Monday Morning Outlook: Bracing for the U.S. Debt Downgrade
Reaction Key technical levels to watch as stocks respond to S&P's ratings cut
by Todd Salamone
8/6/2011 9:30 AM
schaeffersresearch.com
It was a generally brutal week in the equities market -- and that was before Standard & Poor's came out with its late-Friday downgrade of U.S. debt. Despite what The Wall Street Journal described as "a $2 trillion error in S&P's math," the agency predicted a rapidly ballooning domestic deficit, accused the government of instability, and cut its credit rating to AA-plus with a negative outlook -- indicating that additional downgrades are not out of the question. While it could be argued that traders spent most of the week pricing in their panic over just such a move, a relief rally hardly seems inevitable.
Particularly troubling, says Todd Salamone, is the fact that several major support levels were broken by the time last week's wild ride wrapped up. As we head into what will surely be a memorable five days on Wall Street, Todd takes a look at the next technical lines of defense for U.S. stocks. Meanwhile, Rocky White's analysis seems to confirm that more short-term pain is likely, now that the S&P 500 is trading well below its 200-day moving average. Finally, we wrap up with a preview of this week's key economic events, as well as a few sectors of note.
Notes from the Trading Desk: Checking the Market for a Pulse
By Todd Salamone, Senior VP of Research
"Last week's option activity on those major ETFs once again created a roll-over in the combined 20-day buy-to-open put/call volume ratio that we closely follow. It's too early to tell if this is temporary or not, as this action was more than likely related to the uncertainty ahead of Congress' Aug. 2 deadline. The risk to the bulls is an extended decline of this ratio, which would suggest continued hedge-fund liquidations and/or increased shorting among hedge funds. The last time this ratio rolled lower from the spot of last week's peak (in March/April), the SPX corrected 7% from top to trough. At Friday's lows, the SPX had dropped about 4.5%. "While we still feel that the risk-reward scales are tipped in the bulls' favor, one should allow for the possibility of support levels breaking, as the final panic may not yet be in place... Our long model portfolio (Schaeffer's Master Portfolio) has exposure to gold, bonds and several consumer discretionary stocks that are highly shorted, unloved by Wall Street analysts, and displaying strong price action amid favorable earnings momentum."
-- Monday Morning Outlook, July 30, 2011
Gold and bonds proved to be excellent places to hide last week, with both assets soaring as equities indeed broke support levels amid persistent worries about the domestic economy and troubles in Europe. At Friday's low, the S&P 500 Index (SPX - 1,199.38) lost 124 points from the previous week's close, or nearly 10% -- in official "correction" territory, as noted by many media outlets.
Meanwhile, as you might have already guessed, the 20-day customer-only, buy-to-open put/call volume ratio on the major exchange-traded funds (ETFs) retreated sharply lower, in a continuation of the decline we discussed last week. This would indicate that hedged players were in anything but accumulation mode, and were likely liquidating or actively shorting, coincidentally putting a huge amount of pressure on the market.
If you're a bull, you are drawn to the fact that this ratio is approaching levels from which the market has previously staged impressive rallies. But before getting aggressive on the long side, it might be beneficial to see this ratio turn higher once again.
Of course, it might also be worth it to confirm that the market has a pulse, from a price-action perspective, after last week's drastic spill. We noticed, for example, that since the decline from resistance in the 1,340 area, rally attempts have been capped at key intraday moving averages that we follow on a five-minute chart. So, at the very least, aggressive bulls looking for an entry point might wait for the SPX to rally back above these trendlines before initiating new long positions.
Also, the key 1,200 century mark on the SPX is also the approximate site of its 80-week moving average (1,206.10), which caught the lows at the July/August 2010 bottom. The index's weekly close below this trendline and the 1,200 century mark is a cause for concern heading into this week's trading.
If you need more convincing, in terms of price action giving you "permission" to enter new long positions, you should look for the S&P MidCap 400 (MID - 844.78) and Russell 2000 Index (RUT - 714.63) to rally back above 900 and 750, respectively. Without leadership and a much-improved technical backdrop in these indexes, stocks will remain vulnerable.
The 900 level on the MID acted as resistance in 2007-2008 prior to a brutal pullback in this index. The decline back below this former resistance level puts the bears in control, and thus a move down to the index's 80-month moving average, at 764, could be in the offing. The 80-month moving average acted as support at the 2002 bottom and at the July/August 2010 bottom, while a move below this trendline in October 2008 was a precursor of more damage to come.
Turning to the RUT, 750 marked a peak before the May 2010 "flash crash," establishing this round-number level as a significant one to watch. Moreover, the RUT broke below its 80-week moving average last week, which is currently sitting at 729.54. It was the first weekly close below this trendline since September 2009 -- not something the bulls wanted to see.
For what it's worth, the 80-month moving average on the RUT is sitting at 686.91. This trendline was supportive during pullbacks in 1998 and 2001, but when broken to the downside, is predictive of more selling.
Due to Thursday's slide and Friday's steep mid-morning pullback, the CBOE Market Volatility Index (VIX - 32.00) spiked, reaching its highest levels since the aforementioned flash crash. Friday's VIX high of 39.25 was 68% above SPX realized volatility, with extremes being 100% above SPX realized volatility. Therefore, the jury is out as to whether or not the VIX has indeed peaked, but from this perspective, there is certainly room for the VIX to move higher and challenge its May 2010 high in the 48 area.
With the storm cloud of the S&P debt downgrade overhead, the threat of another possible ratings cut on the horizon, and the market's technical backdrop now in question, we advise maintaining long exposure to gold and bonds to hedge your long equity exposure. We remain bearish on big-cap banks and big-cap technology stocks. We still have exposure to consumer-discretionary names, but would not add to this group until price action begins to improve, which could put renewed pressure on the shorts.
Indicator of the Week: S&P 500 Falls Below Its 200-Day Moving Average
By Rocky White, Senior Quantitative Analyst
Foreword: It was another wild week in the market, and the S&P 500 Index (SPX) has now seen its biggest two-week slide since March 2009. The drop has taken us well below the index's 200-day moving average, which is a widely followed trendline among technical analysts. This week, I'm taking a look at past breaks of this moving average to see when the bleeding typically stops.
First Break in 200 Days: Prior to last Tuesday, the SPX had not closed below its 200-day moving average in almost year. Since September 2010, actually -- or, to be specific, 224 trading days. Below is a table showing the last 15 times a cross below the moving average occurred after at least 200 days above it. I also show typical, "at any time" SPX returns since 1975, which covers the time span of the 15 returns.
Notice in the very short term, the average returns are negative, despite the relatively high percentage of positive returns. This is because when the returns are negative, they are very negative. We've already experienced some of this, with the market down almost 5% since Tuesday's close.
The table also shows that if the SPX is negative over the next two weeks, it averages a loss of more than 5% -- doubling the typical average loss of 2.35%, and then some. On a brighter note, despite the bearish short term-returns, the longer-term returns (over three months and six months) significantly outperform typical market returns.
This Week's Key Events: Fed's Latest Rate Decision Due Out Tuesday
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
- There are no major economic reports scheduled for Monday, which means the U.S. debt downgrade may single-handedly steer the market action. On the earnings front, we'll hear from Tyson Foods (TSN), 99 Cents Only Stores (NDN), Dollar Thrifty Automotive (DTG), Brigham Exploration Co. (BEXP), Coeur d'Alene Mines (CDE), Silver Wheaton (SLW), Clean Energy Fuels (CLNE), Live Nation Entertainment (LYV), MGM Resorts (MGM), and Youku.com (YOKU).
Tuesday
- Tuesday's docket features a report on second-quarter productivity and labor costs from the Bureau of Labor Statistics (BLS). However, traders will likely be holding their collective breath ahead of the latest monetary policy decision from the Federal Open Market Committee (FOMC), which is due out in the afternoon. Quarterly earnings results are expected from Walt Disney (DIS), AOL (AOL), Demand Media (DMD), Fuel Systems Solutions (FSYS), Harbin Electric (HRBN), ReneSola (SOL), SunPower (SPWRA), Beazer Homes (BZH), Cree (CREE), Dish Network (DISH), and EchoStar (SATS).
Wednesday
- On Wednesday, we'll hear reports on wholesale inventories for June, the July Treasury budget, and weekly petroleum inventories. Scheduled to report earnings are Cisco Systems (CSCO), Computer Sciences (CSC), InterClick (ICLK), Macy's (M), Polo Ralph Lauren (RL), Advance Auto Parts (AAP), MBIA (MBI), News Corp. (NWS), and Jack in the Box (JACK).
Thursday
- Weekly jobless claims are due out on Thursday, along with June's trade balance. Brinker International (EAT), Red Robin Gourmet Burgers (RRGB), Wendy's Co. (WEN), Sara Lee (SLE), SodaStream International (SODA), Nvidia (NVDA), Renren (RENN), Hoku Corp. (HOKU), Kohl's (KSS), Nordstrom (JWN), and Molycorp (MCP) are expected to report earnings.
Friday
- The economic calendar concludes on Friday with the release of retail sales for July, June's business inventories, and the preliminary Reuters/University of Michigan consumer sentiment index for August. Meanwhile, J.C. Penney (JCP), Century Casinos (CNTY), Mentor Graphics (MENT), and Tree.com (TREE) will share the earnings spotlight.
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