Monday Morning Outlook: The No. 1 Technical Risk to the Market
A Fed policy decision and October jobs data are just over the horizon
by Todd Salamone 10/29/2011 9:00 AM
schaeffersresearch.com
Stocks ended the week broadly higher, boosted by major signs of progress out of the debt-laden euro zone. While there are still plenty of details left to hammer out, the united front presented by European leaders was sufficient to send the major market indexes north of significant technical levels. The rally was broad-based, with both small- and large-cap stocks scoring meaningful victories on the charts. Since big-money players have some ground to make up before year-end, it's not unreasonable to think the positive momentum could continue. But, as Todd Salamone notes, there are still several risks to the bullish case as we wrap up the month of October. Fortunately, Rocky White has crunched the numbers on the market's leaders and laggards to find out which names might be poised to outperform during the near term.
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 -- including an update on the suddenly surging financial sector.
Notes from the Trading Desk: Hedge Funds Could Play Year-End Catch-Up
By Todd Salamone, Senior VP of Research
"The VIX spike to an area that has historically marked buying opportunities, coincident with various indexes finding support at intriguing levels this past week, suggests you can begin accumulating equities in the small- and mid-cap spaces -- but do so on a smaller scale than normal. The equity market is not out of the woods, despite some initial signs of stability. For example, the RUT is still below 750, and the MID remains below 900."
- Monday Morning Outlook, August 13, 2011
"We have been saying for weeks that the increasingly negative sentiment backdrop could lead to sharp gains in the market, but investors first needed a reason to cover their shorts or move from the sidelines... a positive outcome in Europe could produce a continued fourth-quarter rally, as fund managers aggressively accumulate long positions or short covering emerges as the technical backdrop improves."
- Monday Morning Outlook, October 22, 2011
"The selloff in most of the global markets in the third quarter heavily impacted a large number of hedge funds. In fact, not only did it put many funds into the red for the year, it pushed a huge number of hedge funds below their high water mark. According to HFR, at the end of the third quarter just 19.3 percent of all hedge funds were above that critical level that determines whether their investors' accounts are in the black."
- Institutional Investor, October 21, 2011
Judging by the price action this past Thursday, when the S&P 500 Index (SPX - 1,285.09) rallied 3.4% and the Russell 2000 Index (RUT - 761.00) jumped 5.2%, European leaders' plan to address the sovereign debt issues in their region was well-received. While Europe stole the headlines, a respectable third-quarter U.S. GDP report also soothed wary investors. The 2.5% increase was driven primarily by solid consumer spending as inventory building came in less than expected, brightening the economic landscape ahead.
On the heels of the news, volatility indexes dropped sharply as stocks roared higher, with the Dow Jones Industrial Average (DJIA - 12,231.11) climbing above the 12,000 millennium mark for the first time since Aug. 1, and the PowerShares QQQ Trust (QQQ - 58.94) once again challenging its 2011 highs.
Leadership came from the small- and mid-cap equities, continuing a long trend in which large-cap, defensive names outperform only in weak market environments, while small- and mid-cap stocks lead the charge during bullish runs. Encouraging for the bulls is that the SPX, RUT and S&P 400 MidCap Index (MID - 910.64) advanced above key levels we have identified in the past, and the CBOE Market Volatility Index (VIX - 24.53) fell below a key mark. For example:
- The SPX advanced above the 1,255-1,260 zone -- site of its 2011 breakeven point, the 61.8% Fibonacci retracement of this year's high and low point, and its 120-day moving average.
- The RUT took back the 750 mark, which is where it was trading right ahead of the Lehman Brothers collapse in 2008 and the flash crash of 2010. But work remains, as the RUT is still 23 points away from making a run at its 2010 year-end close of 783.65.
- The MID closed the week back above the critical 900 century mark, an area that acted as resistance for months in 2007 before the index experienced a 55% haircut into the 2009 trough. Furthermore, the MID moved barely back into the green for 2011 as of Friday's close, after rallying above its breakeven at 907.25 to settle at 910.64.
- The VIX fell below the 30-31 zone, which is an area that has spelled trouble for the equity market since September and represents double the 2011 low. The VIX's failure to advance above 50 in August, a multi-year resistance level going back to 1997, plus the subsequent break below the 30 mark is encouraging for bulls. The next key level on the VIX is 24, which is August's half-high.
While the technical backdrop has improved on many fronts, there is still work to be done to further pressure the shorts and/or drive sideline cash into the equity market. Some of these risks are still technical related, as multiple potential resistance areas come into play when equities dig out of a deep hole.
That said, three short-term risks to the bullish case include:
- The RUT is still in the red for 2011, and the MID is barely in the green, with the index's first-half lows just overhead at 920. The fact that the MID is trading around a key round number with historical significance, which also happens to coincide with its year-to-date breakeven, is perhaps the No. 1 risk from a technical perspective. It will be of importance for the MID to make a more convincing move above 900 in order to squeeze more shorts.
- Another technical risk relates to the QQQ, a benchmark driven by many large-cap technology stocks. While outperforming impressively, it still has not taken out the 60 level, which is half its all-time high and has marked multiple peaks in 2011.
- A third risk is that much of the short covering related directly to the huge build-up of put open interest in exchange-traded fund (ETF) and index options is likely expended, as heavy put strikes that will expire in a few weeks are far out of the money and less sensitive to market gyrations. That said, short covering is still possible on individual equities, and those that are highly shorted with a strong technical and fundamental backdrop are likely to lead if the market continues to rally.
The bottom line is, the equity market's backdrop continues to improve, even as many hedge funds have been significantly underinvested and are in the red this year. With more clarity on how Europe plans to address their issues amid an improved technical backdrop, risk-taking could increase significantly and drive stocks higher in the coming months, as fund managers look to play "catch-up" with the year winding down. Risks do remain, so it's still prudent to hedge your long positions -- even though some market players may choose to forgo such a strategy in order to try and capture quick gains in a short period.
Indicator of the Week: Leading & Lagging Stocks During Big Market Gains
By Rocky White, Senior Quantitative Analyst
Foreword: Last Thursday, the S&P 500 Index (SPX) had its third-biggest day of the year, rising 3.4%. Those are the type of days where you get excited to see how your portfolio did. However, there's nothing more demoralizing than being heavily exposed to a stock (or group of stocks) that does not participate in such a strong rally. It got me curious to compare the stocks which did participate against those that did not participate. Is this a signal that non-participating stocks are weak, and should be sold -- or is the opposite true? It seems that many recent studies show that stocks have a strong tendency to mean-revert, where equities that are weak over a certain time frame will generally tend to outperform going forward.
Leading & Lagging Stocks: To analyze this, I looked at days when the SPX gained 3% or more going back to 2010. This time frame includes six prior returns of 3% or more (actually, seven -- but one just occurred on Oct. 10, for which we do not yet have a one-month return). Then, I organized the stocks into three groups based on their relative strength to the market. The stocks that underperformed (relative strength of less than 0.97) are listed as "laggards," those that outperformed (relative strength above 1.04) are the "leaders," and those in the middle... well, they're the "middle."
The table below shows mean reversion ruling the day, as the leading stocks on big up days significantly underperformed the laggards and middle-of-the-road stocks. Meanwhile, the laggards were the strongest performers going forward.
Finally, below is a list of 25 of the most liquid stocks that qualified as "laggards" during Thursday's big market rally. According to the research above, these names could have a tendency to outperform other stocks during the short term. The list is sorted from the worst-performing stocks on Thursday to the best.
This Week's Key Events: FOMC Decision, Jobs Data on the Horizon
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 economic calendar begins with Monday's release of the Chicago purchasing managers index (PMI) for October. Allstate (ALL), Humana (HUM), AvalonBay Communities (AVB), Cavium (CAVM), Leap Wireless (LEAP), Taser International (TASR), Anadarko Petroleum (APC), and W&T Offshore (WTI) are scheduled to report earnings.
Tuesday
- The ISM manufacturing index is set to hit the Street on Tuesday, along with data on construction spending and auto sales. On the earnings front, we'll hear from Pfizer (PFE), Marathon Oil (MRO), Valero Energy (VLO), Archer Daniels Midland (ADM), CF Industries (CF), Corinthian Colleges (COCO), Dollar Thrifty Automotive (DTG), Dunkin Brands (DNKN), OpenTable (OPEN), Overseas Shipholding Group (OSG), Primerica (PRI), Sirius XM Radio (SIRI), and XL Group (XL).
Wednesday
- The monthly onslaught of jobs data begins on Wednesday, with ADP's private-sector employment report and the Challenger, Gray & Christmas update on monthly job cuts both due for release. Around midday, the Federal Open Market Committee (FOMC) will announce its latest monetary policy decision, with a 2:15 p.m. press conference to follow. Earnings are due out from Kraft Foods (KFT), Mastercard (MA), News Corp. (NWS), Qualcomm (QCOM), AOL (AOL), Time Warner (TWX), Comcast (CMCSA), Clean Harbors (CLH), Transocean (RIG), Dendreon (DNDN), Whole Foods Market (WFM), Tesla Motors (TSLA), and Zipcar (ZIP).
Thursday
As usual, Thursday's calendar features weekly jobless claims. Also on the day's docket are the ISM services index, third-quarter productivity and labor costs, and factory orders. Meanwhile, quarterly earnings reports are expected from American International Group (AIG), Starbucks (SBUX), Kellogg (K), Sara Lee (SLE), Eastman Kodak (EK), Chesapeake Energy (CHK), Alpha Natural Resources (ANR), CBOE Holdings (CBOE), NYSE Euronext (NYX), MGM Resorts (MGM), Agrium (AGU), CBS Corp. (CBS), DirecTV (DTV), Estee Lauder (EL), LinkedIn (LNKD), and SunPower (SPWRA).
Friday
- Bright and early Friday morning, all eyes will be on the Labor Department's nonfarm payrolls report for October. The earnings calendar wraps up with reports from Plains Exploration and Production (PXP), Washington Post (WPO), Olympic Steel (ZEUS), YRC Worldwide (YRCW), Broadwind Energy (BWEN), Genpact (G), Horsehead Holding (ZINC), and Madison Square Garden (MSG).
And now a few sectors of note...
Dissecting The Sectors
Sector Utilities
Bullish
Outlook: The utility sector has emerged as a pocket of technical strength in 2011, with the PHLX Utility Sector Index (UTY) breaking out above the $455-$460 region to touch a new three-year high this past week. However, Wall Street hasn't exactly jumped on the bullish bandwagon just yet. Drilling down, 70% of stocks in the electric utility group are trading above their 200-day moving averages, but they've attracted only 40% "buy" ratings from brokerage firms. Meanwhile, the gas utility group boasts the highest percentage of stocks trading above their 200-day moving averages among all sectors we follow, at 76% -- yet these names have garnered only 49% "buy" ratings. The broader utility sector also sports some attractive dividend yields, which are certainly a selling point in the context of a choppy market environment. Within the group, Duke Energy (DUK) and Consolidated Edison (ED) have racked up double-digit percentage gains in 2011, and both stocks are within striking distance of their respective annual highs. Nevertheless, there's not a single "buy" endorsement between the two. Going forward, a round of well-deserved upgrades could draw a fresh wave of buyers to the table, helping these stocks extend their positive price action.
Sector Leisure/Retail
Bullish
Outlook: The Commerce Department noted recently that retail sales rose by a solid 1.1% in September, marking the biggest monthly increase since February. However, the National Retail Federation is predicting a year-over-year slowdown in holiday sales. For what it's worth, this group underestimated 2010 holiday sales growth by more than half -- leaving room for another potential upside surprise this year. Meanwhile, on the charts, the SPDR S&P Retail ETF (XRT) is making a run at its all-time high of $56.44, which was touched back in July. One point of caution is the XRT revisiting a 10% year-to-date gain, as the fund stalled around these returns in May and June. We remain upbeat on select outperformers within the consumer discretionary group, and recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism. Amazon.com (AMZN) got hit hard on earnings last week, but we still like the shares on a pullback. Looking back, AMZN has a long history of sharp, scary pullbacks that are quickly resolved to the upside. Choice restaurant stocks also hold some appeal, with under-loved names like BJ's Restaurants (BJRI), Chipotle Mexican Grill (CMG) and Domino's Pizza (DPZ) basking in the glow of positive earnings reports. As these high-flying discretionary names continue to outperform on the charts, a capitulation by the lingering skeptics could provide an influx of buying pressure.
Sector Gold
Bullish
Outlook: A recent pullback in the SPDR Gold Trust (GLD) was contained by its 120-day moving average, which has played a key role as support over the past couple of years. After meeting up with this reliable technical floor, GLD rallied, breaking out above short-term pressure at its 80-day moving average in the process. On the sentiment front, various indicators we track point to significant pessimism on gold, even as the technical backdrop improves. Plus, cumulative buy-to-open option volume is beginning to pick up once again on GLD, following a recent plunge in activity. Previous downturns in buy-to-open option volume have corresponded with periods of weak price action, whereas increasing buy-to-open volume has corresponded with strength -- suggesting this latest bounce from trendline support could herald the beginning of the next leg higher within GLD's longer-term uptrend.
Sector Financials
Bearish
Outlook: The financial sector outperformed during the second half of October, taking part in a broad-market advance sparked by signs of progress on the European debt crisis. The bears were stung by this bounce in bank stocks, which propelled the Financial Select Sector SPDR (XLF) back above the historically significant $13.50 area. However, the fund is still in negative territory year-to-date, even as the broader S&P 500 Index (SPX) has moved into the green for 2011. Meanwhile, short interest on XLF has increased, and we have seen what appears to be hedged call buying on the fund. In the past, heavy shorting amid XLF call buying has preceded periods of weak price action. It remains to be seen if this most recent bout of shorting activity is smart money at work, especially in light of the sector's sudden outperformance. It's worth noting that the financial group also rallied strongly at this time last year, as beaten-down banks became a favorite among bargain-hunters. Should the market rally into year-end, there is a possibility of repeat performance -- with another possible let-down in 2012. Given this mixed outlook, it may be appropriate to lighten up on short financial exposure at the moment. However, if the group's positive momentum begins to break down, it could signal an opportunity for the bears to pile back on.
Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insight about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.
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