Monday Morning Outlook: Is It Time to Get Defensive?
The SPX is still drawn by the magnetic pull of its double low near 1,333
by Todd Salamone 5/28/2011 1:00 AM
schaeffersresearch.com
Last week was a low-volume loss, as stocks unceremoniously deepened their monthly deficits. The bulls showed a few signs of life just ahead of the holiday weekend, but three consecutive days of modest gains left the major market indexes just shy of all-too-familiar technical hurdles. As stocks chop their way lower, evidence indicates that big-money players are flocking to historically defensive plays. However, with key support and resistance levels still up for grabs, Todd Salamone suggests keeping an open mind -- and keeping an eye on the small caps, while you're at it. Meanwhile, Rocky White takes a look at the unusually wide yield spread, and runs the numbers to determine whether this indicator can pinpoint market tops and bottoms. Finally, we wrap up with a preview of the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: Small Caps Are Bent, but Not Broken
By Todd Salamone, Senior VP of Research
"Throughout this range-bound period, the SPX has found support at its 80-day moving average, which is currently situated at 1,320. This trendline marked a low in mid-April, and once again earlier this week. Moreover, the March 2009 'double-low' in the 1,333 area has proven to be supportive on various occasions during the past couple of weeks, and this is exactly where the SPX is situated ahead of next week's trading... Disturbing for bulls is the series of lower highs put in during this month, as a trendline drawn through various peaks rests in the 1,340 area -- which is also the site of the February peak that preceded a month-long, 6%-plus correction earlier this year... The bears, meanwhile, are fighting a series of higher lows in place since mid-March."
-- Monday Morning Outlook, May 21, 2011
After hitting a three-year high in early May, the S&P 500 Index (SPX - 1,331.10) has experienced four consecutive losing weeks. On a net basis, the index has traded sideways since mid-February, when the SPX closed in on 1,333 -- double the March 2009 low. Since this period, which has encompassed about three and a half months, there has been a lot of noise-related trading above and below the 1,333 level. But this "double low" area has exerted its magnetic pull every time the SPX strays a little too far north or south, resulting in a trading-range environment.
The weakness this month has been ongoing, but pretty much contained. For example, the SPX is down only 2.4% in May, as it and other widely watched indexes continue to respect support levels during pullbacks.
During this period, worries are festering about the domestic economy entering another recession -- which some expect by year end -- and concerns are mounting about slowing world growth, driven by central-bank tightening in China and the continued debt crisis in Europe. This adjustment in expectations has kept a lid on stocks recently, and may continue to do so in the near term. But, as contrarians know, lower expectations create a backdrop for upside surprises and rising stock prices in the future.
Catching our eye on Friday was a MarketWatch article entitled, "Small-Cap Run is Done but Cycle Will Return." This article did a good job of capturing the current sentiment in the marketplace, as it discussed hedge funds fleeing small-cap names deemed "riskier" in favor of more defensive, larger-cap stocks. The article also pointed out that brokers are "scared to death." With sentiment this negative, a return of small-cap leadership seems likely in the near future.
The two charts below suggest the negative sentiment toward small-cap stocks is misplaced, with the Russell 2000 Index (RUT - 836.26) recently finding support at its 120-day moving average -- a period of time which is equivalent to about six months' worth of trading days. As you can see, this trendline has played a significant role in the past. Moreover, the RUT's relative-strength uptrend versus the SPX "bent," but clearly did not "break."
We continue to believe that market advances will be led by small-cap and mid-cap equities. If you are going to put money into the market at this juncture, opt for the names deemed "risky" -- oil, silver, gold, and small-cap/mid-cap stocks. This trade has become less crowded in recent weeks, as hedge fund managers flee to "safer" names and take a more defensive stance.
We have seen evidence of this defensive posturing by hedge funds, as the 20-day buy-to-open put/call volume ratio on the combined SPDR S&P 500 ETF (SPY), iShares Russell 2000 Index (IWM) and PowerShares QQQ Trust (QQQ) has rolled over again. The dip in this composite ratio has been driven primarily by a downturn in the IWM's buy-to open put/call ratio, which supports the case that hedge fund managers have moved away from the small-cap space. Bulls would like to see this ratio turn higher from its current level, as it did in March. Should this ratio continue to move lower, we would expect more choppiness in the market, with a downward bias.
For the immediate term, whether you are focused on small-cap or large-cap indexes, the major risk as we enter the week ahead is the presence of overhead technical levels that are capable of capping rally attempts -- and especially in the absence of hedge fund accumulation, as noted above. The S&P 400 Midcap Index (MID - 990.19) is still below the 1,000 millennium mark, and the RUT is south of 850, which is the site of its July 2007 peak and all-time high prior to a brief move above this level in April. Finally, per the chart below, the SPX is back below the 1,333 zone, and its high on Friday coincided with the site of a trendline connecting a series of lower highs.
We suggest you continue to be open to opportunities on both the long and short side of the market. A few of our preferred sectors include commodities and small- and mid-cap equities, in anticipation that sideline money will move back into these groups. We continue to view the financial sector as an area of risk.
Resistance for the SPX is just overhead, at the aforementioned trendline connecting the lower highs in May. However, a breakout could push the index to 1,355-1,360, around the area of a few closing highs in April. Support is in the 1,300-1,320 zone, as 1,320 is the vicinity of the 80-day moving average, and 1,300 represents both the April low and the site of peak put open interest in the June options series.
Indicator of the Week: The Yield Spread
By Rocky White, Senior Quantitative Analyst
Foreword: This week, we'll talk about the relationship of stocks with yields on Treasury notes. The chart below shows the S&P 500 Index (SPX) since 1990, along with the yield on the 10-year and 2-year note. Rates have been declining, and are now at historically low levels. Note that since the 2008 market crash, the short-term rate has continued lower while the longer-term rate has started to stabilize. Thus, the spread between the yields is currently very high.
SPX vs. 10-year and 2-year yields
There are many theories about why rates are where they are. Some say it's manipulation by the Fed; some say the longer-term rates are staying high because of inflation expectations; and others say it's because investors are expecting more growth. These theories are often politically charged, so we're not worried about that debate. All we're going to discuss is what these yields mean, or have meant in the past, for the stock market.
Yield Spread: Below is a chart that shows the yield spread, which is the difference between the yields of the 10-year and 2-year Treasury notes. It's clear that the last two major market tops occurred when the spread was extremely low. Also, the last two recoveries didn't happen until the spread became very high. That's comforting news, since -- as I mentioned earlier -- the spread is extremely wide right now.
SPX vs. yield spread
At first glance, the chart above seems pretty simple: Buy when the spread gets high, and sell when it gets low. After a closer look, though, you realize it's not quite that easy. The spread began to rise soon after the market top in 2000, and it could have been considered "high" well before the market bottomed. You would have suffered pretty steep losses right off the bat had you followed only this indicator and bought into the market at that time. Plus, the spread fell below zero right around 2006... which may have compelled you to sell, when there was still over a year of gains to be had.
In an attempt to quantify the results, I grabbed some SPX returns going forward depending on the yield spread. I broke the data into five brackets by size, dividing them so that each had an equal number of returns. Bracket No. 1 represents the smallest spreads, from -51 basis points to 19. The fifth bracket is where we are right now, and this is where spreads are their widest. Bracket No. 5 has pretty high returns, averaging about a 13% gain over 52 weeks, with 79% of these returns being positive.
The data is comforting in the sense that we're in the bracket with the widest spreads, and those returns are relatively bullish. But something about the tables doesn't seem quite right, which causes the yield spread to lose some credibility as a standalone indicator. The fourth bracket -- where spreads are high, but not the highest -- has the lowest average returns, and the second bracket -- where spreads are low, but not the lowest -- have the best average returns. This makes the indicator seem pretty random, without much predictive value. On the other hand, the market has not seen any sort of massive sell-off with the 10-year/2-year yield spread at such wide a margin, which may be worth something.
This Week's Key Events: May Payrolls Punctuate the Post-Holiday Week
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 market is closed Monday in observance of Memorial Day.
Tuesday
* The economic schedule kicks off Tuesday with the S&P/Case-Shiller home-price index for March, the Chicago purchasing managers' index, the Dallas Fed manufacturing survey, and the Conference Board's consumer confidence index for May. Lions Gate Entertainment (LGF) and E-House China Holdings Ltd. (EJ) are expected to report earnings.
Wednesday
* On Wednesday, reports on construction spending and vehicle sales will hit the Street, along with the ISM manufacturing index and ADP's employment report for May. On the earnings front, we'll hear from Coldwater Creek (CWTR), Daktronics (DAKT), Dollar General (DG), and Vera Bradley (VRA).
Thursday
* Thursday brings us the government's weekly jobless figures, along with reports on April factory orders and first-quarter productivity. The Energy Information Administration's (EIA) holiday-delayed update on petroleum supplies will also be released. Quarterly earnings are due out from Joy Global (JOYG), Quiksilver (ZQK), Verifone Systems (PAY), and The Fresh Market (TFM).
Friday
* The economic calendar wraps up with a bang on Friday, with the release of the Labor Department's nonfarm payrolls report and the ISM services index for May. Wrapping up the week's slate of earnings reports are American Woodmark (AMWD) and Blyth Inc. (BTH). |
