The Dow Dips Below Breakeven for 2012; Will Others Follow?
The most important technical levels to watch this week
by Todd Salamone 6/2/2012 9:30:13 AM
Traders emerged from the holiday weekend refreshed, rested, and ready to trade. Unfortunately, the buying campaign that powered the markets higher on Tuesday was a distant and bittersweet memory by the time Friday's calamitous session rolled around. The seemingly never-ending plague of worries from the euro zone teamed up with disappointing numbers on domestic soil to send the Dow Jones Industrial Average (DJIA) into the red for the year. All may not be lost for the bulls, however, as Todd Salamone points out some remaining technical areas that could serve as significant support against an increasingly skeptical sentiment backdrop. For option traders wondering what path to take as volatility builds, Rocky White shares whether cheap or expensive options make the most sense. Finally, we wrap up with a look at next week's notable earnings and economic events, as well as three sectors of note.
Notes from the Trading Desk: Minding Our Breakeven Levels
By Todd Salamone, Senior VP of Research
"Even if the 320-day moving average is taken out, the bears would likely be challenged by other longer-term support areas -- namely in the 1,240-1,280 area. This area represents the SPX's year-to-date breakeven (1,257), and is home to other long-term moving averages that have acted as support and resistance on pullbacks over the years -- most notably, the 80-week and 80-month moving averages, perched at 1,287 and 1,240, respectively."
"...the sentiment backdrop at present is one that usually marks important bottoms. Therefore, the SPX low at 1,291 support during expiration week, the PowerShares QQQ Trust's (QQQ) pullback to its half all-time high in the 60 area, and the Russell 2000 Index's (RUT) pullback to its 2012 breakeven and the 750 area -- site of the peaks ahead of the Lehman Brothers crisis in 2008 and 'flash crash' in 2010 -- argues for a bottom being in place... "
"...with the SPX trading below 1,333 (the March 2009 double-low) and 1,340 (resistance in 2011), the bulls are not yet out of the woods. And as an added risk as we head into the holiday weekend and shortened trading week, the CBOE Market Volatility Index (VIX) remains above 20.49 and 21.36, which are 50% above the intraday and closing March lows. Up until recently, this area provided resistance, but acted as support this past week." - Monday Morning Outlook, May 26, 2012
It may go without saying that the technical backdrop deteriorated this past week, especially after Friday's drubbing -- ignited by an employment number that came in far below expectations -- fanned worries that our economy has hit an abrupt slowdown. This report came in as credit issues continue to fester in Europe and emerging economies (such as China and India) show evidence of slowing down after previously growing at a blistering pace.
As we head into next week's trading, here are some technical notes of interest that might be useful in preparing for the weeks ahead:
- The S&P 500 Index (SPX – 1,278.04) dropped below 1,290, site of the index's 320-day moving average and a 38.2% Fibonacci retracement of its October low (1,074.77) and April peak (1,422.38). This breach followed Tuesday's failed attempt to push above 1,333, double the 2009 low on the index and a level we viewed as important for bulls. The drop below 1,290 leaves the market vulnerable to more selling, although as mentioned last week and excerpted above, there are other areas of potential support in the 1,240-1,280 region, which could save the day for the bulls after a disappointing failure to hold 1,290.
- The Dow Jones Industrial Average (DJIA – 12,118.57) moved into negative territory for the year last week when it fell below 12,217.56. Year-to-date breakeven levels for other key benchmarks are listed below and could serve as pivotal levels in the week or weeks ahead, if more selling persists:
- The Russell 2000 Index (RUT – 737.42) peaked last Tuesday right at its 320-day moving average in the 780 area. This moving average is now rolling over, which is an ominous sign. The failure at 780 was followed by a break below 750, a key level that marked peaks in the small-cap index ahead of Lehman going under in 2008 and the "flash crash" in 2010.
- In concert with the SPX's failure at 1,333, the CBOE Market Volatility Index (VIX – 26.66) bottomed last week in the 20.49-21.36 area that is 50% above the March intraday low and closing low. In late April, this area acted as resistance and defined short-term buying opportunities for stocks. Since mid-May, however, pullbacks in the VIX to this area have signified selling opportunities. The next area to watch as potential resistance for the VIX is between 27.32 and 28.48, which is the double range of the VIX's March intraday and closing lows.
Continuing with the VIX discussion, we thought Friday's 10.8% advance was relatively mild amid a near-2.5% drop in the SPX. Since 1990, there have been 98 instances when the VIX was below 30 ahead of a single-session SPX plunge of 2% or worse. The average VIX "pop" in this scenario was 14%, which suggests Friday's move was relatively mild. This might suggest a modest amount of complacency heading into next week. Such a backdrop might leave the market vulnerable to additional selling, but hopefully not like that seen in January 2008...
In mid-January 2008, the VIX crawled higher by 2% (from 22.90 to 23.34) on a 2.5% SPX drop (similar to Friday's decline). During the following week, the SPX surrendered more than 5% before a short-term bottom was in place. This proved to be an extreme in complacency for 2008. Still, a VIX pop of 20% or more on Friday might have been a more comforting sign for the bulls, indicating that panic selling has finally arrived.
The sentiment backdrop continues to grow more pessimistic and remains consistent with negativity seen at major bottoms during corrective pullbacks the last few years. Hedge funds are no longer showing interest in stocks, the National Association of Active Investment Managers' survey reported the lowest allocation to equities since October 2011 (among active investment managers), and the 10-day, equity-only, buy (to open) put/call volume ratio is rising and approaching the Fall 2011 peak. The risk to bulls is that the sentiment backdrop worsens from here, but bears should also be on guard for a reversal in the sentiment backdrop, as major short-covering could follow.
As we said last week, play the current risk in the market via put plays or short positions on large-cap financial names, such as JPMorgan Chase (JPM). Agricultural commodity stocks also look particularly vulnerable. If you are looking to enter long positions, a pullback to the SPX breakeven point or a VIX move into the 27-28 area could present decent entry points for potential short-term rewards, but keep your stops tight in the event the current pullback has more life in it
Indicator of the Week: Cheap Options vs. Expensive Options
By Rocky White, Senior Quantitative Analyst
Foreword: One of the first things option players must realize in order to be successful is that they are not simply trading stock prices; they are also trading volatility. Option prices consist not only of intrinsic value but also time value, which factors in the implied volatility of the stock. Any move in the stock must overcome this time value for the option to yield a sufficient profit.
Established large-cap companies typically have very low implied volatilities. Their options are therefore often priced cheaper than options on other stocks, which in turn means a smaller stock move is required to turn a decent profit in the options. While stocks that have high implied volatilities need to make a bigger move for a similar profit, the chance of that big move is considered to be much higher.
This is the trade-off every option buyer must consider. On one hand are low-priced options that can profit handsomely on a relatively small move in the underlying. On the other are high-priced options on stocks that need to make a sizable move for the option to profit, but the potential for that sizable move is greater. In the analysis below, I take a look to determine which strategy would have been more profitable so far in 2012.
Low Implieds vs. High Implieds: One way to measure the extent by which options are mispriced is to look at an equity's straddle returns. A long straddle is a volatility play that combines a long call and a long put with the same expiration date and strike price. This strategy makes money when the stock moves enough in either direction to overcome both premiums.
Specifically for this analysis, I assumed that for each regular monthly expiration cycle, you purchased an at-the-money straddle 10 trading days before expiration (the third Friday of the month). I assumed you held the straddle until expiration and closed it at intrinsic value. I did this for each stock with options that met some pretty strict liquidity criteria. Then I grouped the stocks into four different "brackets" according to their implied volatility. In bracket 1 are stocks with the lowest implied volatilities; bracket 4 has the highest.
Notice the average implied volatility of each of the brackets below. The only bracket that showed a positive return using straddles was bracket 2, which averaged a 6.5% return per trade. Bracket 1 showed a modest 0.8% decline, which was the second best. The first two brackets also had the highest percentage of positive straddle returns. I would conclude that for the first part of 2012, options on lower-volatility stocks proved to be better deals than their high-volatility counterparts.
May Expiration: The data below is similar but only considers the most recent May expiration cycle. This assumes you purchased straddles at the close on May 4 and held the trade for the two weeks leading up to May expiration on the 18th. This two-week period was an interesting time in the market because the SPX collapsed 5.4% in that timeframe, making put options huge winners.
The first three brackets have especially good returns, averaging around 60% on the straddle trades. The highest-volatility stocks in the fourth bracket stand out as their straddles significantly underperformed the other brackets. Bracket 4 had an average return of only 25% per trade (I say "only" because I'm comparing that to the 60% average in the other brackets). Also, 60% of the straddles were positive in the fourth bracket with 18% of them doubling in value. These figures are also underwhelming compared to the other three brackets, which saw an average of 71% positive returns with 27% of them doubling. So, in the most recent expiration, the highest-priced options were once again the worst deal.
This Week's Key Events: The Fed's in Focus with the Beige Book, Bernanke on Deck
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 week kicks off with an update on factory orders. Dollar General (DG) and Shuffle Master (SHFL) are due to step into the earnings confessional.
Tuesday
- Tuesday features the ISM non-manufacturing index. Companies on tap to report earnings include JA Solar Holdings (JASO), FuelCell Energy (FCEL), and Ulta Salon (ULTA).
Wednesday
- The revised nonfarm productivity and unit labor costs data for the first quarter, the Fed's Beige Book for May, and the regularly scheduled crude inventories report will hit the Street on Wednesday. Meanwhile, investors will get a chance to reflect on earnings results from Analogic (ALOG), Men's Wearhouse (MW), Hovnanian Enterprises (HOV), and Vail Resorts (MTN).
Thursday
- Thursday's round-up will include weekly jobless claims and the most recent consumer credit report. Ben Bernanke will also speak at 10:00 a.m. before the Joint Economic Committee. Wall Street can expect earnings reports from J.M. Smucker (SJM) and Lululemon Athletica (LULU).
Friday
- The week concludes with updates on the trade deficit and wholesale inventories. Benihana Inc. (BNHN) and Piedmont Natural Gas (PNY) will wrap up the week's slate of quarterly earnings.
And now a few sectors of note...
Dissecting The Sectors
| | Sector | Leisure/Retail
Bullish |
Outlook: Consumer spending remains healthy, with a 2.9% uptick in this metric during the first quarter contributing two percentage points to the gross domestic product (GDP). In April, retail sales were up 0.1% sequentially, and 6.4% on a year-over-year basis (May sales numbers will be released in two weeks). Same-store sales for May were a mixed bag; the collective number slightly outpaced estimates, but Kohl's (KSS) sales results came in worse than expected. The big winners included TJX Companies (TJX) and Ross Stores (ROST). Also encouraging for consumers is a string of new record lows in 30-year mortgage rates (currently at a fresh nadir of 3.75%). This trend could mean potential refinancing activity will free up discretionary funds among U.S. consumers. On the charts, the SPDR S&P Retail ETF (XRT) remains in a solid long-term uptrend and is flirting with double-barreled support at its 160-day moving average, which coincides with the ETF's July 2011 peak. Restaurants, especially Buffalo Wild Wings (BWLD) and Chipotle Mexican Grill (CMG), are particularly compelling at the moment, with the group sporting just 49% "buy" ratings as roughly 71% of the sector's components trade atop their 200-day moving averages. A couple of other names we like from the broader retail sector include O'Reilly Automotive (ORLY) and Whole Foods Market (WFM). Sherwin-Williams (SHW) is another intriguing setup, given the equity's strong price action, low "buy" ratings (two out of 11), and interesting short-interest backup, with shorted shares rising by 43% in the last two reporting periods. With skepticism still prevalent toward consumer-dependent stocks, contrarians can continue to capitalize on situations where sentiment has yet to catch up with bullish technicals.
| | Sector | Homebuilding
Bullish |
Outlook: The housing sector has seen some positive developments in 2012, thanks in part to positive earnings results from Toll Brothers (TOL) and all-time lows in mortgage rates, which have reignited interest in the real-estate market. Pending home sales for April dropped 5.5%, however, falling short of expectations, hitting a year-to-date low, and raising concerns that perhaps the recovery might have a speed bump or two in its path. While this monthly reading adds risk to the sector, the index's year-over-year reading still climbed 14.4% in April. Technically speaking, we're continuing to monitor the SPDR S&P Homebuilders ETF (XHB), which is trading at the lower end of its recent trading range between 19 and 22. We are also watching the fund's 2011 peak as a site of potential support. If the price action proceeds to deteriorate from this point, however, we would be prepared to exhibit more caution. For now, investors may opt to hedge any long positions held on homebuilding names by employing XHB puts. From a sentiment standpoint, analysts remain overwhelmingly negative. With 73% of builders trading above their 200-day moving averages, these names have attracted only 45% "buy" ratings from brokerage firms. Along with TOL, some of our preferred names in the sector are Lennar (LEN), Meritage Homes (MTH), PulteGroup (PHM), and D.R. Horton (DHI), all of which sport relatively high short-to-float ratios of 10% or greater. Going forward, these stocks could benefit from upgrades or short-covering activity as the technical and fundamental performance continues to surpass the Street's low expectations. As a further caveat, we've seen some positive coverage of homebuilders lately, including a recent Barron's cover story titled "Home Prices Ready to Rebound." However, we think this optimism is in the very early innings after years of negativity, and other sentiment data we track suggests there is still plenty of skepticism surrounding homebuilding stocks.
| | Sector | Big-Cap Banks
Bearish |
Outlook: For as long as the broader market continues to be weak, big-cap banks will collectively remain vulnerable. On Friday, in "Big Banks Are In Big Trouble," Schaeffer's Senior Technical Strategist Ryan Detrick pointed out that the Financial Select Sector SPDR ETF (XLF) "looks ripe for further lower prices" after resolving a bearish flag pattern to the downside. The ETF is also trading back below its 320-day moving average after its October 2011 peak around $14.10 failed to act as support. Three notable mega-cap names within this group that look particularly bearish from a contrarian perspective are JPMorgan Chase (JPM), Goldman Sachs (GS), and Citigroup (C). All have seen call buying outpace put buying in recent months, even while the equities have trended lower. What's more, JPM and C continue to earn positive marks from their peers; JPM has 15 "strong buys" out of 25 overall ratings, while Citigroup has 13 "strong buys" from the 21 brokerage names that follow it. JPM has now violated its lows from two weeks ago while C has breached short-term support around the $26 level. Both are within striking distance of new 52-week lows, and GS is less than 10% away from its respective annual nadir. |
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