Bearish Signals Emerge Amid Market Weakness and Liquidity Drain
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The S&P 500 and Nasdaq experienced sharp declines, with both indexes forming bearish engulfing patterns on their weekly charts—a rare but potentially significant technical signal. Coupled with overbought monthly conditions, declining liquidity due to TGA rebuilding, and signs of increasing volatility, the market may be approaching a pivotal inflection point.
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Terms and Transcript by ChatGPT:
Defined Terms and Jargon
Bearish Engulfing Pattern: A candlestick chart formation indicating potential reversal, where a large red (down) candle fully engulfs the previous green (up) candle.
RSI (Relative Strength Index): A momentum oscillator measuring the speed and change of price movements; values above 70 typically indicate overbought conditions.
Bollinger Bands: A volatility indicator using a moving average and standard deviations; trading above the upper band can signal overbought markets.
Moving Average (20-day, 10-day EMA): A technical analysis tool that smooths price data to identify trends; EMA gives more weight to recent prices.
Rising Wedge Pattern: A bearish chart pattern indicating a potential reversal during an uptrend.
Realized Volatility: A measure of actual market volatility based on historical prices.
Implied Volatility: Market’s forecast of likely price movement, derived from option prices.
Implied Correlation Index: Gauges the average correlation between stocks in an index; lower values may precede market turbulence.
Volatility Dispersion Trade: A strategy betting on differences between index and constituent stock volatility.
TGA (Treasury General Account): The U.S. Treasury’s primary account at the Federal Reserve; changes impact market liquidity.
Reverse Repo Facility: A Fed tool allowing institutions to park excess funds overnight, affecting liquidity.
SOFR (Secured Overnight Financing Rate): A benchmark interest rate for overnight borrowing; movements indicate funding conditions.
Fully Edited Transcript
It was an interesting day in the markets today, with the S&P 500 falling about 1.6%. The Nasdaq declined even more sharply. A noteworthy pattern emerged on both the S&P and the Nasdaq weekly charts: a bearish engulfing pattern. These patterns are significant and relatively rare on weekly charts, though we’ve seen a few recently—in February and March of this year, for example. There were also similar patterns in July 2023 and in December 2022 through January 2023, reinforcing the importance of taking notice.
These patterns can sometimes mark inflection points in the market. While it may amount to nothing, the rarity of such weekly signals suggests they warrant attention. Particularly with the Nasdaq, just yesterday it was at extremely overbought levels on the monthly chart, with an RSI of 72 and closing just above the upper Bollinger Band. It’s uncommon to see both these conditions—RSI above 70 and price above the upper Bollinger Band—converge on a monthly chart.
The last clear examples were in August 2020, January 2020, and January 2018—all periods that preceded challenging market environments. This supports the view that the market was overheated heading into the end of this month. Interestingly, much of yesterday’s gains were given back late in the session, which made today’s close more significant.
Another key point is the extremely low volume seen in July on the S&P 500 futures monthly chart. In fact, July saw the lowest monthly trading volume since August 2021—a month that was followed by a difficult September that year. Such low-volume environments coupled with overbought conditions set the stage for a pullback. Today, some sidelined sellers re-entered the market, producing the strongest volume in some time. Volume has been increasing over the last few sessions, signaling renewed selling pressure.
Technically, there’s notable support around the 6100 area. The lower Bollinger Band may drift down over the next few days, providing further support. Importantly, the S&P closed below both its 10-day exponential and 20-day moving averages—something not seen since April 24. We even saw a gap lower below these averages, breaking an existing uptrend and completing what appears to be a rising wedge pattern. This technical breakdown reinforces the likelihood of a pullback.
Additionally, realized volatility has been extremely low in recent weeks, hitting levels not seen in a long time. The 10-day realized volatility was at unusually low levels, implying a rebound was likely. Implied correlations were also extremely low. The one-month implied correlation index indicated that correlations were set to rise—something we’ve discussed extensively.
Once earnings season ends and the largest companies have reported, implied correlations often increase. You can confirm this trend by looking at implied volatility on names like Apple and Amazon—where implied volatility spikes heading into earnings and drops immediately afterward. Overlaying the VIX with these stocks reveals this dynamic, a product of the volatility dispersion trade, which depresses implied correlations before earnings and raises them afterward.
Beyond technicals, liquidity factors are playing a key role. The Treasury General Account (TGA) is being rebuilt, draining liquidity from markets. Unlike in past years, there’s little left in the Fed’s reverse repo facility to offset this drain. In mid-2023, reserve balances funded the TGA rebuild. This time, we lack that cushion, making this environment more akin to 2022, when liquidity tightness drove market weakness.
We’ve entered a potentially precarious liquidity phase. Watching the size of the TGA and movements in SOFR will be important. SOFR moved up 7 basis points to 4.39%, and while it may come down slightly Monday, sustained T-bill issuance could keep it elevated. This adds to the reasons for caution as we navigate the coming days.
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