“If there is anything one might take away from last week’s debt downgrade, using 2011 as the most recent history, is the risk after the initial reaction was very little, albeit ugly price action followed for months. By that same token, note that from a technical perspective, the SPX has a much stronger technical backdrop at present relative to late-summer 2011.”
- Monday Morning Outlook, August 7, 2023
In last week’s market commentary, the debt downgrade I was referencing was the Tuesday evening, after the market close, downgrade of U.S. debt by Fitch rating service. Using 2011 as a guide, I made the comment that while there was little downside risk in 2011 after the downgrade, the price action in the weeks following was choppy.
This time around, the SPX has been entrenched in a steady decline since the Aug. 1 downgrade of U.S. debt by Fitch. We learned early last week that another downgrade was imminent, with Moody’s Investor Services downgrading the debt ratings of 10 small and midsized banks, causing market participants to assess risk in the financial sector and broader economy just five months after regulators closed Silicon Valley Bank.
In evaluating the market’s reaction to the U.S. debt downgrade and the subsequent credit downgrade of ten financial companies, I looked to the Cboe Market Volatility Index (VIX — 14.84), which was risking from its pre-Covid lows in January 2020. One thing that immediately stood out in the first day of trading after Moody’s downgrade was the VIX peak at 18.22, which was one-half the 2022 closing high in March of that year. While early 2022 was the start of months of weakness for U.S. stocks, could last week’s VIX peak at one-half last year’s closing high be signaling that this could be the worst of the speed bumps in the months ahead? Time will tell, but for now, continued VIX readings below 18.22 could hint at a bottoming process from those late-July highs. However, stocks should be viewed cautiously if the VIX moves north of 18.22 in the days or weeks ahead.
That said, note the VIX troughed for weeks in the 13.00-13.25 zone, which is one-half this year’s closing high around the time of the failure of Silicon Valley Bank. As such, if the VIX trades down in this area again, view it as an opportune time to hedge a portfolio of long positions with broad market exchange-traded fund options. While a sell-off may not immediately occur, one might view a VIX reading in this area as increasing vulnerability to a risk-off mindset, at least in the short term.
“Even though the SPX remains above its 40-day moving average and 4,475, or double the 2020 closing low, there were a few things that I did not like about Friday’s action. … tune to potential levels of support and resistance…if additional selling occurs in the days ahead and the SPX moves below its 40-day moving average, look for the bottom rail for the developing bullish channel as a potential support area.”
- Monday Morning Outlook, August 7, 2023
Last week indeed resulted in “additional selling” which I presented as a strong possibility when going into detail about the Friday, Aug. 8 disappointing price action and our buy (to open), equity-only, put-call volume ratio rising from extreme lows.
By Wednesday, the SPX had closed below potential support from double its March 2020 closing low at 4,475. And on Friday, the SPX opened below its 40-day moving average, which was supportive in Wednesday’s and Thursday’s trading sessions. The 40-day moving average, which was situated at 4,475 on Friday, claimed to be Friday’s intraday high.
But if there was any glimmer of hope, the 4,443 low on Friday occurred just above the SPX’s rising (and more popular) 50-day moving average, situated at 4,438. I would prefer to see the SPX back above its 40-day moving average and 4,475 to confirm that Friday’s low could be a major trough for the time being. If you need to see more, you might await a move back above the (now) declining 20-day moving average, which comes into this week’s trading at 4,530.
I made the comment last week that one thing the SPX has going for it at present relative to 2011 is a much stronger technical backdrop. As such, there are multiple layers of potential support as the bears try to regain control. For example, even with the move below the 20-day moving average two weeks ago and its 40-day moving average last week, bears failed to push the SPX below the popular 50-day moving average.
And remember, if indeed a bullish channel is developing since March, the bottom rail of that channel comes into this week at 4,420 and ends the week at 4,443. There is an “if” attached to ‘bullish channel,’ because the bottom rail is simply a parallel line with the top rail, but the bottom rail hasn’t connected as many lower highs as the top rail has connected higher highs.
However, if you want to speculate that the bottom rail of this channel will eventually mark a meaningful low, which is not a horrible bet given much of the short-term optimism that prevailed at the July top has been wrung out the past two weeks, you can conclude that there is more reward than risk in the weeks ahead.
Speaking of the SPX’s July top, note that it occurred precisely 20% above last year’s close – those darn round number percentages! (if you are a bull) As I have repeatedly said, round number year-to-date percentages or percentages above a key high or low often mark hesitation and/or pivot points.
Turning to the sentiment backdrop, I mentioned that optimism is being wrung out of the market. One example is in the options market, where the 10-day, buy (to open), put-call volume ratio on SPX components is now at its highest level since mid-May. When the SPX peaked, this ratio hit an extreme low.
A risk to bulls is that this ratio continues to rise, which has potentially bearish implications. As such, if you wait for this ratio to roll-over, you may miss the bottom, but not be too premature in the playing a shift in sentiment.
Also, for what it is worth, active investment managers have retreated from the market. Using weekly survey data from the National Association of Active Investment Managers Survey (NAAIM), this group went from fully invested on average in late July to only 65% invested last week, the lowest allocation to stocks since late May.
The sentiment-based conclusion is that there is money on the sidelines to leg into stocks at or near the support levels discussed above. But the risk is that the current build in pessimism has not yet shifted, an exception being VIX behavior, and a shift in sentiment is necessary for a trough.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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