“One of Wall Street’s Most Vocal Bears Says Sell The Rally…Strategist says U.S. economy is in late-cycle expansion phase. Investors should use strength to position defensively: Wilson”
- Bloomberg, March 21, 2022
“El-Erian Says Cut Stock Holdings as Stagflation Concern Grows”
- Bloomberg, March 22, 2022
A bounce in a bear market, or a recovery in the continuation of a bull market? As I see recession and stagflation risks cited as a growing concern these days, and many market commentators last week making proclamations as excerpted above, it is certainly a question worth pondering -- especially if you are debating with yourself about how your longer-term investments should be managed.
The excerpts above reflect some of the commentary that I saw on CNBC last week, too. On Thursday for example, at least two commentators suggested a test of the January lows could be in the offering, which followed Tuesday’s comments on CNBC from a Cantor Fitzgerald strategist, which said this is a bounce in a bear market.
A few of the commentators correctly noted that vicious rallies similar to what we have experienced is the hallmark of bear markets. Then again, strong rallies have tended to persist for a long stint following corrective periods in the market, which makes it difficult to determine whether or not the recent action is a bounce in a bear market, or a continuation of the bull market after a corrective phase.
Fortunately, as market participants assessing risk and reward, we don’t necessarily have to make a bold projection, but instead use price action to guide us in our decision-making process.
The first is a long-term monthly chart of the S&P 500 Index (SPX -- 4,543.06) that displays bear market periods in 2000-2003, 2007-2009, and the speed bear market in early 2020. As bear markets usually persist for lengthy periods of dismal price action, we used long-term moving averages to demarcate heightened risk of a sharply declining market and/or a continued sustained period of poor price action.
The SPX’s 24-month and 36-month moving averages have been pretty good indicators of what is to come, based on the behavior of the SPX around these trendlines.
As you can see in the chart below, a cross below the 24-month moving average has signaled an additional decline to the 36-month moving average or worse, if the 36-month moving average is not supportive (this script is true since at least the 1970’s, but this period is not displayed on the chart).
Both long-term moving averages have marked excellent buying opportunities, but then again crosses below have signaled continued weakness in the market. The SPX’s monthly close below its 24-month moving average in November 2000 and January 2008 signaled significant and persistent weakness to come. Monthly closes below the 24-month moving average in 2011, 2016, and 2018 were followed --fortunately for bulls, to support at its 36-month moving average.
The SPX is still 25% above its 36-month moving average, and 12% above its 24-month moving average, admittedly too much to "bear" in a wait-and-see approach. So, if you are emphasizing the long side after the recent SPX breakout, what is your "uncle" point for guiding you in asset-allocation decisions?
The question as to at what level your risk increases may lie in comments that I made last week:
“If you are more aggressively playing the SPX’s breakout above resistance, you might think about lightening your position if the SPX moves back below the top rail of its channel, which begins this week at 4,360 and ends the week at 4,325. Unfortunately, since the top rail of this channel is sloping lower, your risk increases as time passes. Therefore, another level to focus on is the one from which the index broke out above the top rail, which is 4,375.”
- Monday Morning Outlook, March 21, 2022
Per the two charts immediately below, encompassing SPX daily price action from August 2000 to March 2001 and September 2007 through July 2008 – when in hindsight the SPX was firmly entrenched in a bear market (note that as various commentator noted last week) – vicious rallies occur within bear markets.
During the two periods below, note that like now, the SPX advanced above trendlines marking lower highs in both periods, indicating a potential change in trend. But these were fake-out moves. If one were focusing on the level from which these breakouts above lower highs occurred, and sold on the SPX’s move below those respective levels, their risk proved negligible.
Keep in mind that during the periods displayed below in which the SPX moved back below its breakout level – February 2001 and June 2008 – the index was trading below its 24-month moving average. This implies that many longer-term investors were feeling pain more so than now, and thus likely to throw in the towel after hints of trouble continuing.
Therefore, if following the historical script and applying to the present, the SPX’s 4,375 level should be your "uncle" point to take action to lighten up on bullish positions you may have initiated coincident with the SPX breakout two weeks ago. If you want to give a little more room, or lighten up even further if the SPX declines, the round 4,300-century mark is another point to focus on, as this represents September and January support. Additionally, it is the current site of the trendline that connected lower highs in December through mid-March.
“Something bulls can hang their hats on is that the VIX closed below a trendline connecting higher lows since early February. This could be a bullish signal for stocks and a sign of lower volatility ahead, just as the VIX’s break above a trendline connecting lower highs in early November signaled higher volatility ahead and with it, a challenging period for stocks.”
- Monday Morning Outlook, March 14, 2022
As I observed could happen two weeks ago, the Cboe Market Volatility Index (VIX -- 20.81) has plunged after moving below a trendline connecting higher lows from February into early March. A potential risk that I am watching is the activity in VIX futures options, as the 10-day buy (to open) call/put volume ratio is currently at 1.90, just short of the 2.0 level that typically precedes a higher VIX and lower equity prices. The VIX futures options activity is occurring as the VIX approaches its February low at 19.96.
If the negative sentiment that was present at the most recent stock market trough continues to be unwound, the VIX could move down to an area between 16.04 and 18.23. The 16.04 level is where the breakout above a trendline occurred in November, which signaled months of higher volatility. The 18.23 level is one-half the VIX’s March closing high and could be perceived by hedgers and speculators as a cheap way to play a broad market slide. In turn, this could be a coincidental headwind for equities if index and exchange-traded fund put options become popular.
If you are a longer-term investor, a VIX decline to the 16.00-18.25 area might be considered a place to put on a hedge to a long position, if that makes you more comfortable in this environment. This would be especially true if the SPX rallied back to its 2021 close at 4,766, as those thinking breakeven for 2022 could overwhelm potential buyers in this area.
Finally, I find it interesting that CNBC did a survey on Thursday, March 24 asking what they think will be the biggest focus of the market in the coming months. The answer was the conflict between Russia and Ukraine. Are investors hyper-focused on this? It’s possible, since the SPX’s close on Feb. 23 (the day prior to the Russian invasion of Ukraine) was 4,225, 7% below Friday’s close.
Todd Salamone is Schaeffer's Senior V.P. of Research
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