Here's What Could Push the S&P 500 to New Highs

“The time has come for policy to adjust”

          - Fed Chairman Jerome Powell, August 23, Jackson Hole, Wyoming

If you had disappeared and ignored the stock market beginning in mid-July and re-engaged on Friday, you would have thought the market had moved sideways in that six-week period, with the S&P 500 Index (SPX -- 5,634.61) trading around the same level as mid-July.

Instead, the SPX has covered considerable ground, traveling more than 1,050 points from its mid-July closing high to the Aug. 5 intraday low and back to Friday’s close in a “V-shaped” pattern.

In that period, panic stemming from fears of a recession and a U.S. Federal Reserve that could be too slow to lower interest rates after an early August Federal Open Market Committee Meeting (FOMC), has calmed. Following the period of panic, a few economic data points didn’t come in as bad as feared. And on Friday morning, Fed Chair Jerome Powell sent a strong signal indicating a policy change could be on the immediate horizon, during a speech at a world central banker annual gathering in Jackson Hole, Wyoming.

A perfect illustration of the calm that preceded the panic and then the ensuing calm is the Cboe Market Volatility Index (VIX -- 15.86), which some view as the market “fear gauge” as it reflects the pricing of SPX 30-day options, which many use to purchase portfolio protection via put purchases. When demand for the portfolio is strong, it will drive up the price of such options.

Note in the graph below the early-August surge in the VIX, followed by the collapse in this fear gauge.

“…the SPX is above its key 30-day moving average at 5,470…With the gap above the 30-day trendline on Thursday morning, bulls are hoping this is a buy signal like that of early May…The sentiment backdrop is certainly supportive of bullish price action in the weeks ahead…note that option buyers on SPX components have reached a level of pessimism that existed at the April trough. The ratio of put buying to call buying is in a zone that is typically bullish for stocks. A rollover of this ratio could be a sign that buyers are in the early stages of returning.”

 - Monday Morning Outlook, August 19, 2024

Per the above excerpt from last week’s commentary, a combination of improving SPX price action and a sentiment backdrop favorable for bulls was enough to push the SPX through its levels around the time of the last FOMC meeting.

Going into last week, the ratio of put buying (bearish bets) to call buying (bullish bets) on SPX component stocks was at a level that marked a bottom during the March- April selling.

When this ratio hits extremes, the market is vulnerable to contrarian buy or sell signals. For example, the higher the ratio, the more pessimism, and the more likely the market will turn higher (with so many in agreement that it is headed lower).

And vice versa when the ratio is low, which signals vulnerability to a selloff with speculators in agreement the next move is higher and buying power exhausted.

Note that as the market peaked in mid-July, the ratio of put buying to call buying hit a low consistent with where the market peaked in July 2023. The circles in the chart below denote extremes in optimism and pessimism that were contrarian bearish and bullish signals.

As it stands now, the decrease in this ratio from the high levels favors the bulls, as we are currently in the middle of an unwind of the extreme in fear that was present in early August. If the ratio gets to previous lows, it will signal higher potential than normal for a loss of momentum or another selloff. 

In fact, as equity option buyers grow more optimistic, the SPX is only one-half percentage-point below its all-time closing high of 5,667, which is the next obvious level of potential resistance. Support is in the 5,475-5,510 area, while the 5,475-5,480 area is in the vicinity of the 30-day and 50-day moving averages, the latter trendline is still sloping higher in a testament of how quickly the three-week decline has been reversed.

Many new highs have been made in 2024, and this is a situation in which another new high may be imminent. Per comments I have made this year, there is a sizeable short position on SPX component stocks that is in the early stages of being unwound (see chart below). This data is from the end of July (mid-August data comes out this week). If we see an uptick as of mid-August, we can be fairly certain that many of those fresh short positions are already underwater.

When stocks succumbed to selling earlier this month, the shorts may not have felt the urge to cover. But with the SPX once again knocking on the door of new all-time highs, short covering may continue.

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

 Continue Reading:

• Indicator of the Week: VIX Spike, Subsequent Crash May Usher Short-Term Tailwinds
• The Week Ahead: Fed's Favorite Inflation Gauge on Tap