Make-or-Break Time for an End-of-Summer Rally

The chances of a rally this week are high

By Serge Berger, InvestorPlace Contributor

Friday saw some follow-through buying in the major U.S. equity indices on the back of Wednesday’s impressive V-shaped reversal. As such, the week ahead could be make-or-break time for a summer-end rally.

For the most part, however, it was a classic summer Friday trading session with little major movement. That is to say that there isn’t too much to read into it except for the fact that the market held up.

This coming week is filled with important retailer earnings that investors are sure to scrutinize closely for a read on the consumer. Target Corporation (TGT) and Wal-Mart Stores, Inc. (WMT) will be reporting, along with housing-sensitive stocks like Home Depot Inc (HD) and Lowe’s Companies, Inc. (LOW). This may provide some volatility for traders, but for my part, there’s not much to do ahead of those earnings reports.

After another round of phone calls with hedge funds on Friday, it was once again confirmed that everybody seems to be waiting around for a better directional move in U.S. equities for the first time in 2015.

The sideways chop, particularly in the S&P 500, has now brought moving averages in many time frames together in a virtual spaghetti formation. This, of course, is the result of the year-to-date sideways shuffle in the index. Bollinger Bands likewise are tightening, all of which points toward an eventual resolution of this range in one direction or the other.

I hear very few market participants discuss the potential of a breakout fakeout, where stocks break out of their range in one direction or another for a few days or weeks, only to sharply reverse in the other direction.

Enter the CBOE SKEW INDEX (SKEW). This index essentially derives its value off the measurement of S&P 500 out-of-the money options. It measures so-called “tail risk,” which is the risk of an outsized directional move in the S&P 500. As SKEW rises and the implied volatility of out-of-the-money options rises because investors are getting more nervous, so too does the probability of a market move two or more standard deviations below the mean.

For example, the index spiked in the middle of September, just before a 10% corrective move in the S&P 500 began. It then dropped sharply and bottomed just as stocks were ready to rally again.

Currently, SKEW is trading at the lower end of its range, which as a single factor, all else being equal, makes it difficult for stocks to drop in the near term.

SKEW Chart
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I remain of the opinion that a summer-end rally stands a good chance. It could result in the S&P 500 breaking to higher highs near 2,150 or possibly higher before all of the market imbalances — from weak market breadth to important sectors having long ago broken down — will come home to roost. The historically more volatile period of September and October could thus usher in a 10% to 15% correction, which would set us up nicely for a sharp year-end rally. For the time being, my target for this potential corrective move is somewhere between 1,900 and 1,930.

S&P 500 Chart
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August equity options expire this Friday, and as I pointed out last week, the probability of a rally this week is high. Below is the chart I highlighted last week where you can clearly see the options expiration rallies this year, which subsequently resulted in near-term tops.

DIA Chart
Click to Enlarge


Between too much bearish sentiment, seasonal tailwinds for stocks and options expiration week rally potential, I see the S&P 500 rising back toward the upper end of its range this week.

A move toward 2,130 to 2,140 could be in the cards, with potential overshooting toward 2,160 to 2,200 in coming weeks before things get rockier in September.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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