FAULTLINES

Last week saw the earth move under the feet of the Tri-State as the largest earthquake in over a century hit the New York region (4.8 Richter) on Friday. Yet no damage was done and the after-shock hours later barely registered.

The epicenter in New Jersey along the Ramapo Faultline is a known source of instability, responsible for dozens of earthquakes in recent history, but seismologists remain hard-pressed to anticipate when a quake might occur, there or anywhere.

A day earlier, on Thursday Wall Street tremored with stocks falling -1.3%, the largest single-day decline in over a year.

After a week of biblical rainfall in the Northeast, an earthquake, flagging stocks, and yesterday’s solar eclipse it’s reasonable to ask, are locusts next?

On Wall Street the bulls have had an easy go of it over the past five months. The bid has been relentless as the narratives of lower inflation and rate cuts have dominated investor sentiment, but a new narrative is slowly emerging; rate cuts might not appear this year.

Some cracks are beginning to form on the lower time frames across the three major index ETF charts:

An interesting change of pace was seen on the SPY daily chart last week, with the price closing below the 21-period EMA for the first time this year. Despite closing only moderately lower than the prior week at $518.43 (-0.89%), the clear bearish RSI divergence is cause for concern.

Much like the SPY, the QQQ also struggled with its 21-period EMA last week, failing to regain it after Thursday’s selloff and closing at $440.47 (-0.80%). The Relative Strength indicator continues to deteriorate, suggesting weakness under the hood.

The small caps (IWM) were the weakest performers of the group last week, closing at $204.45 (-2.78%). Much like its more favored counterparts, the IWM is also showcasing clear bearish RSI divergence while the price struggles below the 21-period EMA.

IWM kicked off the first week of Q2 underperforming both the S&P 500 (SPX) and Nasdaq100 (NDX). Last quarter was the seventh consecutive quarter where IWM underperformed either SPX or NDX, with the last time small caps having their relative day in the sun going back in Q2 2022. However, we say relative because IWM was down about 2.5% and the other two indices were down more than IWM. The last positive performance and outperformance from IWM occurred in Q1 2021.

Also last week, a 3.02-point weekly gain for VIX was the biggest move since September last year. That gain occurred in conjunction with about a 3% loss for SPX. This past week SPX was down less than 1%. One interpretation of VIX rising 3 points on a relatively small SPX move is that the market is suddenly on edge.

The VIX term-structure flattened with the move higher, indicating that many volatility traders expect a reversal of the recent rise in VIX.

A final look at market volatility turns to Europe and VSTOXX. The Euro Stoxx 50 was down by 1.35% which led to a 20% gain for VSTOXX.

Yet the market’s ongoing bullish trend continues, despite the mind-numbingly narrow price channel, generally anemic volatility, and high complacency.

A correction would likely test the 200-DMA (SPX 5080) and reverse much of the recent bullish market exuberance.

A reversal of sentiment and price deviations would provide a better entry point for increasing portfolio equity exposures. Of course, the market has been so complacent for so long.

With the market overbought and extended currently, we are cautious about aggressively committing to the broad market.

However, such can be very hard to do in a rising bull market that seems unstoppable.

“Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.” – Gerald Loeb

There is always something to worry about, both on the calendar or looming as a macro threat. And giving into those fears can easily displace profitable market participation and trading activity; as a common saying, the market climbs a wall of worry. But if given a structural green light, and knowing where the risk boundaries are, then we can think more objectively rather than trying to size up the world’s puzzles and trying to predict their impact based on the news or punditry.

Regarding market safety, we consider option flows a key barometer of risk. Shown below is a series of warnings on the Magnificent 7 stocks (MAG7): net call selling is depicted by the orange line moving downward, and net put buying is shown where the blue line is also moving downward. In either case, these lines show a directional influence on price, and a stronger one when they are coordinated.

Source: SpotGamma

Such models help us interpret the sum of all market forces and inform the status of immediate market safety. Systematic tools like this lean on billions of dollars’ worth of active risk pricing from Wall Street – that cannot be hidden in the option chain. This allows for objective thinking rather than worrying about the next series of events.

Currently SPX (5204) finds itself slightly above critical option support at 5200, a very narrow margin of safety. Option gamma is quite thin below that level with little to support it until 5000, especially if 5100 were to break. These fault lines deserve special attention, especially in a time of widespread complacency. Until more gamma is accumulated to provide a more robust margin of safety, the prevailing risk outlook is at best neutral.

(Read more on gamma here).

Whether these fissures in market topology become chasms is of course unknown, but a safety net seems reasonable at this point of the climb.