Technicals are Improving the Prospects for the Rally

By John Jagerson and Wade Hansen

There are some in the financial press calling last week’s volatility a “bear trap.” We think that is a little hyperbolic, but we agree with the sentiment of that expression.

A bear trap occurs when a stock (or index) is rising and then starts to correct where profit taking a short-selling accelerates. The trap is sprung once buying momentum picks up and the short sellers have to cover again.

To characterize the retracement last week as a bear trap is an exaggeration if we only focus on price movement. A better example of a bear trap would be September 2020. However, the pace at which short-selling jumped last week is concerning.

Bloomberg is reporting that short selling by hedge funds outpaced buying by a ratio of 10:1. Of course, the ostensible purpose of a hedge fund is to “hedge” the market, so this ratio isn’t unprecedented, but it is higher than normal.

Figure 1 –S&P 500 Bear Trap

Something that could help us think about risks to the market is the Commitment of Traders Report (COT) released by the CFTC each week. Although the data lags by a few days, it helps us see how traders are positioned in the futures market. If risk-takers (speculators) are as bullish on the major stock indexes as they have been in the past, then the rally is likely to be fine regardless of hedge funds short selling.

We measure speculator momentum in the COT report by looking at whether they are still net long, and if so, how large is that cumulative position. In the following chart, the blue line represents small speculators (individuals and small firms) and the green line represents large speculators (hedge funds and institutional traders.) In both cases, the level on the y-axis shows that risk-takers are net-long. Compared to the last two years, both classes of traders have larger than average long positions as well.

Figure 2 –Speculator Momentum in the COT

Despite major unknowns in the market including COVID-19 future infection rates, the Fed’s bond purchasing taper, and low market breadth, the COT report implies that the trend is relatively strong, which gives us more opportunities to sell income with both short puts as well as covered calls on the portfolio’s long stock positions.

Another key measure of market strength that we have been discussing for a few weeks now has also continued to improve, which should support the rally even further. This is the S&P 500 Equal Weight index. The idea behind the index is to weigh each of the components of the S&P 500 equally rather than disproportionately favoring the biggest stocks like AAPL and MSFT. If the equal weight index is breaking to new highs with the S&P 500 itself, then it acts as confirmation of the rally.

The best way to chart the equal weight index in your own watchlist is with the Invesco S&P Equal Weight ETF (RSP) which is included below. As you can see, the index broke to new highs at the end of July and has now retested that breakout point with a bounce on August 19th, which establishes support.

Figure 3 – S&P Equal Weight ETF (RSP)

From our perspective, the confirmation we would still like to see is a breakout in small caps and transportation stocks. In the case of small-cap stocks, you can see a chart of the Russell 2000 below that has been channeling between $2120 and $2320 since February. Momentum among transportation stocks is even weaker.

In our view, the lack of momentum in these two categories is largely due to uncertainty around the pandemic. Will travel be curtailed again? Are parents going to be able to stay at work or will they have to deal with school dismissals this year? Are services like restaurants going to be shut down again? Traders are likely pricing in a discount in the major indexes over those questions.

Figure 4 – Russell 2000

The positives in the market of strong earnings growth rates, new hiring, and momentum in the major indexes should prevent any major retracement this quarter. The negatives of narrow breadth and uncertainty about the pandemic are not serious enough yet to trigger a major reversal, but we expect volatility to remain high. The regular ebb and flow we have seen this year (including last week’s “Bear Trap”) will probably continue.

The Bottom Line

Now that second-quarter earnings are behind us (for the most part,) the next few economic reports will take on greater importance. New home sales ticked higher on Tuesday after falling for a few months. Based on information from some big builders, this trend should continue through the end of the year. Preliminary GDP will be released for the quarter on Thursday. We aren’t expecting any surprises, but the inflation data included with GDP could be a market-mover.

Finally, the Jackson Hole Financial Symposium takes place this weekend. Over the last 13 years, this has become a traditional location for the Fed Chair to make big monetary announcements. Jerome Powell will be speaking on Friday and his comments are the most likely short-term threat to the market if traders detect any (real or imagined) hints that the Fed will pull back on its current easing program.

For now, we recommend maintaining a bullish bias with a focus on maximizing income.

Sincerely,

John Jagerson and Wade Hansen
Editors, Strategic Trader