Central Banks Could Hold the Cards This Week

Could today's underperformers by tomorrow's broad-market standouts?

by 7/28/2012 9:40:54 AM
Stocks quoted in this article:

The bulls proved victorious yet again last week, as encouraging developments in Europe overshadowed lackluster earnings from the tech sector. However, as Todd Salamone points out, investors' appetite for risk could increase even more this week, should global central-bank moves pan out in the bulls' favor. Meanwhile, Rocky White examines the conventional wisdom to stay away from equities that sit out major market rallies -- and the results might surprise you. Finally, we preview this week's notable economic and earnings events, and check out a few sectors of note.

Notes from the Trading Desk: News from Europe Could Jolt Stocks Out of Their Trading Range
By Todd Salamone, Senior VP of Research

"Within our mandate, the ECB is willing to do whatever it takes to preserve the euro and, believe me, it will be enough."
- European Central Bank (ECB) President Mario Draghi, July 26, 2012

"Spanish and Italian bond markets rallied yesterday as investors cheered Draghi's signal that the ECB is prepared to intervene to reduce soaring yields. Now he has to deliver, or face deep disappointment on financial markets, analysts said. The risk in doing so is alienating key policy makers on the ECB council, such as Bundesbank President Jens Weidmann. The Bundesbank reiterated its opposition to bond purchases today."
- Bloomberg, July 27, 2012

"Going back to early June, the SPX has grinded higher in a very choppy fashion ... staring at resistance from the 2011 calendar-year high ... support at 1,333 -- double the March 2009 low and a 38.2% retracement of the June low and July high..."
- Monday Morning Outlook, July 14, 2012

"Since April, we've seen a huge spike in short interest on all optionable stocks ... In fact, the number of shares sold short recently climbed above the peak seen last September. What is extremely encouraging here for the bulls is that short interest just ticked lower, suggesting the shorts could be covering. We've long considered increasing short interest to be a headwind for stocks, and that headwind now appears to be receding. The last time short interest was this high and rolled over, we had a 30% rally in the SPX over the next six months ... In conclusion, the odds of higher prices are still very good right here."
- Monday Morning Outlook, July 21, 2012

Well, finally some news out of Europe that's a little easier to digest. In addition to the Opening Ceremonies and the arrival of the 2012 Summer Olympic Games in London, ECB President Mario Draghi sent a signal that bold action may be taken by the ECB to stabilize the euro -- a message market participants have long been waiting for in the midst of the continuing European sovereign-debt crisis. So, as athletes from around the world battle it out during the coming weeks, the brutal competition between bulls and bears since April -- which has essentially resulted in a stalemate -- may take on a new twist.

The S&P 500 Index (SPX - 1,385.97) roared higher on Draghi's remarks, and broke north of the roughly 40-point range -- between the 1,333 area (double the March 2009 low) and the area just above 1,370 (2011's calendar-year high) -- it's been exploring since mid-June. While this is encouraging, we've had a few "fake-out" moves above 1,370 that eventually reverted this month, so we'll continue to watch this level. But, as the Bloomberg excerpt above describes, all eyes will be on the ECB meeting next Thursday -- which could be a catalyst that dictates a move out of the short-term range, in one direction or the other, depending on the outcome.

30-Minute Chart of SPX since Mid-June

With support on the SPX holding in the 1,333 area last week, another encouraging sign for the bulls was the CBOE Market Volatility Index's (VIX - 16.70) failure to topple the area that is 50% above this year's intraday and closing lows of 13.66 and 14.26, respectively. This resistance area is between 20.44 and 21.39, and, as you can see on the chart below, the VIX failed to overtake this region before falling back below the round-number 20 strike late in the week. We have talked about the importance of this neighborhood in the past, and continue to view it as significant.

30-Minute Chart of VIX since Mid-June

Turning to option activity on the VIX and major exchange-traded funds (ETFs) like the SPDR S&P 500 ETF (SPY - 138.68), PowerShares QQQ Trust (QQQ - 64.87) and iShares Russell 2000 Index ETF (IWM - 79.32), we are observing major call activity on VIX options, amid little put activity on the SPY, QQQ and IWM. Our takeaway on this light put activity on equity-based ETFs is that hedge funds remain underweight, and the fact that this group is not in accumulation mode could be why the market has struggled in recent months. The good news for the bulls is that equities have been relatively resilient, despite a lack of a major bid from the hedge-fund players.

Moreover, as you can see in the chart immediately below, the surge in the VIX's 20-day buy (to open) call/put volume ratio has been coincident with a decline in equities. In prior instances when this ratio trended higher, equities coincidentally rose, and our interpretation was that hedge funds were using VIX calls to hedge equity long positions they were accumulating. This pattern has changed, and we view the rise in the VIX call/put volume ratio as a sign of speculative bets against the market. In other words, we believe speculators are purchasing VIX calls in anticipation of profiting from a sell-off in equities that drives VIX futures higher. This interpretation is certainly consistent with the build-up in short interest in recent months, as noted by Ryan Detrick in last week's Monday Morning Outlook. We find this interesting, as any unwinding of these bearish speculative bets could be supportive of equities. Furthermore, a rollover in this ratio could have bullish implications, as it could signal more short-covering.

SPX and VIX 20-Day BTO Call/Put Volume Ratio Since January 2009

SPX and SPY/QQQ/IWM 20-Day BTO Put/Call Volume Ratio Since January 2011

In conclusion, we remain bullish, as expectations are low, which sets up a favorable risk/reward environment for the bulls. Short-term traders should be aware that we are at the top of the recent range, and should have exposure to both a breakout and a failure at resistance. The sentiment backdrop suggests a breakout above the range could drive a sustainable rally, with the outcome of the ECB meeting next week a potential catalyst.

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