Monday Morning Outlook:
Inflated VIX Premium Could Deter Potential Buyers
Optimism is on the rise, even as stocks approach formidable resistance
by Todd Salamone 2/11/2012 9:55:06 AM
schaeffersresearch.com
Despite a few new multi-year highs for the major equity indexes, stocks ended last week modestly lower. Traders were spooked when euro-zone finance ministers demanded deeper spending cuts from Greece, which raised the prospect that the cash-strapped country could miss a looming deadline to secure bailout funds. With the drop-dead date set for this Wednesday, Feb. 15, it's entirely possible that more choppy trading is on the horizon.
In fact, Todd Salamone notes that a pullback is likely at this point, as the major equity indexes finished last week just below significant resistance levels. Against this backdrop, Todd examines whether the recent crop of bullish headlines is a potential contrarian indicator -- or just a natural reaction to the market's impressive rally. On the technical front, Rocky White takes a look at the cluster of "golden cross" formations to determine whether this indicator is truly a positive sign for stocks. Finally, we wrap up with a preview of the key economic and earnings reports for the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: A Pullback Is Possible, but Panic Selling Is Unlikely
By Todd Salamone, Senior VP of Research
"The apparent increase in shorting activity among institutional players could result in a pause or consolidation, as equities were previously enjoying a bid from both short-covering and institutional buying. While evidence of institutional buying remains, a renewed interest in short selling could result in a coincident headwind that might lead to choppiness in the immediate days ahead." "Since the SPX's breakout above 1,260 in late December, it has been a straight march higher, with only one minor hiccup along the way: a pullback from the intraday highs of 1,330 to 1,300 from Jan. 26 to Jan. 30. The index comes into this week's trading at another potential resistance level, in the 1,340-1,350 area. As you can see on the chart below, the SPX was turned back from these levels on multiple occasions in 2011, suggesting this could be the next speed bump with which the index must contend."
- Monday Morning Outlook, February 4, 2012
Last week, we discussed the growing possibility of a pause in the impressive stock market advance, as some institutional players were showing signs of initiating short positions once again, following a period in which the equity market enjoyed a bid from both short-covering activity and underweight institutions deploying cash into the market. Since the big pop higher on Friday, Feb. 3, the market has done very little. A negative turn in the Greek debt saga last Friday, Feb. 10 sent stocks sharply lower, erasing a choppy grind higher throughout most of last week. The only encouraging technical note is that the SPDR S&P 500 ETF Trust (SPY - 134.36) never retreated beneath the previous Friday's post-gap lows, or its lows earlier in the week.
Hitting our radar last week was fresh evidence of optimism creeping into the market, right as the S&P 500 Index (SPX - 1,342.64) and the S&P 400 MidCap Index (MID - 964.49) approached their 2011 resistance levels in the 1,350 area and the 1,000 millennium mark, respectively. With key equity indexes lingering near resistance, these bullish headlines suggest we could be ripe for a pullback -- or, at the very least, continued choppiness in the days ahead. For example, headlines that caught our eye included:
In addition to the Feb. 9 headline suggesting a bullish technical backdrop, we saw technical research suggesting the CBOE Market Volatility Index's (VIX - 20.79) recent breakout has bullish implications. While we respect those publishing this research and think the studies are indeed valuable, our main takeaway is that the technical crowd seems to be taking a bullish stance -- the same crowd that was voicing concerns in late 2011, and roughly 100 SPX points ago.
Therefore, as contrarians, we are open to the fact that the market may be vulnerable to giving back some of its gains in the near term, as we see optimism coming in as the SPX and MID approach key resistance areas. A short-term pullback would be healthy, and would not jeopardize our overall bullish stance on equities for the intermediate and long term.
That said, it isn't necessarily a "slam dunk" that we retreat in the short term. After all, the positive sentiment isn't exactly misplaced, with the SPX up about 22% in a four-month period. In other words, one should put less weight on the contrarian implications of optimism in the context of strong price action, and more weight on the contrarian implications of optimism that occurs within the context of weak price action.
The good news for bulls is that in the event of a pullback, we would not expect a decline to be exacerbated by panic selling, since those that have recently accumulated stocks have purchased index or exchange-traded fund (ETF) puts, or VIX calls, as insurance against a correction. This was not the case around this time last year, when un-hedged buyers drove equities higher into mid-February, before negative European headlines surprised investors, resulting in a 7% correction in a month's period. Moreover, institutions at present do not have the exposure to equities that they did at the beginning of 2011, which suggests fresh cash on the sidelines that could mute a decline.
Finally, the "VIX Premium" indicator is again on our radar, which is a measure of the VIX relative to the SPX's actual, historical volatility. Given the steady demand for index and ETF put options that have accompanied the rally, put premiums have risen considerably relative to call premiums, driving the VIX to a substantial premium relative to SPX historical volatility.
For example, the VIX closed at 20.79 on Friday, or 146% above the SPX's current historical volatility of 8.44. As you can see on the chart below, the current VIX premium is relatively high. Therefore, a risk to bulls is that hedged players find put premiums too expensive, and thus sharply reduce their equity accumulation due to the expensive portfolio insurance. As you can see on the chart below, when the VIX is at a discount or is trading at a small premium to historical volatility -- implying cheap portfolio insurance -- major short-term buying opportunities have occurred during the past several months.
With portfolio insurance relatively expensive -- and thus unattractive for some hedge fund managers looking to put cash to work -- and the SPX and MID trading just below former resistance, the near-term price action may not be as rosy as the past several weeks. But pullbacks should continue to be viewed as buying opportunities, as considerable cash remains on the sidelines.
Indicator of the Week: Golden Crosses Everywhere
By Rocky White, Senior Quantitative Analyst
Foreword: Just over a week ago, on Feb. 3, the Nasdaq Composite (COMP) experienced what market technicians call a "golden cross." That is when the 50-day moving average crosses above the 200-day moving average. This pattern is often viewed as bullish, as it can be used to determine whether we're in a bull or bear market trend.
Below is a chart showing the S&P 500 Index (SPX), along with different-colored markers showing when each of the three major equity indexes -- the Dow Jones Industrial Average (DJIA), SPX, and COMP -- had a golden cross. Note that each of those indexes have had a golden cross already this year: the Dow on Jan. 3, the SPX on Jan. 31, and the aforementioned COMP cross on Feb. 3.
Golden Cross on the Individual Indexes: So, is the golden cross truly a bullish sign for these indexes? Below are three tables showing the average returns for the indexes after they experience a golden cross, looking at time frames ranging from one month to one year. When calculating average returns, if multiple golden crosses happened within a month's time frame, I only considered the first signal. Each table also has the typical returns since 1975, for the sake of comparison.
Looking at the tables, you'll notice a golden cross on the Dow has actually been slightly bearish compared to typical returns. But for the SPX and COMP, the returns are bullish across all time frames.
Golden Cross on All Indexes: The span of 31 days -- from Jan. 3 to Feb. 3 -- in which all three indexes experienced a golden cross was a very short time frame for that to happen. It made me curious as to whether this might be more bullish than a typical signal. Using the SPX as our gauge, below are the dates that saw all three indexes complete a golden cross within two months of each other, or 60 days.
As you can see from the tables below, this is an extremely bullish indicator. The 13 times in which these three indexes formed a golden cross within two months of each other saw an average return of 10% over the next six months, and 15% over the next year. Typically, the SPX averages a gain of just 4.4% and 9.1%, respectively, over those time frames. Furthermore, six months after a "triple cross" occurrence, the SPX was positive all 13 times -- compared to just 69% positive over a typical six-month time frame. So, in the past, this rare event has had very bullish implications for the market.
This Week's Key Events: Earnings Flood Continues, from Agilent to Zillow
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
- There are no major economic reports on Monday. On the earnings front, we'll hear from Alexander & Baldwin (ALEX), AsiaInfo Linkage (ASIA), Health Management Associates (HMA), Limelight Networks (LLNW), Nordic American Tanker (NAT), Rackspace Hosting (RAX), Seattle Genetics (SGEN), and Skilled Healthcare Group (SKH).
Tuesday
- Retail sales figures and business inventories are due out on Tuesday, along with the latest data on import and export prices. Avon Products (AVP), BorgWarner (BWA), Fossil (FOSL), Goodyear Tire & Rubber (GT), MetLife (MET), Michael Kors (KORS), Peet's Coffee & Tea (PEET), United Therapeutics (UTHR), Weight Watchers International (WTW), Zipcar (ZIP), and Zynga (ZNGA) will share the earnings stage.
Wednesday
- The Empire State manufacturing index hits the Street on Wednesday. Also on the day's docket are the NAHB's housing market index, industrial production and capacity utilization, weekly crude inventories, and the minutes from the latest meeting of the Federal Open Market Committee (FOMC). Quarterly earnings are expected from Abercrombie & Fitch (ANF), Agilent Technologies (A), Athenahealth (ATHN), CBS Corp. (CBS), Clearwire (CLWR), Cliffs Natural Resources (CLF), Comcast (CMCSA), Deere & Co. (DE), Dr Pepper Snapple Group (DPS), Goldcorp (GG), Marriott International (MAR), MEMC Electronic Materials (WFR), NetApp (NTAP), Nvidia (NVDA), Tesla Motors (TSLA), and Zillow (Z).
Thursday
- Thursday brings us housing starts, the producer price index (PPI), the Philadelphia Fed manufacturing index, and the weekly report on jobless claims. The Fed also remains in focus, with Chairman Ben Bernanke slated to speak at an FDIC conference. Plenty of earnings are also on tap, including results from Advance Auto Parts (AAP), Applied Materials (AMAT), Aruba Networks (ARUN), Baidu (BIDU), Cloud Peak Energy (CLD), Demand Media (DMD), DirecTV (DTV), Duke Energy (DUK), General Motors (GM), Hyatt Hotels (H), J.M. Smucker (SJM), Nordstrom (JWN), Orbitz Worldwide (OWW), P.F. Chang's China Bistro (PFCB), Red Robin Gourmet Burgers (RRGB), and SunPower (SPWR).
Friday
- The economic calendar concludes with the consumer price index (CPI) and the Conference Board's index of leading indicators. The weekly slate of earnings wraps up with reports from Campbell Soup (CPB), EOG Resources (EOG), H.J. Heinz, Lincoln Electric (LECO), and Pilgrim's Pride (PPC).
And now a few sectors of note...
Dissecting The Sectors
Sector Utilities
Bullish
Outlook: The positive momentum in the utility sector has dimmed lately, as this traditionally defensive group has cooled its heels amid strength in the broader equities market. However, within the context of the longer-term uptrend in the PHLX Utility Sector Index (UTY), pullbacks like the one we're seeing now are not unusual, and we would view these dips as buying opportunities. In fact, UTY continues to find support at the $455 area -- a site of former resistance in mid-2011. In addition to the sector's solid long-term technical performance, utilities offer attractive capital appreciation potential, as well as appealing dividend yields (with a number of sector components going ex-div this month). As a result, we view utility stocks as a nice complement to a portfolio that consists of some other names deemed as more "risky." Meanwhile, despite the technical and fundamental appeal, there's still a healthy amount of skepticism surrounding these stocks. We typically don't see this group mentioned in articles that advocate high-yielding stocks, and many analysts remain on the sidelines. Within the utility sector, Duke Energy (DUK) and Consolidated Edison (ED) have turned in impressive uptrends over the past year, and both securities are lingering near annual-high territory. 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 trend of improving jobs data has continued, with January payrolls surging impressively, and the unemployment rate pulling back to its lowest point in nearly three years. Additionally, consumer-level inflation has been relatively tame, pointing to an improving fundamental backdrop for the U.S. consumer -- and, by proxy, consumer discretionary stocks. On the charts, the SPDR S&P Retail ETF (XRT) remains a technical outperformer. XRT notched another week of impressive gains, with the fund extending its lead above formerly staunch resistance at $54, and setting a new all-time high of $57.77. For those seeking a bullish play in the retail/leisure space, we recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism. A few of our current favorites include retailers AutoZone (AZO), Advance Auto Parts (AAP), and Whole Foods Market (WFM), along with restaurateurs Chipotle Mexican Grill (CMG), Domino's Pizza (DPZ), and McDonald's (MCD). With skepticism still lingering toward these consumer-dependent stocks, contrarians can continue to capitalize on situations where sentiment has yet to catch up with the bullish technical performance.
Sector Homebuilding
Bullish
Outlook: The SPDR S&P Homebuilders ETF (XHB) pulled back last week, but maintained its footing above former resistance in the $19.50 area. From here, XHB still has room to rally to $23.25 -- which is half its all-time high, reached only three months after the fund was launched in 2006. Within the group, a few housing stocks are now running into key trendline resistance. For example, Meritage Homes (MTH) and Toll Brothers (TOL) are challenging their 80-month moving averages, while Hovnanian (HOV), KB Home (KBH), and PulteGroup (PHM) are testing their 40-month trendlines. Although this moving-average resistance could cap the sector's collective momentum in the short term, we continue to like the negative sentiment backdrop. For example, builders were hit with yet another round of downgrades on Friday, with analysts warning that these stocks have gotten ahead of themselves. Going forward, these names could benefit from upgrades or short-covering activity as the technical and fundamental performance continues to surpass the Street's low expectations.
Sector Energy
Bearish
Outlook: The Energy Select Sector SPDR Fund (XLE) has underperformed, with the security lately encountering resistance at its 52-week breakeven level. Indeed, it doesn't appear that hedge funds are particularly interested in energy stocks, as the 50-day put/call volume ratio on XLE has plunged dramatically of late. Since hedged players typically purchase puts as they're accumulating equities, it would appear that these deep-pocketed investors don't see much value in the energy sector at the moment. Meanwhile, the inability of crude futures to establish a foothold above $100 per barrel is another reflection of generally weak energy demand. In fact, last Friday, the International Energy Agency (IEA) took a hatchet to its global demand forecast, and noted that the market could withstand the loss of oil from Iran. Despite these technical and fundamental issues, we've recently spotted some bullish coverage on energy stocks in the financial media -- making this a potential contrarian bearish play to watch during the near term.
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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