Monday Morning Outlook: Dow Tests 10,000; Overseas Fallout Could Make for Choppy Week Ahead
Reaction to China lending curbs shows expectations are low
by Todd Salamone 2/13/2010 12:31 PM
Global economic worries and concerns about how the Federal Reserve will unwind its massive stimulus programs made for a volatile week, with the Dow Jones Industrial Average (DJIA) closing below 10,000 on Monday. Still, by Friday, the DJIA recovered that landmark and managed a weekly gain for the first week in five. Looking ahead to next week, Todd Salamone, Senior Vice President of Research, notes that the S&P 500 Index (SPX) is trading above its rising 160-day moving average, but below its declining 80-day trendline. Todd thinks this might indicate a short-term trading range. Next, Senior Quantitative Analyst Rocky White examines the Rydex Nova/Ursa ratio, which compares the amount of assets in two Rydex mutual funds. Nova is a bullish fund and the Ursa is a bearish fund. A high ratio indicates optimism, while a low ration signals pessimism. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: A One-Day Slip Below 10,000
By Joseph Hargett, Senior Equities Analyst
The previous week ended with the Dow Jones Industrial Average (DJIA) clinging precariously to the 10,000 level. It failed to hold that level Monday, dropping 1.04% on the session, and logging its first close below 10,000 since November 2009. Anxiety was heightened by a weekend Wall Street Journal report that Federal Reserve Chairman Ben Bernanke would begin "to lay out a blueprint for a credit tightening," while traders were also concerned about the ongoing Greek debt drama.
However, the DJIA roared back Tuesday, with bulls encouraged by the prospect of a bailout for Greece. Elsewhere, Dow component Caterpillar (CAT) scored an upgrade to "overweight," while Boeing's (BA) new 747-8 Freighter successfully completed a test flight near Seattle. Against this upbeat backdrop, the DJIA rebounded 1.52%.
The market took a breather on Wednesday, as it digested the Federal Reserve's plan to unwind various stimulus measures. However, the Fed declined to offer a timeline, stating only, "The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments." By the close, the Dow succumbed to a minor loss of 0.2%.
After dipping into the red early in the session, stocks rebounded sharply on Thursday as details of the Greek bailout began to emerge. Stronger-than-expected weekly unemployment figures also helped propel the Dow to a gain of 1.05% by the close.
The Dow was rocked early on Friday by news that China had taken steps to curb lending for the second time in as many months. Elsewhere, data indicated that gross domestic product across the euro zone expanded at a smaller-than-expected rate in the fourth quarter. By the close, the Dow had rebounded from its lows, but still suffered a loss of 0.44%. For the week, the DJIA rose 0.9%, its first gain in five weeks. Meanwhile, the S&P 500 Index (SPX) also added 0.9%, and the Nasdaq Composite (COMP) soared 2% for the week.
What the Trader Is Expecting in the Coming Week: Low-Expectation Environment Favors Bulls
By Todd Salamone, Senior Vice President of Research
"We find it intriguing that many investors have quickly soured on the market's prospects. For new readers, buying opportunities usually occur when investors become fearful, as this is a sign that most of the selling pressure has been exhausted. Yes, there may be logic in this sentiment within the context of the magnitude of the pullback and the break below an important trendline. But, for those with a four- to six-month time horizon, or longer, we strongly recommend evaluating and acting upon opportunities on the long side. You can hedge these plays with short-term put options in case the current situation continues to deteriorate beyond our expectations."
--Monday Morning Outlook, Feb. 6, 2010
"Many major indexes are trading just above strike prices with major put open interest, as expiration is only two weeks away. For example, there is significant put open interest at the 105 strike on the SPY, which equates to SPX 1,150. Should this level break, delta hedging amid those players that sold the puts could create significant selling. But if the indexes hold above these major put strikes in the days ahead, short covering related to the expiring put open interest could drive the market higher in the days ahead."
Monday Morning Outlook, Feb. 6, 2010
The U.S. market's subdued reaction to China's surprise hike in banks' reserve requirements confirms our view that short-term traders are operating with a low-expectation mindset. This is a change from the optimism that we noted in January, when we cautioned the market was more vulnerable than normal to negative surprises. In fact, when China raised reserve requirements for the first time, on Jan. 12, the SPX declined 10 points; the SPX reacted with just a 2.96-point decline following the second announcement on Friday. Low expectations among short-term traders suggest the market is now less vulnerable to negative headlines and more likely to rally strongly on positive surprises.
The SPX is still trading above its rising 160-day moving average, which is located at 1,051.80. However, it remains below the (now-declining) 80-day trendline at 1,099.10. If these respective moving averages continue to play a significant role going forward, a trading range between 1,050 and 1,100 might be in store for the very near term. Therefore, longer-term traders should continue to leg into long positions that have been on your shopping list, but hedge your bets with short-term put options. With the CBOE Market Volatility Index (VIX – 22.73) retreating back below its 200-day moving average this week, index portfolio protection is cheaper now than it was one week ago, when the VIX was at 26.11.
Bulls might find it encouraging that the Russell 2000 Index (RUT – 610.72) closed back above the 600-century mark this week, after diving below this level two weeks ago. Its 50-day moving average, which capped the early-February peak, is currently at 617.36. This is an important area, as it also marked the March 2000 top. Moreover, the 620 level acted as resistance in September and October 2009. Like the SPX, the RUT found support at its 160-day moving average earlier this month, which is currently situated at 586.53.
Finally, the Dow Jones Industrial Average enters the week above the 10,000 millennium level again, despite a daily close below this mark last Monday. It is currently locked between two very long-term moving averages that we monitor. Its 80-month moving average sits at 10,822 and capped the recent high. Meanwhile, the 160-month moving average is sitting at 10,020.
With a holiday-shortened expiration week imminent, it is important to have a grasp on the option open interest configurations of major exchange-traded funds (ETF), as areas of heavy put open interest will tend to be supportive on pullbacks, while strikes with heavy call open interest may act as resistance.
The SPDR S&P 500 ETF (SPY), for example, comes into the week trading above the put-heavy 105 and 106 strikes, which equate to 1,050 and 1,060 on the SPX. In fact, SPY put open interest at the February 106 strike is now larger than the 105 strike, and the lows last week were just above the 106 area. Absent a move below the 105 and 106 put strikes, one thing the bulls have working in their favor this week is short covering related to the expiration of these put options, as put open interest around current levels is monstrous relative to call open interest. That being said, should these big put strikes get violated on the downside, those who sold the puts may short futures to stay neutral, creating exaggerated movement lower.
The apparent early stages of hedge fund accumulation of technology stocks could be another factor currently working in the bulls' favor. The chart below features a 50-day average buy (to open) volume put/call ratio on the PowerShares QQQ Trust (QQQQ), with a QQQQ overlay. When the ratio is rising, it means put buying is predominant, and has often coincided with strength in technology stocks. Declines in the ratio, suggesting put buying is low relative to call buying, often coincide with weakness in this group. Our theory is that as hedge funds accumulate technology shares, they hedge via the purchase of QQQQ puts. With the ratio now turning higher, it would appear that big money players are in accumulation mode. This is an indicator that we will continue to monitor closely in the weeks ahead.
The lower-expectation environment also favors the bulls. In fact, this week's poll by the National Association of Active Investment Managers (NAAIM) revealed a group that is extremely under-invested. In fact, the last time the members of this group were this under-invested was the July 2009 low, which may again suggest that the early-February selling was exhaustive. However, amid a weakened technical backdrop and uncertainty with respect to news out of Washington and the rest of the world, we suggest hedging your longer-term bullish positions with protective put options.
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.
Indicator of the Week: The Nova/Ursa Ratio
By Rocky White, Senior Quantitative Analyst
Foreword: One indicator that we use at Schaeffer's to gauge sentiment is the Rydex Nova/Ursa ratio. Nova and Ursa are a couple of mutual funds offered by the Rydex Series Trust. The Nova fund is a leveraged fund designed to return 150% of the daily return of the S&P 500 Index (SPX). The Ursa fund is designed to return the inverse of the SPX. In short, Nova is a bullish fund and the Ursa is a bearish fund. The Nova/Ursa ratio compares the amount of assets in each fund. When this ratio is high it means there is a lot of money invested in the bullish Nova fund compared to the bearish Ursa fund. Therefore, it signals a lot of optimism in the market. On the contrary, a low Nova/Ursa ratio signals a lot of pessimism in the market.
Current Reading: From a contrarian perspective, the current reading on the Nova/Ursa ratio is very bullish, arriving at its lowest point since the middle of 2006. Below is a chart of the Nova/Ursa ratio alongside the SPX. The green dots mark points on the SPX when the Nova/Ursa ratio hit fresh one-year lows. Note that this ratio has trended lower during the past year, despite strong price action in the market. This high amount of pessimism represents plenty of sideline cash that can still flood into the market and reinvigorate this rally.
Nova/Ursa ratio chart versus SPX since July 2006
Historical Performance: As I often do, I looked back to see if this indicator has had any historical significance. In doing so, I considered it a "buy" signal every time the Nova/Ursa ratio hits an annual low. Furthermore, I considered only one signal every two months for data dating back to 1994, when we started collecting data on the ratio. The table below details returns following a "buy" signal.
As you can see from the table above, returns following a "buy" signal are quite bullish when compared to typical market returns since 1994. This is especially true at three and six months out. The average returns significantly outperform, despite being dragged down a bit by one particularly bad signal in late 2008 - which is why the median returns show even better performance than the average.
Implications: The Nova/Ursa ratio is showing pessimism at a multi-year extreme. Furthermore, the pessimism has been growing during the past year despite the strong price action of the market. Remember, this indicator is not a phone survey or investors checking boxes. It measures actual dollars being put at risk. I like what we're seeing from this indicator, as it tells me there is plenty of money on the sidelines to propel this market higher.
This Week's Key Events:
By Joseph Hargett, Senior Equities Analyst
Here is a brief list of some of the key events for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective Web site for official reporting dates.
Monday
* The market is closed for the President's Day holiday on Monday.
Tuesday
* The January Treasury budget is the lone report scheduled for release on Tuesday. Abercrombie & Fitch Co. (ANF), CF Industries Holdings Inc. (CF), Merck & Co., Inc. (MRK), Teva Pharmaceuticals Industries Ltd. (TEVA), Cray Inc. (CRAY), ValueClick Inc. (VCLK), and Whole Foods Market Inc. (WFMI) are slated to release earnings.
Wednesday
* January's building permits, import/export prices, housing starts, and the capacity utilization and industrial production reports will hit the Street on Wednesday. Deere & Co. (DE), Hecla Mining Co. (HL), OfficeMax Inc. (OMX), Applied Materials Inc. (AMAT), Chesapeake Energy Corp. (CHK), Hewlett-Packard Co. (HPQ), Las Vegas Sands Corp. (LVS), NetApp Inc. (NTAP), NVIDIA Corp. (NVDA), and priceline.com Inc. (PCLN) will report earnings.
Thursday
* Traders will see the report on U.S. weekly petroleum supplies, weekly initial jobless claims, the January producer price index (PPI), January's leading indicators, and the Philadelphia Fed's manufacturing index for February on Thursday. The Goodyear Tire & Rubber Co. (GT), Hormel Foods Corp. (HRL), MGM MIRAGE (MGM), Wal-Mart Stores Inc. (WMT), Dell Inc. (DELL), First Solar Inc. (FSLR), and Intuit Inc. (INTU) are scheduled to report earnings.
Friday
* Friday brings a close to the week, with only the consumer price index (CPI) on tap. J.C. Penney Co. Inc. (JCP) and PG&E Corp. (PCG) are releasing their earnings reports on Friday. |
