foxex: Market holding at support... barely

Focus on the Price

Monday, December 10, 2018

1. S&P 500 – Support holding - Pending triple bottom

2. SKEW index still shows big traders aren't panicked... yet

3. What to watch in Gold and the US Dollar

Editor's Note:

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Major Moves

The European Union says that the UK can still decide to stay in the EU. The soft-sell strategy to keep the country in the union may spoil the plans of Prime Minister, Theresa May, and her government's dreams of Brexit. May canceled a vote on Brexit today, which triggered a selling frenzy in the British pound (GBP).

The market's reaction to today's Brexit news fits neatly within the theme this quarter: "uncertainty leads to discounts."

Investors will ignore positive fundamentals if the uncertainties remain unresolved. Trade tariff disputes with China; the destiny of a "new NAFTA" in Congress; and back and forth negotiations over Brexit will dominate positive earnings, consumer confidence, and industrial data in the US.

S&P 500

The S&P 500 is technically still at support near $2,630. If this level holds, the index could complete a triple-bottom technical pattern. Although uncertainty could punch some holes in support, the emerging pattern is worth watching. If traders get a positive surprise from the Fed next week, or progress on international trade disputes, the current channel might finally end.

It is too early to talk seriously about price targets if the major index breaks resistance near $2,790, but a preliminary ball-park estimate puts the index back at its long-term highs in the $2,920 range. This estimate is based on a fibonacci retracement anchored to the depth of the triple-bottom price pattern – as you can see in the following chart.

Risk Indicators
Small cap investors and high yield bond traders often provide the first signals of improving or worsening market conditions. For example, the fall back to support last week was preceded by weakness in the high yield bond market. In October, the big break of support on the S&P 500 (and the DJIA) was signaled a week earlier by a support break in the small-cap Russell 2000 index.

Looking for current signs of strength in these complimentary indexes is not encouraging. The Russell 2000 broke support on Friday, and high yield bonds are holding their lower-lows established on November 23rd. The "Market Fear Index" (VIX) is back at its highs while gold and the dollar follow each other higher. None of these signs offer much to get excited about. However, there is an interesting counterpoint to the dismal current view – the SKEW index looks bullish, and it has a pretty good historical track record.

What is the SKEW?

Imagine you are an institutional investor and your portfolio looks a bit like the other large-cap indexes (why reinvent the wheel, right?) but you are nervous about the market. You could buy SPX put options with strike prices well below the current market price of the S&P 500 for imperfect protection. This so-called "cheap delta" strategy gives you a hedge if the market tanks and the options are relatively inexpensive. The SKEW index tracks this activity.

As a group, if traders are nervous, they will hedge more aggressively and drive the value of these cheap puts higher. If they are less worried about a crash, the puts fall in value. The SKEW index follows this push and pull and will rise or fall with the value of the options. Unlike the VIX, the SKEW is focused on these kinds of options exclusively, so it does a better job picking up on confident or fearful investors.

The SKEW is considered bearish if it's really high while prices are rising (mid-August 2018) or bullish if it's really low when prices have fallen (October 2015, February 2016). Historically, a low SKEW when prices are at support has been a bullish signal with an impressive track record. In the following chart, you can see the SKEW and S&P 500 are currently in a bullish configuration.

What's the catch?

The SKEW has a good track record of signaling rallies, but its signals aren't very precise from a timing perspective. Patient investors might need to give the market 5-20 trading sessions on average before expecting a rally. The way I think about it is that the SKEW is indicating a low probability that the S&P 500 is going to break support because large investors aren't planning for a big drop.

Dollar and Gold

Investors looking for a faster signal that conditions are improving should keep their eye on the dollar and gold, which have been trending higher at the same time recently. This is unusual because gold is priced in dollars, so the two assets are naturally inversely correlated. However, gold and the dollar will move in tandem like this when investors are doing some preliminary safe-haven buying.

If the correlation between the dollar and gold breaks, especially if accompanied by a rise in Treasury spreads, then investors should look for a rally. This could be a good leading indicator if it plays out as it did in February 2017, when the two assets were moving higher together, just before the market rallied. It's still early, but this is an indicator that could be worth watching in the near term.

Bottom line: Not bearish yet

Despite the unknowns, the fact remains that earnings have continued to grow and will likely hit another all-time fourth quarter high. As long as the rate of change in earnings remains positive, it is unlikely that a bear market will fully take over the market. However, that won't help traders much in the short-term. Even if support holds as expected, the current channel may last a while yet.