Monday Morning Outlook: An Even-Handed Options Strategy for a Wild Market
The SPX endured a devastating defeat last week in the critical 1,225 area
by Todd Salamone 9/3/2011
schaeffersresearch.com
Stocks put a bow on the miserable month of August with a solid four-day winning streak... just in time to ring in September with a two-day, 373-point Dow drop. After Friday's utter letdown of a nonfarm payrolls report, the technical outlook for the major market indexes remains in critical condition. In fact, equities have endured some disturbing defeats at significant chart levels lately, which could embolden the bears as we enter the historically trying fall season.
Going into the holiday-shortened week ahead, Todd Salamone highlights the key trendlines and retracement levels traders need to watch to determine whether this bull has any life left in it. Plus, with the overall uptrend still up for grabs, Todd explains how the "buddy system" can aid your trading. Meanwhile, Rocky White takes a look back at the monumentally volatile month of August, which boasted the biggest daily SPX trading ranges in more than two years. Finally, we wrap up with a preview of the notable earnings and economic reports for the coming week, as well as a few sectors of note.
Notes from the Trading Desk: SPX Suffers a Crushing Blow at 1,225
By Todd Salamone, Senior VP of Research
"If a post-Jackson Hole rally occurs, like it did last year, it would happen in the context of a weaker technical backdrop. For example, ahead of the 2010 meeting, the S&P 500 Index (SPX - 1,176.80) was sitting just above its 80-week moving average, whereas it's trading below this trendline at present. After Friday's rally, bulls would prefer that the SPX immediately trade back above this moving average, which is currently at 1,209.40. "After Friday's advance, there is still work to be done to repair the technical backdrop, as it has been a volatile, choppy ride since the Aug. 9 lows. Encouraging for the bulls is that the CBOE Market Volatility Index (VIX - 35.59) remains well below 50, major equity indexes remain above historically significant long-term moving averages, and there are signs that heavy pessimism among hedge fund managers is dissipating.
"In this environment, we recommend you dip your toes into highly shorted equities that are trading at long-term support -- such as consumer discretionary stocks that have pulled back recently, but are still in the black for 2011. If a bottom is in place, these equities will likely outperform. However, continue to maintain exposure to gold and bonds, and avoid the large-cap financials."
- Monday Morning Outlook, August 27, 2011
Last week, we discussed evidence that the short-selling activity that had helped push equities to their August lows was showing signs of lightening up, allowing for a short-term boost in equities as the meeting of central bankers in Jackson Hole, Wyo., came and went.
As noted, the technical backdrop of the major equity indexes around the time of the Jackson Hole summit was more unstable this year than last. This meant that stocks were more vulnerable to being greeted with selling pressure on rallies -- which is exactly what occurred late last week, as the benchmark indexes we follow surged up to key levels, only to sell off after an August employment report that showed zero jobs growth. The payrolls number was considerably worse than expected, and sparked more talk about a potential recession and a third round of quantitative easing, thereby depressing stocks and sending bond yields lower. We may indeed be in a period where expectations for slower growth get ratcheted down to recession expectations, which would have a coincidentally negative impact on stocks.
The advance in the 20-day combined buy-to-open put/call ratio on major exchange-traded funds (ETFs) led us to believe that shorting activity was no longer accelerating, but we are curious to see how this ratio behaves after Friday's employment numbers, as this negative report may very well embolden the shorts again. This week's failure at key technical levels, which we'll discuss later, served as an important reminder that a rising put/call ratio must occur within the context of the major market indexes displaying a more positive technical backdrop. Said another way: While we continue to see evidence that there is unwinding potential from the building pessimism over the past several weeks, the price action has to improve before pressure is felt among market players to cover their shorts, and/or move out of other assets and into equities.
One notable failure last week was the S&P 500 Index's (SPX - 1,173.97) inability to take out the 1,225 area. This level is important for two reasons:
- It is the site of the SPX's 80-month moving average. This trendline has played a historically significant role, including marking the lows in September 2001.
- The 1,225 region represents a 50% retracement of the early July highs in the 1,340 area and the August low in the 1,100 neighborhood.
In addition, while the SPX briefly moved above its 80-week moving average, at 1,210, during the week, it experienced another weekly close back below this important trendline -- the fifth consecutive weekly close below this level. For new readers, this moving average acted as support during the 2004-2005 rally, marked the July 2010 bottom, and marked a peak in May 2008.
Turning to other major indexes, the headline Dow Jones Industrial Average (DJIA - 11,240.26) tried, but failed, to make it back into the green for calendar year 2011. The Dow's year-to-date breakeven currently stands at 11,577.51. As you can see on the chart below, there were attempts to sustain a move above this level, but by the end of the week, the Dow failed to hold positive ground.
Moreover, we have mentioned on several occasions the importance of the 750 level on the Russell 2000 Index (RUT - 683.36) and the 900 level on the S&P 400 MidCap Index (MID - 832.99). The 750 area on the RUT marked the highs in 2008, right before Lehman Brothers went under, and again in 2010, prior to May's flash crash. Meanwhile, the 900 area was the site of the MID's high in 2007. Both indexes came within a chip shot of these significant technical levels last week, but retreated before touching them.
As we have said time and again, it is important for small- and mid-cap stocks to begin showing signs of leadership, which would begin with a rally back above these resistance levels. In the meantime, it will be important for the RUT to stay above support at 650, and the MID to stay north of 767, which is where its 40-month and 80-month moving averages converge.
An additional risk to the bulls is the action in the CBOE Market Volatility Index (VIX - 33.92), as it was not able to penetrate back below the 30 area. This round-number level marked the VIX's 2011 high ahead of the early August breakout. Plus, the low in the 30 area this past week is a 50% retracement of the 2011 high and low.
Continue to maintain exposure to gold and Treasury bonds, and concentrate your equity exposure to highly shorted consumer-discretionary stocks with favorable price action. Avoid financials and large-cap technology names.
If you are playing options, be balanced in your approach, and concentrate on short-term opportunities. One strategy to consider is pairs trading, which involves buying calls on a stock you like within a sector, and buying puts on a stock you dislike within the same sector. This approach positions you to benefit from either a major short-covering rally in the event of a positive catalyst, or from a potential trip back down to SPX 1,100 after last week's failure to overcome key resistance levels.
Indicator of the Week: Volatility Returns
By Rocky White, Senior Quantitative Analyst
Foreword: It's official: Volatility is back. The month of August saw 14 days in which the S&P 500 Index (SPX) was up or down at least 1%. That's the most "1% days" we've seen in a month in more than a year (the last time was the "flash crash" month of May 2010). The table below shows all months since 2000 that had as many 1% days as last month. It's interesting that during the big August decline, there were just as many 1% up days as there were 1% down days. However, as you scan the table, you'll notice it's not entirely uncommon for an equal number of big up and down days to result in major overall market moves (see: March 2009, September 2008).
Everyday Volatility: During August, every day was a roller-coaster ride. Even when the market ended relatively flat from one day's close to the next, that didn't necessarily mean it was a quiet session. One trader here at Schaeffer's noted there were huge intraday swings all month. Therefore, I looked at the range the SPX traded in every day as a percentage.
The chart below shows the average daily range of the SPX alongside the index's performance. Sure enough, every single day in August had an intraday range of at least 1.5%. Prior to August, only 16% of trading days in 2011 had such a substantial range. In fact, that's the first time we've seen that kind of day-to-day volatility in over two years, since April 2009.
As you can see, the average daily range spiked above 3% in September 2008 and July 2002. There were only two other spikes above 3% in the last 30 years. The first occurred in October 1987, after the "Black Monday" crash, and the second happened in September 1998, during the Russian default crisis.
This Week's Key Events: Fed's Beige Book Headlines a Light Post-Holiday Week
Schaeffer's Editorial Staff
Here is a brief list of some of the key events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.
Monday
- The market is closed Monday in observance of Labor Day.
Tuesday
- The ISM services index for August is due out on Tuesday. Altera (ALTR), FuelCell Energy (FCEL), KongZhong (KONG), Pep Boys (PBY), and VeriFone Systems (PAY) are expected to report earnings.
Wednesday
- The Fed's Beige Book report for September will hit the Street on Wednesday. On the earnings front, we'll hear from AeroVironment (AVAV), Hovnanian Enterprises (HOV), Men's Wearhouse (MW), Smith & Wesson (SWHC), Sycamore Networks (SCMR), and Talbots (TLB).
Thursday
- Thursday features the usual weekly report on jobless claims, as well as July's trade balance. Crude inventories are also on the docket -- a day later than usual, due to Monday's holiday. Smithfield Foods (SFD), Titan Machinery (TITN), Ulta Salon (ULTA), and United Natural Foods (UNFI) will share the earnings stage.
Friday
- Wholesale inventories for July will round out the week's economic calendar on Friday. Kroger (KR), Lululemon Athletica (LULU), and Piedmont Natural Gas (PNY) are scheduled to reveal their latest quarterly earnings.
And now a few sectors of note...
Dissecting The Sectors
Sector Leisure/Retail
Bullish
Outlook: The technical outlook for the SPDR S&P Retail ETF (XRT) is a little hot-and-cold at the moment. The fund recently crossed back above its 80-week moving average, and is still trading above support in the $45 area. However, XRT suffered a harsh rejection this past week in the $50 area, which is home to a convergence of its 40-day, 160-day, and 195-day moving averages. Plus, the ETF ended the week below its year-to-date breakeven at $48.36. From a sentiment perspective, we have yet to see an uptick in XRT's 50-day buy-to-open put/call volume ratio, which would suggest that big-money players are once again building long positions in the retail space. With these points of caution in mind, we remain upbeat on select outperformers within the group, and recommend focusing on stocks in solid technical uptrends that remain surrounded by skepticism. Chipotle Mexican Grill (CMG), Lululemon Athletica (LULU), and AutoNation (AN) have racked up double-digit percentage gains in 2011, easily surpassing the broader market -- yet all three equities have been heavily targeted by short sellers, and the majority of analysts also remain dedicated to the bearish camp. Meanwhile, near-term options traders continue to favor puts on Green Mountain Coffee Roasters (GMCR), even though the shares have rallied roughly 215% year-to-date. As these high-flying discretionary stocks continue to outperform on the charts, a capitulation by the bears could provide a fresh influx of buying pressure.
Sector Large-Cap Tech
Bearish
Outlook: From a technical standpoint, the PowerShares QQQ Trust (QQQ) spiraled lower after a recent test of the $60 level -- which represents exactly half its all-time high of $120, set back in March 2000. Furthermore, the trust remains stuck beneath its year-to-date breakeven level, located near the $54 area. This former layer of support now seems to be emerging as stubborn resistance for QQQ, as the shares were simply unable to sustain a move above this region during the past week. Within the tech sector, semiconductor stocks could prove to be a particular pocket of weakness, as analysts remain surprisingly upbeat on this underperforming group. The percentage of "buy" ratings on components of the Semiconductor HOLDRS Trust (SMH) peaked at 58.2% in late July, hitting its highest level since May 2010. Meanwhile, the percentage of "sells" is resting near an annual low. In the same optimistic vein, a few upbeat analysts have recently flagged the poor price action in chip stocks as a buying opportunity. Last Thursday, we saw a clear picture of just how quickly this optimism can unwind, as Novellus (NVLS) was pummeled by price-target cuts after slashing its full-year revenue forecast. With SMH faring even worse than the broader QQQ in 2011, the semiconductor sector as a whole could be vulnerable to a similar shift in sentiment as the weak technical performance continues.
Sector Financials
Bearish
Outlook: Bad news continues to roll in for the banking sector, as the Federal Housing Finance Agency (FHFA) filed suit Friday against 17 of the biggest banks in the U.S. over their involvement in the soured mortgage-backed securities (MBS) market. Plus, concerns continue to linger about European debt exposure, further weakening the already-shaky fundamental outlook. Taking a broader look at the group, the technical backdrop for the Financial Select Sector SPDR (XLF) remains bearish. The fund was rejected this past week at $13.50, which previously served as a major support area during 2010. As a point of caution, the 50-day buy-to-open call/put volume ratio for XLF has rolled over sharply from its recent peak, which may be indicative of short-covering activity. However, the ratio is turning south from a much lower level relative to 2009 -- suggesting that the short-covering potential from here is nowhere near that of 2008, when the sector doubled from its lows in a year. In fact, the XLF's 14% top-to-bottom rally from its August nadir may be all that is left in the tank for now. With this in mind, traders should keep an eye on the $13.50 level, as a rally above this area would be an added risk to any short positions in the big-cap financial sector. |
