“…the trendline that has connected all major highs since the January 2022 peak comes into the week at 3,970 and ends the week at 3,955. The important 4,000-4,020 zone lingers just above this trendline as potential resistance, should a breakout occur… The sentiment backdrop leans bullish, as extremes in pessimism like we have witnessed the past few weeks are necessary for a meaningful trough.”
– Monday Morning Outlook, January 23, 2023
If I were to summarize this commentary over the past few weeks, I would describe it as a market that has moved above potential levels of resistance, but the next resistance level always seems to be overhead.
This theme repeated last week, with the S&P 500 Index (SPX – 4,070.56) breakout above a trendline that has connected major highs since its January 2022 peak, in addition to the index’s move above the 4,000-millenium level, and its prior week highs. Plus, the SPX closed last week above its 12-month moving average at 4,040, which is a trendline that marked its August peak.
Now, the September closing high at 4,010 and the December intraday highs at 4,100 mark the area where another set of sellers could surface, at least in the short term, amid a technical backdrop that has improved weekly since the beginning of 2023, but still has a Federal Open Market Committee (FOMC) meeting ahead.
Each time a resistance level is overcome, it makes the sentiment case I presented over the past several weeks more compelling. For example, I have observed extremes in pessimism among equity option buyers and global fund managers that are necessary for a market bottom to emerge. Such sentiment extremes are more significant in their implications when those betting against the market or sitting on the sidelines feel pressure to re-enter.
While I cannot say exactly what global fund managers – who were recently reported to have their lowest allocation to U.S. stocks on record – are doing now, option buyers are in the middle of unwinding a multi-year extreme in negativity on individual stocks.
This is evident by the direction of the 10-day, equity-only, buy-to-open put/call volume ratio on SPX components. Note in the chart below that it is declining from a record reading since we have been tracking. This ratio has made a series of higher highs and higher lows since the SPX’s peak, so I would like to see the ratio move below its prior low to confirm that the unwinding of fear in this group is for the long run.
The SPX is potentially poised to close January above 3,880, the site of its three-year moving average that has marked multiple troughs over the years. Plus, the index’s move above a trendline on a daily chart that marked key peaks in 2022 and its 12-month moving average, indicating it is possible we are transitioning into a bull environment.
If that is the case, the current 10-day, equity-only, buy-to-open put/call volume ratio on SPX components of 0.80 is a high reading compared to the low readings between 0.35-0.40 that tend to occur during bull environments. This implies there is still a lot of room for short-term traders to further unwind the skepticism that existed at the December low, if indeed the technical indicators I am observing point to a bull environment in the coming months.
“The dash for cash on Wall Street is back on…Investors have added about $135 billion to global money-market funds over the past four weeks, according to EPFR data through Jan. 18. That is the best stretch since the four-week period ended May 2020, when those funds logged roughly $175 billion in net inflows.”
– The Wall Street Journal, January 25, 2023
A couple of other sentiment measures I find intriguing amid the technical developments discussed above are fund flows and total short interest on SPX components. Both measures make the case for a constructive market in the months ahead.
The first is a graph we look at regularly, compiling data from Investment Company Institute (ICI). As you can see below, in five of the past six months through December, and so far this month, there have been net outflows from domestic equity mutual funds and exchange-traded funds.
Note in early 2022, as the market was in the early stages of a pullback, investors flocked into these funds. If they are fleeing the funds amid a decline, it does not mean as much to us relative to selling into an advance. When these investors feel like they are missing out on rallies, which is the case now, they are more apt to reenter the market, which is a potential source of future buying power.
Another sentiment indicator I find interesting amid the technical breakouts to the upside is short interest. Around this time last year, with total short interest on SPX components at multi-year lows, I said the biggest risk to bulls was a long build in short interest.
As the Federal Reserve began its interest rate campaign, equities weakened and the shorts smelled blood, building positions throughout most of 2022. With the market rallying, there are likely more and more shorts feeling pain, which might explain the rollover in short interest. The implication is the potential for short-covering to be another source of buying power in the months ahead.
While I continue to build a bullish case, there is still one thing that could knock the market off its current course. An immediate risk for bulls is this week’s FOMC meeting, as the last three meetings acted as catalysts for sharp, short-term selloffs.
With the Fed in focus mid-week and the potential for a market reaction similar to those that occurred after the three previous meetings, keep tabs on important levels of potential support. A first line of potential defense for bulls is the 3,940-3,970 area, as 3,940 will be the site of the trendline that connected the lower highs in 2022 on FOMC day, in addition to the popular 50-day moving average. Meanwhile, 3,970 is the close prior to last Monday’s breakout above that major trendline.
Todd Salamone is the Senior V.P. of Research at Schaeffer’s Investment Research.
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