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SPY: Don’t Say I Didn’t Warn You
The market is not looking nearly as bullish fundamentally, or technically as it did in the stellar first 4 months of the year. SPDR S&P 500 ETF (SPY) surged by more than 25% from the December 2018 bottom to its recent top, precisely as May began.
SPY 1-Year Chart
Source: StockCharts.com
I wrote of taking profits in my “Sell in May” article, about a week into the month. Now that May is ending and the slower months of summertime begin, we are likely to see continued weakness in equities due to fundamental, technical, and psychological/sentiment-based reasons.
SPY and the market, in general, have fewer reasons to recover and head higher than they do of melting down a bit more from here. With the $280 level now firmly breached, we are likely to see SPY test substantially at lower levels, which suggests the S&P 500 and most stocks, in general, will likely head even lower from here.
SPY: Build Exposure to S&P 500 Average
SPY is the first major and most popular ETF in the world. It’s designed to mimic the exact movement of the S&P 500. The SPY index fund has roughly $278 billion in net assets, and each share in the fund represents a fraction of the holdings.
SPY provides investors with exposure to the S&P 500 index, which is widely regarded as the most significant stock market average for U.S. equities.
Since SPY essentially tracks the exact movements of the S&P 500, I will use SPY and the S&P 500/SPX interchangeably throughout this article.
Data by YCharts
We can see that SPY’s and the S&P 500’s performances have been essentially identical over the last 5 years. The same applies to other time intervals as well.
The Economic Image: Becoming Increasingly Bearish
Markets are all about sentiment. Sentiment is what drives demand and thus price in SPY and in just about anything else. After years of extraordinarily high sentiment and low complacency surrounding stocks, the ground is starting to look increasingly shaky.
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The Chinese trade deal debacle and elections in 2020 are likely to only complicate matters going further, which should reflect positively on volatility, but poorly on SPY’s price.
Also, recent economic indicators haven’t been great
Retail sales, housing data, and even manufacturing are starting to show weakness. Recent retail sales came in down 0.2% vs. a 0.2% projected increase, housing starts and existing home sales have been disappointing, and with PMI barely above 50, manufacturing data has been coming in worse than expected as well.
Looking at the VIX for Guidance
The VIX is starting to look increasingly bullish in recent weeks. Unfortunately, this is quite bearish for SPY in the short to intermediate term.
VIX 1-Year Chart
We saw a clear bottoming in mid-April, as the VIX touched the 11 level. Since then, the VIX has made a series of higher lows as well as a new multi-month high, coupled with an upward trajectory.
The VIX appears to want to go higher, and it will likely blow right past 20-25 level next time it surges. This is a warning signal that investors should not overlook, as a sharp rise in the VIX will likely send SPY down to the $260 level or lower.
This implies that we may be looking at an S&P 500 correction of around 12% or more from recent highs. This also indicates that we are around halfway through the correction process as SPY has an additional 6.5% to fall from here to strike my $260 range (initial significant support).
SPY’s Technical Image: Deeply Unsettling
If we look at SPY’s 1-year chart, we see a possible double top developing. In addition and more concerning is the recent development of a head and shoulders pattern. What’s worse is that the crucial neckline at $280 has been breached and current technicals imply SPY could fall a lot lower.
SPY 1-Year Chart
I’m looking for some support at $270, then major support at $260. However, if these two levels break down, we are likely looking at a retest of prior lows, and under this scenario, we may be in the early stages of a bear market.
The China U.S. Trade War
The China/U.S. trade war is already expected to inflict significant damage to global growth. Some models imply U.S. GDP growth could fall by about 0.7%. However, it is quite possible implications could be a lot worse, especially if the situation with China trade escalates.
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Also, per recent GDP projections, the U.S. economy is supposed to grow by 2.4% this year. If we subtract the 0.7%, essentially stagnant 1.7% GDP growth could be expected in the U.S. This will likely be even below the rate of inflation and provide very little stimulus to bid SPY and U.S. equities, in general, higher from here.
This is also a mid-case scenario, but a much worst-case scenario may put the U.S economy in a recession within a 12-18 month period. Some analysts consider this a real possibility, and I do as well. That is why you should be especially cautious with stocks around these record high levels.
Possible Investment Strategies
Take more profits and/or decrease positions in higher alpha, high multiple names. For example, a company like Axon (AAXN) is up by 25% this quarter alone and is up by roughly 50% YTD.
I own it in my portfolio, and it is a great company, but at a frothy trailing P/E of 92, you could probably buy shares at substantially lower prices over the next few months.
This is just one example, but it applies to many companies trading at abnormally high multiples.
By reducing positions now, investors can raise cash to deploy at lower levels as the market continues its drip lower from here.
Use Covered Call Options
In case you don’t want to reduce positions, you can implement a covered call dividend strategy. This could deliver yields of 4-5% per month or more on many higher alpha positions.
You could also implement put options or short positions on certain names you are fairly convinced will decline in price, but this strategy is risky and is best when implemented by professionals in my view.
Hedge Using the VIX
You can always use the VIX to hedge. While I am not a proponent of using ETN-based VIX products due to their tendency to degrade dramatically under most market conditions, VIX futures contracts can be used as an effective hedging tool at times.
If you believe the market may go down in a relatively short time frame, a long VIX futures position can make up for a lot of the losses your portfolio would sustain without the hedge.
Diversification is Key
Don’t put so much emphasis on 30 + multiple tech names with questionable growth prospects (especially those with significant ties to China). Rotate into what works in a slowdown, healthcare, some utilities, certain staples, and other high dividend paying names with limited downside potential.
The Bottom Line
SPY’s technical, fundamental, and sentiment/psychological image is deteriorating. With no end to the China trade war in sight, the fundamental backdrop for stocks appears substantially weaker than in previous months. Additionally, economic indicators are softening, and the VIX is signaling warning signs here. SPY’s technical picture appears to be breaking down as well.
Diversify, raise cash, and implement hedging strategies, as SPY’s slide is likely to continue from here. I am expecting initial retracement to $270, then to $260.
In a more severe correction scenario, we may see a retest of the December lows, and in a worst-case bear market debacle, we could see SPY decline to the $200 level or lower.
On the S&P 500, these projections reflect levels akin to 2,700, 2,600, and 2,000 (or lower, considering a worst-case scenario).
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Disclosure: I am/we are long AAXN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.
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