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Is This the Top? Don't Count On It

The stars aren't yet aligned for a major sell-off

by 7/26/2014 8:28:41 AM
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Despite a deluge of data points, not to mention growing geopolitical concerns, the S&P 500 Index (SPX) called it a wash last week. The index enjoyed three straight sessions of record highs, as traders applauded a few stellar earnings and economic reports, but the pendulum swung the other way on Friday. Going forward, Senior Equity Analyst Joe Bell explains that, while there may be a few short-term hiccups on the horizon, the overall outlook remains upbeat.

  • The one-word summary of why this rally has legs
  • What to expect ahead of Wednesday's Fed decision
  • The round-number levels on the radar

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: Why a Sell-Off Isn't Imminent
By Joe Bell, Senior Equity Analyst

Schaeffer's Senior VP of Research Todd Salamone is on vacation this week, so I'll be filling in.

Two Ukrainian fighter jets were shot down last week. The Israel and Hamas fighting continues. U.S. is poised to implement more sanctions on Russia. Russia put sanctions on Microsoft Corporation (NASDAQ:MSFT) and International Business Machines Corp. (NYSE:IBM). On top of all this, we still aren't 100% sure who shot down that Malaysia Airlines plane, though the U.S. is pointing at Moscow.

Despite the geopolitical uncertainty swirling around, market participants just don't care that much. Last week also saw a flurry of earnings reports and the lowest initial jobless claims since February 2006, but even those data points couldn't shake this market. With volatility plummeting after mid-July's short-lived spike, the S&P 500 Index (SPX - 1,978.34) grinded slightly higher during the week and then gave it all back on Friday.

With the SPX essentially flat for the week, it didn't do much to change the landscape of U.S. equities in any major way. The SPX just barely eked out a new all-time high on Thursday, but the 1,980-2,000 area still lingers overhead as potential resistance. The 1,950 area continues to act as the bottom of the index's recent range.

Daily Chart of SPX since February 2014 with 50-Day and 200-Day Moving Averages

While the SPX gets most of the press, let's take a look at some of the other major indexes in play. The Wilshire 5000 (W5000 - 20,907.17) and NYSE Composite Index (NYA - 10,985.81) are both trading near important round-number areas of 21,000 and 11,000, respectively. Both indexes still contend with their previous 2014 highs made in early July as well. Until we see a more significant breakout, these round-number hurdles remain in place.

Not wanting to be left out of the party, the Dow Jones Industrial Average (DJI - 16,960.57), Nasdaq Composite (COMP - 4,449.56), and S&P 400 MidCap Index (MID - 1,405.72) all have their own round numbers to contend with. While the Dow finished slightly negative for the week, the COMP and MID stayed just above breakeven. Patience is in order until we see a more pronounced move past these areas.

Small-caps have been one of the big stories in 2014, as the Russell 2000 Index (RUT - 1,144.72) has severely underperformed the SPX and Dow since March. While most major indexes are flirting with all-time highs, the RUT is still struggling below its 2014 breakeven level of 1,163.64.

Daily Chart of RUT vs SPX since August 2013

Generally, bulls want to see leadership out of the small-caps as a signal that investors have a healthy risk appetite. Maybe Fed Chair Janet Yellen's negative take on small-cap social media and biotech stocks is the contrarian signal they've been waiting for. Time will tell, but for now this goes in the category as a concern and something we will continue to monitor.

Speaking of concerns, there are a few things that I would add to this category. On Thursday, the SPX made a new all-time high and its Relative Strength Index (RSI) closed at about 61. RSI is a momentum oscillator that measures speed and change of price movements. It ranges from zero to 100, and traditionally the underlying is considered "overbought" when the RSI is above 70, and "oversold" when below 30.

Daily Chart of SPX since March 2014 with 14-Day RSI

While the SPX's current RSI isn't overbought, it has clearly signaled a bearish divergence. This occurs when the index makes a higher high and the RSI forms a lower high. RSI is not confirming the new high and this shows weakening momentum. Also, take note that the Powershares QQQ Trust (QQQ - 96.74) is making a similar bearish divergence. Let's remember, sometimes during strong trends RSI can show numerous bearish divergences before a top actually occurs. We have seen two since June, though, so something to keep in mind.

Let's also take a look at the study below. Over the last 50 years, August-September was the only two-month period with an average return that was negative on the SPX. In other words, the time period we are about to enter next week has historically marked periods of underperformance.

SPX Two-Month Returns Over 50 Years

As you can see in the table below, August in particular has been a very weak month. Over the last 20 years, August was the worst-performing month of the year. What might be the reason for this? Most believe continued warm weather leads to investors and traders taking more vacation days and paying less attention to the stock market during the summer months. Whatever the reason, history tells us that these time periods haven't done so great.

SPX Average Return By Month Over 20 Years

Okay, so I have some short-term concerns. Is this the top, though? We don't think so. We are in a bull market and an incredibly strong uptrend. It sounds simple, but sometimes it pays to keep it simple. With that being said, it has been 72 trading days since our 4% pullback in April. That's a pretty nice run. There is potential for short-term weakness and we continue to expect sideways price action during the summer.

So, what's keeping me from thinking we could be due for a major sell-off? One word: Sentiment. Short interest on the SPX and QQQ components is still high. In fact, short interest on SPX components is higher than 61% of the readings taken during the past five years.

SPX vs Short Interest since January 2011

Also, check out short interest among stocks in the QQQ. The QQQ is heavily tech-weighted, which is one of the stronger sectors in 2014. Short interest on components of the QQQ is higher than 79% of the readings taken during the past five years. The price action is strong, but we are still seeing signs of skepticism. That's a good thing for bulls.

QQQ vs Short Interest since January 2011

Another theme we continue to see play out is call buying on CBOE Volatility Index (VIX - 12.69) options, which we believe decreases the probability of major market sell-offs. If the hedges are in place, there just won't be as much panic selling in response to market weakness.

There was also an interesting survey of fund managers by Bank of America-Merrill Lynch this month. These managers oversee $700 billion in assets. While global equity exposure is at its highest level since February 2011, most of that exposure continues to be over in Europe. This seems to be the case for equities and bonds and one of the big reasons we think U.S. bonds have done so well in 2014. This could be a theme we continue to see, as cash from European equity and bond investments potentially make their way back to U.S. equities. That could be supportive.

While the sentiment backdrop for U.S. equities continues to be supportive, we have some technical and seasonality issues to work through in the short term. This next week certainly delivers in terms of potential market-moving events. Consumer confidence figures for July are released on Tuesday, and the latest gross domestic product (GDP) estimate will be out on Wednesday. In addition, we get the latest Federal Open Market Committee (FOMC) rate decision, and then monthly job figures at the end of the week. Oh, and let's not forget about earnings season! Have fun and good luck in your trading.

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