S&P 500: The 2040 Level Must Hold

About: SPDR S&P 500 Trust ETF (SPY), Includes: UPRO, VXX
by: Taylor Dart

The S&P-500 has seen three consecutive losing months, since making new all-time highs in July.

The S&P-500 has not been down 8 straight days in a row since October of 2008.

The market remains bullish on all time frames, despite the 2016 uptrend line being violated.

The S&P 500 (NYSEARCA:SPY) has been down 7 days in a row, while the Volatility Index (NYSEARCA:VXX) is up 8 straight days thus far, tying the longest streak in history. The S&P 500 currently sits just below the 2100 level, and the bull case is starting to see some holes. Those that have followed me this year known that I have been unwaveringly bullish since April. In April I went long at 2050, and called for the market to make new all-time highs. My thesis was proven right in July when the market broke through the 2135 level, closing at a new monthly high. Since then, the market has seen 3 straight months of declines, and is now flirting with the 2100 level. I still remain long my (UPRO) position from $62.50, but the S&P 500 technicals are starting to show slight red flags.

(Source: TC2000.com)

I still remain bullish on the market, and have no reason to abandon my thesis of 2250-2400 going forward. Having said that, I feel the need to point out important levels for the market going forward. My lines in the sand for the S&P 500 are the 20-month moving average, and 200-day moving average. A close below both of these levels would signal that the bull market may need a rest, and could be in jeopardy. Despite the 7-day sell off, the odds currently favor the bulls. The McClellan Oscillator is in oversold territory, and at levels from which we typically see bounces. The equity put/call ratio is also very elevated, at the highest level since Brexit. In addition, we are on the verge of the first 8-day sell-off since this bull market began in 2009.

The S&P 500 and the McClellan Oscillator

The McClellan Oscillator closed the day yesterday at a reading of (-) 140.65. Readings below the (-) 100 level are typically great buying opportunities when the market is in an uptrend. Over the past 9 months, the market was up over 3% within 10 trading days after touching the (-) 100 level. I have shown the past 3 occurrences below, as well as the current reading to the right side of the chart. To put things in perspective, the current oversold reading is lower than the reading which registered during the Brexit correction.

(Source: TC2000.com)

Looking at the oversold condition of the McClellan Oscillator, the bulls should see some short term relief soon. There is no guarantee that this indicator will work as it has in the past, but generally readings this low are followed up with a breather for the bulls.

Equity Put/Call Ratio and the S&P-500

The equity put/call ratio is a tool for measuring put volume relative to call volume. Put options are used to hedge against market weakness or bet on a decline, while call options are used to bet on an advance. The current equity/put call ratio is at extremely elevated levels, with more bearish bets than any time in the past 4 months. The last time we saw the equity put/call ratio this high was during the Brexit correction. Prior to the Brexit correction, the equity put/call ratio hit these levels during the lows for the year at 1840. As we can see in the below chart, put/call ratios this high are quite rare. This is only the 7th time since 2012 that the equity put/call ratio has hit these levels, and typically this marks bottoms for the market.

(Source: SentimenTrader.com)

(Source: SentimenTrader.com)

The last 3 times the market hit similar levels on the equity/put call ratio, the market gained 4% or more within 10 trading days. Once again while past returns do not guarantee future results, the odds are certainly in the bulls favor here. If the current scenario were to play out similar to the past 3 occurrences, the S&P 500 would be above 2080 by mid November. I am not betting on this nor am I predicting it, I am simply putting in perspective how this indicator has worked during past high equity put/call readings. The below chart shows the last 3 times the equity/put call ratio hit these levels, and how the S&P 500 reacted.

(Source: TC2000.com)

Sentiment Predominantly Bearish

The Daily Sentiment Index provides a glimpse into the sentiment of futures traders on several different asset classes. Looking at the sentiment picture for the S&P 500, we are at very pessimistic levels. This does not mean the market can't go lower due to more pessimism, but it's worth taking a look at. As we can see the sentiment moving averages on the S&P 500 and are all trending down. The S&P 500 sentiment has currently 21% bulls, with the 5-day moving average for sentiment sitting at 31.2% bulls, and the 10-day moving average at 38.1% bulls. A similar reading was present on gold (NYSEARCA:GLD) a few weeks ago, and this unleashed an avalanche of selling.

(Source: Daily Sentiment Index)

Typically when the sentiment moving averages are trending down above the sentiment reading, this means things have the potential to get worse short term. What I prefer to see in a sentiment reading is a low sentiment reading, with the moving averages trending up below sentiment. An example of this would be copper currently, with sentiment at 33% bulls, and the 5-day moving average for sentiment sitting at 30% bulls, with the 10-day moving average at 23% bulls. This does not mean that I think we should go long copper, this is simply an example to better explain my ideal sentiment setup on an asset class. I do not believe we can lean to any direction based on the current sentiment reading for the S&P 500 of 21% bulls. While the reading itself is overly pessimistic, the trend is down and caution should be taken.

Technical Outlook & Summary

Moving to the technicals, I will explain some of the minor red flags I am seeing. Taking a look at the weekly chart of the S&P 500, the market has broken below its breakout level at 2130. This allows for the possibility that the all-time high breakout was a failed breakout, and is not a positive for bulls. It is still far too early to call this a failed breakout, but I would have liked to have seen the 2130 level hold.

(Source: TC2000.com)

The second red flag comes from the daily chart, and in the form of a broken daily uptrend. As I stated in my most recent article on the S&P 500, I was not overly concerned if this trend line did not hold. The uptrend this year has been quite steep, and I did not believe it to be material to the validity of this bull market. Having said that, it did break and it is still worth noting. As we can see below the uptrend line that came from connecting the February lows at 1800 to the Brexit lows at 2000 has been violated by over 2% now. The market briefly tried to regain the uptrend line but was rejected on two occasions on the 12th and 14th of October.

(Source: TC2000.com)

The final red flag worth pointing out is the break of support at 2120. The S&P 500 despite having broken its uptrend line was holding support at the 2120 level since September. This horizontal support has now been violated as well, and the market has made new 3-month lows. This is certainly not a positive development for bulls, and there's no sugar coating it. Having said that the Brexit lows were also 3-month lows, and proved to be a huge trap for bears eager to short. We can see the previous 3-month lows that was a bear trap in the chart below, as well as the current breakdown below support.

(Source: TC2000.com)

So how am I positioning myself? I currently remain long the S&P 500 and am keeping my stop at the 2040 level on a closing basis. A break below the 2040 level would equate to a 2% break below the 200-day moving average. In addition, this would also erase the massive 1.7% up day just after the Brexit lows. If the market breaks below the 2040 level, I will have to revisit my bullish thesis on the S&P 500. I will exit my S&P 500 position for a loss from my entry in April at the 2050 level.

(Source: TC2000.com)

In summary, the bulls are skating on thin ice going forward. While the 200-day moving average is beneath them and may act as support, the first test of the 200-day moving average (NYSEARCA:JUNE) is more reliable than the second one. The fact that the market has made new 3-month lows is also slightly concerning. Having said this, the market is at a level where it tends to bounce very hard from in the past. The McClellan Oscillator and equity put/call ratio are at readings which have been excellent buying opportunities in the past. On a short term basis this looks like a buying opportunity, but regaining the 2130 level is important long term for the bulls. If I was a swing trader I would be entering the market here looking for a bounce from these oversold conditions. Being a trend follower, I am sitting with my position and keeping a close eye on my stop level. In my opinion we should see a relief rally soon, but anything is possible. My goal is trying to avoid the election noise, and keeping a close eye on the 2040 level to determine if I will remain long this market. I continue to stand by my bull case for 2250 - 2400 on the S&P 500 next year, but this is contingent on the market not closing below 2040.

Disclosure: I am/we are long SPY, UPRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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