“…short interest hit a multi-year high in December, with evidence of covering activity in recent weeks that I anticipated would be supportive of the market. I would imagine short covering is still supporting the market, as the SPX easily sliced through a level of potential resistance at 4,940 last week. Bears are likely panicking, as there was not profit-taking at 4,940, which is 20% above the October 2023 closing low... The 5,000-millennium level is now in sight and poses a potential hesitation or pivot point. In April 2021, the SPX shot right through 4,000, rallied strongly to its January 2023 all-time high”
- Monday Morning Outlook, Feb. 5, 2024
We received end-of-January short interest figures late Friday night and expect to “slice and dice” the data today. However, judging by the price action from the past two weeks, I still believe that we are in a major short-covering rally.
Just like April 2021, when the S&P 500 Index (SPX--5,026.61) broke through the 4,000-millennium level without hesitation, the SPX sliced through 5,000 last week. In 2021, the SPX would go on to rally with minimal drawdown into its early-January 2022 peak, which was taken out roughly three weeks ago.
Per the chart immediately below, throughout 2021, stocks rallied as the shorts covered. Fast forward to the present, and short interest levels are significantly higher than 2021, which is a major positive for bulls if short covering is going to be supportive in the months ahead.
“The best course of action when momentum like this occurs is stay the course, as rallies will persist longer than most anticipate. That said, anything can happen in the short term, so be open to all possibilities.”
- Monday Morning Outlook, Feb. 5, 2024
At some point, yes, the momentum will slow, or the SPX pulls back. Based on the current slope of the SPX’s 30-day moving average, which marked the mid-January low, it will be at 4,880 at week’s end. In other words, a decline of nearly 3% would be painful for short-term traders with a long bias, but the SPX would still technically be in trending mode.
Given there is lots of “room” to this potential support, long-term investors should not panic if there is a pullback to 4,880, even if it occurs in a short period. But short-term traders should be open to the fact that the SPX is coming into the week more than 3% above a moving average that provided support less than a month ago. A revisit of this moving average is a technical risk within the bigger-picture momentum higher.
A reason I would not be surprised to see momentum continue higher is the contrarian implications of short-term option traders, a time frame of a week or less, on the SPDR S&P 500 ETF Trust (SPY--501.20). Since December, this group has and continues to emphasize puts, or downside bets on the SPY.
My tool for gauging the sentiment among traders with the time frame of a week or less is analyzing the five-day cumulative open interest changes on the most recently expired SPY options, or the Friday, 2/9 expiration SPY options.
Per the chart below, note the continued emphasis on put volume, or the red bars. I used strikes that were 10 points below the SPY low in this period and ten points above SPY high heading into Friday’s trading.
A potential red flag is when we see an emphasis on calls, which are the blue bars in the below graph.
That is not to say that sentiment is pessimistic or cautious among all option players. In the equity world, our quantitative analysts here at Schaeffer’s Investment Research created a new chart that looks at the percentage of SPX component stocks whose 10-day, buy (to open) put/call ratios are above 1.0. Ahead of the late-October bottom, the percentage was near 50%. Now it is 20%, with longer-term extremes reaching 10% but 20% also marking levels that preceded significant pullbacks. This is something to keep in the back of your mind if anticipated support levels break down. But as it stands now, such optimism is to be expected in the presence of all-time highs and therefore, for now, means less from a contrarian perspective.
Finally, in evaluating last week’s price action and the SPX’s push through 5,000, it did so in the face of headlines about commercial real estate being a potential global contagion, continued push-back from multiple Federal Reserve officials about an imminent rate cut and a second major brokerage house in as many weeks sounding alarms that risk is growing and a sell-off is near. Remember, many brokerages have been ringing alarm bells for investors from late-November through mid-December, when the SPX was 6-10 percent below current levels.
Eventually, Wall Street will be correct, but then again, timing is everything, especially for anyone that listened to these warnings and missed out on a rally like this that does not occur very often.
Bears are hoping that consumer price index (CPI) data tomorrow and/or retail sales numbers later in the week knock the bulls off course. If not, we can expect to see more short covering.
Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.
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