Why the S&P 500 Might Be In for Some Smooth Sailing

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“…if following the historical script and applying to the present, the SPX’s 4,375 level should be your ‘uncle’ point to take action to lighten up on bullish positions you may have initiated coincident with the SPX breakout… If you want to give a little more room, or lighten up even further if the SPX declines, the round 4,300-century mark is another point to focus on, as this represents September and January support.”

– Monday Morning Outlook, March 28, 2022 

“The historical script I discussed in the excerpt above referred to the action in the SPX following strong rallies within two previous multi-year bear market environments. In other words, breakouts above bearish channel lines occurred in the 2000-2003 and 2007-2009 bear markets but were followed by moves back below the breakout level. Such moves back below the breakout level preceded declines to lower lows.”

– Monday Morning Outlook, April 11, 2022

I am taking you back to excerpts from March and April because it was then I used prior bear markets (2000-2003 and 2007-2009) to highlight what might become of a bear market rally. 

Back then, the S&P 500 Index (SPX – 3,961.63) broke out above a trendline connecting its January and February highs, after a period of extremely weak price action. While the breakout felt good to some bulls, I thought it might be a good idea to look back at prior bear market rallies to identify a level that might indicate the SPX was at higher risk of returning to its lows or making new lows, which occurred in prior bear markets after impressive rallies.

I found that if the level from which the bear market rally broke out above the trendline connecting lower highs failed on a pullback, there was a high probability that significant selling would follow, with possible new lows on the horizon. The level I focused on back in March was 4,375, or the yellow dashed horizontal in the chart immediately below. When 4,375 broke in mid-April, it wasn’t long before the SPX made new lows. 

The action in the SPX a few months ago was not unlike that of 2007-2009, when the index broke above the 1,390 level in April 2008, where a trendline connecting lower highs since the October 2007 peak sat. The SPX’s move back below the 1,390 level in June 2008 proved disastrous for bulls, just as the April breakdown below 4,375 earlier this year.

In both cases, a trendline connecting lower highs from the peak prior to the breakdown below the former breakout level is evident. In July 2009, the trendline connecting lower highs from the “false breakout” high in May 2008 was sitting just above the 900 level. It was clear sailing for years when the SPX broke out above it later hat month, before correcting from the 1,390 level in 2012.

Ironically, the SPX broke out above the 3,900 level, which is the site of the trendline connecting lower highs from its March 2022 “false breakout” high point. The breakouts above these trendlines occurred in July.

Might this indicate clear sailing ahead for the next few months, perhaps back to the 4,375 area? If so, it would be the same pattern as 2007-2009, albeit much different in duration and magnitude from bottom to top. Consider playing a move up to 4,375 on the SPX, which is 10% above Friday’s close.

But also assign a stop on closes back below the 3,800-3,900 area, scaling out of the long if the SPX closes back below last week’s 3,900 breakout level, and scaling out of the rest of the position if it closes back below 3,800. This would represent roughly 3% downside risk.

“…you may be surprised by the speed of the move, as last Monday’s gap from the (SPX’s) 3,900-century mark pushed the index below last month’s support at 3,850, which I said would likely precede a move to the SPX’s 36-month, or three-year, moving average in the 3,700 range… pullbacks to the vicinity of this moving average have marked tremendous buying opportunities in the past, except in instances where they didn’t – 2008 and briefly in 2020. As such, history would suggest that both bulls and bears should remain on high alert. If you are a bear, be cognizant of the fact that major buying opportunities have occurred in the vicinity of this long-term moving average.”

– Monday Morning Outlook, June 18, 2022 

Not only is the risk-reward appealing if past is prologue, but so too is the fact we are entering the heart of earnings season, which has been preceded by fear that earnings and downgrades will further dismantle the market. Instead, in the early going, equities have rallied. Moreover, last week’s SPX technical breakout above 3,900 occurred after its June close above the 36-month moving average in the 3,700 zone, which has produced major buying opportunities historically.

The short-term sentiment landscape becomes brighter too, as the breakout could inspire further unwinding from a pessimistic extreme among equity option buyers, which could be a tailwind.

“Stock markets are yet to see full capitulation, Sanford C. Bernstein strategists said, taking a contrary view to that of Bank of America Corp.’s fund manager survey… ‘We have not yet seen capitulation in outflows from equity funds,’ strategists Mark Diver and Sarah McCarthy wrote in a note on Wednesday. ‘In fact outflows, excluding Europe, have only just begun. By contrast, Bank of America’s July global fund manager survey showed on Tuesday that full capitulation had been reached after investor allocation to stocks plunged to the lowest since October 2008, while exposure to risk assets dropped to levels not seen even during the global financial crisis.”

– Bloomberg, July 20, 2022

Debate has raged in recent weeks on whether a bottom is in place for equities, per the excerpt above. However, whenever I see headlines like the ones below that capture the mood of the market, amid the possibility of a historical technical pattern repeating that is bullish for equities, my contrarian alarm rings bullish for at least a 10% rally. However, if the SPX breaks back below the 3,800-3,900 area in the days or weeks ahead, all bets are off.

Risks to the bull case include what I mentioned last week, which is the major Cboe Volatility Index (VIX – 23.03) call buying that has since decreased. However, pullbacks have emerged after VIX call buying relative to put buying peaked and, as such, that is worth noting with this week’s July Federal Open Market Committee (FOMC) meeting, and the heart of earnings season fast approaching.

“The Stock Market Is On Sale. That Doesn’t Make It Cheap.”

– The Wall Street Journal, July 21, 2022

“As Fed Tightens, Economists Worry It Will Go Too Far”

– The Wall Street Journal, July 17, 2022

“Risk tolerance plunges to 11-year low among worried retirement investors.”

– Financial Planning, July 15, 2022

BlackRock Warns Against Dip Buying as High-Volatility Era Dawns”

– Bloomberg, July 11, 2022

Todd Salamone is a Senior V.P. of Research at Schaeffer’s Investment Research

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