Make or Break Time: Q3 Earnings at a Technical Crossroads

Before delving into an extremely busy trading calendar for the week ahead, let’s first review the price action of the past 5 sessions in the equity market.

Monday started off on a positive note, as geopolitical developments over the weekend were not as bad as feared. Stocks rallied, bonds lost ground, and gold let up as well - safe haven plays basically deflated. The positive momentum carried over into early Tuesday, where SPY challenged the 50-DMA at $440 and failed to break through. The rest of the week was pretty much all downhill from Tuesday’s high, with SPY registering a 3.8% loss from that point onward. Stocks ran into what appeared to be a technical liquidation event at Friday’s session close.

Fundamentally it was Jerome Powell’s speech on Tuesday is what spooked the markets, despite the fact that his message was initially rather dovish:

“Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening. We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy.”

Nothing new in that statement. He’s saying the market is doing the Fed’s tightening job, and a pause would be the next step. This was echoed by other Fed speakers throughout the week. Markets initially rose on the statement. However, it was the next statement that caused markets to dive:

“Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy. In any case, inflation is still too high, and a few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal.”

This part isn’t new either. The Fed needs to keep market participants on their toes, and needs to maintain credibility that another hike is on the table. If mr. Powell would concede that the Fed is done hiking, then yields could go lower in anticipation of his next move - a cut. This would embolden risk appetite and the economy would receive a boost that the Fed doesn’t want yet.

As a result, both equities and bonds fell. SPY closed just below the 200-DMA technical support. The Russell 2000 broke below the M-Trend, a key stop-loss level. A huge swath of sectors and factors ETFs triggered short term MACD SELL signals (namely XLK, QQQ, IVW, SPY, MTUM, EEM, XLF, XLI, XLB, RSP, XLRE, MDY, IWM). Let’s see where that leaves us:

SPY Analysis

It’s important to note that on Friday, as the markets closed, there were no major earnings or economic data announcements. However, last Friday was an Options Expiration (OPEX) day. As monthly option contracts expire, market participants are forced to adjust positions due to “pin risk” and various other imbalances, leading to abnormal volatility. We don’t usually work with intra-day pricing, but take a look at Friday’s session:

The 200-DMA (at $422) offered support up to the last 45 minutes of trading. In the last hour of trading SPY fell -0.41%. Let’s take a look at transaction volume, and get a feel for how significant this week’s developments are:

Not a ton of transaction interest as well as “contained” realized volatility tells us there’s still some complacency left in the market. From a sentiment perspective, the market is NOT trading in “Extreme Fear” just yet. We also find evidence of “double bottoms” in sentiment, before the “real” rally.

Breadth Breakdown

As a quant data analysis platform, we’d be remiss not to discuss market breadth at this juncture. For the first time since November 2022, we are getting a break lower in stocks trading above their 200-DMAs. There’s been an “unofficial” level that has held up for almost a year: at any point, at least 400 (out of the highest volume 1000 stocks in the market) have been trading above their 200-day moving averages. Friday, just 350 stocks closed above the key support level. We shall turn to our stock screener to understand the equities that made that “break”.

We set Dollar Volume Average to column A, so we can limit the analysis to the top 1000 stocks by volume. Then, on column B, we set Sigma 200 to between -0.1 and 0 in order to find the exact stocks that broke lower (Sigma 200 negative measures usually tell us a stock is trading below the 200-DMA; it can vary between -1 at max negative, to +1 at max positive; isolating the -0.1 to 0 range gives us just the stocks that are close to the 200-DMA and presumably sold off). As expected, 53 stocks made the list. They are most correlated with:

• Mid-Caps (MDY) and Nasdaq (QQQ) factors

• Transports (XTN) and Tech (XLK) sectors

Below the screener, we output the combined chart.

The break lower is evident on the chart above. Furthermore, all broad market ETFs (IWM, MDY, RSP) have broken below the M-Trend level, which acts as a Stop-Loss for down-trending instruments. All of these ETFs are maximum oversold (0/100).

Conclusion: the market must rally on Monday, or face significant downside in the near term from a technical perspective. Earnings will play a key role on the fundamentals side, as major S&P 500 companies report results: Microsoft and Alphabet on Tuesday, Meta on Wednesday and Amazon and Mastercard on Thursday; plus many others. The combined market cap of the companies that we just mentioned exceeds 17% of the index weighting, so expect the market to be heavily influenced by their results.

Combined analyst price targets for these stocks suggest there is a 19% upside available. Positive results would certainly improve the technical situation as well.

Our Trading Strategy

While drawing excessive conclusions from a single OPEX trading day is ill advised, the technical picture is not pretty. We already know of several trend following systems that have been forced to liquidate and go to 100% cash. While holding excess risk is probably a bad idea at this point, so is “selling into a hole” - or when fear reaches “Extreme” levels. This puts several market participants in an awkward spot.

On October 05 we wrote:

…those that got “sweaty palms” during this drawdown episode (a.k.a. carry too much risk) may consider taking some money off the table at $431 resistance, where the real test of the rebound shall happen;

As expected, SPY did test and exceed $431 on the rebound, and that was the “reduce your risk” opportunity. Our view is that the following period will test the conviction of the “new highs by year end” crowd. Since there is still potential for more downside, a clear break of the 200-DMA is the technical event where we expect most folks to fold and become bearish at exactly the wrong time.

Assuming SPY reaches $410 to the downside, then even our “Pessimistic Scenario” price target of $450 satisfies a 9.5% 1 year return (4 % Equity Risk Premium + 5.45% Risk Free Treasury Yield).

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