Monday Morning Outlook: Two Signs of Trouble for Small- and Mid-Cap Stocks
The RUT and MID ended September beneath historically significant technical levels
by Todd Salamone 10/1/2011 11:59 AM
schaeffersresearch.com
The uniformly dismal third quarter is finally over -- but with burning questions about the state of the global economy still unanswered, what do investors have to look forward to? Friday's session ended with a thud, as Wall Street weighed softer manufacturing activity out of China and higher consumer prices in the euro zone, which raised questions about the European Central Bank's ability to accommodate the region's dicey fiscal situation. Plus, we're on the cusp of three solid days' worth of U.S. jobs data, which seems an unlikely source of inspiration, at best.
From a technical standpoint, Todd Salamone notes that the S&P 500 Index still remains well within the confines of its recent trading range. On the other hand, an apparent breakdown for small- and mid-cap stocks gives the bulls cause for concern -- particularly as sentiment continues to deteriorate among big-money players. Meanwhile, Rocky White weighs the historically bearish implications of the Dow's five-month losing streak against typically sunny fourth-quarter seasonality. Finally, we wrap up with a preview of the key economic and earnings events for the week ahead, featuring Friday's nonfarm payrolls report for September.
Notes from the Trading Desk: Hedge Fund Managers Grow Increasingly Gloomy
By Todd Salamone, Senior VP of Research
"With equities pulling back to potential long-term support areas as negative sentiment continues to grow, now is a good time to add equity exposure to your portfolio for a potential rally back to the resistance areas discussed last week. But be careful if there is a break of support, as short-covering activity or a shift from other assets will not be as urgent, undermining the potential reward for the risk you are taking."
- Monday Morning Outlook, September 24, 2011
Coming into last week's trading, the major market indexes were sitting just above significant support areas -- and buyers stepped up to the plate quickly, with the S&P 500 Index (SPX - 1,131.42) rallying 5% by Tuesday afternoon. Unfortunately, that rapid surge higher brought technical resistance levels back into play, and the advance was over almost as soon as it started. The SPX ran up near the top of the recent range, to the 1,200 area, but the index was once again turned back, as sellers proved to be just as powerful as the early-week buyers. For bulls, it was a disappointing end to the week, as Thursday's much-anticipated German vote to approve the expansion of the European Financial Stability Facility (EFSF) failed to provide lasting inspiration for investors.
As we enter this week's trading, the SPX remains locked in the same volatile trading range that has been in place since early August. The sideways channel formed after the SPX had experienced a two-week, 17% decline from its calendar-year highs. While the SPX is still trading above the key 40-month moving average, situated at 1,108, bulls should take note of the lower highs that have occurred on the last two rally attempts.
From a technical perspective, other concerns include the continued deterioration in the technical backdrop of small- and mid-cap stocks, as evidenced by the following developments:
1. The Russell 2000 Index (RUT - 644.16) closed below 650, which was the site of resistance in 2005 prior to acting as support in early 2008.
2. For the first time since September 2010, the S&P 400 MidCap Index (MID - 781.26) experienced a monthly close below 800, which is double its 2009 low. The index remains above its 80-month moving average, situated at 766.80 -- a trendline that marked major lows in 2002 and 2010. As we move into the final quarter of the year, there is not a strong consensus as to whether or not this range will resolve itself to the upside or the downside. However, a recent Reuters poll of global strategists indicated that the SPX would be modestly lower by year's end. In fact, our analysis of option activity on major exchange-traded fund (ETF) options suggests that hedged players could be looking for weakness immediately ahead -- which marks a change from the past few weeks, when we saw evidence that this group was split.
For instance, we are now seeing a roll-over in the 20-day combined buy-to-open put/call ratio on the SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 Index Fund (IWM) and PowerShares QQQ Trust (QQQ), after a period in which this ratio turned higher. When the ratio is advancing, it is usually evidence that hedge fund managers are buying stocks, as they simultaneously purchase these puts to hedge the long equity positions they're accumulating.
Another hedging tool for those accumulating equities are call options on the CBOE Market Volatility Index (VIX - 42.96), as the VIX will usually advance sharply in the event of a correction. Thus, the profit from the call options could cushion equity losses. But, during the past 20 days, VIX puts have been in heavier demand than VIX calls. During the past several weeks, the VIX's buy-to-open call/put ratio has fallen below 1.0, due to a surge in put buying and a significant decrease in call buying. This could be a signal that the hedge fund world is positioning for a weaker market ahead, and using VIX puts to hedge growing short positions. The market has tended to struggle as this group turns negative, which they appear to be at the moment.
The only piece of good news in the chart below is that the VIX's call/put ratio is approaching extreme lows. A turn higher in the ratio from these levels has been associated with major advances in the equity market on previous occasions. For now, though, bulls should be on guard, as this ratio continues to decline alongside a bearish roll-over in the 20-day combined SPY/QQQ/IWM put/call ratio (second chart below).
Keep tight stops on your long equity positions -- especially those in the consumer-discretionary area, as we are seeing some breakdowns among former leaders in this group. Large-cap banks continue to be the biggest area of vulnerability, and these are names to consider if you are actively shorting. Treasury bonds should remain in your portfolio, and utilities are a sector worth adding, given the attractive dividend yields, strong price action, and the low percentage of "buy" ratings from analysts, hinting at future upgrade potential.
Indicator of the Week: Five-Month Losing Streaks and the Fourth Quarter
By Rocky White, Senior Quantitative Analyst
Foreword: September ended last Friday, and for the fifth month in a row, markets were lower. This is the 15th time since 1900 that the Dow Jones Industrial Average (DJIA) fell five months in a row. Below is a table showing each instance. We're down nearly 15% during the current losing streak. Unfortunately, these streaks do not typically stop at five months. Only six out of 14 times, and only once in the last five occurrences, was the sixth month positive. The longest monthly losing streak ended in 1942, when the Dow was down nine months in a row (December 1941 was the fifth negative month, for the record).
Fourth Quarter: Now, for the good news (such as it is). The following tables summarize Dow returns by quarter since 1950, and over the last 20 years. Historically, the third quarter is easily the worst, and this last one saw the Dow fall about 12%. So, it's good news that it's over, at least. Furthermore, the table shows the fourth quarter has been the most bullish, averaging a gain of about 5%, and reaping a positive return almost 80% of the time over the last 20 years.
I decided to take a closer look to see if any individual stocks stood out during the fourth quarter of the last few years. So, I went back five years and gathered fourth-quarter returns on the most liquid stocks in our database. Only four equities had positive returns in each of the last five fourth quarters, and those outperformers are listed below. Priceline.com (PCLN) has fared the best over the last five fourth quarters, averaging a 20% gain over the final three months of the year. The last stock on the list -- Safeway (SWY) -- stands out from the rest by virtue of the simple fact that it's in a long-term downtrend. But over the last five years, your portfolio would not have been harmed by owning this stock during the fourth quarter.
Finally, below is an expanded list of 20 stocks with the biggest average returns over the past five fourth quarters, looking at those equities that were positive in four of those quarters. You can see from the "Min Return" column that the one negative fourth-quarter return for these stocks was often quite dramatic (remember the fourth quarter of 2008...?).
This Week's Key Events: All Eyes on September Payrolls
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 kicks off Monday with the ISM manufacturing index for September and construction spending for August. Wolverine World Wide (WWW) is scheduled to report earnings.
Tuesday
On Tuesday, the Census Bureau will report on August factory orders. On the earnings front, we'll hear the latest quarterly results from Global Payments (GPN) and Yum Brands (YUM).
Wednesday
Employment data starts to roll in on Wednesday, with the release of ADP's private payrolls report for September and the Challenger, Gray & Christmas update on job cuts. Also due out is the ISM services index for September, as well as the usual report on weekly petroleum supplies. Acuity Brands (AYI), Costco Wholesale (COST), Marriott International (MAR), Monsanto (MON), and Ruby Tuesday (RT) are expected to report earnings.
Thursday
Weekly jobless claims are set to hit the Street on Thursday. Notable earnings reports include AngioDynamics (ANGO), Constellation Brands (STZ), Helen of Troy (HELE), and International Speedway (ISCA).
Friday
Friday's marquee economic event is the Labor Department's nonfarm payrolls report for September. Also on the day's docket are wholesale inventories and consumer credit for August, as well as the latest quarterly earnings from Material Sciences (MASC).
And now a few sectors of note...
ssecting The Sectors
Sector Utilities
Bullish
Outlook: The utility sector is often preceded by its "defensive" reputation, and it has indeed emerged as a pocket of technical strength, even amid the recent broad-market turmoil. In fact, the electric utility group currently boasts the highest percentage of stocks trading above their 200-day moving averages among all sectors we follow, at 58%. Plus, the sector sports some attractive dividend yields, which are certainly a selling point in the context of a tumultuous market environment. However, Wall Street hasn't exactly jumped on the bullish bandwagon just yet. Electricity stocks have attracted only 39% "buy" ratings from brokerage firms, which is one of the most bearish ratings configurations around right now. Within the group, Duke Energy (DUK) and Consolidated Edison (ED) have racked up double-digit percentage gains in 2011, and both stocks have recently tagged new 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 SPDR S&P Retail ETF (XRT) remains in technical limbo on the charts, with the fund hovering between familiar support and resistance levels. XRT closed last week beneath the round-number $50 level and its year-to-date breakeven at $48.36, but wrapped up the month of September just north of support in the $45 region -- which previously served as resistance in 2007 and 2010. Despite the technical stagnation here, we remain upbeat on select outperformers within the group, and recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism. Amazon.com (AMZN) is one such example, with the shares up more than 20% year-to-date -- despite a 45% surge in short interest over the course of the past month. Whole Foods Market (WFM) also holds contrarian appeal, as the stock has enjoyed a years-long uptrend atop the support of its 10-month moving average. With WFM attracting a significant amount of speculative put buying in recent weeks, there could be some skepticism yet to unwind toward this technical standout. Heavily shorted Sturm Ruger (RGR) is another one to watch, after the stock last week found support near former resistance at the $25 level. As these high-flying discretionary names continue to outperform on the charts, a capitulation by the skeptics could provide an influx of buying pressure.
Sector Large-Cap Tech
Bearish
Outlook: From a broad perspective, the tech-rich Nasdaq Composite (COMP) found resistance last week near the round 2,600 level, which previously served as a layer of support. In similar fashion, the PowerShares QQQ Trust (QQQ) recently spiraled lower after an unsuccessful test of the $60 level -- which represents exactly half its all-time high of $120, set back in March 2000. Within the tech sector, semiconductor stocks are among the more notable laggards, 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, and remains at an elevated 57.5%. Meanwhile, the percentage of "sells" is resting near an annual low, at 5.2%. In fact, a few upbeat analysts have recently flagged the poor price action in chip stocks as a buying opportunity. However, with a seemingly endless string of semiconductor names slashing their financial guidance in the face of sluggish 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 shift in sentiment toward the bearish end of the spectrum as the weak technical performance continues.
Sector Financials
Bearish
Outlook: Bad news continues to roll in for the banking sector, as Moody's recently lowered its debt ratings for Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC). The ratings agency maintained a negative outlook on all three banks, noting that the U.S. government is "more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled." Adding to the gloomy headlines, B of A and JPMorgan Chase (JPM) were slapped last week with a new lawsuit regarding their involvement in the mortgage-backed securities market. Plus, concerns continue to linger 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, with the fund sitting on a steep year-to-date decline of nearly 26%. XLF tumbled lower in late August 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. Meanwhile, the 20-day buy-to-open call/put volume ratio for XLF moved higher recently, suggesting that short sellers are buying calls in order to hedge new bearish bets against the group. Previous upticks in this ratio have coincided with periods of weak price action for banking stocks. However, traders should keep an eye on the aforementioned $13.50 region, as a move back above this area would be a risk to any short positions in the big-cap financial sector. |
