“With the SPX below its 80-month moving average (albeit not a monthly close), various Fed actions and other stimuli failing to convince investors, a red flag is waving. ETF flows suggesting a ‘buy the dip’ mentality has not been supportive either. I suggest reducing your equity exposure until the technical environment improves and we see a roll-over in the pessimism that continues to build outside the ETF world… With the Fed continuing to step up amid a stimulus package on the horizon, such actions could push the SPX back above the 80-month moving average by month end. Therefore, if you can take on such risk and exercise patience, it may be worthwhile to see how the rest of the month plays out before making a noteworthy reduction in your equity portfolio.”
-Monday Morning Outlook, March 23, 2020
On the heels of a historic decline in equities -- in terms of both magnitude and duration -- the S&P 500 Index (SPX – 2,541.47) scored a double-digit percentage gain last week. The first of a few catalysts that could be attributed to the advance includes more efforts by the Fed to provide liquidity. Another was anticipation, and the eventual congressional passage of a $2 trillion stimulus bill, to address an economy that is in "stall mode," and unemployment numbers that are soaring amid the coronavirus pandemic. Finally, U.S. President Donald Trump hinted that some areas of the country could be recommended to ease certain mitigation efforts soon if viewed as less vulnerable to the spread.
So, while we have more certainty about what the Fed and Congress are doing to limit coronavirus damage to the economy, the major uncertainty is how long will this last and whether or not enough has been done. Treasury Secretary Steve Mnuchin mentioned that the stimulus package anticipated a period of three months in which the economy would need help. Still, other questions linger, such as, will a second wave hit sometime in the fall or winter, will we be better prepared to handle the wave, and lastly, will there be an immediate bounce back after mitigation policies are lifted? Such uncertainties suggest that we should not be ready for the CBOE Market Volatility Index (VIX – 65.54) to be lingering between 12-20 anytime soon.
The rally pushed the SPX back above its 80-month moving average, and a close above this trendline today would certainly be a positive for bulls. For those of you that were willing to exercise patience and ride out the historic volatility before making a noteworthy reduction in your equity portfolio, you were rewarded for staying the course last week. That said, last week’s advance does not suggest upping your allocation to levels seen before the pullback, as the SPX remains below its 36-month moving average. This trendline has provided support on pullbacks not only on multiple occasions since the bear-market bottom in 2009, but throughout the history of this index, as discussed in my March 16 commentary.
As I am working from home like many other Americans, I heard commentators and analysts discuss ad nauseum on Friday whether the market bottomed last Monday. One theme I heard is that bottoming is a process -- it could take months, or there could be retest of the Monday low before a bottom is in place. Do any of these analysts really know? I doubt it, and I’ll admit that I really don’t know, although many sentiment indicators suggest we are nearer to a bottom.
So without making a firm commitment on what the market will do, instead being open to "anything can happen," you can continue to finetune an action plan that is based on as much history as you can draw from.
A plan may involve hedging, reducing, or simply holding on to current equity exposure. As you know, we prefer to focus on monthly closes with respect to long-term and off-the-radar moving averages as a guide. As we head into the last data point for March, it appears the SPX will close above its historically significant 80-month moving average, which is a positive for bulls, and suggests not making a significant reduction in your equity portfolio. However, it is still below its 36-month moving average, which hints at the potential for continued volatility.
So how can you remain not just unemotional, but rational, especially with the next monthly close data point weeks away? One potential action after this rally is to lock in your risk, using the SPX’s 80-month moving average as your guide to defining said risk during the next few weeks.
For example, buy weekly 5/1 SPDR S&P 500 ETF Trust (SPY – 253.42) puts, or a put debit spread to hedge a month-end close below the SPY’s 80-month moving average (which is currently at 235). The SPY 235 level corresponds to roughly SPX 2,350. While the straight purchase of a put is more expensive than a debit spread, remember that the maximum value of a debit spread is limited to the difference in the strike prices, whereas a straight put purchase gives you full protection regardless of how far the SPY falls below the 235 strike.
And what if a bottom is in and you want to postpone the decision to hedge, given how expensive hedging is right now? If that is the case, you can look for a clue that the SPX is more at risk of taking out the prior lows. For example, you could look for a close below the trendline connecting higher lows since 2012, shown on the chart above in blue. This trendline is sitting around 2,500-2,510.
With many sentiment indicators at levels that have been consistent with market bottoms, the latter “trigger point” for implementing a hedge may be a good course of action for now. But even with sentiment indicators tilted toward the bull side, one reason to suspect last week’s rally as a technical bounce was supported by the curious timing of government actions is in the below chart.
The “timing” of Trump’s comments about opening the economy in weeks not months came last Monday, the day the SPX closed below the level it was at when he took office in January 2017. The timing of his comments was curious given how much he has beat his chest about the stock market as a barometer of his success in the past. Friday’s decline from its 1,000-day moving average is something to note too, a trendline that was supportive at the December 2018 low.
Above said, let’s revisit a couple short-term indicators that we have long followed that support the bullish case. First, the equity-only, 10-day buy (to open) put/call volume ratio has rolled over from a multi-year peak. Roll-overs from high levels are good times to enter the stock market. But with that said, note that there have been brief roll-overs in the past that were short-lived before another influx of put buying generated another high. The action in this ratio currently is encouraging and supports holding current long exposure, but the jury is still out as to whether the unwinding of this pessimism will continue.
Another indicator I follow closely is the positioning of large speculators on VIX futures, who have been notoriously been on the wrong side of timing equity market volatility, which is usually inverse to stock market direction. Large speculators were net short an extreme 170,000 contracts in late January, which at the time I mentioned as a risk to market bulls. This extreme short position occurred ahead of a historic pop in volatility that was coincident with an equally historic drop in stocks. However, the latest Commitment of Trader (CoT) report showed huge short covering of VIX futures, and now the net short position is a puny 19,000 contracts, despite the typically mean-reverting VIX and VIX futures trading at multi-year highs.
Given the large speculators’ poor track record on timing volatility, the current positioning of this group is a positive for bulls and suggests that if we haven’t hit bottom, last Monday’s lows may be near where a bottoming process begins, at least for the near to intermediate term.
Todd Salamone is Schaeffer's Senior V.P. of Research
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