Untangling a Messy Month for the Stock Market

The SPX's 80-day moving average stepped up as support last week

Senior Vice President of Research
Aug 21, 2023 at 8:59 AM
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August expiration week was not friendly to bulls, as the S&P 500 Index (SPX — 4,369.71) experienced its third consecutive week of declines, moving below the popular 50-day moving average and the bottom rail of a potential channel drawn from the March low and discussed in this commentary in prior weeks.

The jury is still out as to whether these technical breakdowns have longer-term bearish implications, as equities were also weighed down by 30-year mortgage rates breaking out to multi-year highs. Moreover, the yield on the 10-year Treasury bond moved higher and revisited its October 2022 peak.

The selloff may have been driven in part too by expiration of August standard options, as the SPDR S&P 500 ETF Trust (SPY — 436.50) broke below put-heavy strikes at 435 and 440 at the end of the week, perhaps forcing sellers of the puts to short S&P futures to remain neutral.

The SPY dipped below the 435 strike briefly on Friday morning, at which point the “put magnets” immediately below were much smaller as expiration was on the immediate horizon. As such, any delta-hedge selling associated with standard August options had likely dissipated, giving SPY stability into the week’s close.  

As such, and I have said this before, I am suspicious of technical breakdowns during expiration week, as delta-hedging declines have everything to do with positioning in the options market and little to nothing to do with technical support levels.

SPY OI August

But if the broader market is unable to recover significantly in the next few days, one should put more weight in the technical breakdown, particularly the lower rail of the potential bull channel.

Per the chart below, I think the broader market could find a floor in the short term if the yield on the 10-year Treasury bond avoids getting above the October 2022 high. Note on the chart below that buyers of the 10-year Treasury bond surfaced when yields hit the October 2022 peak.

While the stock market proved resilient in March through mid-July to a rising yield, it has reacted negatively to the latest burst in rates from late July’s short-term low at 3.75% to last week’s peak at 4.30%.

10 Year Treasury Yield

Call options on the SPY performed best on pullbacks to somewhere around the 80-day moving average to 120-day moving average. We’re not quite there yet.”

          - Indicator of the Week, August 16, 2023

At risk of continually drawing lines in the sand as the SPX declines, an encouraging development was Friday morning’s low at the 80-day moving average, which may have been coincident with the end of delta-hedge selling related to expiring put options on index and broader-market exchange-traded fund (ETF) options.

Per the excerpt above from Senior Quantitative Analyst Rocky White posted on our web site last Wednesday, he found in a research study that if using moving averages to buy call options on the SPY during pullbacks after a period of significant strength, the most opportune time to purchase one-month calls on pullbacks in the neighborhood of the 80-day and 120-day moving averages.

As such, Friday’s low at the 80-day moving average may prove timely after Rocky’s commentary was posted. In fact, when the SPX broke below a developing bullish channel in March 2021 (second chart below), it was the 80-day moving average that marked the bottom. In more recent times, note that the 80-day moving average acted as support in early May, about two months after the March 2023 trough and after two weeks of sideways to lower action as the index stalled at a level 10% above the 2022 closing low at 4,160.

SPX 80-Day MA

SPX Tri Star

“… first day of trading after Moody’s downgrade was the VIX peak at 18.22, which was one-half the 2022 closing high in March of that year…stocks should be viewed cautiously if the VIX moves north of 18.22 in the days or weeks ahead.”

          - Monday Morning Outlook, August 14, 2023

If you are using the Cboe Market Volatility Index (VIX — 17.30) as your risk barometer, you are still holding on for a trough. Per the below graph, the VIX made another run at the 18.22 level, which is one-half the 2022 VIX peak. This half-high and the VIX’s 200-day moving average marked a peak in Friday’s trading, which might give bulls another reason to anticipate a bottom.

“…optimism is being wrung out of the market. One example is in the options market, where the 10-day, buy (to open), put-call volume ratio on SPX components is now at its highest level since mid-May. When the SPX peaked, this ratio hit an extreme low.  A risk to bulls is that this ratio continues to rise, which has potentially bearish implications. As such, if you wait for this ratio to roll-over, you may miss the bottom, but not be too premature in the playing a shift in sentiment.”

          - Monday Morning Outlook, August 14, 2023

VIX Daily 200-Day

Admittedly, for bulls, it is a challenging environment to navigate, after a few months of a rally with little drawdown. Now, anticipated levels of support have given way to bears, but other levels of support - or resistance with respect to bond yields and the VIX – are in play.

Plus, equity option buyers are nearing a historical pessimistic extreme in sentiment that, on one hand, has marked bottoms in the past. But on the other hand, as we have seen historically, such pessimism can become even more extreme. And with the ratio taking out prior highs from this year, we could be on the verge of transitioning back to a 2022-like environment, as this ratio made higher highs in 2022 as short-term rallies were sold.

It is difficult to make a read on this, as it took a much deeper and longer pullback in the SPX to generate the readings in this ratio that we are seeing now.

SPX 10day pc August

Active investment managers have quickly shifted from a high allocation to stocks to a relatively low allocation (see the charts below). But even with the retreat, this sentiment indicator is neutral because if this group’s intent is to reach the allocation of stocks like that of the lows in 2022, more selling will be on the horizon.

However, prior to 2022 and just a few months ago, this is the level at which they began increasing equity exposure, which would have bullish implications. I will be looking for how this group behaves in the weeks ahead. If a rally occurs, are they sellers or buyers? If the market continues to dip, is this group buying into the dip or still contributing to the decline?

NAAIM August

A way to play the crosscurrents/ambiguity is to reduce stocks in your portfolio highly correlated to the SPX, or reduce equity exchange-traded fund holdings, such as the SPY.  And use call options on the SPY to play a potential rally.

Essentially, by implementing such a strategy, you would be reducing your dollars at risk in the market and using a fraction of the proceeds to buy option premium. The leverage gives you the potential to book healthy profits, even with less market exposure.  

Looking ahead to next week, I see potential resistance around 4,465 - 4,470, or the area that represents double the March 2020 closing low and the trendline that connected the March and May lows. A break of the 80-day moving average could mean 4,200 - 4,220 is in the cards, which is the vicinity of the 120-day moving average and the level that is a round 10% above last year’s close.

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

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