Monday Morning Outlook: Dog Days, as DJIA Slips a Second Week in a Row
Contrarians search for clues in gloomy sentiment picture
by Ryan Detrick 8/21/2010 11:14 AM
schaeffersresearch.com
The dog days continued last week, with the Dow Jones Industrial Average slipping another 0.9%, following on the heels of the previous week's 3.3% slump. The Dow is now down about 2% for the year, while the year-to-date losses for the S&P 500 Index and the Nasdaq Composite are closer to 4%. Looking ahead, Senior Technical Strategist Ryan Detrick is sitting in for Todd Salamone. The normally ebullient Ryan sees more to like in the long term than not, but he's increasingly frustrated by the choppy technical action. Next, Senior Quantitative Analyst Rocky White examines buy-to-open put volume on three exchange-traded funds (ETFs) that track the S&P 500, the Russell 2000, and the Nasdaq 100. Money managers often buy put options on these ETFs to hedge long accumulations in their portfolios -- so we would regard this put buying as a bullish signal. The put buying recently spiked, but now is in a clear decline. Rocky considers the implications. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Thursday Delivered Triple Whammy
By Joseph Hargett, Senior Equities Analyst
The Dow Jones Industrial Average made a gallant midweek attempt to bounce back from the previous week's slump, but a hat trick of economic reports on Thursday confirmed worries that the economic recovery is woefully underpowered. As if we needed more evidence, Thursday's disappointing numbers on weekly jobless claims, leading indicators, and manufacturing in the Philadelphia region made it clear that the economic road ahead is likely to be a long slog.
Traders were already riding a four-day losing streak when the week began, and the downward momentum continued Monday morning. The Dow initially dropped 100 points as the Street considered weaker-than-expected economic data out of Japan and a disappointing manufacturing report out of the New York region. But the bulls clawed their way back to nearly breakeven by the close, and the Dow settled just a point -- a scant 0.01% -- below the previous Friday's close.
Recession? What recession? Retailers and Dow heavyweights Home Depot (HD) and Wal-Mart Stores (WMT) reported better-than-expected earnings, and the bulls were off to the races Tuesday. Potential merger-and-acquisition activity also tickled traders' fancies when BHP Billiton's (BHP) launched a bid for Potash Corp. of Saskatchewan (POT). The Dow gained 100 points, or 1.01%, snapping the five-day losing streak in style.
The Tuesday rally gave way to early weakness on Wednesday. But retailing titan Target (TGT) followed on Wal-Mart's heels by posting a 14% rise in quarterly earnings and offering an optimistic outlook for sales in the fall. Could the consumer be back? The Dow played tag with the breakeven line all day long, and finally settled on a tiny gain of 0.09%.
The bad news arrived Thursday morning like a decisive flurry of punches ending a boxing match. The Philadelphia Fed manufacturing index plunged into negative territory for the first time in a year; analysts had expected continued growth. Weekly new jobless claims surged to 500,000, the highest level since November 2009. The 500,000 level marks an unofficial demarcation point for recession, according to some armchair analysts. Once again, analysts had expected a small decline in first-time filings. Finally, the Conference Board's index of leading economic indicators inched up just 0.1% in July, defying expectations for a slightly more robust gain. The Dow dropped 144 points, or 1.39%.
Friday was a slow news day, and the bulls couldn't muster much energy after Thursday's triple whammy. A listless day ended with the Dow down 0.59%. The Dow wrapped up the week on a loss of 0.9%, and ended beneath its 10-week moving average for the first time since July 16. The S&P 500 Index shed 0.7% last week, but remains perched above support at 1,070, while the Nasdaq Composite actually gained 0.3% during the week.
What the Trader Is Expecting in the Coming Week: In the Short Term, Our Advice is to Hedge
By Ryan Detrick, Senior Technical Strategist
Todd is at the San Francisco Money Show this week – so I'll be filling in for him.
As regular Schaeffer's readers know, the three tenets of Expectational Analysis® are fundamentals, technicals, and sentiment. I'm seeing some interesting developments in each, so I'll take some time analyzing each leg of our methodology.
On the fundamental front, we have a very interesting dichotomy. The bad news is the economic data has taken a steady turn for the worse the past few months. Jobs simply aren't coming back, as jobless claims recently made a nine-month high. Retail sales are weak, consumer sentiment continues to deteriorate, and manufacturing data is sinking as well. Not to mention continued new lows in the two-year yield, suggesting the bond market is still worrying about this recovery.
The good news is earnings season was excellent once again. Interest rates are low, and productivity during the first half of this year was over 6%, the highest since the 1960s. But what really has me excited is the recent merger-and-acquisition activity. When companies are actively buying each other, it is a sign companies could be undervalued, and is usually a very bullish sign for the overall market. Considering U.S. companies have more than $2 trillion combined in cash and short-term investments on their books, and continued low interest rates make financing big deals attractive, M&A could be a major factor the remainder of the year. In fact, last week was the most active week for M&A since late last year. From Potash Corp. of Saskatchewan (POT) saying it is worth more than BHP Billiton (BHP) is willing to pay (and the market agreeing with a huge move in POT's price); to Pactiv Corp. (PTV), the maker of Hefty trash bags, being bought for $4.6 billion,; to Dell (DELL) buying McAfee (MFE) for $7.68 billion; to the largest bank merger since the financial crisis – it is obvious that deals are being made all across the board. [EDIT: Whoops, he meant Intel, not Dell; who proof reads these things?!]
Similar to fundamentals, technicals are a mixed bag as well. Longer-term things still look good, but short term is anyone's guess. In the near term, the S&P 500 Index (SPX) is trapped in a trading range from the recent peak around 1,130 to its lows around 1,040. I wish there was more to say, but until we break out in either direction, making a short-term bet is tough. There is so much indecision right now regarding the economy and Washington, that this chart screams uncertainty. We've had a lot of movement, but gone nowhere the past few months.
Turning to the SPX's 200-day, it is still slightly pointing higher – which is a good sign. Nonetheless, since May we haven't been able to get above this trendline and stay there. With this trendline at 1,116 and the SPX beginning the year at 1,115 – this is an area that won't go down with a fight.
Speaking of 200-day moving averages, the CBOE Market Volatility Index (VIX) continues to stay above its 200-day moving average. As we've mentioned before, for a rally that actually has some staying power, the VIX will need to move beneath this trendline and stay there.
Longer term, the 80-week moving average is one to keep an eye on. As Todd has mentioned before, this trendline served as support during the last bull market, and buyers stepped in last month when the SPX came close to touching it. From a longer-term perspective, as long as we can stay above this trendline – the odds favor that the rally that began in March 2009 will continue.
As the Senior Technical Strategist, one chart that has the technical community talking is the action in tech stocks, specifically the PowerShares QQQ Trust (QQQQ). As you can see, it is in the process of forming a massive head-and-shoulders top. Should the neckline break, it would target a move clear down to about 35. I'm not a huge fan of head-and-shoulders formations as indicators –I just don't think they work very often. In fact, the past two Julys, I noted how head-and-shoulder formations were predicting big declines – only to be dead wrong and mark the start of huge rallies two years running now. You can read about those July head-and-shoulder formations here and here. Nonetheless, last summer a less talked about inverse head-and-shoulders pattern predicted a move from 950 to about 1,235. Given the SPX recently peaked around 1,220, that wasn't a bad call. So we'll have to see how the current pattern plays out and if it receives much fanfare.
Turning to sentiment, we continue to see a very skeptical crowd. In fact, no one seems to have much faith in equities. Since the beginning of 2008, nearly $600 billion has been invested into bonds funds – versus more that $200 billion pulled out of stock funds. Now, given some of the discouraging news out there, it is tough to make compelling arguments for being long stocks – but that could be exactly why stocks might outperform going forward. Remember how everyone felt about the stock market and economy in 1999? The following decade wasn't very good for the stock market from a buy-and-hold point of view. Well, we are seeing the exact opposite now: no one believes in stocks or has much faith in the economic recovery. Also, don't forget we are likely looking at three straight years of equity mutual fund outflows if 2010 continues the current trend. The last time we had three straight years of equity mutual fund outflows was 1979 to 1981 – right before a huge 18-year rally.
The gloom doesn't end there. Recently we've noticed several large hedge fund managers closing up shop, with Stanley Druckenmiller leading the way. Also, a recent poll by Bank of America/Merrill Lynch of fund managers showed the most extreme negative stance toward U.S. equities since January 2008. Plus there was a big drop in investor sentiment polls the past week, with the results consistent with past bottoms.
Here is a chart I think is powerful, as it shows the difference in bulls and bears, according to Investors' Intelligence. As you can see, during the last bull market – a pullback to 0% (in other words, even bulls and bears) was a great buying opportunity. Fast-forward to right now and we recently went down to this level before bouncing. As long as this can stay above the critical 0% area, I view this as being a great longer-term contrarian bullish signal.
Bulls-Bears line from Investors Intelligence data versus the S&P 500 Index Since 2004
Finally, the action in bonds has nearly everyone talking. As mentioned earlier, billions of dollars have been moving into the bond market, and this has the prices soaring higher. I've noticed quite a bit of talk about bonds being in a bubble, and the arguments are very compelling. But you must remember that bubbles usually tend to last much longer than most people think. We could be seeing that with bonds here.
The weekly chart of the iShares Barclays 20+ Year Treasury Bond Fund (TLT) has spiked much higher the past two weeks, as well as a big move from its lows back in April. But look what happened in late 2008. If we are about to see a similar move, then there could be significant gains yet to come.
The key thing to remember in this environment is to keep your trading short term, and for all longer-term trades to have a hedge in place. Stay diversified as there are some good arguments to be bullish or bearish stocks (although I think there are more compelling arguments for the bulls). As well as solid arguments for higher or lower prices in bonds. Don't forget to own some gold and some cash for safety as well.
Lastly, I invite you to read the latest edition of SENTIMENT magazine. Thanks for reading and good luck trading.
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Indicator of the Week: Dwindling Buying Volume on Major ETFs
By Rocky White, Senior Quantitative Analyst
Foreword: The SPDR S&P 500 (SPY), the iShares Russell 2000 Index (IWM), and the PowerShares QQQ Trust (QQQQ) are three exchange-traded funds (ETFs) that track major indexes (S&P 500, Russell 2000, and the Nasdaq 100, respectively). Money managers often buy options on these ETFs to hedge their portfolios. When they buy stocks and increase their exposure to the market, they purchase put options on a major index to guard against huge losses in the event of a market decline. Therefore, our typical contrarian interpretation of option activity is thrown out the window. When put options are purchased on these ETFs, it does not necessarily mean that the buyers are bearish on the market. In fact, since they are hedging their long exposure, it often means the opposite -- that they are bullish and buying equities, and their put buying is simply a hedge.
Money Flow Indicator: We closely track what's happening in the options market on these major ETFs. Using proprietary data we get from the International Securities Exchange and from the Chicago Board of Options Exchange, we combine the option activity of the three major ETFs to get a put/call volume ratio. Please note we are looking only at the buy-to-open (BTO) data, which shows only option volume initiated by traders buying to open a new position. This excludes closing trades and trades initiated by option sellers.
The chart below shows the S&P 500 Index (SPX) along with the ratio of puts bought to open compared to calls over the last 20 trading days. The chart goes back to 2008 and illustrates the money manager activity I mentioned at the beginning. Notice the ratio tends to trend with the market. The ratio's uptrend since the March 2009 bottom is not because traders are getting bearish (the typical interpretation of a put/call ratio), but because their portfolios are growing and they need more and more put options to hedge them. Therefore, the ratio is not a sentiment indicator like most put/call volume ratios, but is really a sign of money flow. The BTO put/call volume ratio has been quite choppy since its peak at the beginning of May. We would like to see the ratio continue its uptrend as it would probably coincide with an advance in the market.
SPX and 20-day moving average of the BTO put/call ratio since January 2008
Buying Volume: In the chart below, I show the average daily option volume for the three major ETFs. In May, there was a big spike in BTO puts after the market initially began to pull back. You saw similar spikes during the 2008 crash. These spikes were possibly hedges being put on by traders in an effort to stem their portfolio losses.
The spike is not the most troubling part of graph; in fact it's a bit expected when the market turns lower. What's troubling is that the put buying is in a free fall. It could be dropping for perfectly innocent reasons: investors are already sufficiently hedged from the previous buying; it's summer; and volume is low. However, if the volume continues to shrink, it may be a sign of deleveraging. That's big money players selling out of positions to get out of the market completely. The market can tank when that happens, as it did in late 2008. We don't know if that's exactly what is happening, but that's why we are suggesting caution. It might be a good idea to have your own hedges in place.
SPX and 20-day moving average of the BTO puts and /20-day moving average of the BTO calls since January 2008
This Week's Key Events:
By Joseph Hargett, Senior Equities Analyst
Here is a brief list of some of the key events for the upcoming 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
* There are no major economic reports on Monday. Focus Media Holding Limited (FMCN) will release its quarterly earnings report.
Tuesday
* The National Association of Realtors will report on existing homes sales in July. Barnes & Noble Inc. (BKS), Big Lots Inc. (BIG), Burger King Holdings Inc. (BKC), Medtronic Inc. (MDT), Trina Solar Limited (TSL), and VeriFone Systems Inc. (PAY) are scheduled to report earnings.
Wednesday
* The Commerce Department will report on new homes sales for July and durable goods orders for July. The usual weekly report on U.S. petroleum supplies is also due on Wednesday. American Eagle Outfitters (AEO), Toll Brothers Inc. (TOL), Guess?, Inc. (GES), JDS Uniphase Corp. (JDSU), and TiVo Inc. (TIVO) will post their quarterly results.
Thursday
* We'll get the weekly report on new jobless claims, as we do every Thursday. It was a huge disappointment this past week. Aruba Networks Inc. (ARUN), bebe stores inc. (BEBE), Novell Inc. (NOVL), and OmniVision Technologies Inc. (OVTI) will report earnings.
Friday
* The Commerce Department will supply us with a revised look at second-quarter gross domestic product, and the University of Michigan will update its consumer sentiment index for August. Frontline Ltd. (FRO) and Tiffany & Co. (TIF) round out the week's earnings. |
