Monday Morning Outlook: DJIA Surges Above 10,850 as Rally Extends to Fourth Week
Dow, SPX break out of summer trading range
by Todd Salamone 9/25/2010 11:11 AM
schaeffersresearch.com
That was enjoyable. The Dow Jones Industrial Average winning streak now stretches to four weeks, ending with a decisive pop of nearly 200 points on Friday. That broke us out of our summer trading range. Looking ahead, Todd Salamone, Senior Vice President of Research, analyzes last week's breakout and concludes there's more where that came from. Next, Senior Quantitative Analyst Rocky White reports that the S&P 500 Index just experienced a 19-day streak, ending Wednesday, without back-to-back down days. Rocky finds that's not necessarily good news. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Full Speed Ahead
By Joseph Hargett, Senior Equities Analyst
Bookend rallies on Monday and Friday lifted the Dow Jones Industrial Average (DJIA) to a healthy 2.4% gain this past week. That was plenty enough to extend the September rally into a fourth week. The Dow also climbed above the 10,800 level, while the S&P 500 Index (SPX) not only regained the closely watched 1,130 mark -- the upper rail of its summer range -- it leapfrogged nearly to 1,150 by Friday's close; neither index had breathed such rarefied air since May.
The National Bureau of Economic Research, the outfit charged with measuring such things, reported Monday that the recession that started in December 2007 officially ended in June 2009, making it the longest recession since the end of World War II. (You can be forgiven for not cheering if you're still looking for work.) While this wasn't actually stop-the-presses news, it was enough to prod the bulls into action. The Dow climbed 146 points, or 1.37%.
In another relatively slow news week, the headline Tuesday was the Federal Open Market Committee's (FOMC) decision on monetary policy. The FOMC -- drum roll -- reiterated its pledge to keep interest rates at exceptionally low levels for an "extended period." But officials also voiced new concerns that very low rates of inflation could threaten the incipient economic recovery, and said they were prepared, if necessary, to resume buying government debt. It was a mixed message, to say the least, and the Dow sputtered to a tiny 0.07% gain.
The Fed hangover continued on Wednesday. Investors followed the Fed's lead, choosing safe havens such as Treasurys over stocks. In fact, gold tagged a record high for the fifth consecutive session. The Dow slipped 0.20%.
Weak euro zone and jobs data gave the bears all the ammo they needed on Thursday. Ireland's second-quarter gross domestic product shrank, as did the composite purchasing managers' index (PMI) for the members of the euro zone. Back home, initial jobless claims rose more than expected. All told, the continued gloom about the strength of the global recovery overshadowed an improvement in the Conference Board's leading economic indicators' index. The Dow slumped 0.72%.
Gloom? What gloom? It was back to the races on Friday. Foreign and domestic economic data appeared to show that businesses are -- finally -- willing to spend some of the cash they've been guarding so carefully the last several years. First, a German index of business sentiment unexpectedly increased. Then, the Commerce Department reported that although orders for durable goods fell 1.3% in August, orders rose 2% after the transportation component was excluded. Moreover, orders for capital goods, such as computers, rose 4.1% in August, after a 5.3% decline the previous month. The Commerce Department also upwardly revised its total reading on durable goods orders in July. The Dow roared out of the gate, spending the entire day in triple-digit gain territory. By the close, the Dow climbed 198 points, or 1.86%, and ended at 10,860. That brought the Dow's weekly gain to 2.4%. For the week, the SPX surged 2.1%, while the Nasdaq Composite led the pack with a 2.8% advance.
What the Trading Desk Is Expecting: Bulls Still Have Some Ammo Left
By Todd Salamone, Senior Vice President of Research
"It is no secret that the SPX comes into the week trading at the top of a four-month trading range. If the index manages to break above its upper boundary within the next few weeks, it would complete a bullish 'inverse head and shoulders' pattern...Contrarian investors should take note: the upside trade is not crowded, which makes it attractive. In fact, the crowd may be playing another topping formation in the 1,120-1,130 area -- the 'obvious' play to those with a bearish slant -- but also a trade vulnerable to a short-covering rally...
"One notable difference that we are seeing now relative to the two prior ventures into the 1,120-1,130 area since June is indications that hedge funds are seeing value around current levels...This would suggest to us a higher-probability chance of a breakout, as investors with an investment time frame beyond a day or week counter the actions of day traders and high-frequency traders playing the short-term, mean-reversion game."
--Monday Morning Outlook, Sept. 18, 2010
Is there too much optimism in the market at present, leaving us vulnerable to a setback? Given sentiment analysis is a key dimension of our market-timing approach, we took great interest in articles and interviews during the past week that suggested the market is vulnerable because optimism is at extremes. Before answering the question above, let's revisit last week's market action.
In the first trading session last week, the S&P 500 Index (SPX) pushed above resistance at the 1,130 level, breaking above a four-month trading range and completing a bullish inverse "head and shoulders" pattern. A three-day pullback to the 1,120 area, site of the 50% retracement of the 2007 peak and 2009 low, quickly followed. But by Friday morning, the bulls were back in control, with the SPX exploding above the 1,130 level on the heels of a better-than-expected durable goods orders report and a narrower-than-expected loss from homebuilder KB Home (KBH).
Another note of interest is that the SPX closed the week above 1,140, site of the 61.8% retracement of the April peak and July low. But the January high at 1,150 lingers just above.
Ahead of the breakout, a host of analysts claimed that there was too much optimism in the market, leaving them doubtful about an imminent breakout. Certainly, this is where assessing sentiment gets tricky – do you put these analysts in the bearish camp if they are warning investors about too much optimism?
For example, the weekly American Association of Individual Investors' (AAII) poll seemed to grab the attention of many market watchers. After all, going into last week's trading, the percentage of bulls in this survey had moved to 50%, from a low of 21% in late August. The bullish percentage reading hit our radar too, and is certainly a risk worth noting.
But we put more weight on option indicators suggesting that underweight institutional money is stepping into the stock market after a long absence. Given that market advances in 2009 and 2010 were driven by short covering and/or institutional purchases, our opinion is that the significance of institutional money returning to stocks trumps that of the sentiment expressed in an AAII survey. By the way, in the latest AAII poll, the bullish percentage dropped to 45%. Think about that: a bullish inverse "head and shoulders" breakout in the SPX is accompanied by a drop in the percentage bullish, with less than half of those surveyed claiming they are bullish.
Going into the last trading week of September, our analysis of option activity on major exchange-traded funds suggests hedged buyers are still in accumulation mode. In other words, put buying relative to call buying continues to be relatively healthy amid a market rally.
So, is optimism amid the SPX's breakout at an extreme?
First, on a subjective note, we do not see or hear the technician crowd getting vocal about the bullish implications of the inverse "head and shoulders" breakout pattern. This might be an indication that there is caution, or even downright pessimism among these folks, over whether the rally has staying power. Remember, when the bearish "head and shoulders" pattern developed weeks ago, we were continuously hit over the head with warnings of an impending decline.
On a more quantitative note, take a look at the historical data from the National Association of Active Investment Managers (NAAIM) survey in the chart below. (Here is how NAAIM describes itself on its website: "NAAIM member firms who are active money managers are asked each week to provide a number which represents their overall equity exposure at the market close on a specific day of the week, currently Wednesdays... Responses are tallied and averaged to provide the average long (or short) position of all NAAIM managers, as a group.")
Per the chart below, the black and blue lines represent the average exposure of this group. The higher their exposure, the more optimism there is among these investors. At present, sentiment is nowhere near the optimistic extremes that existed at the beginning of 2010 or in the April/May 2010 period. Perhaps the two major corrections this year have created a little bit of hesitancy among this group. The major takeaway here is that optimism among this group is nowhere near an optimistic extreme, suggesting there is still sideline money to power stocks higher.
Another tool we use to measure sentiment is the 10-day average of the all-equity, buy-to-open put/call volume ratio on the International Securities Exchange and Chicago Board Options Exchange. The lower this ratio, the more optimism there is among equity option players. As you can see on the chart below, the ratio is nowhere near the levels that have represented optimistic extremes in 2010.
The bottom line is there is still plenty of firepower to support a rally, suggesting warnings of too much optimism could be overblown. The wild card is whether hedged buyers will continue to deploy their cash into the market, based on fear of missing a year-end rally after the SPX's breakout above 1,130.
Support on the SPX is 1,130, while potential overhead resistance resides at 1,166, the index's close the day prior to the May 6 "flash crash." Despite warnings over an overly enthusiastic investing crowd, we think there is sideline power to drive stocks higher. At the same time, keep in mind that "anything can happen," so use cheap index puts to hedge your long positions.
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Indicator of the Week: A Streak Without Consecutive Down Days
By Rocky White, Senior Quantitative Analyst
Foreword: The S&P 500 Index (SPX) went almost a whole month without back-to-back down days. That streak, which spanned 19 trading days, ended on Wednesday last week. That was the third longest streak this year. In April, another streak ended at 21 days, and in January a streak ended at 28 days. The end of those streaks, which I marked on the SPX chart below, foreshadowed some pretty significant market pullbacks.
Daily SPX chart since January 2010
More Bad News: The chart above shows pullbacks at the end of the streaks, but it's only two data points. What if we go back farther, to say, 1990? The first table summarizes SPX returns after it goes at least 19 trading days without consecutive down days. We see it has happened 23 other times since then. The data is not very promising for the next month. In those 23 occurrences, the SPX was positive less than half the time one month later, and averaged no gain. The results were even more bearish in the shorter term (two weeks). However, when you look two months after a signal, you see the market outperforms when compared to the typical returns in the bottom table.
SPX data following signal since 1990
Finally, I show each individual result since 2000. Notice during the most recent streak, the SPX was up 8.36%. That's the biggest return during a streak since 2000 -- which is actually more bad news. The more the market gains during the streak, the more overbought it seems to be.
Looking at the one-month returns in the table below, when the SPX gained at least 4% during the streak, five of six are negative, averaging a loss of 6.8%. If the returns during the streak are up less than 4%, then four of five are positive, averaging a gain of 0.89%. The big returns are historically a bad sign.
SPX returns during streak and returns following streak
This Week's Key Events: Expect Deluge of Data on Friday
By Joseph Hargett, Senior Equities Analyst
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
* There are no major economic reports scheduled for Monday. Cal-Maine Foods Inc. (CALM), Jabil Circuit Inc. (JBL), and Paychex Inc. (PAYX) will report earnings.
Tuesday
* The Case-Shiller home price index for July and the Conference Board's Consumer Confidence Index for September will be released Tuesday. Walgreen Company (WAG) and Sealy Corporation (ZZ) are scheduled to issue their quarterly reports.
Wednesday
* We'll get the usual weekly report on U.S. petroleum supplies. Scheduled to report earnings are Actuant Corp. (ATU), American Greetings Corp. (AM), and Family Dollar Stores Inc. (FDO).
Thursday
* The report on new jobless claims will be available early, along with the latest look at second-quarter gross domestic product. Later in the morning, we'll get a read on manufacturing activity in the Midwest when the Chicago purchasing managers' index is released. Accenture Plc (ACN) and McCormick & Company, Inc. (MKC) will report earnings.
Friday
* Friday will be chock full of economic data. The Commerce Department alone will report on August construction spending, personal income and spending, and September auto sales, while the University of Michigan will give us a final look at consumer sentiment in September. The Institute for Supply Management will release its September manufacturing index. There are no earnings reports scheduled for Friday. |
