What Will It Take for Bulls to Become Sellers?

There's capitulation to the bullish camp among some market participants

Senior Vice President of Research
Jul 24, 2023 at 8:50 AM
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"We enter expiration week with the SPX in the vicinity of its half-millennium 4,500 mark and in an ‘overbought’ condition, according to its 14-day Relative Strength Index (RSI). This is the third time an overbought condition (RSI reading at or above 70) has occurred in 2023 and the second since mid-June. The early February overbought condition, with the SPX at the round 4,200 century mark, preceded a five-week decline. But the mid-June overbought reading, with the SPX nearing the 4,400-century mark, was worked off with no harm to bullsdon’t be surprised if we see a weak beginning to expiration week or an overall expiration-week pullback. But if any such weakness replicates recent periods of short-term weakness, bulls should not be shaken."

- Monday Morning Outlook, July 17, 2023 

The S&P 500 Index (SPX – 4,536.34) had several reasons to pull back last week. It was  overbought, selling was a risk due to the unwinding of long positions from overhead call open interest (OI) on index and equity exchange-traded fund (ETF) options that were expiring, and earning season began with reports from major and regional banks, the latter of which concerned market participants looking for decreases in deposits.

However, the market continued to defy naysayers, locking in another week of gains, implying those waiting for a significant pullback likely remain on the sidelines.

Wednesday’s trading produced another potential technical reversal indicator, with the emergence of a doji candle on the SPX, which occurs when the daily open and close are the same. When such candles surfaced in 2022, it spelled trouble for the market in the following days and weeks. In April and May, however, doji candles appeared without consequence.

For what it is worth, the doji day occurred just one day after the SPX moved above 4,535, which marked a short-term peak in September 2021 and acted as support in December 2021. Also, the SPX’s intraday high on the day of the doji candle was just 29 points below the 4,607 level.

The 4,607 mark is 20% above the 2022 close. Round percentage year-to-date levels can sometimes act as hesitation or pivot points. For example, in the second half of May, the SPX paused just below the 4,223 level that was 10% above its 2022 close.

As such, be open to the possibility that Wednesday’s reversal indicator could foreshadow weakness or a period of relative weakness in the days and weeks ahead. But also keep in mind that the SPX has recently defied overbought conditions, and did not respond unfavorably to a bearish island reversal pattern earlier this month.

This sounds wishy-washy, but as I alluded to last week, it would likely take a move below the SPX’s 40-day moving average and a trendline connecting higher highs in March through early May to shake bulls’ confidence. This area moved up relative to the prior week and is presently between 4,355 and 4,370 since both measurements are sloping higher. Weaker bullish hands would likely grow nervous and be prone to selling if the SPX breaks below its 20-day moving average, which acted as support in mid-July, and currently resides at 4,450.

MMO 0724 1

We are seeing capitulation to the bullish camp among some market participants. For instance, active investment managers have their highest exposure to equities since November 2021. While this does not mean this group will turn around and be sellers in the near term, there is a growing risk that this camp will not be a major driver for bulls in the weeks ahead. And for the first time in 116 weeks, bullish respondents topped 50% in the retail-oriented American Association of Individual Investor’s (AAII) weekly survey.

The key to the above is that while we are seeing increasing bullishness, the contrarian implications of this optimism are downgraded by the strong technical backdrop. Should the technical backdrop weaken, those that have recently capitulated are more likely to be sellers, but not until the market forces their hand.

"Eighteen of the two dozen houses covered by Bloomberg’s regular survey expect the S&P to decline between now and the end of the year. If and when they capitulate, that will add to the upward pressure on the market."

- Bloomberg, July 21, 2023 

As I have covered recently, not everyone has capitulated to the bull camp, suggesting there is firepower to keep the upward trajectory alive. Wall Street strategists, except for only a few, are still advising caution. To the extent their clients are listening, this represents potential fuel for the market.

And per the short interest graph below on SPX components as of early July, shorts are in the early stages of what appears to be covering. But relative to past total short interest on SPX components, there is plenty of potential covering that could be supportive of this market.

As such, I would grade the sentiment backdrop as slightly bullish, which is only a mild downgrade relative to early June, when the SPX broke out above 4,160 amid pessimism from all corners of the marketplace.

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

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