Tuesday's Market Minute: Proceed With Caution?

CPI data published today surprised the street for both the headline number and Core CPI which removes food and energy. The market has rallied in anticipation of today’s print, but it would be wise to proceed with caution. This week may provide a fair amount of false signals on the strength of this rally.

The Technical Breakdown: The S&P 500 (SPX) started off last week in sell-off mode, dropping all the way down to the 61.8% retracement level from the June lows to the August highs. Bulls typically can digest a 50% retracement with ease; this sell-off was a little more aggressive than expected and volume confirmed the price action. Remember, technicians have hundreds, if not thousands, of indicators they can use to analyze a chart, but at the end of the day two remain paramount: Price and Volume. Volume confirmed the downtrend as it increased above the 5-day volume moving average. 

The upside move that started on Wednesday, however, tells a different story, and therefore traders need to proceed with caution. As the market moved to the upside, volume did not confirm the trend as aggressively as the sell side. In fact, on Friday the gap up candle (although bullish in nature) saw the weakest total market volume measured by the NYSE Total Volume indicator ($TVOL) for the entire week. This week, we could see a fake out as we lead into the September quarterly expiration. Even if the technicals could justify the recent bounce, volume this week will be strong due to market mechanics and not purely off trader sentiment.

The Fundamental Breakdown: Every three months, the market experiences heightened volume because of quarterly option expirations and equity rebalancing. Quarterly options tend to have the largest open interest as large institutions leverage options and other derivatives products like futures to hedge or speculate in the marketplace. On Friday, we will see quarterly equity index options, futures options, and index futures contracts expire. The result of this event will be heightened volume as portfolio managers offset existing positions or rebalance their portfolio in preparation for the fourth quarter.

This is why market mechanics matter. It is inherent that volume will be higher, but that is because of the nature of the event and not completely trader sentiment. This could lead technicians to believe a trend has been “confirmed,” when in fact it may not be at all. For instance, based on the CFTC’s Commitment of Traders report that was published last Friday, we saw Asset Managers and Large Traders reduce their long E-Mini S&P 500 (/ES) positions and increase their short positions, which shows bearish intent. In fact, long positioning across all speculative trader categories (Asset Manager, Leveraged, Other Reportable, and Non-Reportable) is still near 5-year lows. Translation: the “smart money” is still on the sidelines. Lastly, as we saw the bounce on Wednesday continue throughout the remainder of the week, Open Interest in the S&P 500 futures decreased, indicating short covering taking place instead of new buy-side positioning.

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