Written by Jim Welsh
Macro Tides Weekly Technical Review 21 January 2020
The rally since the October 3 low of 2856 on the S&P 500 has been stunning in its persistence, the absence of any measurable pullback, and the lack of volatility. The daily percentage change in the S&P 500 has not been greater or less than 1% since October 11, 2019 a span of 69 trading days. This is the longest stretch since June 26, 2018 to October 9, 2018, a span of 73 trading days.
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The current streak is the sixth-longest streak since the end of 1969 and third-longest since the end of 1995, according to Dow Jones Market Data. Prior to the peak on January 26, 2018 the S&P 500 avoided a move of greater than 1% for 93 days, so the current streak could have more room to run. However, there are a number of reasons why an increase in volatility is likely soon.
The magnitude of the rally since the October 3 low has pushed the S&P 500 to 2.5 standard deviations beyond its 20 day moving average as measured by Bollinger Bands. The last time the S&P 500 was this extended was in January 2018 as that low volatility streak was ending. In October 2018 the S&P 500 didn’t quite reach the 2.5 standard deviation boundary.
On March 1, 2017 the S&P 500 reached 2400 and touched the upper limit of the Bollinger Band. Although the S&P 500 only fell -3.2% after the March 1 high, it didn’t break out above 2400 convincingly until May 25 almost 3 months later. This suggests an expectation of a minimum correction of 3% or so is realistic and probably fairly conservative.
Bullish sentiment remains elevated as measured by the 10-day average of the Call / Put Ratio, which is comfortably higher than in January and October 2018 when the last two low volatility streaks expired.
The Option Premium Ratio is lower than in January 2018 and almost as low as in October 2018.
Volatility picked up noticeably in the 100 days after prior streaks since 1969 ended. Interestingly the 2 largest increases in the daily range of the S&P 500 since 1969 occurred after the 2018 streaks ended. The average daily range almost tripled after the January 2018 streak ended and more than tripled after the October 2018 was over. The S&P 500 peeled off a quick -11.8% in just 9 trading days after the January 2018 high and a rattling -20.1% following the October high.
The decline after January 2018 high was kicked off after a big increase in Average Hourly Earnings on February 2 raised concerns that the Federal Reserve would increase interest rates. The big correction after the October 2018 high was triggered in anticipation of the fourth rate hike in 2018 by the Fed and a big decline in Apple which has the largest weighting in the S&P 500.
The declines following the highs in January and October 2018 received an assist from a large short position in VIX futures. A short position is taken when a trader expects volatility to continue to fall. When volatility rose sharply in February 2018 and in the fourth quarter of 2018, those short positions quickly became big losers and to stop the bleeding were bought to cover the short. The buying caused the VIX index to quickly move above 20 which contributed to an increase in fear and selling pressure in the S&P 500.
On January 15, 2018, and just before the February decline, the short VIX position held by Large Speculators, Asset Managers, and Leveraged funds were -139,259 contracts. On October 1, 2018 the short position by these traders was -289,726, and was -244,461 contracts as of January 14, 2020.
While the current short position isn’t as large as it was in October 2018, it is far bigger than in January 2018 and certainly large enough to contribute to a decline in the S&P 500 if the VIX closes above 16.50 in coming weeks.
A VIX close above 16.5 would exceed the intra-day high of 16.39 on January 6 and break above the downtrend line from the December 2018 high of 36.20 in the VIX.
From its low of 2347 on December 26, 2018 the S&P 500 rallied to a high of 2954 on May 1 (Wave 1) a gain of 607 points. From the S&P 500’s Wave (2) low of 2729 on June 3, an equal rally of 607 points targets a high of 3336 as the potential high of wave (3) from the December 2018 low.
The current streak of low volatility will be broken when the S&P 500 moves by more than 1% in either direction. However, the S&P 500 may top and begin to correct well before a 1% down move occurs. A short term high will be signaled if the S&P 500 closes below 3280, and a stronger confirmation will be provided when the S&P 500 closes below 3250 (30 minute chart below). These two levels are the support levels the S&P 500 has traded at since the beginning of the year.
Another confirmation will be given when the 5-day moving average (red) falls below the 13 day moving average (green) which has not occurred since early October. This crossover by the 5 day versus the 13 day has preceded every pullback since the December 2018. The 13-day average is at 3282 as of January 21 which coincides with the chart support at 3280.
Once the S&P 500 closes below 3280 and remains below that level for a few days, the 5-day average will likely be pulled below the 13-day average.
If the S&P 500 does top near 3336 a shallow correction (0.238%) of the 607 point rally since June 3 would bring the S&P 500 down 145 points, while a 38.2% pullback would retrace 230 points. These modest retracements suggest the S&P 500 can fall to 3200 and possibly 3100.
Given how extended the S&P 500 is above its 20-day moving average and the large short position in VIX futures, a correction down to these levels could be quick and sharp as the initial declines were following the highs in January 2018 and October 2018. The S&P 500 lost -11.4% after the high on October 3, 2018 before striking a low in 18 trading days on October 29, and lost -11.8% in 9 trading days post the January 26, 2018 high. An 11% correction would bring the S&P 500 down to 2969.
If this analysis is on target and Wave (3) does top near 3336, the S&P 500 has reached a level where reducing exposure makes sense. For those who are comfortable in being more aggressive, establish a 20% short position in the S&P 500 via the ETF (SH) when the S&P 500 is trading above 3320, using a stop of 3370. If the S&P 500 doesn’t stop near 3335 the next target is 3463 which is 607 points above the low of 2856 on October 3, 2018.
Disclosure
The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.
Due to the Martin Luther King holiday this has been a shortened Weekly Technical Review.
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