Monday Morning Outlook

The Crucial S&P 500 Levels to Watch This Week

Can the rest of the year possibly measure up to the stock market's blowout first quarter?

by 3/31/2012 10:40:21 AM
Stocks quoted in this article:

It was an historically awesome first quarter for the market, as the S&P 500 Index (SPX) turned in its best January-March performance since 1998. (To put that in perspective: the last time the SPX fared this well in the first quarter, notorious tech-bubble casualty was still five months away from launching.) It's a funny thing about this bull market, though -- three years and more than 600 SPX points later, retail investors still aren't buying it. This week, Todd Salamone lists three major signs that skepticism is mounting, despite the market's technical feats. Meanwhile, Rocky White crunches the numbers to discover whether an outsized first-quarter return might cannibalize April's typically bullish seasonality. Finally, we wrap up with a preview of the key economic and earnings reports for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: First-Quarter Earnings Could Bring Some Surprises
By Todd Salamone, Senior VP of Research

"Some technical indications are being thrown around as corrective warnings, yet our own research on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID) making its second run in as many years at the 1,000 millennium mark."
- Monday Morning Outlook, March 17, 2012

"Short selling rose at the New York Stock Exchange and Nasdaq Stock Market during the first half of March... the number of short-selling positions at the NYSE not yet closed out, known as short interest, increased 2.05%... On Nasdaq, short interest rose 2.54%... Over the period covered by the latest short-interest report, the Dow Jones Industrial Average rose 300.69 points, or 2.32%. The Nasdaq Composite Index increased 89.48 points, or 3.02%. Marketwide, the short ratio, or the number of days' average volume represented by outstanding short positions, rose to 4.2 days from a revised 3.7 days, at Nasdaq, in late February."
- The Wall Street Journal, March 26, 2012

"AAII % bulls on 2/9 =52% AAII % bulls on 3/29 =42%. SPX on 2/9=1,351...SPX now= 1,400 - bullish from contrarian view"
- @ToddSalamone on Twitter, March 29, 2012

Two weeks ago, we pointed out the numerous calls for a correction we were seeing based on varying technical indicators. Our own research on these indicators -- together with the fact that equity benchmarks, such as the S&P 500 Index (SPX - 1,408.47) and S&P MidCap 400 Index (MID - 994.30), were bumping into the round-number areas -- suggested there was a higher probability of a choppy period, rather than a correction. Frustrating for both bulls and bears alike is that we have experienced the higher-probability choppy scenario, with the bulls experiencing a jolt once things look good, and the bears getting shocked just when a breakdown appears underway.

30-Minute Chart of SPX since March 16

With the market directionless during the past couple of weeks, we still think the next significant move is higher, as we see skepticism building even as the technical backdrop remains healthy. The skepticism, of course, represents potential future buying power. With respect to the short term, we find it impressive that the SPX has still experienced only two closes below its 14-day moving average since Dec. 20. This trendline, which we briefly discussed last week, came into play during the past three trading days, and enters the week at 1,403.70.

Daily Chart of SPX since December 2011 With 14-Day Moving Average

The aforementioned build-up in skepticism is evident on a few fronts, including:

  1. The retail investor has been getting increasingly worried since early February, according to the American Association of Individual Investors' (AAII) weekly survey. The skepticism comes amid an advance in the market since this period. The fact that only about four in 10 retail investors think the market is headed higher is mind-boggling, given the short-term and intermediate-term trends.
  2. Moreover, short interest recently ticked higher, even as the market advanced. The short interest statistics cited in The Wall Street Journal earlier this week came as no big surprise to us. It is usually the professionals who do the bulk of the shorting, and we are seeing increasing nervousness among professional market players through our daily analysis of the options market, where put buying on CBOE Market Volatility Index (VIX - 15.50) futures has grown rapidly in recent weeks -- probably as hedges to the short positions some fund managers have initiated in recent weeks.
  3. The first-quarter earnings season is only a couple of weeks away, and it appears analysts aren't expecting much. Low analyst expectations set the stage for positive surprises, and high expectations sets up an environment ripe for disappointments. Evidence that low expectations for earnings are in force:

    "'While companies still seem to be trying to operate as leanly as possible, it is going to be harder for them to translate whatever cost-cutting measures are still possible into profits that can surprise analysts and beat the latter's earnings estimates,' Thomson Reuters says. That's the big worry as investors turn their sights to first-quarter earnings season."
    - The Wall Street Journal, March 30, 2012

    "The fourth-quarter company results season was the worst since 2008 in terms of firms beating estimates. That was largely overlooked by a market in the middle of a liquidity surge, but it may come home to roost this quarter."
    - Reuters, March 29, 2012

The coincidental impact of the growing wariness among professional market players -- as the SPX challenges 1,400, the MID stares down the barrel of 1,000, and the Russell 2000 Index (RUT - 830.30) closes in on all-time highs and former resistance points -- may account for the frustrating tape we have seen in recent weeks. For bulls, the good news is that the market remains on solid footing, and a fair amount of caution is apparent heading into first-quarter earnings season.

A pullback like we saw in late February and early March would push the SPX down to the 1,370 area -- which we view as support, given it is the site of the 40-day moving average and last year's high. Potential resistance is in the 1,450-1,470 zone, the SPX target after the inverse "head and shoulders" breakout above 1,260 and site of the May 2008 peak.

Monthly Chart of RUT since February 2002

Daily Chart of SPX since February 2011 With 40-Day Moving Average

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