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Is S&P500 due for a deeper pullback to the $3900 level?

S&P 500 is starting the week with a sharp move higher after an overdue sell-off that was triggered by the FED meeting last week. However, there are still some technical warning signs that require our attention and S&P500 might need more time to establish a strong footing to take out its previous high. In this article I will examine some of these warning signs and a potential trading strategy should the sell-off continues and picks up steam.

The FED is now signaling that intertest rates will need to rise sooner and faster than they previously expected, and their new forecast suggests two rate hikes in 2023. 

Market participants have already been expecting a post-pandemic inflation which was believed to be temporary however they were not expecting the FED to switch to a “hawkish” tone this fast hence the self-off you witnessed in the overall market and most stocks last week. The chair of Federal Reserve Jerome Powell continues to assure investors that this post-pandemic inflation will only be transitory and does not cause for too much concern but perhaps their eagerness to raise interest rates this fast suggests otherwise.

As most of you know, I’m a stock market technician and I’m not going to analyze the post-pandemic economy or the fundamentals of financial markets to be able to trade the S&P500 so let’s leave that to the economists and CFAs and dive into examining the technical picture of this market before we get lost in the fundamentals.

Regardless of my time horizon for a potential trade, I always start my analysis with the longer-term charts such as the monthly chart. That allows me to focus on the primary trend of the market before getting lost in minor details. As you can see in the monthly chart below, the primary uptrend is very well intact and there is no reason to turn bearish! However, the S&P 500 has been marching higher for the past 8 months with no meaningful pullback. The 9-day exponential moving average or EMA9 is a very underrated tool that can really help you identify trends and execute your trades with much better timing. If you notice on the chart, price often converges with the EMA9, or the blue line and it is rare for the S&P500 to continue trading higher for 8 consecutive months without testing the EMA9 not even once! That is not to say that this a bearish technical indicator, but you still need to be mindful of this divergence between the price and EMA9 and buying the S&P500 up here definitely leaves you exposed to downside volatility and unnecessary risk! The 9-month exponential average or the EMA9 is currently around $3900 which is more than 7% lower than where S&P 500 is trading right now. In addition, volume has been declining in the past few months suggesting that less traders are participating in this rally as S&P500 continues higher. This does not cause for too much concern as this is somewhat typical of summer trading volumes but with July and August being historically weaker months for the market, buying the S&P 500 up here definitely exposes you to too much risk going forward.

When it comes to formulating a trading strategy, weekly chart is what I spend most of my time analyzing. So, let’s examine the weekly chart further so we can formulate a trading strategy and be prepared regardless of what the market decides to do. You know the saying, “always plan your trade and always trade your plan!”.

As you can see in the weekly chart below, there is a potential bearish divergence between the price and RSI that I have identified. Bearish divergences take place when price makes a new high, but RSI fails to do the same. Notice how a bearish divergence between the price and the RSI in early 2020 signaled a major crash that finally unfolded due to the global pandemic. Last week S&P 500 managed to print an all-time-high of $4257.16 but RSI failed to take out its most recent high and market finally sold off after the FED meeting and S&P500 closed the week lower than the weekly EMA9 of $4181. Again, this is not to say that I think market will crash here just like it did in early 2020 and more confirmation is required before we can jump into a potential trade but should this bearish divergence signal play out we want to be prepared to take advantage.

So how to trade the S&P 500 going forward?

It’s currently Monday June 21st, 2021 as I’m writing this article and S&P500 is bouncing significantly higher and almost shrugging off the Friday’s sell off. If you have a bullish bias and trying to chase this move, make sure $SPX can take out its most recent high of $4257.16 before executing a long trade and buying stocks that trade with a high correlation with the market. If you follow me on StockTwits you already know how I always say, sometimes it’s better to sacrifice some early gains to avoid getting caught in the trending ranges!

However, if $SPX fails to stay above the $4218 level which happens to be the 9-day exponential moving average then the recent sell-off can continue and even pick up steam! If that happens it would be reasonable to assume that $SPX can eventually test the $3900 level in the remainder of June or in the month of July.

Maintain an open mind, patience and discipline and be prepared to take advantage of this market volatility according to your trading plan.

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