Some Context For Last Week's SPX Pullback

There's encouraging historical context for U.S. credit downgrades

Senior Vice President of Research
Aug 7, 2023 at 8:49 AM
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If a pullback of significance is to materialize, the source will likely be some unknown that is lurking…”

               - Monday Morning Outlook, July 31, 2023

In last week’s commentary, I made the above comment after the prior week gave market watchers more clarity on earnings, fresh inflation data, and the Fed’s outlook after raising the fed funds rate by a quarter point.

Amid the plethora of significant events two weeks ago, the market held up and sellers failed to materialize. With the S&P 500 Index (SPX—4,478.03) holding up amid overbought conditions and plenty of earnings and economic data to digest, my gut was it would take a perceived negative “unknown, unknown” – or event not on the calendar with an uncertain outcome - that catches investors by surprise and acts as a selling catalyst.

That “unknown, unknown” surfaced Tuesday evening, as Fitch downgraded U.S. debt from its triple-A rating to AA+.  It was the first downgrade of U.S. debt by a ratings agency since S&P’s downgrade on August 5, 2011. The timing of the downgrade surprised many market participants since the reasons given for it have been lingering for some time. The SPX gapped lower Wednesday morning in response to the Tuesday evening headline and selling continued into Friday.

There are comparisons and contrasts to last week’s initial reaction to the downgrade and 2011’s.

For example, the SPX dropped 6.6% in the first trading day after the early-August 2011 debt downgrade. The SPX dropped the trading day after the Tuesday downgrade, but only by 1.4%. The 1.4% decline was mild relative to 2011 but very noticeable at present given the index went 47 consecutive days without a drop of 1% or more.

In analyzing the bond market, the 10-year Treasury yield dropped in a flight-to-safety trade in 2011. But the 10-year Treasury yield moved higher in its initial reaction last week, as one would expect with a debt downgrade. By Friday’s close, the 10-year yield was about where it closed the evening of the downgrade.

In 2011, the SPX’s short-term low occurred on the day of the reaction close, with the index trading minimally above the reaction low in the two months following as it traded in a choppy range below long-term moving averages. In early-October 2011, the SPX closed barely below the early-August closing low before rallying  16% off this low into the end of October 2011. It went on to trade in a range again into the rest of 2011, with its 200-day moving average acting as resistance on multiple occasions in the fourth quarter of that year.

SPX 2011

If there is anything one might take away from last week’s debt downgrade, using 2011 as the most recent history, is the risk after the initial reaction was very little, albeit ugly price action followed for months. By that same token, note that from a technical perspective, the SPX has a much stronger technical backdrop at present relative to late-summer 2011.

In fact, the SPX was trading around multi-month highs and roughly 12% above its 200-day moving average ahead of last week’s debt downgrade.

Given that there is a relatively high level of short interest on SPX component stocks and many strategists are cautious, my instinct is there is enough buying power to contain major pullbacks, should one be in the cards…”

“New to our SPX chart above is a potential channel that connects higher highs and higher lows since the trend higher began in MarchA break of the 20-or 40-day moving averages – both of which have provided support on pullbacks since March – would likely lead to movement down to the trendline that connects higher lows in the developing channel.”

          - Monday Morning Outlook, July 31, 2023

From a short-term technical perspective, one might not have been totally caught off by the selling that transpired last week, but certainly caught off guard by the headline that generated the risk-off mentality. After all, the SPX was making little progress as it battled the upper rail of a channel since March. Plus, there were a few “doji” candlestick days (indicating potential trend reversal) and a bearish “outside day” in late July that I had previously observed that had hinted at momentum slowing or taking a turn for the worse.

Last week’s action could be the start of more meaningful selling, but it is also too early for some bulls to panic amid this fluid situation.

Even though the SPX remains above its 40-day moving average and 4,475, or double the 2020 closing low, there were a few things that I did not like about Friday’s action. 

They are: 1) the inability of the SPX to rebound back above its 20-day moving average when buyers briefly surfaced, 2) the high point at 4,535 being met with sellers (this level proved important in late 2021 – resistance in September 2021 and support in November and December 2021). The January 2022 decline back below 4,535 was the start of months of trouble for equities. Finally, Friday’s candle was its second bearish “outside” day since July 27, with July 27 marking 2023’s high point on an intraday basis.

SPX Rate Hikes

“…option buyers on SPX component stocks have become increasingly bullish, which is coincidentally supportive of the market, until it isn’t. At extremes, this group is vulnerable to being wrong-footed at key inflection points…with the 10-day ratio of call-buying volume to put-buying volume coming off its lowest level in more than one year and sitting around levels that coincided with major highs in January and April 2022, consider this another flashing yellow sign as it begins to tick higher.”

          - Monday Morning Outlook, July 31, 2023

To the extent market participants are listening to cautious Wall Street strategists, there is buying power that remains supportive of equities. Plus, there is still a decent-sized short position outstanding that represents future buying power. Where buyers come in is the immediate question at hand.

One area of the market that was showing enthusiasm for stocks and who were vulnerable to being on the wrong side of a potential pullback were equity option buyers, as alluded to in last week’s commentary.

Per the graph below, this group reacted to last week’s headline by buying considerably less call options relative to put options in comparison to days prior. Such actions likely created a headwind last week and present a risk to bulls in the immediate days ahead if put buying continues to increase relative to call buying.

SPX PC Ratio August MMO

From a short-term sentiment perspective, the turn higher in the 10-day equity-only, buy-to-open put/call volume ratio presents an immediate risk to bulls, as the turn higher in this ratio from an extreme low is usually when the market is most vulnerable to being at its weakest over a period of days to weeks. Weak can mean anything from choppy trading range to correction-like movement. What could “neutralize” this sentiment indicator is shorts using this opportunity to cover and/or those using the pullback as their chance to buy after sitting on the sidelines.

The best one can do is stay in tune to potential levels of support and resistance as discussed in this commentary. As I said last week, if additional selling occurs in the days ahead and the SPX moves below its 40-day moving average, look for the bottom rail for the developing bullish channel as a potential support area. This trendline comes into the week at 4,390 and at Friday’s close will be sitting at 4,413.

Todd Salamone is the Senior V.P. of Research at Schaeffer's Investment Research.

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