Last week's 'sell the winners' activity could persist if bond yields remain elevated
“…. sellers came in on Thursday, with the SPX only four points below its Jan. 23, 2022 record closing high of 4,797…if the current week ends nine consecutive weeks of gains, it is not necessarily a bearish omen, especially if the SPX does not move below support levels. The first of which is its 20-day moving average, while another is the 4,500-4,600 range -- site of the rising 50-day moving average at 4,502 and the July peak at 4,600.”
- Monday Morning Outlook, January 2, 2024
After nine consecutive weeks of gains, the bears finally seized control, with the S&P 500 Index (SPX—4,697.24) gapping lower to begin the new year and sellers dominating into week's end. The action continued selling that first emerged just ahead of the turn of the calendar, when sellers swept in on Dec. 28 as the SPX approached its all-time closing high just below the round 4,800 level.
With that, a new technical risk emerged, in addition to a couple of sentiment-based risks that I mentioned last week. That is, the SPX crossed below its 20-day moving average in Thursday’s trading.
In a previous commentary, I observed that in the second half of 2023, crosses below this moving average signaled that bears had asserted control for a period of a week or two after the cross below. This was the case in all three instances beginning in August. A cross below the 20-day moving average in February 2023 also signaled short-term trouble, although crosses below in April and May were false sell signals.
Last week’s selling consisted in some cases of ‘sell the winners,’ including those megacap names that got all the attention due to their impressive rallies in 2023. But other stocks that had rallied strongly on perceptions of a Fed pivot to a dovish stance last month reversed sharply, as rates rose, and the probability of an expected rate cut in March was reduced.
Rates rose as one Fed governor “pivoted” somewhat on the early-December perceived Fed shift to a more dovish policy. A stronger-than-expected December employment number also contributed to reduced expectations for a Fed rate cut in March.
“…in addition to the technical risks of the early-2022 high being in sight, there are a couple of sentiment-based risks that become more relevant if there is a short-term technical breakdown below support levels…For example, active investment managers are now slightly leveraged long on equities… equity option buyers are more optimistic now relative to weeks ago and the level of optimism is at a level at which corrective moves have begun.”
- Monday Morning Outlook, January 2, 2024
A potential challenge for the bulls in the weeks ahead is a shifting sentiment backdrop. If you remember, the market rallied sharply on the heels of the 10-year Treasury yield peaking in late-October and coincident with investor sentiment being at a negative extreme. The more accommodative interest rate environment caused an unwind of an extreme in pessimism and helped drive a rally as equity option buyers turned to more call buying and active investment managers increased exposure to stocks.
Since late-December, however, the yield on the 10-year Treasury bond has ticked higher. And per the chart below, this occurred when short-term equity option buyers on SPX component stocks near a bullish extreme.
If the 10-year Treasury yield, currently at 4.04%, pushes above its 200-day moving average at 4.04% and/or remains above the round 4.0% level, the unwind of an optimistic extreme that is now in motion may continue and send stocks lower.
The latest data from the National Associations of Active Investment Managers (NAAIM) showed a massive reduction in equity exposure last week, but their net long exposure is still more than double that of early November. And per the chart below, note that equity put buying has picked up relative to call buying on SPX component stocks, which is typically a coincidental headwind.
Inflation data is due out later this week, and this will have an impact on investor sentiment. Data that suggests that Fed rate cuts will be pushed out would likely have negative implications for stocks, based on how stocks behaved last week and as investors adapt to the current “rates higher for longer” thinking.
If you are not hedged for a short-term pullback, now is the time to do so. Sentiment-based indicators along with the SPX’s break of potential short-term support sets the stage for a potential pullback to the 4,500-4,550 zone, the latter number being the approximate site of the SPX’s rising 50-day moving average. Plus, there are the uncertainties of the inflation data later in the week and the start of earnings season.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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