levels to watch overhead include 3,811 and 3,850

Senior Vice President of Research
Oct 24, 2022 at 9:02 AM
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“...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)…The upside is that if the SPY remains above put-heavy strikes as expiration nears, they can act as a tailwind, as short covering eventually occurs that is related to the out-of-the-money put strikes set to expire.

            - Monday Morning Outlook, Oct. 17, 2022

Last week was a win for bulls from two perspectives. The S&P 500 Index (SPX – 3,752.75) avoided a delta-hedge selloff, unlike in September, even though the risk of this happening for the second-straight month was high. Instead, stocks may have benefitted from short covering related to expiring big put open interest strikes on the SPDR S&P 500 ETF Trust (SPY – 374.29) and other index options, posting a gain for the week. Moreover, the SPX broke out above the trendline connecting lower highs since August, which I mentioned might be a potential resistance level last week.

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In fact, the SPX advanced more than 2% on Friday, during a year that has seen a near record number of Fridays in which the SPX has recorded a loss of at least 1%, as investors worry about carrying risk into the weekends. Additionally, Friday marked the index’s second bullish outside day in six trading days. 

Friday’s action follows Oct. 13, when the SPX hit a 52-week low and experienced a bullish outside day on the heels of a worse-than-expected consumer price index (CPI) reading. As I summarized in last week’s commentary, and as seen in the table below, the index has historically experienced bullish returns after a technical setup like this. 

The price action over the past couple of weeks gives me the feeling that there isn’t enough selling interest in the fourth quarter of what has been a disastrous year for bulls. In other words, the rally on a worse-than-expected CPI reading two weeks ago, combined with the SPX avoiding an immediate threat to another delta-hedge selloff last week, and a strong advance on Friday, could be hinting that a risk-on phase is imminent. 

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Moreover, stocks advanced even as commentary from several Federal Reserve officials last week suggested the end point for interest rate hikes will be somewhere around 5% next year, even though forecasts from the last Federal Open Market Committee (FOMC) meeting in September landed on 4.50% as a potential end point.

The FOMC meets again on Nov. 1, and another 75-basis point Fed funds rate hike is expected. With this meeting just eight trading days away, it may be worth noting that SPX returns preceding FOMC days in 2022 in which a rate hike occurred have been notably weak, per the table below.

Will the SPX defy recent history again? Only time will tell, but this is an immediate risk to short-term bulls, even though there is reason to be optimistic in the days and weeks ahead.

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With pre-FOMC risk, and perhaps post-FOMC risk lingering in the days ahead, a potential tailwind that could offset that risk is what appears to be a climax in bearish sentiment among equity option buyers on SPX component stocks.

Combine the SPX’s technical breakout above the trendline connecting lower highs since August with equity option buyers showing signs of taking a less bearish stance toward equities, and you have the making for at least another notable short-term advance in this bear market. In fact, sentiment is at such bearish extremes that overhead technical resistance levels could be taken out if a rally occurs. 

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That said, do not disregard such layers of potential resistance, which begin between the SPX 3,790 and 3,812 levels. This area also marks the close after the September FOMC meeting, and a region that coincides with a round 20% below the the index's 2021 close. Also, 3,811 is the current site of the all-important 36-month moving average on the SPX, which I discussed in detail last week. This is interesting as we move toward October’s close.

Finally, 3,850 was the SPX’s level when President Joe Biden took office, which marked lows first revisited in May. This level could be important – at least in the short term – if revisited again.

Support levels to account for include SPX 3,678, which was its close prior to the
August-October trendline breakout. Since that breakout on Tuesday, there have been three closes above this level. The June lows at 3,636 mark another area of support. If those lows are broken, support could come at the extension of the August-October trendline, as it did last Thursday. This trendline begins the week at 3,620 and ends the week at 3,560. 

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

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