Last Thursday's gap open lower created an unmistakable classical Island Top Reversal pattern on the S&P 500 Index chart. Then, making a double whammy, it closed below the operative upward sloping trendline, turning the near term view bearish. The Market Review includes charts to help explain the sudden and mostly unexpected transformation.

S&P 500 Index (SPX) 3041.31 declined 152.62 points or -4.78% last week, just 3 points more than it gained the week before. While an expected pullback into the gap created after the surprising nonfarm payroll report the previous Friday, the large gap open on Thursday completely changed the picture. The 200-day Moving Average at 3013.88 supported the decline as it bounced up in the last hour on Friday on what may have been short-covering before the weekend.

This chart shows both the Island Top and the breach of the operative upward sloping trendline, USTL.

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EG marks the first gap made on Friday, June 5 designated as an Exhaustion Gap while the second, BG for Breakaway Gap, made last Thursday isolates four days trading ranges into an Island Top. The measuring objective is a retracement of the minor price move that preceded it or the entire move from the March 23 low. 

"Sometimes the second gap–the breakaway that completes the Island–is closed a few days later by a quick pull-back reaction. More often is in not." - Edwards & Magee, Technical Analysis of Stock Trends, Revised 5th Edition, p.207.

Should last Friday's rebound off the 200-day Moving Average continue higher this week and close the Breakaway Gap, then the status will change again since it will also be back above the upward sloping trendline shown above.

CBOE Volatility Index® (VIX) 36.09 jumped up 11.57 points or +47.19% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, gained 10.35 points or +52.54%, ending at 30.05%.

The spike up to 77.15% on Monday, March 16, the day SPX declined 324.89 points, likely marks the top for this market decline. While difficult to see in this chart, it turned higher once again.

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Put/Call Ratio 

Often useful as a contrary indicator at extremes the equity only put call ratio can confirm overbought and oversold markets. On Friday, June 5, when the ratio closed at a low of .41, Larry McMillan later wrote, "it hasn't been this low in over 16 years." Then last Monday it ended even lower at .37. While our chart doesn't go back 16 years, this one starting in 2018 does show the extreme low along with the spike up above 1.25 in March.

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VIX Futures Premium 

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts as of last Friday.

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With just two trading days until June expiration, the day-weighted premium between June and July allocated 10% to June and 90% to July for a premium of -3.08%, moving back into the red bear zone, vs. 8.42% for the week ending June 5. 

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the VIX at the next monthly futures expiration on Wednesday, June 17.

The relationship of the futures curve to the VIX, as measured by the premium, makes a good real-time sentiment indicator based upon actual commitments of large Asset Managers and Leveraged Funds.

Strategy

While several reasons are attributed to last Thursday's sudden unexpected market decline including valuation measures, excessive optimism, an overbought market, COVID-19 worries, and others, the one that seems to have suddenly made a difference was Jay Powell's comments on Wednesday.

While the Nasdaq was making new highs, few would take much action based on one or two indicators suggesting the market was overbought. Then, after Powell's comments, the market immediately switches from euphoria to reality. With so many unknowns cranked into their forecasting models it seems irresponsible to say anything more than we don't know– but here are some possible outcomes.

"We have two classes of forecasters: Those who don't know– and those who don't know they don't know." – John Kenneth Galbraith

WTI Crude oil also experienced a pullback on Thursday. However, as of the COT report on Tuesday, June 9, the various participants' position changes and open interest were small and didn't provide any insight about the decline that occurred two days later. 

Since odds favor the activation of an Island Top Reversal by the S&P 500 Index, consider opening new hedges with out-of-the money SPY put spreads and/or collars for individual long stock and ETF positions. First, watch to see if the 200-day Moving Average again provides support. If not, and it turns lower again, assume it's headed back down the retest the March 23 low while marking the June 8 high of 3233.13 the long-awaited Elliott 4 wave, presuming the decline to the March 23 low was an Elliott 3 impulse wave and the start of a bear market.

Prudent traders and strategist follow the rule of unknowns by initially positioning their portfolios for up or down markets and then adjust when the direction becomes apparent.

Summary

Last week a modest expected pullback by the S&P 500 Index to close the previous week's gap up turned more threatening as it made a breakaway gap lower to create a bearish Island Top Reversal pattern, implying it could retrace the entire minor move from the March low. While there are several explanations for the sudden change of sentiment, the one that seems to hold the most water was Jay Powell's comments on Wednesday. This week watch carefully to see if support at the 200-day Moving Average holds.