Monday Morning Outlook: Using the VIX as a Road Map
Five compelling sentiment indicators to comfort contrarian bulls in a choppy market
by Todd Salamone 9/10/2011 11:03 AM
schaeffersresearch.com
It was an abbreviated holiday week, but there was no shortage of drama on Wall Street during the past four sessions. With traders anxious to grasp at any available sliver of hope after a major August payrolls miss, much-hyped speeches from Federal Reserve Chairman Ben Bernanke and President Obama were both very well-received... until they were actually delivered, with traders pricing in back-to-back anticlimaxes by the final day of the week. Serious questions about the health of the global economy remain unanswered, giving investors little motivation to step back into an increasingly unpredictable market.
This week, Todd Salamone cites evidence of an uneasy mood among hedge fund managers -- which, coupled with the uninspiring price action, suggests that it's still too soon to sound the all-clear signal. However, Todd can think of at least five compelling reasons why traders might want to maintain some (selective) equity exposure, even as the market's relentless pops and drops keep investors on their toes. Meanwhile, Rocky White weighs the facts to decide whether it's time to write the obituary on stock-picking in the current, high-correlation environment. Finally, we wrap up with a preview of the key economic and earnings events for the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: Why Bulls Need to Watch the VIX's Call/Put Ratio
By Todd Salamone, Senior VP of Research
"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." "An additional risk to the bulls is the action in the CBOE Market Volatility Index (VIX), 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."
- Monday Morning Outlook, September 3, 2011
Since early August, U.S. stocks have been engaged in a volatile chop, reacting to a mix of positive and negative headlines out of Europe and here at home. Last week ended with a thud, after Fed Chairman Ben Bernanke failed to offer any meaningful stimulus hints; President Obama's American Jobs Act created the potential for more bickering among Congressional leaders; and the resignation of the European Central Bank's chief economist stirred more uncertainty with respect to the debt problems in Europe. We enter this week's trading nearer the bottom of the recent trading range.
With the major market indexes now in negative territory for the year after peaking four months ago, such headlines create more uncertainty and a "sell first, ask questions later" mentality among investors. At the same time, pessimism is growing, which can lead to rapid advances when positive news hits the wires -- potentially sparking brief short-covering rallies.
From a contrarian perspective, the building pessimism makes it very tempting to buy equities. Consider that:
- There has been a 15% increase in short interest since March, although short interest is still far from the peak levels of the financial crisis.
- In August, the $36 billion in outflows from domestic equity funds was the second highest ever.
- Hedge fund managers have been selling for months, although we have seen a little bit of evidence that some are dipping their toes into equities. With $2 trillion under management, this is an industry that could immediately propel stocks higher at any given time.
- On individual equities, the number of puts that have been bought (to open) relative to calls bought (to open) is the highest in two years, suggesting more bets are being placed against individual stocks, and/or hedging of individual stock positions is growing -- both signs of an increasingly cautious crowd.
- Last week's survey of investment advisers by Investors Intelligence revealed that the percentage of bulls and the percentage of bears is nearly the same. This is unusual, as it is typical for bulls to outnumber bears. On previous occasions when the two factions have neared parity, major buying opportunities have occurred. One exception was in 2008, when the bearish percentage was significantly higher than the bullish percentage before stocks began climbing.
But as we've been stating for weeks now, the price action and/or headlines have to make a dramatic improvement before a major unwinding of this pent-up negativity will occur. At present, those playing the market from the short side haven't had a strong reason to cover short positions, and those on the sidelines -- whether in cash or other assets -- have not "missed out" on anything in months, and thus do not feel any pressure to chase the market.
For example, the S&P 500 Index's (SPX - 1,154.23) advance early last week was stopped cold in the 1,200 area, just below its historically significant 80-week moving average. Plus, the index faces stiff resistance at 1,225 -- which, as we mentioned last week, is the site of its 80-month moving average and a 50% retracement of the recent highs and lows. At a minimum, bulls would like for these levels to get taken out, but should also be watching 1,100 as potential support. This round-number area is the site of the SPX's key 40-month moving average, as well as the index's recent lows.
Moreover, the popular Dow Jones Industrial Average (DJIA - 10,992.13) came within 100 points of its year-to-date breakeven, at 11,577.51, before being turned back. And the tech-based PowerShares QQQ Trust (QQQ - 53.18) experienced a similar fate as the DJIA last week, climbing just above its 2011 breakeven point at $54.46 before a sharp sell-off took hold.
The Russell 2000 Index (RUT - 673.96) did not make a serious attempt to take out its "flash-crash" high of 750, and the S&P 400 MidCap Index (MID - 823.36) still has not made a convincing run at 900 (its 2007 peak, and now a potential resistance area). The 650 level on the RUT and the 765 area on the MID are the next significant levels of support.
If you are using the CBOE Market Volatility Index (VIX - 38.52) as a road map, we continue to think a break back below the 30 level is important for the bulls, while the bears would welcome a move above the 50 area, which was the site of the recent high and several other major peaks dating back to 1997. While we are seeing increased put buying relative to call buying on major exchange-traded funds (ETFs) based on equity indexes -- a sign that some hedge funds are inching back into the market -- we are concerned about the lack of call buying on VIX options, which are another hedging vehicle for fund managers.
Specifically, an increase in VIX call buying can be a sign of hedged players accumulating equities, as the VIX will tend to increase sharply if stocks falter badly. But as you can see on the chart below, the VIX's buy-to-open call/put ratio continues its descent, suggesting there may be some fund managers still playing the short side of this market.
With one of our hedge ratios suggesting that fund managers are no longer actively shorting stocks, and the other suggesting that shorting activity continues, there is a strong possibility that fund managers have conflicting views at present, which might explain the volatile, range-bound activity we've experienced in recent weeks. This is in contrast to the relentless selling that took place in the weeks prior, when all of the hedged option activity we were seeing was suggesting an increase in shorting activity. At this stage, increased VIX call buying would be a plus for the bulls as potential evidence that more hedge fund players are warming up to equities.
Our takeaway is that this is a market that has the proper sentiment backdrop for a major V-bottom, but the technical backdrop is not as supportive. So, in the absence of a catalyst, the pressure to unwind bearish bets or move from the sidelines is not as great. Therefore, we continue to recommend that you maintain a healthy exposure to gold and bonds, avoid financials, and be open to buying stocks that you like on pullbacks to support, as "pops" can be equally as sharp as "drops" in the current environment.
Indicator of the Week: Death of a Stock Picker
By Rocky White, Senior Quantitative Analyst
Foreword: It's getting harder and harder to be a stock picker in this market. It seems stock fundamentals are taking a back seat to the latest Fed speech, jobs report, news from Europe or policy proposal, depending on the day. So, maybe we should all become macroeconomists?
I found the chart below to be particularly striking. Using S&P 500 Index (SPX) stocks, I found the 21-day correlation of returns of the individual stocks to the index itself. The average correlation is almost 90% right now! That's even higher than where it peaked during the 2008 market crash.
Wherever the Market Goes... : Here's another way to illustrate my point. Look at the table below showing what the market has done each day so far this month. The last column shows the percentage of stocks that moved in the same direction as the market (looking at about 2,700 stocks in our database). What is a stock picker worth when about 90% of stocks are moving in the same direction?
Here's a chart with a longer-term look at this data. Again, it's pretty shocking. During the 1980s, the percentage of stocks moving with the market on a daily basis was typically only in the 40s or 50s, and peaked in the 60s during the 1987 crash. The percentage was consistently in the 50s during the tech boom, and then rose pretty significantly when the tech bubble burst. Since then, this metric has remained at a higher level. During this most recent pullback, the number shot higher, reaching just above 80%. Prior to this, the only previous time the percentage jumped this high was at the peak of the 2008 crash.
This Week's Key Events: Inflation Data, Consumer Sentiment on Tap
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 due out on Monday. A light week of earnings kicks off with the latest quarterly reports from Brady Corp. (BRC) and Pharmacyclics (PCYC).
Tuesday
- The monthly report on import/export prices will hit the Street on Tuesday, along with the latest Treasury budget. On the earnings front, we'll hear from Best Buy (BBY) and Cracker Barrel (CBRL).
Wednesday
- Wednesday's economic calendar features the producer price index (PPI) and retail sales for August, July's business inventories, and the regularly scheduled weekly update on domestic petroleum supplies. Clarcor (CLC) and Pall Corp. (PLL) are expected to report earnings.
Thursday
The data will be flying fast and furious on Thursday, when traders will digest the Empire State manufacturing index and Philly Fed business index for September, the consumer price index (CPI) for August, industrial production and capacity utilization, and the usual report on weekly jobless claims. Earnings are due out from Research In Motion (RIMM), Diamond Foods (DMND), and Pier 1 Imports (PIR).
Friday
- The preliminary Reuters/University of Michigan consumer sentiment index for September will be released on Friday. Netsol Technologies (NTWK) wraps up the week's slate of earnings reports.
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 still up in the air. The fund found a foothold this past week at its 80-week moving average, and is still trading above support in the $45 area. However, XRT continues to be stymied by the $50 area, which is home to a convergence of its 40-day, 160-day, and 195-day moving averages. Plus, the ETF ended yet another 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 be an indication 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 223% 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. However, with the likes of Novellus (NVLS), Texas Instruments (TXN), and Fairchild Semiconductor (FCS) recently slashing their financial guidance in the face of weak demand trends, the outlook for this struggling group seems unlikely to improve anytime soon. 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) recently filed suit 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 mount 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 tumbled lower after an unsuccessful test of the $13.50 level, which previously served as major support during 2010. Going forward, this area could prove to be a troublesome resistance level. As a point of caution, the 50-day buy-to-open call/put volume ratio for XLF has rolled over sharply from its rent 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% bottom-to-top 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 a risk to any short positions in the big-cap financial sector. |
