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When to Start Selling S&P Rallies
By: Schaeffer's Investment Research | December 24, 2018

Could the action in stocks be foreshadowing a recession?

How last week's selling in the stock market turned into a bottomless pit

A steady bout of selling on Wall Street is clearly "Trumping" holiday cheer this month. The excerpts above give you a glimpse into the deteriorating price action in U.S. equities and the coincident growing risks to investors, beginning in November with the S&P 500 Index's (SPX - 2,416.62) weekly closes below its historically important 80-week moving average. This was followed by last week's break below the early 2018 lows -- the last remaining technical "lifeline" for bulls.

The break below the 2018 lows on the heels of a Fed rate hike drove the SPX down to the 2,400 area, its lowest level since July 2017 and an area that acted as resistance in March-May 2017. In fact, as I cautioned in late November, the SPX's 80-week moving average breakdown meant that the index was at risk of at least another 10% move lower to the 160-week moving average, which occurred in 2011 and 2016, and marked a bottom. Last week's decline was just over 7%, with the SPX now sitting 9.4% below the 80-week moving average and right alongside its 160-week moving average -- leaving little-to-no room for additional error if you're a longer-term bull.

And if you are a bull, you're hoping for action reminiscent of 2011, when the 80-week moving average was breached and there was a quick additional decline of about 8% down to support at the 160-week moving average. The SPX traded for about six weeks between these two longer-term moving averages before eventually making its way higher again. If this scenario repeats, we will see several weeks of choppy, volatile action, with the lows around 2,400.

A scary situation for longer-term investors is a significant break below the 160-week moving average, which occurred in February 2001 and March 2008. After the first such instance, a retest of the 160-week moving average occurred just ahead of years of prolonged downside action, and in the second case, the declining 80-week moving average was retested before the SPX was nearly cut in half over the following six-month period. In both instances, a major move below the 160-week moving average acted as a "first warning" to use rallies to sell into what eventually would be a prolonged period of weakness that put a huge hurting on bulls.

While the decline to the 2,400 area from last week's close at 2,600 may not come as a huge surprise to many of you, the fact that it took only a few days to occur may have been the most surprising. Once again, the accelerated selling may have had something to do with options expiration, in a week that was filled with negative catalysts to get the ball rolling to the downside (a Fed rate hike, Fed Chair Jerome Powell foreshadowing more tightening, the threat of a looming government shutdown, President Donald Trump's trade advisor indicating a deal with China is not likely within 90 days, and so on).

The expiration effect that I saw was twofold. First, and soon after the rate hike, stocks sold off and there was evidence that put sellers at the SPDR S&P 500 ETF Trust (SPY - 240.70) December 255 and 250 strikes bought back their puts, creating a headwind (usually, there is a slight tailwind if put sellers stay pat, which they did not do in this instance).

Moreover, with upwards of 160,000 SPY December 245 strike puts purchased last week, this strike eventually became a huge magnet, with delta-hedge selling likely contributing to even more selling once the SPY moved below $245. In other words, demand for SPY put options that expired on Friday -- whether in the form of buying back previously sold-to-open puts or buying to open new positions -- likely added to the multiple bouts of heavy short-term selling pressure. Add in things like chart support being broken, and growing perceptions that the Fed is being careless, and so it was that last week's action became a bottomless pit.





If you're a long-term investor, and have stayed pat, you're hoping that this is 1987, 1990, 2011, or 2016, when the decline to the 160-week moving average was the end of "it." But you should also be prepared for the growing possibility that we're in the grips of a bear market, in which you should look for an exit point. A weekly SPX close that is significantly below the 160-week moving average should be the first warning of prolonged, serious downside to come in the months ahead. If a noticeable close below the 160-week moving average occurs, you might get an immediate tradeable rally back to either the 80-week or 160-week moving averages, at which point you would sell into these rallies in anticipation that we are only in the early stages of a bear market.

A worry of mine stems from watching fund managers, analysts and Fed Chair Powell on financial TV last week. With stocks in a freefall -- not only this past week, but since early October -- I saw no one predicting a recession in 2019, or at most giving a very low probability of a recession occurring. This sets up these multiple economists, fund managers, and advisors of being blindsided by a recession that comes sooner rather than later. Could equities be foreshadowing a recession? This is certainly something you must be open to, especially with the Fed raising rates at a time when the stock market is discounting unfavorable news in the future.

As I said a few weeks ago, whether you are a bull or a bear, options should be employed to reduce your dollar risk in recognition of the growing stock market risks. You can purchase call options to play anticipated upside or as part of a stock-replacement strategy. And put purchases should also be utilized, whether to hedge long equity positions or to leverage further downside on technically "broken" stocks with high expectations.

Finally, enjoy the holidays, and we wish safe and patient travels to those of you who are on the road during this busy travel season.

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