Improvement in Market Outlook May Be Premature

Improvement in breadth continued last week

Senior Vice President of Research
Jun 12, 2023 at 9:00 AM
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The percentage SPX components that are higher using a three-month lookback has increased to 40% from an early-May trough of 25%...The contrarian takeaway is at a time the consensus is buying into the potential bearish implications of only a few stocks doing the heavy lifting, we could be on the verge of a broad-based rally that drives the SPX higher, even if mega-cap stocks lose their leadership.”

            - Monday Morning Outlook, June 5, 2023

This Rally Is All About a Few Star Stocks—and Some Investors Are Worried

            - The Wall Street Journal, June 6, 2023

Per the excerpts from last week’s commentary and The Wall Street Journal, market breadth has been – and continues to be – a concern among some market participants.

But as I pointed out last week, the data we use suggests that breadth had improved from early May to early June when analyzing the percentage of S&P 500 Index (SPX – 4,298.86) components trading higher using a rolling three-month lookback.

This is something that I thought had potentially bullish contrarian implications, as the breadth concerns are getting louder and louder at a time that breadth has been improving for more than a month.

Improvement in breadth continued last week. The three-month rolling return of the iShares Russell 2000 ETF (IWM – 185.03) moved from a decline of 6% at the beginning of this month to an advance of 1%, thanks to the IWM rallying around 3% last week.

Per the chart immediately below, the advance in the IWM last week followed a mid-May breakout above a trendline connecting lower highs since late-January -- a nearly three-month period in which the IWM was “stuck” in a sideways pattern around its 2022 close. As such, those that are worrying about poor market breadth may not be positioned for an improvement that is supportive of the market in the days and weeks ahead.

mmochart1

 

“…the index gapped above the 4,225-hesitation point, and now the August closing high of 4,305 is in immediate view. Also of interest is that the 4,292 level is 20% above the October 2022 closing low and a point at which some would declare a new bull market. Plus, 4,315 is 10% below the January 2022 all-time closing high.”

            - Monday Morning Outlook, June 5, 2023

 

S&P 500 Starts a New Bull Market as Big Tech Lifts Stocks

            - The Wall Street Journal, June 8, 2023

mmo2

The S&P 500 also rallied last week, closing above the 4,292-level, which is 20% above the October 2022 closing low. As predicted, such action was declared by some to be the start of a new bull market. I found this interesting as on the same day a new bull market was proclaimed by The Wall Street Journal with the index 20% above its 2022 closing low, J.P. Morgan Chase (JPM – 141.01) strategists reacted by warning of a 20% drop in equities if bond traders are proven correct in pricing inflation volatility. Bank of America strategists warned on the same day that tech stocks may be set to pause.

I was wondering how Wall Street would react to a rally, after four major brokerages in April and May warned of a correction or a lower stock market into year-end 2023. In early April, in fact, J.P. Morgan anticipated the 2022 lows being revisited in the next few months. Two months later, the SPX is up 5%and at its highest level since August 2022, so JPM’s comments last week simply reiterate their early-April caution, as a 20% decline from here would push the SPX to the area of the October 22 lows.

U.S. inflows from individual traders hit their highest in three months last week, averaging at $1.36 billion per day, Vanda Research said in a note on Thursdayrisk-on sentiment seemed to have returned to the retail investor base this past week as we witnessed bullish flows across the ETF, single stock, and options space, mainly benefiting technology names," J.P. Morgan analyst Peng Cheng said.”

- Reuters, June 9, 2023

As impressive as the rally in stocks has been since mid-March, we did see some capitulation from both retail investors and active investment managers. In fact, the SPX component buy (to open) put/call volume ratio that we track is now at its lowest level since March-April 2022 that preceded a 20% pullback into last June.

mmo3

With market participants expecting a pause in rate hikes when the Federal Open Market Committee (FOMC) releases its interest rate decision on Wednesday, the SPX trading at its next potential hesitation point between 4,292-4,315 and the level from which a massive sell-off began in August 2022. Signs of weaker hands accumulating stocks appeared last week and the Cboe Market Volatility Index (VIX -- 13.83) is trading at levels last seen just before the Covid-related volatility explosion in February 2020. In other words, a hedge is worthwhile ahead of the FOMC meeting this week.

Above said, even if a pullback materializes, technical damage would not be evident until there is a close below the 4,160 level. This mark was resistance in February and April and is the current site of the up-sloping 40-day moving average -- which acted as resistance in mid-March and support last month.

Finally, it is June standard expiration week. The biggest thing that stands out to me is that if we see selling, bulls are at risk of an expiration pin at the SPDR S&P 500 ETF Trust (SPY -- 429.90) 420 strike (which is equivalent to SPX 4,200). The SPY 420 strike is where the maximum number of calls and puts expire worthless (as of this pat Friday’s open interest configuration). The potential call wall at the 430 strike is also something to note.

mmo4

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

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