Why Stocks Could Be Set For a First-Quarter Surge

The technical and sentiment outlook in December 2013 is eerily familiar

by 12/28/2013 7:48:39 AM
Stocks quoted in this article:

It was a relatively quiet holiday week on Wall Street, but the Santa Claus rally appears to be in full swing. Despite a lack of major news drivers, the major equity indexes extended their reach into record-high territory. Following the market's stellar 2013 performance, can bulls possibly hope for additional gains as we head into 2014? This week, Todd Salamone explains the key drivers that could determine the next move for stocks.

  • Six reasons why we could be poised for another breakout first quarter
  • One short-term risk to the bullish case, courtesy of the VIX
  • Rocky White measures the Dow's weight in gold

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: Can Shorts Help Fuel Another Leg Higher?
By Todd Salamone, Senior VP of Research

"U.S. fund managers increased their average cash positions in December to the highest level in nearly six years and slightly cut their equity holdings, a Reuters poll showed ... Cash levels rose to 4.4 percent of assets this month, the highest level since January 2008 ... "
-Reuters, Dec. 20, 2013

"U.S. investors are generally wary about stocks as a way for Americans to build wealth, as 37% say the stock market is an 'excellent' or 'good' way for average Americans to grow their assets, while 46% consider it 'only fair,' and 16% call it 'poor.'"
-Gallup.com, Dec. 20, 2013

"The fear leading up to the meeting explains the huge rally after the Fed's announcement. The lifting of the taper-timing uncertainty -- coincident with the Fed saying the Fed Funds rate could remain low well past when the unemployment rate falls below 6.5% -- created a huge unwind of this caution ... The good news for bulls (we think) is that major benchmarks rallied strongly off round-number support or back above round-number resistance levels that have been plaguing equities since mid-October ... Short covering could very well be the next driving force in the rally, assuming round-number speed bumps are behind us for good."
-Monday Morning Outlook, Dec. 21, 2013

"Hedge funds have made returns for their investors of 9.4 percent since 2011, and 39.6 percent since 2009, data from Hedge Fund Research shows, but an investment in a fund tracking global stocks would have made around 32 percent and 75 percent respectively ... Despite the relatively poor performance, investors continue to put more money into hedge funds ... Total inflows by the end of November topped $71 billion, almost double last year, eVestment said in a report this week. Combined with performance gains, this has raised industry assets to $2.8 trillion, 3 percent below its all-time high."
-Reuters, Dec. 23, 2013

With 2013 winding down, multiple U.S. equity benchmarks staged another impressive rally last week, hitting all-time highs or multi-year highs in the process. And as we get ready to say goodbye to a tremendous 2013 and turn the calendar to 2014, one has to consider the possibility of a repeat of 2013's first-quarter performance, in which the S&P 500 Index (SPX - 1,841.40) staged a low-volatility 10% advance.

A repeat of 2013's first quarter may seem improbable, especially after this year's fourth-quarter advance of nearly 10% versus the "flattish" fourth quarter of 2012. While this quarter's bottom-line performance was significantly better than last year's fourth quarter, there are some similarities, including:

  1. A strong mid-November to December period.
  2. SPX historical volatility in the single digits as the end of the year neared.
  3. A pullback to the SPX's 40-day moving average that marked the beginning of market strength.
  4. Total short interest on SPX components around multi-month highs, but showing signs of declining.
  5. Last December, the "fiscal cliff" was avoided at the last hour, while this year Congress struck a budget deal, but well ahead of the final hour.
  6. There were few bets on lower volatility ahead as we entered 2013 and as we enter 2014, as evidenced by option activity on CBOE Volatility Index (VIX - 12.46) futures. For example, using a 20-day look-back period, the ratio of VIX buy-to-open call volume to buy-to-open put volume was over 3.0 just ahead of the turn of the calendar year, with buy-to-open put volume around annual-range lows.
December 2012 pullback to 40-day moving average preceded strong first-quarter 2013 rally

Daily Chart of SPX, October 2012 - March 2013 With 40-Day Moving Average

December 2013 pullback to 40-day moving average -- precursor to another first-quarter rally?

Daily Chart of SPX since September 2013 With 40-Day Moving Average

Short interest on SPX components relatively high last year at this time, and again at present -- short covering on the horizon again?

SPX with Total Short Interest

After reading various articles in Reuters and Gallup.com, and reviewing our own commentaries in recent weeks that have observed the trend higher in short interest (excerpts above), we can only wonder how many market participants (hedge funds, professionals) or potential market participants (retail investors) have missed out on the fourth-quarter gains? Despite an impressive 2013 and fourth quarter, hedge funds are clearly underweight equities, professionals are still steering hefty amounts of cash into hedge funds as protection trades, and most retail investors still have little confidence in the market, after getting bruised and battered twice in a decade. If, like last year, the new year ushers in a hint of improved confidence, equities could surge in 2014's first quarter. This may be an unpopular viewpoint, but the ingredients are in place.

The first day of trading in 2013 got the bulls off to a gangbuster start, but a short-term risk we see as we move into 2014 is the relatively tame VIX, which hit a low of 11.69 late last week. While the "fear gauge" is still not low relative to the SPX's single-digit historical volatility, and we continue to think a move down to 10.50 is possible (half its recent high), it is not a secret that the market has struggled from a short-term perspective after the VIX has moved down to this area during the past year.

VIX -- The 12 area marked a floor throughout 2013

Daily Chart of VIX since January 2013

We remain bullish, although a modest pullback or sideways movement to work off the current short-term overbought situation would not be a major surprise. Support for the SPX is in the 1,800-1,810 zone -- a round number and a resistance area a few weeks ago. We are looking at the 1,860 area as a potential short-term resistance level, as 1,860 is roughly 20% above the 1,750 breakout level that marked major tops in 2000 and 2007.

Finally, we wish you, your family and friends a happy new year and the best of luck in 2014.

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