Oversold Conditions Loom Ahead of the Fed – The Market Breadth

Stock Market Commentary

The post-oversold divergence resolved to the downside. The downward pressure was evident across a wide swath of stocks, and big cap stocks were only strong enough to keep the S&P 500 (SPY) aloft for a day (at an all-time high). Now, the stock market looks toppy and heavy enough to dip back into oversold territory. This weighty price action is happening just ahead of another decision on monetary policy from the Federal Reserve. Is the stock market trying to scare the Fed into backing down? Or is the stock market bracing itself for the worst possible expression of hawkishness given current economic conditions? The answers lay just ahead as oversold conditions loom.

The Stock Market Indices

After a week where the S&P 500 (SPY) gained 4 out of 5 days, I am a bit surprised that this week did not feature a buyable breakout. Instead, the index lost 0.9% on Monday and 0.8% today. The end result is an index that looks toppy thanks to the congestion at and near the all-time high (see the black line below). However, support at the 50-day moving average (DMA) (the red line below) is beckoning with reassurances. The S&P 500’s 50DMA exerts an overwhelming force against selling pressure. Accordingly, do not count the S&P 500 out until a major support line breaks. In this case, major support sits at the December lows.

The S&P 500 (SPY) broke out above its 50DMA and likely brought the bearish cycle to an end.
The S&P 500 (SPY) pulled back sharply from its all-time high but stopped short of testing its 50DMA.

The NASDAQ (COMPQX) came into this week already facing downward pressure from its 20DMA (the dotted line below). With a 50DMA breakdown already in play, the tech-laden index is staring down a test of critical support from the December lows. Losses in important stocks like Apple (AAPL) and Microsoft (MSFT) helped push the NASDAQ into a 1.1% loss.

The NASDAQ (COMPQX) gained 0.7% to end a week the strung together a series of all-time highs.
The NASDAQ (COMPQX) gapped down below its 50DMA support. It now faces a critical test just above a double intraday bottom earlier in December.

The iShares Russell 2000 ETF (IWM) is on a 4-day losing streak. With a confirmation of 200DMA resistance (the blue line below) in the books, IWM is now working on support from its 2021 trading range. On Monday, I bought a weekly $224/$221 calendar call as a play on a bounce from this support. I picked $224 for the short side given it corresponds to upside resistance. Even if IWM rallies sharply from support, I am not expecting the index of small cap stocks to easily break free of resistance.

The bottom of the trading range has been even more reliable than the S&P 500’s 50DMA as a pivot for trades. So a change in behavior here will create a major red flag for trading.

The iShares Russell 2000 ETF (IWM) faded from a gain to a 0.9% loss. IWM is now right back to the bottom of its near year-long trading range.


Stock Market Volatility

The volatility index (VIX) is back to “elevated” levels (above 20). Given the precarious positions of the above indices, I fully expect the VIX to surge back to recent highs if the Federal Reserve’s decision triggers a synchronized breakdown.

A rounded bottom for the volatility index (VIX) could be setting up a major surge in the coming weeks.
The volatility index (VIX) bounced 7.8% for its second straight close above 20.

The Short-Term Trading Call With A New Divergence

  • AT50 (MMFI) = 25.7% of stocks are trading above their respective 50-day moving averages
  • AT200 (MMTH) 38.7% of stocks are trading above their respective 200-day moving averages
  • Short-term Trading Call: bullish

AT50 (MMFI), the percentage of stocks trading above their respective 50DMAs, closed at 25.7%. My favorite technical indicator sits just above the the oversold threshold of 22%. Accordingly, I left my short-term trading call at bullish. Either the market will plunge into oversold trading conditions which I treat as the extreme start of a buying opportunity, or the market will respond positively to the Fed and keep the post-oversold period alive. Note well that the resumption of a downtrend in AT200 continues to warn of the potential for multiple trips to oversold territory.

In the meantime, I took profits on my key hedge on bullishness. The iShares Expanded Tech-Software Sector ETF (IGV) sank 3.3%. At one point, IGV sliced right through 200DMA support. IGV closed just above its closing low for December and faces the most immediate test of the indices mentioned here.

One of many reasons why the Fed finally cares about current inflationary pressures:

AT50 (MMFI), the percentage of stocks closing above their respective 50DMAs, dropped to 25.7% and looks ready to drop right back to oversold territory.
AT200 (MMTH), the percentage of stocks closing above their respective 200DMAs, continues to warn of new threats to the underlying technical health of the stock market.

Be careful out there!

Footnotes

“Above the 50” (AT50) uses the percentage of stocks trading above their respective 50-day moving averages (DMAs) to measure breadth in the stock market. Breadth defines the distribution of participation in a rally or sell-off. As a result, AT50 identifies extremes in market sentiment that are likely to reverse. Above the 50 is my alternative name for “MMFI” which is a symbol TradingView.com and other chart vendors use for this breadth indicator. Learn more about AT50 on my Market Breadth Resource Page. AT200, or MMTH, measures the percentage of stocks trading above their respective 200DMAs.

Active AT50 (MMFI) periods: Day #419 over 21% (overperiod), Day #2 under 31% (underperiod), Day #13 under 40%, Day #17 under 51%, Day #19 under 60%, Day #199 under 72%

Source for charts unless otherwise noted: TradingView.com

Full disclosure: long IWM calendar call spread

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*Charting notes: Stock prices are not adjusted for dividends. Candlestick charts use hollow bodies: open candles indicate a close higher than the open, filled candles indicate an open higher than the close.

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