Candlestick patterns could indicate short-term weakness
2021 is now behind us, but as we enter 2022, investors will have to sort out some of the same uncertainties that surfaced in early 2020, and lingered for all of 2021.
First and foremost - how will we deal with Covid-19 and its economic impact both domestically and around the world? Will variants of the virus emerge that are more threatening to life and elusive to current vaccines? Will we begin to live with the virus without the threat of cancelled events, tests, and quarantines that many thought would have been a thing of the past by now?
As investors fret about Covid-19’s impact on the economy going forward, all eyes will be on the Federal Reserve as it continues to wind down bond purchasing and hint toward rate hikes in the months ahead. In fact, some have argued that the Fed’s easy-money policies have been behind the impressive rally that reversed a massive slide in the market, back when the economy was essentially "shut down" for a period beginning in March 2020.
With the prospect of bond purchases by the Fed going away and the first rate hike in years, will this reverse the path of the stock market, or slow the well above average returns posted in both 2020 and 2021? For bulls, the good news is that the Fed has telegraphed its intentions, implying investors should not be surprised by the Fed’s actions, even though it is -- by the Fed’s own admission -- a fluid situation that depends on future economic data.
“…there has now been two V-bottoms this month. But this V-bottom could have more staying power, since sentiment is more negative now than in early December by some measures, implying buying potential could be greater now than earlier this month.”
- Monday Morning Outlook, Dec. 27, 2021
Regardless, we enter 2022 with the bulls firmly in control; a theme throughout most of 2019 and 2020. Furthermore, a familiar channel that the S&P 500 Index (SPX—4,766.18) traded within from late 2020 and throughout most of last year, came back into play last week. After the V-bottom rally that began on Dec. 21 continued with last Monday’s surge in stocks, the SPX failed to move above the bottom rail of that channel, as it served as a resistance area for the last four trading days of 2021.
As long-time readers of this commentary know, this channel began in mid-November 2020, when investors pushed stocks higher on positive headlines regarding Covid-19 vaccines. With the Fed in stimulus mode and hopes that vaccines would end the pandemic, stocks rallied in an orderly fashion within the channel for months.
But as we entered the late summer of 2021, stocks were “derailed.” The emergence of the delta variant and huge numbers of people not being vaccinated led to growing Covid-19 cases and hospitalizations, renewing fears of lockdowns and continued supply chain issues. Plus, hints from Fed members around that time, including Chairman Powell, that tapering of bond purchases was going to be discussed, caused overly optimistic traders and investors to re-assess risk. This risk re-assessment pushed the SPX below the lower rail of its channel, and the orderly uptrend bulls became used to is no longer as apparent. However, since those late-September lows, the SPX has recovered admirably, considering another Covid variant has emerged and the Fed has pushed ahead with its tapering, as foreshadowed in the late summer.
Amid Covid-19 uncertainty, the Fed and SPX channels seem to be a recurring theme. Therefore, I zoomed in on the past six months with the SPX chart above. My thought is that one channel prevailed during Covid-19 vaccinations, and the Fed in stimulus mode via bond purchasing is keeping rates near zero.
Now, after investors had to weigh new Covid-19 variants, the Fed winding down bond purchases, and the prospect of a rate hike(s) in 2022, might we be on the verge of another bullish channel following the selloff in stocks in September lows?
In other words, the market has gone through the reality of emerging variant risks and the Fed becoming less accommodative in the future. This risk re-assessment pushed the SPX out of an orderly pattern of highs and lows in place from November 2020 through September 2021. But it is quite possible that a new channel is in place, with the bottom rail of that 2020-2021 channel acting as resistance instead of support, and a new lower rail connecting the September and December lows. If such a channel persists like most of last year, bulls would welcome this. After re-assessing risk in September and pushing stocks lower, there may be a sense of relief in terms of when and how the Fed would remove the punch bowl, in addition to how we would deal with other Covid-19 variants.
Looking ahead to next week and the short-term, the biggest risk for bulls is the Tuesday through Thursday daily candles on the SPX, as they look similar to three-day patterns that preceded short-term market declines last year. In other words, the doji-like days on Tuesday and Wednesday, where the open and close are the same or about the same, typically hints of a reversal. This was followed by Thursday’s bearish outside day and looks most like the early-November three-day pattern. The fact that this three-day pattern occurred at the bottom rail of a former channel is also noteworthy.
For bears, the biggest risk is the momentum off the Dec. 20 low, which occurred in the absence of retail call buyers. This group could be a tailwind for stocks if they go on a call buying spree after the holidays like they did last year.
For perspective, buy (to open) call volume is around the lowest of the year. This could be a seasonal thing, but as of Dec. 28, buy (to open) call volume on equities was running 25% below the level of one year ago, even as buy (to open) put volume was running about the same.
Todd Salamone is Schaeffer's Senior V.P. of Research
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