Tactical Trading Approach

We’ve used the latest sell-off to deploy capital for a tactical trade higher. A few things brought us to this point. The S&P 500 had sold off 20% from its high and appeared to hold the line and bounce from that level.

On the weekly chart for the S&P 500 we tested the 200-week moving average and held. We also held the 50% Fibonacci retracement from the lows hit in 2016.

On the monthly S&P 500 chart we approached the 50-month moving average of 2330 and held.

VIX

We’re under the assumption that the US economy isn’t headed for a recession. With the VIX over 30 this is usually a good time to start buying equities. VIX spot v. future pricing is currently inverted and represents a time to buy. The equity put/call ratio hit 1.8 which is a major contrarian buy signal.

The chart below shows the long-term Z-score (inverted) of VIX prices relative to long-term averages. We have recently dropped below 2 standard deviations in relative volatility. This has represented good near-term buying opportunities in the past.

In the past, when the Z-score dropped below -2 as we recently have, the S&P 500 was up 5.2% over the next three months compared to just 2.0% when it was above -2. It was higher 67.7% of the time in the following 3 months after a -2 reading.

If we exclude the periods of US economic recessions, the S&P 500 was up on average 11.7% in the following 3 months and was higher 90.6% of the time. If we are correct that we are not barreling into an economic recession, this market pullback has offered us a great opportunity to trade tactically into 2019.

Point & Figure Bullish Formations

Currently only 12% of the companies that make up the S&P 500 are in a bullish P&F formation. Historically, when the percent of companies in the S&P 500 in bullish P&F formations drops below 30%, the index went on to rally in the following 3 months. Since 1996 there have been 235 instances when this figure dropped below 30% and in 177 cases (75.3%) the market was higher in 3 months by an average of 5.5%. This compares to an average 3 month return of 1.8% when the index was above 30%.

If we exclude the periods of US economic recession, the S&P 500 was up on average 12.0% in the following 3 months and was higher 92.3% of the time.

Percent of Companies Above Their 200-Day SMA

There are only 54 companies in the S&P 500 that trade above their 200-day simple moving average. This is a -2 standard deviation event for the market. During non-economic recession cycles, this has represented a good buying opportunity. When this metric is this low, the S&P 500 has gone on to rally an average 6.1% in the following 3 months compares to 1.2% when above -2 standard deviation. It was higher in 76.0% of the observations.

THIS IS A TACTICAL TRADING CALL

Based on the chart below we are willing to hold the trade up to 2600 (ish) on the S&P 500. We will most likely take profits at this level and await further signals from the market.

While I’m not one to try to catch a falling knife, it’s my opinion that the sell-off is overdone if the headline risks remain geopolitical, earnings recession and/or Fed related. We are still on the hunt for indications that this selling is related to a coming recession. If in fact we are heading into an economic recession than we should be heading much lower from here.

That’s not to say we couldn’t rally back to 2600 on the S&P 500 and then have a recession related sell-off. If you take the previous two recessions and factor in earnings deterioration and multiple contraction, then path forward would look something like the chart below.

Joseph S. Kalinowski, CFA