Ride Out the Short Term for the Next Major Market Surge

Tracking fourth-quarter returns in election years

by 10/6/2012 9:30:47 AM
Stocks quoted in this article:

The fourth quarter is off to a fine start for the bulls, as the major market indexes shook off some early malaise to settle higher for the week. The Dow Jones Industrial Average (DJI - 13,610.15) even took out the 13,600 level on Friday and touched its highest level in half a decade. Stocks mustered these gains despite an increasingly stubborn and skeptical contingent that remains content to stay on the sidelines.

With indexes at or near critical historical levels on the charts, as earnings season and a Presidential election draw near, Todd Salamone outlines the bullish case from a short- and longer-term perspective. Also featured in this week's analysis:

  • Two technical levels to keep an eye on.
  • Three signs that hedge funds are still sitting out this rally.
  • Does the fourth quarter of an election year mean more upside, or just more volatility?
And finally, we'll end with a review of next week's calendar, as well as a look at two of our favorite sectors.

Notes from the Trading Desk: Eyeing the Four "E's"
By Todd Salamone, Senior V.P. of Research

"Alcoa kicks off third-quarter earnings when it reports on Oct. 9, and it's sure to be a lousy season. The S&P 500 companies are expected to report contracting profits, by about 2%, for the first time since 2009, according to S&P Capital IQ. That's certainly not a good thing for stocks."
-The Wall Street Journal, October 1, 2012

"...hedge funds are turning away from a rally in the global stock market. The ratio of bullish to bearish bets among professional speculators fell last week and is below historical averages, according to a survey by International Strategy & Investment Group ... Hedge funds make up more of the equity market after their assets expanded and individuals pulled record cash from U.S. mutual funds."
-Bloomberg, October 5, 2012

The four "E's" -- Earnings, Economy (a/k/a the "fiscal cliff"), Europe, and Elections -- continue to breed uncertainty in the equity market. The ambiguity is translating into caution and hesitation on the part of major market-movers, such as hedge funds. With respect to price action, major indices are situated around all-time highs or multi-year highs, with small- and mid-cap indices -- such as the Russell 2000 Index (RUT - 842.86) and S&P 400 Midcap (MID - 996.36) -- challenging resistance levels in the 850-860 and 1,000 areas, respectively.

Monthly Chart of the Russell 2000 Index (RUT) since December 2002

Weekly Chart of the S&P 400 Midcap Index (MID) since September 2010

Meanwhile, the S&P 500 Index (SPX - 1,460.93) ran into last month's highs in the 1,470 area before sellers overcame buyers on Friday, keeping the broader index about 5% below its all-time high-water mark. Finally, the CBOE Market Volatility Index (VIX - 14.33) is struggling to take out its calendar-year "half-high" in the 13.33-13.80 area, after bouncing from this level on Friday for the third time since late August.

Daily chart of the CBOE Market Volatility Index (VIX) since January 2012

With major benchmarks trading at or near their respective highs, price action at present suggests we could be in for some choppy action, at least until we see some resolution among the four "E's" looming over the marketplace at present.

Like last quarter, investors are approaching earnings season with low expectations, which increases the likelihood that lackluster reports and negative earnings growth are baked into the market. In fact, the ratio of negative pre-announcements to positive pre-announcements is near the ratio that existed in the first quarter of 2009, another sign that bad news may already be factored into stocks.

The good news for bulls is that many have missed this rally and still have little net exposure to the market, so pullbacks to previous breakout areas could be met with buyers, such as those in the hedge fund community. Signs that hedge funds have little exposure to the market are evident in the options market and in short-interest data. For example:

1. Hedging activity is relatively small among those that use exchange-traded funds (ETFs) to hedge long positions. This is evident in the combined ratio of put buying to call buying on the SPDR S&P 500 ETF Trust (SPY - 146.14), the iShares Russell 2000 Index Fund (IWM - 84.11), and the PowerShares QQQ Trust (QQQ - 68.98) during the past month. Our theory is, when the ratio is low, there is little equity exposure to be hedged and therefore, little put buying relative to call buying.

While such caution among fund managers can be a negative in the immediate term (since they are the market movers), it also suggests there is enough fire power to push indices through their respective resistance levels once any uncertainty is resolved. In fact, the fire power might be equivalent to that of early 2009, given how low the ratio is (see the chart below).

20-day buy-to-open put/call volume ratio on SPY, QQQ, and IWM, since January 2011

2. Short interest continues to rise, even on stocks that may be deemed "high quality" or defensive. For example, short interest on SPX component stocks again ticked higher in the most recent reporting period, and is barely below the peak levels of last year that preceded a major rally in equities. The current high level of short interest is indicative of the pessimism that exists, and is likely contributing to the net low exposure to equities among hedge fund managers.

SPX with Total Short Interest since January 2011

3. Finally, it appears most traders expect volatility to increase, as the ratio of calls bought (to open) versus puts bought (to open) on the VIX is approaching a margin of three to one during the past 20 trading days. This ratio is at its highest level since July amid heavy volume, as VIX call open interest is around 5.31 million contracts, growing daily, and near the all-time high achieved last month. VIX call buying is another headwind for the market in the immediate term, but also has the potential to unwind in bullish fashion in the future.

The short term could be choppy amid a myriad of uncertainty and major indices trading near key resistance levels. But we expect that the next major move is higher, as underperforming hedge fund managers represent a huge source of buying power in the coming weeks.

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