The Warning Signs In The Stock Market Are Clear And Present (SP500)

The S&P 500 (SP500) and a few of its key sectors have reached over-bought levels based on a few technical indicators suggesting that this market is overextended from a technical standpoint at a time when the dynamics of the options market are flashing warning signs all over the place, and expected future returns plunge.

As discussed previously, the options market has helped push the equity market to these overbought levels daily, weekly, and monthly. But the dynamics of these overbought conditions are shifting, and the window for a significant market decline is not only open, but the time for the unwind appears to be in progress.

The overbought levels in the S&P 500 can be seen on the daily and weekly chart by looking at the relative strength index, which climbed above 70 during the middle of last week. It isn’t often that the S&P 500 sees its RSI rise above 70 on the weekly chart. It only happened once during the rally of 2023 and before that you have to go back to late 2021.

These conditions are also present in sectors like Semiconductors, with the VanEck Semiconductor ETF (SMH) also seeing its RSI on the weekly chart climb above 70. That decisive move in the sector likely reflects the big move higher in stocks like Nvidia (NVDA) and AMD (AMD). In addition to the SMH ETF seeing its RSI rise above 70, it has also seen its price rise above the upper Bollinger band, another overbought condition on the weekly chart.

The Communication Services Select Sector SPDR (XLC) ETF also finds itself similarly positioned, with the RSI climbing to more than 77 last week. At the same time, the price closed above the upper Bollinger band, also flashing the conditions of being overbought on two separate indicators. The move higher in the XLC is likely a reflection of the strong performance of Meta (META)

The SPDR Select Sector Technology ETF (XLK) has reached similar overbought levels, but only with the RSI climbing above 70. Unlikely, the other has not seen its price rise above the upper Bollinger band. So, while the ETF could be considered overbought based on the relative strength index, it doesn’t present the same overall exuberance.

Options Flows

These overbought conditions appear to reflect, in some cases, the positioning in the market in select stocks that make up some of these sectors. It could also result from the implied volatility dispersion trade discussed previously and option hedging flows that had been very supportive of the shares over the last few months.

But with the big January options expiration date and significant earnings behind us, those supportive hedging flows should be diminished and implied volatility levels across the mega-cap stocks have now fallen too sharply lower levels.

It has led the 1-month implied correlation index to rise off its recent lows after challenging the levels last seen in July 2023 and parts of 2017 and 2018- periods that also saw stretched sentiment, such as in January 2018. Usually, when the implied correlation index rises, the S&P 500 reverses its gains and heads lower, as has been the case in the past.

When the implied correlation index falls, the implied volatility of the S&P 500 moves in the opposite direction of the components in the S&P 500. When the implied correlation index rises, it is a function of the implied volatility of both the index and basket of stocks moving in the same direction and being more correlated.

So, at least on the surface, the current overbought reading on the S&P 500 and a few sectors, mainly the ones that have the most significant impact on the implied volatility dispersion trade, appears to signal that the market has reached an overextended position.

It doesn’t have to mean that stock prices and indexes fall; it could result in the index marking time and consolidating sideways. However, valuation and growth rates suggest the market could see a significant pullback.

Expected Market Returns Plunge

The S&P 500 is trading at more than 22 times 2024 earnings estimates, which puts it back at levels last seen in 2021 when interest rates were near zero and the Fed was conducting QE. This is opposed to the overnight Fed Funds rate now being more than 525 bps higher, as the Fed is running quantitative tightening.

Meanwhile, the spread between the last twelve months’ earnings yield and the 10-year rate has contracted to just 35 bps. That is the narrowest the spread has been since the 1990s and is associated with a time of falling interest rates, not during a time of rising interest, such as in the 1960s and 1970s.

Additionally, the expected market returns have plummeted. In the past, changes in market expected returns have, at times, acted as a leading indicator of the direction of the S&P 500. It could be that the significant gains witnessed in the broader indexes and many market sectors have pulled forward future returns.

All of this seems to point to an overheated market that needs a big reset, which appears to be already in motion.