Monday Morning Outlook

Charts to Watch and Things to Know this Expiration Week

The Dow and Its 200-Day Moving Average: A History Lesson

by 11/10/2012 10:42:56 AM
Stocks quoted in this article:

What a week it was. An Election-Day rally was quickly forgotten Wednesday morning, as concerns over the election's unpredictable outcome were replaced by "fiscal cliff" fears. By week's end, the major market indexes were down more than 2%. But Todd Salamone notes that while bullish investors may be on the ropes, they haven't been knocked out, as there are still encouraging signs on the sentiment front and levels of support to watch. Speaking of levels, Rocky White takes a look at the Dow's relationship with its 200-day moving average over the last century, and the results may surprise even the most seasoned technical analysts.

  • Levels of potential support to watch on the major indexes
  • VIX inertia may support the bullish case
  • Why the Dow's break of trendline support might not be a bad thing

Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: The Bulls Are Down, But Not Out
By Todd Salamone, Senior V.P. of Research

"A related query: Is it likely that the impending 'fiscal cliff' -- the coming fiscal drag from expiring government stimulus -- will be this year's market bugaboo, given that it has already become Wall Street's pervasive preoccupation? A Factiva news search shows that the term 'fiscal cliff' quintupled in usage this month versus the prior two. True, sometimes the snake you're watching still bites you, but not as often as the one that's hidden."
-Michael Santoli in Barron's, April 28, 2012

"Goldman [Sachs] to Clients: Get Out of Stocks Before Fiscal Cliff Hits", August 20, 2012

"... some of our short-term and intermediate-term measures, much like the technical picture, are mixed ... If support at 1,400...breaks, we could see the SPX pull back to last year's high in the 1,350-1,360 area ... Amid a technical backdrop that can be viewed as bearish if focused on the near term -- or bullish, if your chart goes back a year -- many short-term traders have turned bearish, playing an SPX trendline breakdown that's been in place since June. Be open to the possibility that they are correct, but also be aware that this could be a crowded trade."
-Monday Morning Outlook, October 27, 2012

"Meanwhile, the S&P MidCap 400 Index (MID - 987.40) continues to hit a brick wall at the round-number 1,000 millennium mark, a resistance level that has been in place since it was first challenged in April 2011. So, the bad news is that the major equity indexes are failing to take out key technical resistance levels, as the four E's -- earnings, elections, Europe and economy (namely, the fiscal cliff) -- prevent buyers from taking a chance by adding long exposure when resistance lies just overhead."
-Monday Morning Outlook, October 20, 2012

"The last time expectations for a volatility spike were this high was in the late-May/early-June period, when the SPX was carving out a major bottom. In fact, the VIX 20-day buy-to-open call/put volume ratio just hit its highest level in 2012, when it peaked at 3.50. Three of the previous four spikes above 3.0 were followed by strong SPX advances. During this time of strong market seasonality, bulls have a lot going for them, even as major uncertainties linger."
-Monday Morning Outlook, November 3, 2012

The excerpts above are aimed to provide perspective on what has been plaguing Wall Street for literally months -- namely the fiscal cliff -- along with our take on the market the past few weeks, as it relates to the technical and sentiment backdrops. If I were to summarize our observations about the technical environment, it would be that major indices have bounced around key levels of support and resistance. The S&P 400 MidCap (MID - 969.82) has failed to take out the 1,000 round number, for example, while the S&P 500 Index (SPX - 1,379.85) has attempted to find footing at the round 1,400 area on pullbacks.

Meanwhile, we observed the anxiety lingering on Wall Street, evidenced by record purchases of CBOE Market Volatility Index (VIX - 18.61) call options, short interest remaining near calendar-year highs (even as stocks rallied to within a chip shot of multi-year highs in late October), and hedge funds' low relative exposure to stocks. This cautiousness understandably related to unknowns such as the economy (fiscal cliff), earnings, the election and Europe. Our takeaway was (and remains) that this fear and cautious mentality on Wall Street represents future buying power.

That said, this past week saw the bulls take a few blows to the face, but we are not ready to call last week's action a knockout punch. A few round numbers on major indices fell by the wayside, with the SPX now below 1,400 and its 200-day moving average. (For more on the 200-day breach, be sure to read Rocky White's commentary below on what has historically occurred after similar breakdowns in the Dow Jones Industrial Average [DJI - 12,815.39]). Moreover, the Nasdaq Composite (COMP 2,904.87) is now well below 3,000 and the Russell 2000 Index (RUT 795.02) is below 800. But as we said a few weeks ago, even if SPX round-number support is broken, last year's highs in the 1,350-1,360 area could come into play as supportive (Friday's SPX low was 1,373.03). The MID -- an index we have closely been monitoring -- is trading just north of potential support in the 960-965 area, which acted as resistance in July and support in August.

MID: Third failure at 1,000 since early October (a region that has been host to a series of failures since April, 2011). The MID continued its outperformance of the SPDR S&P 500 ETF Trust (SPY - 138.16) last week, however, which we find encouraging for the bulls.

Daily chart of MID since June 2012

From a technical perspective, the market is admittedly on shakier ground, with the first line of defense giving way last week on some benchmarks. A potential scenario is an additional decline of just over 4%, to the 1,320 area, which Bernie Schaeffer and other analysts discussed in a Bernie Schaeffer on Charts post on Friday.

Confounding many is the action in the VIX this week. Since Oct. 25, when the SPX closed at 1,412.97, there have been roughly 700,000 call additions, as investors positioned themselves for a potential pop in volatility ahead of the election. The SPX is down about 33 points since Oct. 25, but the VIX is up only 0.49 point. In fact, the VIX is up only 0.19 point since the day prior to the election. Our takeaway is that volatility was "pre-bought" ahead of the election, and the passing of the "unknown" had a deflating impact on implied volatility.

The encouraging news for bulls is that the VIX has still not advanced above the level that is defined as 50% above its calendar year low (13.30 in August). This would suggest that volatility buyers view portfolio insurance as too expensive at current levels. In turn, this could have a calming effect on the broader market, as the mechanics of portfolio insurance purchases are a coincidental capping mechanism. In fact, a bullish unwinding of speculative downside bets or hedges against a decline is now a possibility, with expiration of index and ETF options this coming Friday and the high-demand VIX options set to expire on Nov. 21.

Daily chart of VIX since April 2012

With expiration week upon us, we typically take a look at the open-interest configuration on major exchange-traded funds (ETFs) in an attempt to identify areas of potential put support and call resistance. What is notable is how the SPY peaked last week at the 144 strike, the first strike in the November series where call open interest is larger than put open interest. The subsequent decline pushed the SPY down to 137.40, which is around the heavy put strike at 138.

Last week's decline could have been exacerbated by a bearish "call unwind, put delta hedge," as the large put strikes act as magnets once momentum picks up to the downside. If Friday's stability holds through early next week, the opposite (bullish) mechanics could be in play -- a bullish put unwind that drives the market significantly higher. That said, should the market weaken, a visit to SPX 1,350 (or SPY 135), would not be surprising. Short-term traders should be prepared for both scenarios.

SPY November Open Interest Configuration

30-Minute Chart of SPY since November 5

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