“Economists and strategists have been expecting inflation growth to slow, as expectations become more difficult to beat from the previous year. Still, we’ve yet to see this come to fruition in recent reports, with the last consumer price index (CPI) reading coming in at roughly 8.6% year-over-year… If inflation remains hot, a break back through 3,840 to resume the prolonged downtrend is the likely scenario. In that case, watch for a break of the SPDR S&P 500 ETF Trust (SPY – 388.67) 380-strike put, as that would open the vacuum to the large open interest 370-strike put, which had been the peak put level last week…continue to express caution during this modest rally until we see how markets react to the CPI data on Wednesday.”
- Monday Morning Outlook, July 11, 2022
“The Consumer Price Index rose 9.1 percent from a year ago, defying expectations and further squeezing Americans’ budgets.”
- The New York Times, July 13, 2022
Our own Senior Market Strategist Matthew Timpane was spot on when discussing last week’s most important data release – the June consumer price index (CPI) reading. He stated the expectation among economists and strategists was for inflation to slow down, though the report did not live up to such expectations, coming in at 9.1% year-over-year.
With the CPI acting as a negative short-term catalyst, a full-basis point hike during the Federal Open Market Committee (FOMC) meeting on July 27 became much more likely, pushing equities lower. The SPDR S&P 500 ETF Trust (SPY – 385.13) broke below the 380-strike put, and by Thursday morning it was trading just above the 370-strike put, as Timpane cautioned could happen if the CPI was hotter than anticipated.
Comments from Federal Reserve Governor Christopher Waller suggesting the market is getting ahead of itself with expectations of a 100-basis point rate hike supported stocks early Thursday, and the SPY managed to rally from the put-heavy 370-strike area.
Better-than-expected economic data followed on Friday morning, in addition to bullish earnings reactions from several financial stocks. As opposed to what happened during June expiration, the unwinding of short positions related to heavy put open interest at the 370-380 strikes on the SPY led to a late-week July expiration rally.
The quiet period for FOMC participants began on Saturday, meaning they cannot speak publicly or grant interviews that give market participants any more hints as to what might be coming in terms of monetary policy. In turn, the uncertainty the CPI report generated will loom into July 27. From this perspective, the immediate risk to bulls is how the S&P 500 Index (SPX – 3,863.16) has behaved during quiet periods in 2022 ahead of rate hikes, per the chart below. The “7-day prior return” represents how the market has performed during that period.
Since the SPX experienced its last closing low, 18 days have passed, which is half the duration of its longest streak between lows in 2022. Bulls can continue to hang their hats on a couple of technical developments right now, including:
- The SPX’s June close above its 36-month moving average, which has historically been the sight of big buying opportunities, including 2011, 2016 and late 2018/early 2019. It was the sight of last week’s low, too.
- The Thursday and Friday July expiration week rebound pushed the SPX above the 3,813-3,836 area, which is a level that is roughly 20% below its 2021 year-end close and the 2022 all-time closing high.
But while the above factors are encouraging, I believe we are still short of factors, at least from a technical perspective. This could generate the unwinding of pessimistic extremes we have been seeing among equity option buyers or survey participants.
In other words, those that are negative towards the market must have reason to bail on those emotions before they represent massive buying power. Major benchmarks holding long-term support is likely not enough to get them off the sidelines. And for those short on the market, it may take a powerful rally to flee positions that bet on lower stock prices.
Per the chart above, note that a crossover back above the SPX’s 24-month moving average, currently sitting at 4,090, presented little downside risk and plenty of reward for bulls. The SPX is still nearly 6% below this level. In this respect, patience remains the order of the day, before moving aggressively back into the market.
Moreover, even with the late expiration week bounce, the SPX is flirting with the 3,850 level, which I noted when President Joe Biden took office in January 2021. It acted as a support level in May, but since late June, rallies above this region have lasted only a few days. Additionally, the SPX’s 40-day moving average continues to point lower and is not far overhead. This trendline capped rally attempts in early June and once again earlier this month.
On one hand, longer-term support levels have been holding. But rallies have hardly been of the magnitude that will squeeze bears, or convince those that have moved to the sidelines that they are missing out.
Finally, I would like to touch on volatility expectations, with the expiration of standard July Cboe Volatility Index (VIX – 24.23) futures options (/VXc1) coming up Wednesday morning. As I have mentioned before, there is a tendency for huge numbers of call and put options on VIX futures to expire worthless from month to month.
If sellers of VIX futures options have their way, the maximum number of put and call contracts will expire worthless. This is something to watch going into the Wednesday morning settlement.
As it stands now, a July contract settlement price in the 28-29 area would maximize the number of calls and puts expiring worthless. This would also suggest there may be an uptick of volatility expectations into the Wednesday morning settlement, as the July contract closed just above 25 on Friday.
Additionally, a short-term risk to bulls remains in place when observing action among VIX futures options buyers. Specifically, the VIX futures options 10-day buy-to-open call/put volume ratio is approaching an extreme high that we last saw in mid-April.
For what it's worth, stocks sold off sharply into the early-May FOMC meeting, and for about two weeks after that rate hike. The VIX nearly doubled in that period. VIX option buyers have had an impressive track record over the years and in 2022, so this is a risk that should not be ignored. This indicator is warning bulls to prepare for the worst, and hope for the best.
Todd Salamone is a Senior V.P. of Research at Schaeffer's Investment Research
Continue Reading: