“August expiration week was not friendly to bulls, as the S&P 500 Index (SPX — 4,369.71) experienced its third consecutive week of declines, moving below the popular 50-day moving average and the bottom rail of a potential channel drawn from the March low…. I am suspicious of technical breakdowns during expiration week, as delta-hedging declines have everything to do with positioning in the options market and little to nothing to do with technical support levels…if the broader market is unable to recover significantly in the next few days, one should put more weight in the technical breakdown…At risk of continually drawing lines in the sand as the SPX declines, an encouraging development was Friday morning’s low at the 80-day moving average…”
– Monday Morning Outlook, August 21, 2023
With two weeks passing by since I posted the Aug. 21 market commentary, the remarks proved to be quite timely in their implications. First, during August standard expiration week, the S&P 500 Index (SPX — 4,515.77) did experience a short-term and intermediate-term technical breakdown when moving below: 1) its July 2023 prior month low, 2) its 50-day moving average, 3) 4,475, or double the 2020 closing low, and 4) the bottom rail of an extended trendline connecting the March and May low points.
The key line in the excerpt from the Aug. 21 commentary related to the comment that the technical breakdown did occur during expiration week, which should all be noted, but viewed with a suspicious eye. Selloffs due to delta-hedging declines have little to nothing to do with potential technical support levels and mostly or everything to do with options positioning.
Said another way, option positioning as expiration nears can impact the market in such a way that perceived technical breakdowns or breakouts can be misleading. For example, if those making markets sold puts in previous weeks (to those seeking portfolio protection), the market makers must sell more and more S&P futures as heavy (and formerly) out-of-the-money put open interest strikes come into play. This is because generally the sellers of the put options want to be neutral and not lose money on additional market declines. Those selling S&P futures to remain neutral are not looking at charts in those instances.
If the expiration-week selling was indeed exaggerated by delta-hedge selling, a recovery would likely occur very soon due to option-related selling suddenly dissipating, whether in the event of a technical breakdown or a decline to a support level.
In evaluating the situation as described two weeks ago, the Friday standard August expiration marked a short-term low at its 80-day moving average. This moving average also marked the trough in May.
Moreover, the suspect bearish technical underpinnings stemming from expiration-week selling was quickly reversed, with the SPX last week moving back above: 1) its July low, 2) its 50-day moving average, 3) a trendline connecting lower highs since the July peak, and 4) the bottom rail of bullish channel connecting the March and May lows. In fact, the Friday low was at the bottom rail of the bull channel.
“…equity option buyers are nearing a historical pessimistic extreme in sentiment that, on one hand, has marked bottoms in the past. But on the other hand, as we have seen historically, such pessimism can become even more extreme.”
“Active investment managers have quickly shifted from a high allocation to stocks to a relatively low allocation (see the charts below). But even with the retreat, this sentiment indicator is neutral because if this group’s intent is to reach the allocation of stocks like that of the lows in 2022, more selling will be on the horizon….I will be looking for how this group behaves in the weeks ahead. If a rally occurs, are they sellers or buyers? If the market continues to dip, is this group buying into the dip or still contributing to the decline?”
– Monday Morning Outlook, August 21, 2023
Also in the commentary from two weeks ago, I dissected a couple of sentiment indicators that we use to gauge risk-reward in the market. The first is the behavior of equity option buyers, particularly on SPX components stocks. Two weeks ago, option buyers were approaching pessimistic extremes, but pessimism was continuing to build, leaving a contrarian buyer of the market vulnerable to being “too early.”
Indeed, the ratio did continue higher as the market struggled to find direction, leaving a question mark as to the expiration-week low point being a short-term low. However, coincident with last week’s rally, the SPX component 10-day, buy (to open), put/call volume ratio finally rolled over. Together with the improving technical backdrop, a continued unwind of the extreme in pessimism could have bullish implications.
I also mentioned two weeks ago that I would be following the action of active investment managers, as measured by the weekly National Association of Active Investment Manager’s (NAAIM) survey. This group was fully invested – reading of 100 – at the peak. This group was quickly in retreat two weeks ago when the survey indicated an average 60% allocation. I wondered if they would be sellers into strength, as they proved to have been in the week following, reducing their net allocation to equities to 2023’s low point before being buyers last week.
The market struggled to hold gains on rally attempts two weeks ago as this group sold into strength. However, note in the chart below, active investment managers were net buyers last week, helping push the market higher.
A bullish takeaway in that if this group’s intent is to become fully invested, there is support for the market from this group.
Risks to the bull case include the fact that the July highs are just above Friday’s close. On Friday the CBOE 10-Year Treasury Yield Index (TNX — 41.73) bounced higher from former 2023 highs after receding for nearly two weeks and the weak seasonality that generally appears later in the month.
This week is a short week due to the Labor Day holiday on Monday, but the week following is a loaded economic calendar, including inflation data. Such data could dictate the next major move in interest rates after a favorable two-week period for bulls.
Todd Salamone is a Senior V.P. of Research at Schaeffer’s Investment Research.
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