If you have been following my commentaries for the past several months, you have likely noticed that the orderly buy-the-dip pattern that has been so apparent since November 2020 has disappeared. This is not to say that buy-the-dip is necessarily out, but the visible tendencies as to when buyers are about to emerge is no longer as clear.
I have observed during the buy-the-dip pattern that, in varying stages of the well-defined uptrend, there was evidence of optimism that many analysts cited prematurely as bearish. They were premature in that the longs, whether weaker or stronger hands, were never really pressed into action from a selling perspective, as pullbacks were shallow and orderly. This hammered home the point that sentiment analysis, while useful and necessary, can’t be used in a vacuum, as technical analysis must be brought into the fold as well.
“Stick with bullish positions until the SPX spends more than a few days below its channel, and/or it breaks below moving averages that have supported pullbacks this year. Amid fears of too much optimism in the market, technical deterioration in the SPX is needed to strike fear in the longs and/or embolden the shorts.”
- Monday Morning Outlook, August 23, 2021
“…as we look at potential resistance levels this week, the 4,475 level is one to watch, or double the 2020 closing low. Channel resistance from the lower rail ranges between the round 4,500-century mark on Monday to 4,517 through Friday’s close. Support is in the area of last week’s closing lows, or 4,350.”
- Monday Morning Outlook, September 27, 2021
Conditions I outlined in mid-August and in prior months that might cause an unwinding of optimism are in place from a technical perspective. For instance, for two weeks now, the S&P 500 Index (SPX - 4,357.04) has been below the bottom rail of a well-defined channel in place since mid-November 2020. Previously, the SPX’s longest streak below that lower rail was four days.
Moreover, unlike previous instances in which buyers emerged at the SPX’s 50 or 80-day moving averages, immediately pushing the index back into its channel, the buying at the 80-day moving average this time around proved to be only a short-lived bounce, before the SPX fell below the prior week’s low and that trendline. In fact, the intraday high after the bounce from the 80-day moving average two weeks ago was around 4,475, or double the 2020 closing low that was mentioned as potential resistance.
As the technical backdrop has become less orderly in terms of buy-the-dip, we are seeing evidence of pessimism growing, a condition that is necessary for a bottom. But in our experience using sentiment indicators, it is not only the absolute level of sentiment measure, but also the direction that the sentiment measure is heading. In other words, the most bullish conditions occur after a relative extreme in pessimism is achieved, and there is evidence that such pessimism has climaxed. Plus, bearish conditions tend to take hold after a sentiment measure hints at an extreme in optimism that is beginning to unwind, as we are seeing now.
Ironically, just as positive news on Covid-19 vaccines began emerging in mid-November 2020 -- sparking a long, orderly rally in equities – Merck’s (MRK) oral antiviral treatment for Covid-19 helped drive Friday’s rally from a month-long drop of nearly 5% from the closing high on Sept. 2, through the month-end September close.
Could it be headlines related to an easy treatment for Covid-19, versus a clear technical signal, that is the green light for a long-lasting rally in equities? After all, rising trends in Covid-19 deaths and hospitalizations amid slowing vaccinations negatively impacted growth last quarter. Investors weighed pandemic uncertainty, slowing economic growth, broken supply chain, and a Federal Reserve that took on a slightly more hawkish tone at their last meeting to sell both bonds and equities during the past several weeks.
At a minimum, the SPX should close back above the 4,475 level, as confirmation that Friday may have been a key bottom on the Merck news. A move above 4,475 would indicate that there is not enough selling interest among those anchoring to double the 2020 closing low as a profit-taking measure, amid recently emerging Fed and Covid-19 uncertainty. Furthermore, a close above 4,475 would suggest there is not enough selling interest among those looking to exit their trades at a breakeven, who bought near highs on Sept. 23, 24 and 27.
Even though Friday may have been the bottom that bulls are seeking, investors should proceed with more caution, since the SPX broke its buy-the-dip pattern that was visible for months. Plus, the Nasdaq-100 Index (NDX - 14,791.87) remains below the key 15,000 millennium level, which should have been supportive on a pullback. Now, there is risk of additional selling in the coming week to 14,370 and 14,000 or the lower rail of its 13-month bull channel, displayed immediately below. A break below that channel would be additional cause for concern for bulls, and likely lead to a visit to the 14,000 level, as the NDX has a recent history of bouncing between millennium levels, especially 11,000-12,000, and 13,000-14,000.
Caution is growing after support levels for the SPX and NDX were breached. Such caution is a welcome sign, as for a bottom to be in place, it is preferable to see a climax in the growing pessimism, because as pessimism grows, there is downward pressure on stocks.
For instance, note in the chart below that the number of puts bought-to open relative to calls bought-to-open on SPX component stocks is now at its highest level in 2021. This is encouraging for bulls, but not if growing pessimism continues to mount. Therefore, bulls would like to see a roll-over in this ratio and/or evidence that pessimists are feeling pain of some kind through a positive technical development, such as a SPX move back above 4,475.
Since caution among option buyers began to grow roughly two months ago, you can also focus on the SPX’s 40-day moving average at 4,450 as a green light that those bets against equities are no longer working, and reverse the recent trend in mounting caution among investors.
There are a couple of other charts that are a cause for concern if you are bullish right now. With equites hitting a multi-month low, it appears there is no pressure on active investment managers to add to their long exposure. Per the weekly survey from the National Association of Active Investment Managers (NAAIM), this group has been reducing long exposure, with the four-week moving average still far above extreme lows. Unless someone else comes in and buys equities, or they use Friday’s Merck news to come back into the market, I don’t see huge pressure on this group to continue doing what they are doing, as long as major benchmarks such as the SPX and NDX remain below the key support levels referenced above.
Finally, the recent multi-year low in SPX components’ total short interest levels has become more of a risk to bulls. Not only has the SPX broken below support levels that have been in place for months, but this breakdown may be emboldening shorts for the first time in a long time, per the chart immediately below.
To the extent their short positions are working, there is less pressure to cover on pullbacks. In fact, rallies may be used to add to short positions, which isn’t something bulls have had to encounter since last year’s short interest peak, which was followed by a long period of vicious short covering. If there is anything to keep an eye on in the weeks and months ahead, it will be the behavior of shorts in the context of SPX price action.
Todd Salamone is Schaeffer's Senior V.P. of Research
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