The S&P 500 Index (SPX - 2,992.07) flirted with the July all-time highs last week as we made it through a quad-witching options expiration and the Federal Open Market Committee (FOMC) decision relatively unscathed, but the market still seems to be paranoid that all is not right within the economy. This nervousness could be festering because the financial media stoked fears throughout August that a yield curve inversion could very well be a precursor to a recession, which it has been the last seven times it inverted -- but as I have written numerous times, the ensuing recession could be months, or even years, away. Conversely, it could be due to the fact that trade negotiations with China remain unstable, even following recent goodwill gestures -- such as the move to postpone tariff hikes to Oct. 15 that were originally set to go into effect on Oct. 1, and the exemption of various products from the list of tariffed goods.
However, others in the financial media have developed a more positive analog that this is a mid-cycle rate-cutting period by the Federal Reserve, similar to 1995, and something Fed Chair Jerome Powell has alluded to in his commentary following the past two rate cuts. Powell also stated the Federal Reserve is open to possibly having organic growth of the balance sheet resume. Many market participants interpreted this as not only the end of quantitative tightening, but that it's essentially "QE light," and full-on quantitative easing could in the near future. While I understand their enthusiasm, the Federal Reserve typically allowed its balance sheet to grow organically in expansionary periods under normal conditions.
With all this said, we are clearly at the intersection of multiple possible longer-term outcomes on the broader macroeconomic front, so I think we should focus on the near-term possibilities by looking at how the market has been reacting to events, the technical landscape of the broader markets, and sentiment data.
"Wall Street is now inches away from reclaiming its record highs, but a rockier ride could be around the corner as stock volatility has been 25% higher in October on average since 1928, according to Goldman. Big price swings have been seen in each major stock benchmark and sector in October over the past 30 years, with technology and health care being the most volatile groups, Goldman said."
-- CNBC, September 20, 2019
In July, when the Federal Reserve cut rates by 25 basis points, it was a sell-the-news event with the SPX lower by -1.67% over the next month. While this certainly doesn't confirm we are in a similar situation after the Fed soothed the market's thirst for a rate cut last week, it could be in the back of traders' minds. Additionally, markets sold off quickly Friday on the slightest whiff of trouble in the trade negotiations between the U.S. and China, when the Chinese trade delegation left earlier than expected.
On top of that, we are in a well-known seasonally weak and volatile period, as September is notably touted as the worst month for stock market performance. Moreover, October typically is the most volatile, as Goldman Sachs' recent study confirmed -- only adding to market participants' skepticism. Furthermore, we've seen a string of recent initial public offerings (IPOs) falter and trade lower after listing, with one delaying their IPO after realizing the market was pricing in a considerable discount to their private valuation. With all this perceived pessimism, it may very well manufacture prime conditions for the next leg up in the markets -- but we'd like the technical and sentiment data to confirm that.
"The takeaway is that a current risk to equity investors is this year's pattern of taking profits when key asset benchmarks reach levels that correspond to a 20% profit for 2019. If this pattern repeats, you will see a rotation out of stocks, and into bonds and gold. Another pattern that has held up in 2019 is the SPX finding support on pullbacks at its year-over-year breakeven level. So, if there is a major pullback, the 2,915-2,930 area should hold on pullbacks, based on where the SPX was trading one year ago this coming Friday and into month's end."
-- Monday Morning Outlook, September 16, 2019
On the technical front, I've been seeing more strategists and analysts turning bullish over the past few weeks. Much of this is due to multiple breakouts in global markets from a technical perspective. I don't disagree that this could be a bullish signal for U.S. markets, as well, but I tend to proceed cautiously in the near term after hearing a rash of bullish takes on the markets -- largely because the breakouts are on long-term time frames, and susceptible to a short-term pullback.
As we noted earlier, the SPX traded near the July all-time-highs, but, in the latter half of the week, pulled back and closed trading near the 3,000 millennium level at 2,992.07. Moreover, those July highs represent the +20% year-to-date (YTD) return level, an area where we observed last week that several assets have struggled for the year.
The index also appears to have formed an ascending triangle inside of a more massive rising wedge. The first is a bullish pattern, and the latter is a bearish pattern -- truly showing the subjectivity technical analysis can sometimes be prone to, and how one can make a case to fit their bias.
Also, multiple technical indicators are leaning bearish and ready to roll over in the near term, if they have not already -- i.e., Relative Strength Index (RSI), Moving Average Convergence/Divergence (MACD), stochastics. Near-term support levels of interest include the 2,940-2,950 range, which coincides with the 40-day moving average, and at the 2,916 level, which would likely be an intersection of the lower trendline and the rising, underfollowed-yet-notable 160-day moving average, and an area where the year-over-year level could be on a pullback.
When looking at the sentiment backdrop, our typical contrarian signals we like to see when looking for bullish setups has waned in recent weeks. The American Association of Individual Investors (AAII) investor sentiment survey showed that the three-week bear change of -34.1% was the biggest drop since Feb. 6, when it dropped by -37.2%.
Furthermore an increase in bullish sentiment can be seen in the percentage of SPX component stocks trading above their respective 200-day moving averages, which recently reached 76.4%. Whenever the percentage has been over 75% the past four years it has warranted caution that a pullback could be near, or at the very least, a sideways consolidation.
Chart courtesy of StockCharts.com
Additionally, the 10-day equity-only put/call volume ratio keeps plunging, and last week reached a low of 0.447, which was the lowest reading since June 2018. But what caught my attention was how the Cboe Volatility Index (VIX - 15.32) responded after previous falls in the ratio. Over the next month, the VIX was positive 56% of the time and, on average, returned +13.6%. Over the next two months, the VIX was positive 67% of the time, and returned, on average, +15.8%.
Commitments of Traders (CoT) data confirms that large speculators continue to increase their net short position in VIX futures, and these investors have notoriously been on the wrong side of the trade. Furthermore, the 20-day VIX call/put ratio continues to expand, recently topping at 3.91 -- a trend we discussed the significance of last week, and will continue to monitor, as extreme readings in this VIX call/put ratio have typically predated large VIX spikes by at the very least a couple of days, out to a couple of weeks.
In conclusion, there is plenty of evidence that there are near-term risks for a pullback in the next month or two. While we could just as well see a breakout to all-time-highs in the coming weeks, I'd remain cautious, as getting overly bullish here is ill-advised until we see a better sentiment backdrop to sustain a breakout.
Matthew Timpane is Schaeffer's Senior Market Strategist.
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