Why Investors Should Stay the Bullish Course... For Now

A bearish outside day last week could signal a short-term pullback

Senior Vice President of Research
Jul 31, 2023 at 9:17 AM
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"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."

- Monday Morning Outlook, July 24, 2023 

"... 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."

- Monday Morning Outlook, July 17, 2023 

In prior commentaries, I have discussed S&P 500 Index (SPX – 4,582.23) technical indicators that could be signaling a hesitation or reversal in the impressive uptrend we have seen since the March low.

One indicator I mentioned was the "overbought" condition, per the SPX’s 14-day Relative Strength Index (RSI) that emerged for the second time in two months in mid-July, which followed a bearish island reversal pattern the week prior. Another is the doji candlestick that appeared on July 19, which technicians interpret as a potential reversal indicator during a trend.

In the immediate days after mid-June’s and this month’s multiple signals that a pause or reversal could be imminent, the SPX marched higher. In fact, it carved out a new 52-week high on Thursday morning following a brief congestion period.

But sellers suddenly appeared when the SPX hit the 4,607 level on Thursday morning. You may be familiar with 4,607, which I pointed out last week as corresponding to exactly 20% above last year’s close. This reversal from 4,607 hinted strongly that profit-taking could be at work.

After the SPX touched 4,607 on Thursday morning, selling persisted throughout the day, forming what is known as a bearish “outside day,” in which the intraday high was above the prior day’s high and the intraday and closing lows were below the prior day’s low.

By Thursday’s close, the mid-July RSI "overbought" reading and the July 19 doji candle were looking to have negative potential consequences for bulls, albeit amid imprecise timing.

MMO 0729 1

The jury is out as to the implications of these recent hints that a short-term pullback is on the way. Our own Senior Quantitative Analyst Rocky White researched the historical implications of bearish outside days on the SPX that occurred on the same day as a 52-week high. Data since 1978 suggests a major downturn typically does not follow, but relative weakness occurs relative to bearish outside days when a 52-week high isn’t achieved.

MMO 0729 2

 

If a pullback is imminent, the question is the duration and magnitude. Given that there is a relatively high level of short interest on SPX component stocks and many strategists are cautious, my instinct is there is enough buying power to contain major pullbacks, should one be in the cards.

New to our SPX chart above is a potential channel that connects higher highs and higher lows since the trend higher began in March. Long-time readers of this commentary may remember a similar-looking channel that I used in 2020 and 2021, along with key moving averages, to guide readers on market direction and evolving technical risks.

In the SPX chart above, there are a couple levels of potential moving average support situated below Friday’s close as the SPX continues to bump along the trendline connecting higher highs, which comes into the week at 4,589 and ends the upcoming week sitting at 4,609, or roughly 20% above the 2022 close where sellers emerged last week.

A break of the 20-or 40-day moving averages – both of which have provided support on pullbacks since March – would likely lead to movement down to the trendline that connects higher lows in the developing channel. This trendline comes into the week at 4,360 and at Friday’s close will be at 4,382.

On the sentiment front, per the chart below, option buyers on SPX component stocks have become increasingly bullish, which is coincidentally supportive of the market, until it isn’t. At extremes, this group is vulnerable to being wrong-footed at key inflection points. If they grow bearish amid technical breakdowns, increased put buying relative to call buying becomes a headwind.

As such, with the 10-day ratio of call-buying volume to put-buying volume coming off its lowest level in more than one year and sitting around levels that coincided with major highs in January and April 2022, consider this another flashing yellow sign as it begins to tick higher.

MMO 0729 3

"There’s More Pain Ahead for S&P 500 as Profit Warnings Loom, Investors Say."

- Bloomberg, July 9, 2023 

"Earnings season began late last week and will be the focus of market participants in upcoming weeks. The good news is the outlook for earnings does not appear to be too robust, suggesting companies do not have a high hurdle to overcome."

- Monday Morning Outlook, July 17, 2023 

"Dow rallies 400 points as Powell hints Fed could slow pace of rate hikes, Nasdaq jumps 4%."

- CNBC, July 28, 2022

If a pullback of significance is to materialize, the source will likely be some unknown that is lurking after the market got clarity heading into last week’s trading. The unknowns that were resolved include earnings reports from mega-cap tech names, key economic and inflation data, as well as the Federal Reserve's July meeting.

The Federal Open Market Committee’s (FOMC) rate hike and subsequent comments from Fed Chair Jerome Powell last week came and went with no surprises, with futures rate hikes to depend on economic data. Keep in mind that at this point last year and per the headline above from late-July 2022, Powell hinted the Fed could slow the pace of rate hikes, but as incoming data came in they did anything but slow the pace.

Economic data last week pointed to an economy that remains strong without negative surprises on the inflation front. As we continue to move through the heart of earnings season, the SPX has not incurred any technical damage, as there is a healthy mix of strong and negative earnings reactions, no different than any other earnings reporting period.

As such, stay in tune with the caution signals, but don't react to this caution prematurely. In other words, stay the bullish course, until you see evidence of the technical backdrop deteriorating significantly.

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

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