On the Way to Oversold, Fed Faces Test of Resolve – The Market Breadth

Stock Market Commentary:

Trading extremes led to a snapback rally as expected. However, the rally was short-lived as bear market action quickly resumed. The stock market looks like it is on the way to oversold trading conditions as March closing lows failed to hold as support. Fear is palpable as traders and investors scramble to position ahead of the coming week’s meeting of the Federal Reserve. In turn, the selling pressure sets up a test of resolve for the Fed. Collectively, the market is reminding the Fed that it desperately needs easy money policy to stay afloat. However, the Fed risks a serious credibility crisis if it backs off policy normalization right after getting started.

Exhibit A for when your core investing thesis fundamentally rests on the Fed maintaining aggressively accommodative policy. These “pleas” worked well in a deflationary environment.

Last meeting, the Fed tried to assure us that the economy is strong enough to endure the necessary normalization. I expect the Fed to stick to those claims despite the negative Q1 GDP print. The stock market even enjoyed strong one-day gains following the release of that report. The surging strength in the U.S. dollar may provide the catalyst to convince the Fed to slow down the pace of its hawkishness. Currency strength provides the economy a buffer against imported inflation. Domestically, the Fed can look to the GDP’s report of declines in wholesale car sales as an excuse to slow. Yet, on-going strength in nonresidential fixed investment and residential fixed investment mean that the Fed’s core inflationary concerns in housing will maintain the test of resolve.

Given all the headwinds converging at this moment, the stock market’s bounce last month off the lows looks particularly perplexing. Fortunately, we have the technicals to provide sufficient explanations. Technicals should reign supreme again as passive and automatic investments flow into retirement accounts to start the month of May. Sellers should pounce on any related bounce as a last chance to get out of the way of the Fed. Next, the Fed’s release should release some anxiety over the “unknown” (really the misunderstood). After that back and forth, the test of resolve will come from figuring out how to trade around oversold or close to oversold trading conditions.

The Stock Market Indices

The S&P 500 (SPY) fought the first four days of last week to hold the March lows as support. The index gave up the ghost with Friday’s 3.6% loss and reversal. The May, 2021 lows are now in play. I do not dare contemplate yet what could come next if that level eventually fails. I took profits on my SPY shares in Thursday’s rally and declined to buy back in Friday’s selling even with the prospects of a bounce to start May’s trading.

The S&P 500 (SPY) lost 3.6% and returned to a sub lower Bollinger Band close. The 11-month low put the May, 2021 low into play.
The S&P 500 (SPY) lost 3.6% and returned to a sub lower Bollinger Band close. The 11-month low put the May, 2021 low into play.

The NASDAQ (COMPQX) led the way to a breakdown with Tuesday’s 4.0% loss and close below the March lows. Friday’s 4.1% reversal put the September, 2020 high into play as support. Recall at that time, the pandemic was still fresh and hopes were building for vaccines that would open the floodgates of potential from mountains of stimulus from the Fed, the Federal government, and state governments. I was stubbornly short-term bearish at that time because, you guessed it, market breadth signals were flashing red in the wake of a near parabolic run-up.

If the September, 2020 highs fail to hold, I will place a pin on NASDAQ turning 10,000 by the treacherous months of August to October. That level would mark the near complete reversal of all the tech-laden index’s pandemic era gains. Perhaps a test of 10,500, the September, 2020 low, will be a sufficient giveback and satisfy even the most panicked sellers.

The NASDAQ (COMPQX) lost 4.2% and closed near a 17-month low. The "reopening trade" euphoria that created the September, 2020 high is a key test of selling pressure.
The NASDAQ (COMPQX) lost 4.2% and closed near a 17-month low. The “reopening trade” euphoria that created the September, 2020 high is a key test of selling pressure.

The iShares Russell 2000 ETF (IWM) is already back to staring down a complete reversal of pandemic-era gains. IWM hit a 17-month low with Friday’s 2.7% loss. Given IWM’s sharp rally in late 2020, I see no “natural” levels of support until the pre-pandemic high. Note how IWM neatly gapped above that line in November, 2020 and then held the line as support.

The iShares Russell 2000 ETF (IWM) lost 2.7% and slipped to a new 17-month low. IWM's pre-pandemic high is now in play.
The iShares Russell 2000 ETF (IWM) lost 2.7% and slipped to a new 17-month low. IWM’s pre-pandemic high is now in play.


Stock Market Volatility

The volatility index (VIX) fought hard against the volatility faders but failed to hold a new closing high on Friday. The VIX rebounded from an initial gap down to score an 11.4% gain on Friday. I held my ProShares Short VIX Short-Term Futures ETF (SVXY) position through all the commotion. I will likely take profits on the next bounce away from or out of oversold conditions.

The volatility index (VIX) jumped 11.4% but faders made sure the VIX failed to set a new high for the week.
The volatility index (VIX) jumped 11.4% but faders made sure the VIX failed to set a new high for the week.

The Short-Term Trading Call With A Test of Resolve

  • AT50 (MMFI) = 23.9% of stocks are trading above their respective 50-day moving averages
  • AT200 (MMTH) = 27.7% of stocks are trading above their respective 200-day moving averages
  • Short-term Trading Call: neutral

AT50 (MMFI), the percentage of stocks trading above their respective 50DMAs, fell just short of oversold trading conditions with its 23.9% close. Typically, I would declare this level “close enough” to oversold to start positioning for a freshly bullish bias, especially with the VIX spiking into recent highs. However, the synchronized breach of March lows makes me a lot more cautious. These conditions are a test of resolve for my AT50 trading rules. I need to see AT50 drop below 20% before I get bullish again. Even then, I see limited upside from there. A test of declining 50DMA resistance would be a big short-term win with bear market trading action weighing heavily.

In my last stock market chart review I once again put the deep bearishness of the ARK funds on display. However, I forgot to mention one: ARK Autonomous Technology & Robotics ETF (ARKQ). This fund is ARK’s best performer on a relative basis. ARKQ is the one ETF that has yet to give up all its pandemic era gains. The ETF still holds a 29.5% gain from those levels. I used Thursday’s fake-out rally to take on a short position as a bet that at some point ARKQ will join its cousins. Indeed, this position strikes me as timely amid on-going bear market trading action. Normalization of monetary policy feels more and more like the payback for all the pandemic largesse (aka free lunches) we enjoyed. A giveback of pandemic era gains is consistent with this payback – a true test of resolve for market participants and the Fed alike.

AT50 (MMFI), the percentage of stocks above their respective 50DMAs, closed at 23.9% and stopped just short of dropping into oversold territory.
AT50 (MMFI), the percentage of stocks above their respective 50DMAs, closed at 23.9% and stopped just short of dropping into oversold territory.
AT200 (MMTH), the percentage of stocks above their respective 200DMAs, retested its low of the year which is also near a TWO-year low.
AT200 (MMTH), the percentage of stocks above their respective 200DMAs, retested its low of the year which is also near a TWO-year low.

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 #513 over 20% (overperiod), Day #4 under 30% (underperiod), Day #6 under 40%, Day #17 under 50%, Day #22 under 60%, Day #293 under 70%

Source for charts unless otherwise noted: TradingView.com

Full disclosure: long SPY put calendar spread, long QQQ put calendar spread, long SVXY, short ARKQ

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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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