We could be on the cusp of a near 10% rally in the coming months
“The week ahead features the standard September expiration week, and the added bonus of the September Federal Open Market Committee (FOMC) meeting. Fed funds futures players are pricing in a 55% probability of a 25-basis point cut, and a 45% probability of a 50-basis point cut. The biggest risk to bulls might be the Fed doing nothing again… With respect to the OI that is about to expire, the SPY is now near a call wall at the 570-strike, implying about 100 points upside to this level… bulls will have to find another source of buying power. One potential source is from short-term traders, who are again at a pessimistic extreme, even with the SPX near an all-time high.”
– Monday Morning Outlook, September 16, 2024
With the Federal Open Market Committee’s (FOMC) interest rate cut discounted into the market, but a 50-basis point cut not entirely factored in, the overwhelming positive reaction to the central bank’s decision may not have been a huge surprise.
In the context of equity, the amount of overly pessimistic options buyers is consistent with levels that preceded strong price action recently, setting the stage for short-term negativity to unwind after the Fed’s bigger-than-expected cut.
The S&P 500 Index (SPX — 5,702.55) pushed above its July all-time high shortly after the FOMC’s decision, but closed back below that level. In fact, Wednesday was almost — but not quite — a bearish outside day candle on the SPX, like those in 2024 that signaled imminent short-term trouble ahead. On Thursday morning, the SPX gapped above its July peak, where it remained at Friday’s close, albeit with a near retest of the record level on Friday morning.
Meanwhile, the SPDR S&P 500 ETF Trust’s (SPY — 568.25) call wall at the 570 strike was in play on Thursday and Friday. For the week, the exchange-traded fund (ETF) tested and ultimately closed below this call-heavy strike, which is equivalent to the SPX’s 5,700 century mark and a strike I expected to be troubling during standard expiration week.
Coincidentally, last week’s high was in the vicinity of 5,724, which is exactly 20% above the SPX’s 2023 close. Readers of this commentary know that round-number percentage gains or losses tied to a year-end close and/or a significant high or low sometimes define support and resistance. This March, for example, the SPX stalled at 5,250, which is a round 10% above its 2023 close.
“…a move to new highs means a move above the neckline of a bullish inverse head and shoulder pattern, with the head marking the early August low and shoulders being the short-term lows in late July and earlier this month. A breakout would signal a 500-point move above the July closing high in the coming months, or about 6,150- 6,200.”
– Monday Morning Outlook, September 16, 2024
So, what now?
Per an observation I made last week, the SPX’s move above the July, August, and pre-FOMC rate-cut highs completes a bullish inverse “head and shoulder” breakout. The circles on the chart above show the head and shoulders of the pattern, with the red line segment representing the neckline.
This pattern is more evident on an hourly chart relative to a daily chart. Nonetheless, the bullish pattern suggests that we could be on the cusp of a near 10% rally in the coming months.
With a bullish technical pattern in place, it’s best to identify a potential source of fuel. As mentioned earlier, option activity on SPX component stocks indicated pessimism in the two weeks leading to the FOMC meeting, and the SPX broke out above its former high. One could see short-term traders being a source of buying power, with FOMC uncertainty behind and a technical breakout occurring soon after the interest rate decision.
Per the chart below, the negative sentiment is unwinding, with the 10-day buy-to-open put/call volume ratio heading lower from a relative high, which usually coincides with bullish price action in the index. A rollover from previous highs in this ratio marked lows in April and early August.
Plus, less than 50% of newsletter advisers are bullish, and this is still highly shorted market. A highly shorted market (see second chart below) is a topic I’ve keyed in on throughout 2024, as it has bullish implications in the context of the SPX hitting new highs, as it did last week.
It’s also worth noting there are more stocks participating in the rally, so it’s likely more and more shorts are losing the battle, and thus represent short-covering potential. At the very least, they may be less apt to build on a losing position, which removes a headwind.
With total short interest at 2020 Covid highs, the chart shows how short covering can unleash a powerful rally. Furthermore, there was a 6% increase in SPX components’ short interest in the month of August. With the SPX above its August high, it is likely many of these new short positions are underwater.
While there is never a guarantee, the risk-reward ratio seems to favor the bulls from both a technical and sentiment perspective.
Todd Salamone is the V.P. of Research at Schaeffer’s Investment Research.
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