How the Fed Could Provide a Spark for This Overbought Market

With tax reform among the highest priorities in Washington, D.C. -- which you are sure to read and hear about in coming weeks -- this week brings us a continuation of earnings season and a full economic calendar. We'll get data on inflation, personal income and spending, auto sales, productivity, and the October payrolls report on Friday.

But from a macro perspective, the biggest news is likely to revolve around the Federal Reserve, with another policy meeting set for Wednesday and President Trump planning to name the next Fed chief by week's end. The latest speculation, as of Friday, had Trump favoring current Fed Governor Jerome Powell -- who many see as maintaining the status quo in terms of raising interest rates, and who is an advocate of deregulation in the banking industry.

With respect to policy action at this week's meeting, according to the CME Group's website, fed funds futures traders are assigning less than 2% odds that the Federal Open Market Committee (FOMC) will raise rates. These odds are significantly less than the 98% probability of an FOMC rate hike at the Dec. 13 meeting. For what it's worth, the FOMC raised rates in December 2015 and December 2016.

If fed funds futures traders are correct, and if past is prologue, bulls should welcome the FOMC standing pat this week. Long-time readers of Monday Morning Outlook likely have sketched into their heads the charts that I've incorporated into this column in the recent past, displaying the price action in stocks surrounding Fed meetings during the current tightening cycle. These charts of the S&P 500 Index (SPX - 2,581.07) and the SPDR S&P 500 ETF Trust (SPY - 257.71) have clearly shown a propensity for stocks to rally in the short term following FOMC decisions to hold rates steady, with a bias toward broad-market weakness in the immediate days and weeks following a rate hike.

In lieu of such a chart this time around, the tables below summarize SPX one-month returns following FOMC meetings since the initial rate hike in mid-December 2015. Clearly, stock market participants favor the Fed holding steady versus raising rates -- although the four rate hikes in this cycle have yet to derail stocks over the longer term, as the SPX has rallied almost 25% since the first raise in December 2015.

"Coincident with the SPY 255/SPX 2,550 drama playing out, the Russell 2000 Index (RUT - 1,509.25) began October at the round 1,500 level, and it has stayed in this area. This century mark has been on our radar in recent weeks, as previous such milestones have been giant speed bumps for RUT during this bull market."
-- Monday Morning Outlook, October 23, 2017

$RUT has crossed the 1,500 century mark in six of past seven trading days; a sideways grind since its first touch of 1,500 on 10/2 $IWM

Surprise, surprise..$SPX 2,550 revisited. Choppy action has followed for weeks after the first touch of 2,2502,350 and 2,450since Dec.. pic.twitter.com/ieGrpm1MTm

It was a tale of different tapes when observing the action in three equity benchmarks last week -- the Russell 2000 Index (RUT - 1,508.32), the Nasdaq Composite (IXIC - 6,701.26), and the SPX.

Beginning with the RUT, the 1,500 century mark has continued to be a magnet since it was first touched on Oct. 2. In fact, by Friday's close, the 1,500 level had been crossed in nine of the past 10 trading days, with Friday, Oct. 20, being the only exception. The RUT carved out a new all-time intraday high in the first week of October, but was trading at its monthly low last Wednesday morning before a "V" rally occurred back above 1,500 by Friday afternoon's close.

Notably, last week's RUT low was just below 1,492.84 -- a level that marks the round 10% year-to-date gain, and a potential support level going forward. If there is a retreat from 1,500, expect 1,450 to hold, as this would represent similar price action to that of the December 2016-February 2017 period, when the RUT stalled just below 1,400 but found support at the 1,350 level.

The SPX was following a similar path as the RUT throughout this month, with the 1,550 half-century mark acting as a magnet. However, last week's mid-week pullback saw the SPX find support at 2,550, before its "V" rally from this level pushed the index significantly above the half-century mark. The SPX first touched 2,550 on Oct. 5.

But it has been almost a mirror image of the RUT, as the RUT stayed above 1,500 early in the month, only to experience multiple crosses of this level in the second half of October. The SPX, on the other hand, experienced multiple crosses above and below 2,550 early in the month, before going on to register two successful pullbacks to this level in the second half of the month, with each rally from 2,550 marking a new all-time high.

With the technology sector representing 26% of the SPX, it was earnings reactions from bellwethers Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), and Intel (INTC) that pushed the SPX to new highs. In the blink of an eye, the SPX comes into the week closer to the round 2,600 level than 2,550. But that doesn't mean SPX 2,550 is gone for good, as disappointing news on the next Fed chief, or perceptions that GOP-led tax reform isn't going as planned, are just two of several potential catalysts that sparks another revisit of 2,550.

Regardless, the SPX has had an obvious upside bias in the past month, whereas the small-cap RUT has had more of a downside bias.

Finally, there is the impressive Nasdaq Composite, which is up nearly 25% year-to-date. Like the RUT and SPX, it came into the week battling a round number, as it had gone sideways at 6,600 from Oct. 9 through Oct. 24, before making a multi-week low around 6,520 in the middle of the week. Now, IXIC comes into the week still battling a round-number century mark -- this time, 6,700 -- on the strength of Friday's impressive tech earnings reactions.

It usually takes catalysts to push benchmarks through key round numbers, and we have seen our share in the past couple of weeks -- from perceived progress on tax reform to earnings, especially among the large-cap, high-priced equities that are more influential than low-priced, small-cap equities.

"I cannot say for certain whether the shorts will continue to cover -- but it does appear that many are playing a losing game, which increases the probability of short covering. Considering how the SPX behaved as it fought headwinds from a build in short interest, just think of its capabilities if the short-selling headwind turns into a short-covering tailwind."
-- Monday Morning Outlook, October 16, 2017

"The SPY has now been in 'overbought' territory since the beginning of the month, as measured by its 14-day Relative Strength Index (RSI). The last time it moved into overbought territory was the beginning of June. In June, sideways movement with a downside bias ensued for more than a month. This time, we're seeing sideways movement with an upside bias.

"Perhaps the key difference between these two periods is that, in June, the shorts were building positions on S&P 500 Index (SPX - 2,575.21) components. But the most recent short interest report suggested the shorts are in covering mode, after building the largest position since the uncertainty surrounding the 2016 election."
-- Monday Morning Outlook, October 23, 2017

"The S&P 500's 14-day RSI has clocked in over 70 -- the threshold considered overbought -- for 15 straight days, the longest streak since 1996. In the 13 instances when the benchmark was comparably overbought since 1975, a decline of at least 2% materialized every single time within 30 days, Mr. Wilson found. The median downturn after long streaks of overbought conditions was 4.5%."
-- The Wall Street Journal, October 23, 2017

Last week's rally in the SPX and IXIC was impressive, as both indexes were trading at round-number levels heading into the week, and technically overbought. The action in the RUT, however, was not surprising. With the RUT still at 1,500, SPX 1,600 lingering just above, and IXIC 6,700 now in play, sideways movement would again be expected -- much like what we've seen throughout most of October as these benchmarks traded around key round numbers.

But catalysts remain on the horizon, whether it be the Fed, tax reform, or earnings. And as I've mentioned during the past few weeks, there is fuel to spark rallies -- mainly short-covering fuel. Short interest ticked slightly higher in the last report, marking a reversal from the decline that we saw in the prior report. And there is strong evidence that last week's rally took many by surprise, given the nature of the SPX's overbought condition. Continued strength in the SPX could eventually generate more sustained short covering, and thus a continued bias to the upside in the weeks ahead.

The Fed remains a wild card, but could provide an additional catalyst if the committee stands pat on interest rates this week, as expected. If the FOMC unexpectedly raises rates, all bets are off.

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