“Bullish momentum remains intact for the S&P 500 and Nasdaq, but near-term overbought conditions coupled with deteriorating breadth make equities vulnerable to a pullback or correction,’ said Craig Johnson at Piper Sandler.”
“… this rally is not accompanied by major euphoria at the strategist level. It is an advance heavily led and influenced by large-cap technology names, but other stocks from different sectors and lower market capitalization levels are also chipping in, and this should not be ignored.”
–Monday Morning Outlook, June 24, 2024
“The possibility that the Fed could wait too long, and allow a downturn to gain momentum in the meantime, might help explain Thursday’s underwhelming market response to the CPI reading, at least in stocks”
–The Wall Street Journal, July 12, 2024
While the excerpt immediately above is just one sentence that appeared in an article in The Wall Street Journal on Friday to make the case for a rate cut either later this month or in September, I think it said a lot. For me, it captured the underlying cautious or fearful sentiment that has been alive throughout the multiple all-time highs in the Standard and Poor’s S&P 500 Index (SPX–5,615.35) this year, one being from a technical perspective, as seen in the first excerpt above.
Yes, the SPX was lower in reaction to the report, but 400 of the 500 stocks in the index were higher, as the equal-weighted SPX (.SPXEW–6,830.68) rallied in reaction to the benign CPI reading. The Russell 2000 Index (RUT–2,148.27), made up of small market capitalization stocks, rallied strongly too, gaining nearly 4%. Is this price action really “underwhelming?”
Bigger picture, my first take-away is that when “breadth” is poor, we are cautioned that this is a warning sign because the assumption is it will remain poor, but not improve. But if breadth is solid, which was the case in Thursday’s tape, the market reaction is considered “underwhelming” because of a few mega-cap tech stocks finally taking a breather. It suggests to me that from a technical perspective, the market, as measured by the SPX, has been considered vulnerable even as it carves pit new high after new high.
The second take-away from the The Wall Street Journal quote is that a fairly large contingent of market observers and participants fear a mistake that either brings back inflation or, by waiting too long to cut rates, plunges the economy into recession. Both have implied negative stock market implications.
In fact, this may explain why, per the latest data from the exchanges, short interest on individual components of the SPX is around the highest levels since the economy nearly shut down due to Covid-19.
Note in the chart immediately below that when short interest declined from the level at present via covering activity that began in the middle of 2020, the coincidental price action was a powerful rally until the market put in a significant peak when total SPX component short interest hit a multi-year low in early 2022.
It is extremely interesting that when quantifying sentiment through the lens of short interest on SPX components, fear now is on par with that of the uncertainty that arose during the Covid-19 scare.
Ahead of a potentially pivotal week last week for stocks, with testimony on Capitol Hill from Fed Chairman Powell and the inflation data at the end of the week, fear continued to be evident. Option traders (again) placed their bets on short-term, just-expired July 12 expiration SPDR S&P 500 ETF Trust (SPY–559.99) options with a bias toward puts, or downside bets (red bars).
The short-term negative outlook among this group of market participants has been a continuing theme in most weeks since the October trough, as some of you might remember from previous commentaries.
From a short-term perspective, the SPX enters standard July expiration week in an oversold condition, according to its 14-day Relative Strength Index (RSI). Bears should be aware that this has been the case on most days since mid-June, implying the index is trending, potentially downgrading the usefulness of this technical tool.
This does not mean we aren’t vulnerable to a pullback as anything is possible, but in most instances this year oversold conditions have been resolved via sideways movement. This means we could continue to see rotation at the sector level, particularly on stocks that are range bound.
In analyzing SPY options, there currently is not a big threat of an option-related, delta-hedge decline, but the call wall at the SPY 562-strike, equivalent to 5,620 on the SPX, could keep a lid on rally attempts. And the put and call open interest at the 544-545 strikes could put a floor on any selling. Open interest at the 544-545 and 562-strikes is low and therefore not as impactful relative to the 100,000 contracts or more that are typical at any one strike in the vicinity of the SPY during standard expiration weeks.
Finally, the bearish outside day on Thursday is worth noting, but it remains to be seen of its implications. As stated earlier, that outside day occurred on a day in which 80% of the SPX components rallied, implying it may have a bigger implication for megacap technology names. A bearish outside day in late May did precede short-term selling before the 30-day moving average acted as support. But a bearish outside day in late June preceded short-term sideways movement before a move to new highs.
In a scenario of sideways movement or a short-term selloff from an oversold condition, I am continuing to monitor the SPX’s 30-day moving average, which has acted as support on two of the three pullbacks this year. This moving average comes into the week at 5,450 and, based on its slope, projects to be around the 5,500-centruy mark at the end of the week, which is coincidentally the area that is 20% above the July 2023 closing high that preceded the correction into late October 2023. Note there was a brief hesitation around this level in June.
Todd Salamone is the V.P. of Research at Schaeffer’s Investment Research.
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