Incoming Interest Rate Decision Likely to Favor Bulls

The market is benefitting from an unwinding of a sentiment extreme

Senior Vice President of Research
Oct 31, 2022 at 8:53 AM
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“...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...

            - Monday Morning Outlook, Oct. 24, 2022

The Federal Open Market Committee (FOMC) meets on Tuesday and Wednesday. Unlike previous instances in the days before a meeting, the S&P 500 Index (SPX – 3,901.06) has held up relatively well, although the highs last week were around the Sept. 20 close of 3,856, prior to the Sept. 21 decision to raise the Fed funds rates by another 75-basis points. 

In 2022, the 10 trading days prior to the Fed raising rates have been the worst, with the SPX losing ground in four of those five instances by an average of 2.15%. With the Fed expected to raise rates again on Wednesday, the good news for bulls is that the SPX has deviated from its typical 2022 bearish pattern, as it has been trading higher the past couple of weeks.

Plus, bulls have a slight edge early this week, because in the three days prior to the meetings that have come with rate hikes this year, the SPX has a positive return on average, rising three out of five times.

“Federal Reserve officials will maintain their resolutely hawkish stance next week, laying the groundwork for interest rates reaching 5% by March 2023, moves that seem likely to lead to a US and global recession, economists surveyed by Bloomberg said. Economists expect the Federal Open Market Committee to announce a 75-basis-point rate hike on Wednesday...

            - Bloomberg, Oct. 28, 2022

What about SPX action immediately following FOMC rate hikes this year? Per the table below, it favors bulls, which I find interesting amid the SPX being down double digits this year.

With a 75-basis point rate hike expected, and market participants now anticipating the Fed funds rate to be at 5% by March – above the projections given at the last FOMC meeting in September – my hunch is it would take a 100-basis point hike and/or indication that the Fed funds rate will be higher than 5% by March to unnerve investors.

That said, there is a slew of economic data to come, particularly the October employment number later this week. So, as we get past one important event in the middle of the week, another macro event that could have a big impact on the market’s direction follows.

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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… 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 index's 2021 close. Also, 3,811 is the current site of the all-important 36-month moving average on the SPX…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...

            - Monday Morning Outlook, Oct. 24, 2022

$SPX at a hesitation point between 3,837 (20% below '22 closing high) and 3,852 (its close when Biden took office)?

 

Per the excerpt above and my Tuesday observation on Twitter last week, the SPX quickly tested its first layer of resistance, as defined by the levels that correspond to 20% below the 2021 close and 2022 closing high -- also known as its close when U.S. President Joe Biden took office in January 2021, and its close prior to the last rate hike.

This hesitation lasted only three days. By Friday’s close, the SPX was testing its next area of potential resistance between 3,900 and 3,942. The former represents the breakout level in July above a trendline connecting lower highs since the March peak.

This breakout level held pullbacks in late July and for a brief period in September. When the SPX broke back below the 3,900 level in mid-September, it was the continuation of a steep, sharp descent into the October low point.

Meanwhile, the 3,942 level is the site of the SPX’s break below a trendline connecting higher lows from June through mid-September. This could also be construed as a layer of potential resistance as the SPX works its way higher from its mid-October low at a level last seen in November 2020.

As we look to potential support, the area where the three-day hesitation occurred last week could be considered the first line of defense. Also of note is the 40-day moving average, which acted as resistance between May and June, and support during the late-July pullback. This trendline is attempting to flatten out after turning lower in mid-September, and is currently sitting at 3,780.

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Bulls have short-term momentum in their favor, with the SPX 9% above this year’s closing low on Oct. 12. And this rally has occurred amid negative headlines, suggesting negative sentiment was overdone. 

For example, the rally began with a positive reaction to worse-than-expected inflation data in the middle of October, then a continuation move as Fed governors warned of a higher end point for interest rate increases during this tightening cycle, and last week’s rally even as tech giants such as Alphabet (GOOGL), Amazon.com (AMZN), Meta Platforms (META), and Microsoft (MSFT) took notable post-earnings dives.

To the extent that option buyers represent short-term sentiment, the market is benefitting from an unwinding of a sentiment extreme – with the equity-only, put/call volume ratio rolling over from an extreme high – that could continue to push the SPX through resistance layers discussed above.

If the previously mentioned support levels fail to hold on pullbacks, this unwinding of pessimism would be at risk of quickly ending. For now, however, the bulls are in control, even as we come into the week at the next level of potential resistance.

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

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