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After Record Highs, Do Stocks Need a Breather?

The Dow and millennium marks -- a walk down memory lane

by 7/4/2014 8:20:23 AM
Stocks quoted in this article:

The holiday-shortened week boded well for U.S. stocks, as the major market indexes rallied to record highs. What's more, an encouraging employment report propelled the Dow north of the 17,000 mark for the first time ever on Thursday, and the S&P 500 is closing in on a round-number level of its own. As Todd Salamone points out, there are plenty of sentiment indicators to suggest the rally has legs, but we could face a few speed bumps in the short term.

  • Evaluating the next major resistance levels
  • Why pullbacks should be viewed as buying opportunities
  • What the Dow's millennial milestone could mean for stocks

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: Round-Number Levels in the Rearview
By Todd Salamone, Senior VP of Research

"... there appears to be caution among many technicians, who have a laundry list of concerns. These include: a RUT and SPX divergence, seasonality, low volume, a low VIX, weakening 52-week highs, and the potential for a bearish 'head and shoulder' formation, even as a bullish inverse 'head and shoulder' pattern is a distinct possibility... "
-Monday Morning Outlook, May 24, 2014

"Not to be forgotten is the SPX, which took out century-mark resistance at 1,900, which abruptly turned away rally attempts in early April and mid-May. The SPX also experienced a bullish inverse 'head and shoulder' pattern that targets 1,980. But we see the 2,000 area as the next major resistance level for the SPX, as this is a round-number millennium level that is 200-percent above the March 2009 low."
-Monday Morning Outlook, May 31, 2014

"Wilshire 5000 -- bullish inverse 'head and shoulders' pattern targets 21,200"
-@ToddSalamone on Twitter, May 29, 2014

"... the 10-day average of buy-to-open put volume relative to call volume is nearing the levels of January, which preceded a 5% SPX pullback. As long as the direction of this ratio continues south, the market is likely to advance. However, if the sentiment shifts and this ratio heads higher, the market becomes at increasing risk of another pullback. As such, we'll continue to closely monitor this indicator."
-Monday Morning Outlook, June 28, 2014

"RUT above 1,200 for first time since 3/21"

"AAII % bulls still only 38%, up from 33% in mid-May when $SPX began initial move ahead of 1,900 breakout"
-@ToddSalamone on Twitter, July 2 and 3, 2014

The holiday-shortened trading week brought new records to Wall Street, with the headline Dow Jones Industrial Average (DJIA - 17,068.26) hitting 17,000 for the first time ever, and the Wilshire 5000 (W5000 - 21,107.54) overtaking another millennium mark -- 21,000 -- after struggling to sustain a move above 20,000 from March through May. The W5000 goes into next week sitting just 93 points below the 21,200 target, following its inverse "head and shoulder" breakout signal in late May.

Meanwhile, the S&P 500 Index (SPX - 1,985.44) climbed above 1,980 -- the target for the inverse "head and shoulder" breakout pattern that was signaled in late May -- and currently sits less than 1% below the 2,000 millennium mark, which is triple the 2009 low. This round number, as we alluded to in late May, is the next major resistance level that could slow the two-months momentum higher that began in mid-May, following a grueling two-month trading range.

Daily Chart of SPX since January 2014 with 40-day Moving Average

Speaking of round numbers, the Russell 2000 Index (RUT - 1,208.15), which has led the advance during the past several weeks, rallied back above the 1,200 mark, an area that marked a top in March before a 10% correction. After the "double bottom" in May (the May low was in the same area as the February low), this index will attempt to take out its March peak, although bears are hoping for a failure to do so, putting a bearish "double top" formation in play.

Daily Chart of RUT since January 2014

Amid the new highs in the SPX, the CBOE Market Volatility Index (VIX - 10.32) closed at a new calendar year and multi-year low. Additionally, it closed below 10.74, which is half its 2014 peak. Despite the trend lower, VIX call open interest eclipsed the 7 million mark, with July VIX expiration two weeks away. It seems the lower the VIX goes, the more option players want to bet on or hedge against higher volatility. Such behavior is likely keeping volatility depressed, as those with hedges in place are less likely to panic-sell on perceived negative headlines, which have routinely accompanied this bull run, breeding never-ending caution. Despite the multi-year VIX low, it remains 68% above the SPX historical volatility reading of 6.13.

VIX tracks lower as demand for VIX calls rises

VIX Daily Open Interest since January 2013
Chart courtesy of Trade-Alert

As we've mentioned in prior weeks, there are many sentiment indicators that suggest the bull can live on, with three straight months of outflows from domestic U.S. equity funds, which was preceded by at least three consecutive months of inflows prior to the 10% correction in the RUT that began in March. We are also intrigued by the elevated short interest on SPX components and PowerShares QQQ Trust (QQQ - 95.70) components.

Additionally, contrarians should like the abundance of caution that exists among fund managers, who are short stocks as a hedge to long positions, or who are aggressively accumulating VIX calls month after month to protect their long portfolios. This caution should continue to keep pullbacks muted, much like those of the past couple of years.

That said, round numbers are back in play, which could slow the current momentum. The RUT is trading just below its March peak around the 1,200 area, the SPX is trading just below the 2,000 millennium mark, and the Dow hit the 17,000 mark for the first time ever (for historical perspective on the Dow hitting a millennium level for the first time, see Rocky White's commentary on page 2).

With round numbers in play as potential speed bumps, one group that recently turned optimistic -- and has for the most part had a poor timing record -- is equity option players. This group was bullish in mid-January, ahead of a pullback into early February, bearish at the February bottom, bullish again ahead of the RUT correction in early March, and extremely bearish ahead of this current rally.

This group just reached an optimistic extreme again. As you can see on the chart below, the 10-day, equity-only, buy (to open) put/call volume ratio recently hit a multi-month low of 0.44, but has turned higher to 0.49. When this ratio turns higher, as it is now, the market becomes more vulnerable than usual to a short-term pullback. But as we've said numerous times, we'd expect pullbacks to be shallow. As such, pullbacks should be viewed as buying opportunities.

We would not be surprised, for example, to see the SPX 2,000 level act as a resistance area in the near term, and for 1,925 (current site of the SPX's 40-day moving average) or 1,950 act as support.

Equity option players just reached an optimistic extreme

SPX with 10-day BTO put-call ratio since 2012

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