There remains plenty of negative sentiment to unwind
“Amid the change in market participants’ outlook on interest rates the past few weeks, the technical backdrop in the equity market has deteriorated… the 3,970 level represents the breakout level in late January above a trendline connecting major lower highs in 2022…continue to watch the 3,970-level, as a close below this level is a red flag. Since April 2022, breaks below prior trendline breakout levels have led to sharp selloffs in the immediate days following the breakdown. Friday’s close was literally at this support level, so continue to keep a close eye on this level... not all patterns remain in place indefinitely, so if 3,970 does break, risk of a sharp sell-off increases, but this doesn’t necessarily mean it is guaranteed to happen...”
“…just like there were multiple levels of resistance that the SPX had to get through as it rallied from its December lows, there are also multiple levels of potential support below 3,970.One such area of support for the SPX is the Friday morning lows at the popular 200-day moving average (3,940), which is also the site of the mid-September 2022 breakdown level below a trendline connecting higher lows from June through early-September.”
-Monday Morning Outlook, February 27, 2023
The excerpts above captured both the technical risks and potential lines of support as we entered last week’s trading. The precise levels discussed were very much in play, creating a dicey situation for bulls on Wednesday and Thursday, but a happy ending for that group by Friday’s close.
During the week that has just passed, the two-year note yield hitting its highest level since 2007 grabbed media headlines, amid continued commentary from Fed governors on the future of interest rate policy and the fascination with zero days to expiration (0DTE) options. But the main storyline from last week is that little changed with respect to the expected terminal point this year in the fed funds rate, and how long this high point will persist.
In other words, the probability that the fed funds rate will be at 5.25% or 5.50% in December 2023 didn’t change all that much from the week prior. No change in these expectations may have been enough to stop the slide in the stock market. Moreover, we may be on the verge of a few weeks in which buyers outnumber sellers coincident with the start of a new month, just as a pivot to a selling mentality took hold at the beginning of last month.
During the past few months, the start of the month has been coincident with reversing short-term trends in the broader market. For example, a major trough occurred in early November, a peak emerged in early-December and buyers serviced vigorously in early January.
Per the chart immediately below, the bulls were certainly tested last week. On Wednesday, the S&P 500 (SPX--4,045.64) closed below the key 3,970 level that, in my opinion, is one of the more important levels that investors should continue to be in tune with in the days ahead. However, and as I mentioned last week, even if 3,970 was breached, there was a “lifeline” of sorts for bulls in the 3,940 area, which was a potential “three-tiered” support zone (200-day moving average, the September 2022 breakdown level from a trendline connecting higher lows from June through early September and a 61.8% Fibonacci retracement of the December 2022 low and early-February high.)
Not only did “lifeline” support hold, but the subsequent rallies late-day Thursday and Friday allowed bulls to be taken off oxygen, at least for now. The late-day Thursday rally pushed the SPX back above the critical 3,970 level and the Friday rally saw the SPX advance back above the round 4,000-millennium level. Not only is 4,000 a psychologically important level, but it is the site of the early-December breakdown from a trendline connecting higher lows in the October-November period that triggered a high-risk versus reward scenario into late December.
On the sentiment front, a couple measures intrigued me this week in the context of the SPX ultimately holding in a major support area and rallying back above the 4,000 level.
First, in the National Association of Active Investment Managers (NAAIM) weekly survey, the average reading dropped from 81 to 47, the largest two-week drop since May 2022. A reading of 100 is considered fully invested. One has to wonder if these active managers are looking for an entry point after a rally off long-term support last week.
Another point of interest is that short interest data as of mid-February was released early last week. During that time, the SPX was chopping around last month’s high. The report showed that covering activity continues on SPX components, so one has to wonder if short covering is helping keep a floor underneath the SPX after the January breakout above the 2022 trendline connected lower highs?
Unwinding of extremes in negative sentiment continues to be a bigger-picture theme in the first couple months of 2023. Per the chart below, if short interest gets to the lowest levels of last year, there is more unwinding to go, which is favorable for bulls, as long as key support levels discussed above keep decline in check.
As we look ahead to next week, if there is follow-through buying, there could be trendline resistance using the January and early-February highs. On Monday, this trendline sits at 4,090 and on Friday this trendline will reside at 4,070, exactly 100 points above the key 3,970 support level discussed above.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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