The Indicator Everyone Is Watching Right Now…

Amber Hestla's picture

Tuesday, February 5, 2019 - 2:30pm

by Amber Hestla

Today, I'd like to follow up on our previous look at the 20-period RSI for the S&P 500 (shown in the bottom panel of the chart below). This indicator has been near a breakout for several weeks. 

You may recall that the 20-period RSI is useful as regime indicator. In a bullish market regime, the indicator stays above 40. In a bearish regime, it stays below 60. In the chart, thin horizontal lines mark the 40 and 60 levels. The red zones indicate moves below 40. 

Despite last week's gains, the indicator remains below 60, which is a cause for concern. 

SPX RSI chart

I expected a breakout last week as traders reacted to earnings from Apple, Facebook, and Amazon. Instead of a defined breakout, the S&P 500 just drifted higher. 

The index has now retraced more than half of the decline that came at the end of last year. That's bullish. But we remain about 1.3% below the 200-day moving average (MA), shown as the solid blue line in the chart. This is a widely followed indicator, and I expect the test of the MA will be a topic of conversation on CNBC this week. A close above the MA is likely to lead to a rapid move higher. 

To benefit from this, we can... 

1) Buy (to open) calls on a break above the MA, or... 
2) Buy (to open) puts if prices fall away from the MA. 

When this happens, buying an at-the-money, short-term option on SPDR S&P 500 ETF (NYSE: SPY) will be the trade that maximizes the potential returns with a reasonable level of risk. The move away from the MA, whether up or down, is likely to be quick, so an option expiring within a month should provide a vehicle to trade this move. 

Fundamentals Paint A Bearish Picture 
Fundamentals indicate that we should see prices move lower. The chart below is from FactSet, and it tracks analysts' expectations for the stocks in the S&P 500 index. The chart shows the expected change in first quarter earnings compared to the first quarter of 2018. The trend is clearly down. 

SPX earnings growth chart

​At the end of September, analysts expected companies to report growth in earnings per share (EPS) of 6.7%. By the end of December, downward revisions had pushed expected growth to 3.3%. Now, analysts expect a year-over-year decline for the current quarter. 

The trend is the same for all 11 sectors that make up the index. Forecasts call for declines in six sectors. Energy stocks have been the subject of the largest revisions. At the end of December, the sector was expected to report growth of 15.5%; now, analysts expect earnings to be down 5.9% compared to a year ago. 

Energy stocks serve as an economic indicator. When the economy is growing, demand for energy increases and the earnings of companies in the sector rise. The rapid downward revisions in EPS forecasts confirms the slowdown in the global economy. 

In the United States, economic data remains strong. Friday's employment report was surprisingly strong. The headlines told us 304,000 jobs were created in January. In December, 312,000 new jobs were added to the economy. 

But it seems that the December report was a mistake. Buried deep in the most recent report, we learned that there were only 222,000 jobs created in December. The Bureau of Labor Statistics revised December gains down by 90,000. That was the largest revision since 2010, a time when the economy was recovering from the Great Recession. 

Large revisions tend to be seen at important turning points in the economy. It is possible that the downward revision in employment marks the top of the economic expansion that began in 2009. 

Both earnings and economic data indicate we should expect a bear market. However, it's always possible traders will ignore these factors (as they mostly have over the past few weeks), which is why I like to trade in line with the market action. But, knowing what we know about this bearish data, we will be prepared for the potential of a quick downside reversal that would be consistent with the fundamentals. 

Market Breadth Also Points Toward Pullback 
Market breadth is now at a level consistent with a pullback. Almost 85% of the stocks in the S&P 500 are above their 50-day MAs. The next chart shows previous times that indicator reached this level. 

SPX market breadth

​This is a relatively rare signal. It tends to occur at the beginning of a strong uptrend or at times when the price advance stalls. We are up almost 14% since the end of December. Breadth is most likely indicating the market is overbought, having rallied too much in a short amount of time.

The weight of the evidence continues to support the bear market thesis. But a rally above the 200-day MA this week would change things.

An Invitation To Trade With Me
Remember, the SPY trade is just a suggestion. If you're familiar with how options work, then feel to make the trade on your own -- or better yet, join us over at Profit Amplifier for more trade ideas

That said, if you're not an experienced options trader, then you can still learn more about how my strategy works... all it takes is a few minutes of your time. We've closed a number of triple-digit gains in the last two months -- and we're sitting on gains of 10.4%, 58.9%, and 60% in our most recent issue. And best of all, anybody can learn how to do this...

In Profit Amplifier, we use a simple options strategy to profit from even the smallest moves in either direction -- making far more than investors who simply buy and sell stocks. To learn more, go here.

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.