Stop Trying to Outsmart the Market

Strength in junk bonds and housing could bode well for equity bulls

by 7/21/2012 10:59:55 AM
Stocks quoted in this article:

It was a winning week for U.S. stocks -- even if it didn't really feel like it on Friday. But while familiar euro-zone concerns are still flaring up, last week also brought a number of well-received earnings announcements, along with a few resoundingly upbeat reports on the housing sector. Another flood of quarterly earnings is set to hit the Street this week, including the latest results from Apple (NASDAQ:AAPL) and a number of other heavy hitters. So, now that July options expiration is behind us, can stocks finally gather enough positive momentum to tackle looming resistance levels? Filling in for Todd Salamone this week is Senior Technical Strategist Ryan Detrick, who cites several indicators to offer the bulls some midsummer cheer. Meanwhile, Rocky White takes a look at the harsh post-earnings plunge in Chipotle Mexican Grill (NYSE:CMG), and wonders whether this one-time outperformer can resume its winning ways. Finally, we preview this week's notable economic and earnings events, and check out a few sectors of note.

Notes from the Trading Desk: Will Stocks Catch a Lift as Shorts Hit the Bricks?
By Ryan Detrick, CMT, Senior Technical Strategist

Well, we had a nice bounce going until the S&P 500 Index (SPX - 1,362.66) ran into resistance near the 1,370 area on Friday. As Todd mentioned last week, there were heavy calls on the SPDR S&P 500 ETF (NYSEARCA:SPY - 136.47) at the 137 strike, and this was already an area the SPX had trouble with back in early July -- so it was a logical place for stocks to hit a roadblock, and that's exactly what happened. Still, bigger picture, the lows from early June are still intact, and the overall uptrend is firmly in place.

Turning to the fundamental outlook, we continue to see signs the economic recovery is slowing. Overall, earnings are coming in better than the Street's much-lowered expectations, yet revenue is missing the mark in a lot of cases. The big question on everyone's mind is whether this is just a slowdown in the recovery, or the beginning of a major recession.

With that said, there are still two areas holding up well that make me think the economy won't tank, and could very well improve drastically during the second half of the year. Housing and junk bonds are both showing some major improvements, and this is definitely an encouraging sign. The majority of the housing data over the past two months has been very positive. In fact, housing starts in June came in at their highest level in three years. Turning to junk bonds, they can be a very good gauge of economic growth. Think about it -- these are bonds on the riskiest of companies, and improvements here show an appetite for risk. Why would anyone buy bonds if you think the company paying would just default? Right now, various junk bonds are breaking out -- suggesting the economy could be on much better footing than most give it credit for.

JNK Daily since August 2009
Chart courtesy of StockCharts.com

Touching on the technicals, that 1,370 area we talked about was definitely a trouble spot. Not to be outdone, though, the Dow Jones Industrial Average (DJI - 12,822.57) is close to 13,000, and the Russell 2000 Index (RUT - 791.54) is flirting with 800. We've found that these psychologically significant big, round numbers can indeed act as sticking points. As long as the SPX is above its double low of 1,333, we are still firmly bullish -- but we'd love to be able to clear all of these other areas sooner rather than later.

Speaking of higher prices, here's a chart that suggests new highs could be coming soon. If you look at the cumulative new highs versus new lows at the NYSE, it has just made another new peak. This shows there are many more new highs than lows, and anytime you get a lot of stocks breaking out to new highs, the overall market will normally follow suit. The bottom line is, internals remain very strong here -- and there's nothing wrong with that.

NYSE New Highs since 2011
Chart courtesy of StockCharts.com

Now let's take a look at some of the various sentiment indicators we follow. The reality is, most of these indicators are still flashing extreme skepticism, and that is nearly always a good sign for contrarian investors. Remember, no matter how bad the news seems, when expectations are extremely low it is much easier to surprise to the upside. That is exactly where we find ourselves here.

Probably my favorite sentiment indicator right now is what's happening in short interest. Since April, we've seen a huge spike in short interest on all optionable stocks (there are about 2,600 in our database). 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. I have no clue if this will happen again, but it's another sign that siding with the bulls is probably a wise move.

SPX with Total Short Interest

Another indicator that continues to bode well for the bulls is the 10-day, equity-only, buy-to-open put/call volume ratio on the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). This ratio recently peaked at its highest level since March 2009, but has since rolled over. Think about that -- we had just a 10% pullback in the SPX, yet there was similar put buying to what we saw at a major generational panic bottom. This is simply amazing, and also sums up the overall level of fear that is out there. This ratio is still firmly pointing lower, and as you can see, a lower ratio has historically been rather bullish for equities.

ISE, CBOE, PHLX 10-day equity-only BTO put/call volume ratio

It's worth touching on mutual fund flows, as well. Looking at domestic equity mutual funds, we've got record outflows over the past 12 months of around $175 billion. What's really amazing to me is that, historically, the 12-month flows tends to move with the overall market. Yet, what has happened since the lows last summer is an increase in outflows, along with a steadily higher stock market. From a contrarian point of view, this could be extremely powerful, as it shows how much more potential there is for higher prices should any flows make their way back to equities.

SPX with Domestic Equity Fund Flows

And here's a chart that also plots bond fund flows. This isn't a huge surprise, but there has been about $200 billion in bond fund inflows during the past 12 months, trouncing the record outflows from domestic equity funds. We have our concerns over bonds here, as this is now an extremely crowded trade. The potential for money to shift out of the popular bond trade and into the much-less-popular equity trade is a very real possibility as equity prices continue to move higher.

SPX with Domestic Equity and Bond Fund Flows

Finally, here's a real head-scratcher. We know most investors want nothing to do with this market, after getting burned by such incidents as the flash crash, the ill-fated Facebook IPO, and various scandals at banks (led by JPMorgan's "London Whale" mess). Well, here's more proof of just how low expectations are. The American Association of Individual Investors (AAII) sentiment poll came out last week with just 22% bulls, which is the lowest reading since August 2010. Plus, this marks the 11th straight week of more bears than bulls.

Schaeffer's Quantitative Analyst Chris Prybal looked into the historical data, and found this is the sixth-longest such streak since 1987. Looking at the previous five times this has occurred, after 10 straight weeks of more bears the bulls, the SPX is up an average of more than 5% over the next 30 trading days -- and it was higher all five times over the next 30-day period. Below is a chart of the 10-week moving average of the AAII bulls since 2002. As you can see, this is the lowest it's been since March 2009, and it's down near previous major buying points going back over the last 10 years. Makes you think this surprise summer rally might continue, doesn't it?

AAII Bulls with 10-Week Moving Average since 2002

In conclusion, the odds of higher prices are still very good right here. Nonetheless, financials and select Chinese Internet names look rather weak, and bearish positions on some of these names could very well be a decent hedge, should the market stall out for any reason.

I'll leave you with a great quote from Colm O'Shea, as stated in the latest "Market Wizards" book by Jack Schwager:

"I think the biggest mistake people make is to assume there is an answer when, in fact, there may be no good answer."

Don't beat yourself up finding reasons to outsmart the market. First and foremost, the uptrend is firmly in place. Then, when you consider our accommodative Fed, low valuations, and historically low sentiment -- it all adds up to a strong likelihood of higher prices at least through the remainder of this year, if not further out. Keep it simple.

Best of luck in your trading.

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