The media pushes a market correction… three indicators and what they’re saying about today’s bull market… the bottom line from our technical experts

 

Lots of drama in the headlines this week…

We’ve seen geopolitical turmoil in Afghanistan… increasing signals from the Fed that a dial-back on stimulus programs could be happening relatively soon… a continuation of the surge in Covid-19 cases…

Meanwhile, the S&P 500 hit an all-time high on Monday, but then slipped lower as negative headlines filled the news cycle.

Below, you can see the three major indices since Monday. Though they’re rallying as I write Friday near lunch, they’re all down between 0.9% and 1.3% on the week.

It seems that anytime the market stumbles like this, we see a flurry of headlines trumpeting a coming correction.

This time is no different.

The below headlines have all popped up over the last 48 hours…

Today, let’s address this concern.

We’ll do so with the help of our technical experts, John Jagerson and Wade Hansen.

As regular Digest readers know, we often turn to John and Wade in our Friday Digests to help us get an idea of what’s right around the corner for stocks. Their analysis of short- to medium-term data points, ratios, chart patterns, and indicators provide valuable insights into tomorrow’s market conditions.

So, as the headlines grow bearish, what’s John and Wade’s analysis showing?

Let’s jump in and find out.

***The trend is your friend

For newer readers, John and Wade are the analysts behind Strategic Trader – InvestorPlace’s premier trading service. In it, John and Wade combine options, insightful technical and fundamental analysis, and market history to trade the markets in all sorts of conditions.

Fortunately, those conditions have been bullish for the majority of this year. But is that changing?

Here’s John and Wade’s top-line:

Currently, this bullish trend is showing no signs of slowing down.

We’re coming out of a blockbuster earnings season where, according to FactSet, 87% of S&P 500 companies have beaten Q2 earnings expectations. Analysts expect this trend to continue in Q3.

Plus, it’s hard to get too bearish when, on Monday, that the S&P 500 set a new all-time high close record of 4479.72.

However, we know the bullish trend is going to slow down and reverse course sometime. It has to. That’s how markets work.

To monitor the extent to which a bearish chill might be in the air, John and Wade are monitoring three indicators: the VIX/VIX3M relative strength chart… the percent of S&P 500 stocks above their 200-day SMA… and the CBOE Put/Call ratio.

Let’s walk through each to find out what they’re signaling.

Most investors are familiar with the CBOE S&P 500 Volatility Index, known as the VIX. It’s a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days. An elevated VIX reading suggests greater anxiety amongst traders.

But John and Wade note that sometimes focusing only on the next 30 days isn’t a long enough view. It can be helpful to expand your horizons to the next three months, or 90 days.

For such a longer-term outlook, traders look at the CBOE S&P 500 3-Month Volatility Index (VIX3M). It’s is a measurement of the anticipated volatility being priced into S&P 500 options for next 90 days.

By comparing the VIX with the VIX3M, investors can get even more information.

Here’s John and Wade:

The value of the VIX3M is usually higher than the value of the VIX.

After all, if you give the market three months to make a move – like the VIX3M measures – instead of just one month – like the VIX measures – it has a greater chance of making a larger move.

Interestingly, there are times when traders will price in a greater chance of a larger move in the short term than in the long term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.

The easiest way to compare the VIX and VIX3M values is to create a relative-strength chart of the indexes. Specifically, you divide the value of the VIX by the value of the VIX3M.

In normal conditions, this chart will have a value of less than 1. That’s because the value of the VIX is usually less than the value of the VIX3M.

When traders are anxious about an immediate market drop, the value will rise above 1. This shows higher anxiety for the next 30 days instead of 90 days.

Back to John and Wade for where we are today:

According to Figure 2, the VIX/VIX3M is currently sitting at 0.83.

Figure 2 –VIX/VIX3M Daily Relative Strength Chart (source Trading View)

This is well below the threshold of 1 that we are watching for. No bearish warning signals here.

***What we can learn from diving into S&P 500 breadth

The second indicator John and Wade are watching is the number of S&P 500 components that are trading above their 200-day simple moving average (SMA).

A general rule-of-thumb with traders is that when a stock is trading above its 200-day SMA, it shows the stock is relatively strong. The converse is believed to be similarly true.

Now, if we look at the S&P index as a whole, it’s currently miles above its 200-day moving average. Here’s the two-year chart showing this.

But remember, the S&P 500 is a weighted index. So, we might not be getting the real picture on how all of the stocks within the S&P 500 index are doing.

Here’s John and Wade to tell us what’s actually happening:

Looking at the daily chart of the S&P 500 Stocks Above 200-Day Average (S5TH) in Figure 3, you can see that only 79.40% are currently trading above their 200-day SMA.

Figure 3 – Daily Chart of S&P 500 Stocks Above 200-day Moving Average (source Trading View)

As you can see looking back on the chart, this percentage is still well above average, which is a great sign. We’re watching the 75% level.

If the indicator drops below this level, we’ll know the S&P 500 is losing broader support. However, as long as the indicator remains above 50%, we won’t be too worried.

***Here’s what the options market is telling us

When option traders are bullish on the stock market, they usually buy call options. These options increase in value when the price of the underlying stock moves higher.

Conversely, a bearish trader would buy a put option. These increase in value when the price of the underlying stock moves lower.

The CBOE Put/Call ratio compares the number of puts to the number of calls on a stock by dividing the number of puts by the number of calls. A reading above 1 means “more puts” which translates to “bearish.” A reading less than 1 means “more calls,” which is bullish.

Here’s John and Wade for current levels:

Looking at the chart of the CBOE Put/Call ratio in Figure 4, you can see that the ratio is <1 at 0.94

Figure 4 – Daily Chart of CBOE Put/Call Ratio (source Trading View)

This tells us that traders don’t appear to be too concerned at all.

In fact, during the bullish run we’ve been enjoying on the S&P 500, there have only been a few times when the ratio has climbed above 1.

We’re watching the level at 1.1. If the ratio breaks that threshold, we’ll be worried.

Until then, we’re not too worried because Wall Street is showing it’s not too worried.

***Tune out the negative headlines and keep focused on what these indicators are signaling

Before we wrap up, a little perspective…

Historically, August and September are rough months for stocks. As you can see below, from 1980 through 2019, these are the only two months with average negative returns.

Yet, as I write, the S&P is up 0.8% on the month. So, some downward pressure on prices at this point should be expected if August will post “average” performance.

Given this, if we see a selloff, take it in stride. As John and Wade’s analysis has shown, a major correction should not be the immediate conclusion if the market wobbles.

Here’s the final takeaway from John and Wade:

There’s a lot of big news stories swirling around out there. Some of it is bearish, but most of it is still bullish.

The bullish trend on the S&P 500 has been our friend this long. We’re not ready to abandon it yet.

Have a good evening,

Jeff Remsburg