Monday Morning Outlook

As Investor Anxiety Spikes, Risks to the Bullish Case Can't Be Ignored

Will first-quarter earnings season serve as a catalyst higher for this choppy market?

by 4/14/2012 10:55:11 AM
Stocks quoted in this article:

Stocks suffered their steepest losses of 2012 last week, thanks to revived concerns about Spain's fiscal fortitude and China's decelerating growth rate. In fact, the level of panic on Wall Street has ratcheted up significantly, with a survey of the current sentiment landscape suggesting that investors are all but ready to write this bull's obituary. Filling in for Todd Salamone this week is Senior Technical Strategist Ryan Detrick, who's been keeping a close eye on the action in small caps as a barometer for the broader market. Amid rising expectations for a correction of painful proportions, Ryan takes a look back at previous rallies to determine whether the current uptrend has overstayed its welcome. Meanwhile, as April-dated options enter their final days as the front-month series, Rocky White explains why the negative price action this expiration cycle could bode ill for stocks in the short term. Finally, we wrap up with a preview of the busy week of earnings reports ahead, as well as a few sectors of note.

Notes from the Trading Desk: Investors and Money Managers Are Running Scared
By Ryan Detrick, Senior Technical Strategist

As Todd Salamone touched on last week, the odds are good that we'll continue to trade in a choppy phase for the time being. With the S&P MidCap 400 Index (MID - 964.41) having issues near 1,000, and the S&P 500 Index (SPX - 1,370.26) bouncing around 1,400, we could see more of this action in the near-term. There were a few technical indicators suggesting that some weakness could be on the horizon -- but overall, after a brief five-day losing streak and 4% pullback, it's amazing how much worry has come back into the marketplace.

The next major driver for the stock market will be first-quarter earnings season. What continues to impress me is how drastically the estimates have been cut over the past few months. Back in September, the consensus was for 10% year-over-year growth in first-quarter earnings. Then, at the start of the year, it was down to 4%. Now I'm actually hearing a good deal of talk that earnings will be negative for the first time since the financial crisis. The odds are strong that analysts have once again low-balled earnings estimates, and should the quarterly results come in just a little bit better than expected, this could spark yet another rally.

Technically, the 1,360 area in the SPX held as support last week, but I continue to think the action in small caps holds the key to the overall market. The March lows of 785 on the Russell 2000 Index (RUT - 796.29) held as support, and just a little below that is the RUT's 320-day moving average. This trendline has been fairly significant over the past several years, and a violation of this area could signal that more pain is coming.

Daily Chart of RUT since 2007 with 320-Day Moving Average

One major positive for the market going forward is how much worry there is. In fact, just this week, I saw an article talking about "The 5 Big Fears Hanging Over the Stock Market". Think about that for a second. Less than two weeks ago the SPX was making new multi-year highs, yet all we ever seem to hear about are all of the reasons not to be invested.

Investors are running scared, as well. Data from EPFR Global showed that equity funds had total net redemptions of $9.26 billion in the week ended April 11, which was a new high for the calendar year. And incredibly, the American Association of Individual Investors (AAII) saw a drop of more than 25% in the number of bulls -- down to only 28% during the last week, compared to 38% the previous week. In fact, that 28% bullish was the lowest reading since September 2011. By no means is this is a flawless indicator, but previous breaks of the 30%-bullish barrier have marked a number of short-term bottoms in the SPX going back to 2009.

AAII Bulls with SPX since 2009

Also, according to the National Association of Active Investment Managers (NAAIM), active managers cut their exposure to stocks last week by the largest amount since late November. Quantitative Analyst Chris Prybal provides a closer look at this data point, but it is yet another sign of how extreme the fear has been on this 4% pullback.

NAAIM Sentiment since March 2009 Trough

Going forward, some other definite positives we're seeing include a few clues that big money could be getting back into stocks here. As Todd has mentioned numerous times over the past months, we think activity on CBOE Market Volatility Index (VIX) futures and major equity-based ETFs is hedging-related. In other words, this activity could suggest institutions are in the process of making either bearish or bullish bets. Back in March, this option activity was a cause for concern, but now we're seeing signs that deep-pocketed players are putting their cash back to work. The 20-day buy-to-open put/call ratio on the SPDR S&P 500 ETF (SPY), PowerShares QQQ Trust (QQQ), and iShares Russell 2000 Index (IWM) has turned higher, and in the past this has had bullish implications for stocks.

SPX with 20-day Buy-to-Open Put/Call Ratio for SPY, QQQ, IWM

Not to be outdone, VIX is also seeing a rebound in call buying. As the chart below shows, when the VIX's 20-day buy-to-open call/put ratio has turned higher from similar lows, it can be a very bullish signal for the overall market.

VIX 20-day Buy-to-Open Call/Put Ratio

We've heard a lot of talk that this rally has gone "too far, too fast," and is ripe to fall flat on its face for various reasons. In fact, just on Friday, I noticed an article citing how "old" the bull is as a reason to be fearful. Just for comparison, we looked back at previous major bull rallies to see where, exactly, this one stacked up in terms of percentage gain and duration. Well, our current bull market is 784 days old and up 106%. There aren't many rallies we can compare this one to -- and looking at the rallies from 1982 and 1995, the results were interesting, to say the least.

First, we are roughly in line with both of those bull markets, as you can see below, and if we keep following the returns from each of those previous rallies, the SPX will be up near new all-time highs by the end of this year. At the end of 2012, we will be 968 days into the bull market. If it follows suit with the 1982 rally, that would mean an SPX close of 1,571. Should it track the move of the 1995 rally, that would put the SPX clear up at 1,613 -- a new all-time high. Of course, this doesn't mean either scenario will necessarily pan out, but it does make the point that we've seen rallies this strong before, and stocks very well could continue to move higher. Then, when you consider how much negative sentiment we are still seeing toward this rally, there's a good chance the overall uptrend will still be firmly in place by the end of this year.

Current Rally vs. 1982 Rally

Current Rally vs. 1995 Rally

And let's not forget that this week is April options expiration. Looking back over the past 12 years, this has historically been a strong week, although the past two have been a little weaker. Expiration weeks have also tended to be somewhat more volatile than usual over the past 12 months, as the past nine have seen the SPX move more than 1%, with several weeks triggering moves of 3% or more in just five days. For a closer look at the market's performance during expiration weeks, check out Rocky White's commentary on the following page.

SPX April Expiration Weeks

SPX April Expiration Weeks Summary

SPX Expiration Weeks

SPX Expiration Weeks Summary

In conclusion, there are definitely concerns out there, and we can't simply ignore them. A slowdown in China or more issues in Europe could put a major stop to the bull market, but overall, we continue to feel there are still more reasons to be bullish than bearish for longer-term investors. In the near term, some continuation of the recently choppy price action could occur -- but eventually, that will give way to higher prices, as the dour outlooks on the economy and stock market will once again be proven too gloomy.

Best of luck in your trading.

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