As I have been saying for weeks, by focusing on key levels in the present and using history as a guide with respect to the S&P 500 Index (SPX—4,158.24), you can eliminate the guesswork and allow the equity market’s action to guide you in making your next move, as investors weigh multiple risk factors and unknowns related to upcoming Fed actions, issues with supply chains, plus geopolitical tensions. Will they combine to slow economic growth, or is recession or stagflation in the cards?
You may be looking for permission to tiptoe back into equities after the SPX broke below the 4,300-4,375 area in mid-late April. These were key levels that I had identified then, with the Fed switching gears to fight inflation and the SPX still far above potential long-term moving averages that could potentially act as support, but significant pain would be incurred if such moving averages were tested, and one was earlier this month.
Per the first chart below, there have been a couple of technical developments that are encouraging for bulls. The first is the area at which the SPX troughed earlier this month, which was a round 20% below the SPX’s all-time closing high and 2021 year-end close.
Note that this low was also in the vicinity of 3,852, the SPX’s close when President Joe Biden took office in January 2021. For historical perspective on the potential importance of the SPX’s close when a new President is sworn into office, one need not look any further than March 2020, when the SPX troughed in the 2,270 area, which is where the index was trading when Biden’s predecessor Donald Trump took office in January 2017. One major difference between now and then is in 2020 we were on the cusp of major fiscal and monetary stimulus, whereas now, the Fed is hiking rates and no longer buying bonds, and fiscal stimulus is a thing of the past.
Moreover, the advance from the mid-May trough has resulted in the SPX trading back above a short-term resistance level from an extended trendline connecting January-February’s lower highs.
“…the SPX is now trading around its 24-month moving average. Major buying opportunities have occurred here over the years, but you should emphasize monthly closes when using this (and other) monthly moving averages as a guide to identifying potential risk and reward… if the SPX experiences a monthly close below its 24-month moving average, it has a tendency to experience additional selling, with the 36-month, or three-year, moving average marking some, but not all troughs… as the SPX flirts with its 24-month moving average, a trendline connecting multiple highs from 2015-2020 and the round 4,000-millennium level, I saw a flurry of bearish headlines on Bloomberg’s app on Tuesday evening. My immediate thought after seeing these headlines and reading the articles was ‘be on the look-out for a significant rally in the short-term, and albeit a lower probability, perhaps a long-term advance.’”
-Monday Morning Outlook, May 14, 2022
Perhaps, more importantly, the rally sets the table for the SPX to close May above its 24-month moving average, a long-term moving average that I have discussed in previous commentaries as having historical importance. Sometimes major buying opportunities occur here, but monthly closes below are typically indicative of more pain to come.
Barring a close below 4,038 on Tuesday, which is also 10% below the important 4,375 level discussed above, the long-term bull trend remains intact when using the 24-month moving average as a guidepost. This may give you reason to “ease” back into equities, with your risk being a monthly close back below this trendline in June or later.
If you like the risk-reward at present, despite what I am about to discuss in the next paragraph, be bolder with your dollar commitment, but use index or exchange-traded fund (ETF) puts to hedge. In fact, this would be a strategy to strongly consider, with SPDR S&P 500 ETF Trust (SPY— 415.26) options reasonably priced. For example, 90-day historical volatility (HV) on the SPY is 25%. Implied volatility (IV) on standard September SPY options is 23%.
But if you make a commitment to equities, you may want to consider easing back in, as there is still major potential resistance from 4,170, the March closing low, and 4,375 above. How the market behaves around these levels, if tested, may further clue us in as to whether this is a short-term rally in a bear market or a longer-term rally. For example, if the SPX fails to take both these levels out and subsequently moves back below its 24-month moving average, the odds increase that the recent lows will be violated. But a move above these resistance levels would enhance odds that a longer-term rally is on the horizon.
A longer-term rally could occur if the market begins discounting an environment in which inflation is not as persistent as recently feared and the Fed doesn’t embark on a rate hike campaign like most, including the data-dependent Fed itself, anticipate.
Speaking of long-term moving averages, check out the Nasdaq 100 Index (NDX—12,681.42) which found support in its 36-month, or three-year, moving average at its May lows. Per the chart below, note that this moving average has marked numerous buying opportunities, including the March 2020 bottom. But unlike the SPX, the NDX is still below its 24-month moving average, situated at 13,538, 6% above Friday’s close.
If you opt to join those that have made leveraged bets on a rally in big-cap technology this year, per the data below from www.etf.com, consider that a risk if you buy this technology dip. From a technical perspective, you have history on your side. But keep in mind that you are “joining the crowd” so be quick to exit the trade if the NDX closes back below this long-term moving average that is currently at 11,800.
It appears a bulk of the Invesco QQQ Trust (QQQ -- 309.10) inflows occurred during late February and into March, when the QQQ’s average price was $345 over that five-week period. Consider that to be a level at which sellers may emerge who are thinking breakeven. But first, the QQQ must take out its mid-March low at $318, which is not a guarantee.
Sentiment indicators are mixed depending on what you are looking at. For example, whereas there are outflows from leveraged technology ETFs betting on declines and inflows into leveraged tech ETFs betting on bullish technology action. However, there have been outflows this year from broader market leveraged ETF’s betting on upside, and inflows into leveraged broader market ETF’s betting on broad market weakness. From this perspective, I would emphasize broad market ETFs if long, thereby avoiding the crowd that is favoring technology.
Per the two graphs below, short interest on SPX components stocks is slowly turning higher from multi-year highs, a longer-term risk if short activity accelerates from such low levels.
But in the options market, equity option buyers are nearing record extremes in pessimism, leaving them vulnerable to being on the wrong side of major short-term moves like last week.
Todd Salamone is a Senior V.P. of Research at Schaeffer's
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