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Momentum Names, Turnaround Plays, and the Power of Sidelined Investors

Market wisdom (fresh from the airwaves)

by 2/15/2014 9:33:21 AM
Stocks quoted in this article:

Concerns about an impending market collapse were relegated to the back burner over the course of the past few days. Major market averages bounced from year-to-date lows and retook control of some significant trendlines, closing the week with solid gains. In fact, technology stocks -- as collectively represented by the Nasdaq Composite (COMP) -- entered positive territory for the year. This strong price action occurred despite mixed economic reports and a few notable earnings disappointments. But although bulls have grabbed hold of the reins, investors continue to exhibit a healthy degree of skepticism, as Todd Salamone outlines this week.

  • Four signs market participants are far from euphoric
  • How fear has marked an "excellent entry point" within the current trend
  • The historical market implications of Presidents Day week (and shortened weeks in general)

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: "Sidelined investors represent a future source of buying power"
By Todd Salamone, Senior VP of Research

"Fear among market participants is emerging once again, despite the fact that we hear over and over again that potential investors are looking for a good entry point. With major indices pulling back to potential areas of support, one has to seriously wonder if those that have missed buying opportunities in the past will miss yet another opportunity?"
-Monday Morning Outlook, Feb. 1 2014

"... bulls should be encouraged by the fear that this pullback has generated, and might look to mid-caps for exposure, with the MID back above the 1,300 level and the VIX back below 18.21."
-Monday Morning Outlook, Feb. 8, 2014

"Nasdaq Composite ($COMP) into the green YTD with close above 4,176.59 ... Still work to do with respect to $SPX $RUT $MID $DJIA"

"$RUT 80-dayMA has been important. Small-cap bulls would like to see a few closes back above this trendline. $RUT $IWM"

"Buy (to open) 5-day, equity-only call/put ratio declines from highest since 3/9/11 to lowest since 8/30/13 $SPX"
-@ToddSalamone on Twitter, Feb. 11-13, 2014

Schaeffer's Investment Research took to the airwaves this past week. Our Senior Technical Strategist Ryan Detrick, CMT, Senior Equity Analyst Joe Bell, CMT, and I all made appearances on CNBC and FOX Business News, discussing topics ranging from individual stocks to stock investment strategies and the broader market.

Just like trading, television interviews require a lot of preparation, even if a segment lasts only a few minutes. So, with that said, I am changing things up a little this week by way of giving you some of the bullets I prepared for myself ahead of my CNBC appearance last Thursday, and using this forum to expand on the related topics.

Television interview notes in bold (with expanded detail un-bolded):

Stocks should continue to move higher over the intermediate and longer term, although short-term speed bumps related to year-to-date breakeven points on some indexes are just overhead.

The good news is that the S&P MidCap 400 (MID - 1,346.86) is back above 1,300, the Russell 2000 Index (RUT - 1,149.21) is back above its 80-day moving average, and the Nasdaq Composite (COMP - 4,244.03) moved back into the green in 2014. Equities recovered relatively quickly from their January decline, the magnitude of which was very similar to other declines we have observed during the past year.

Table of Index Closing Prices and 2014 Breakeven Levels

Major peaks usually coincide with euphoric behavior, but we are not seeing euphoric behavior.

Scary headlines (Europe, a "rigged" marketplace, Fed policy, earnings worries, China, emerging markets, Congressional bickering), two bear markets still fresh on investors' minds, and multiple short-term pullbacks since the 2009 lows (five significant pullbacks in the past 18 months alone) have all combined to push potential investors out of the market. These sidelined investors represent a future source of buying power.

Earlier this week, I had our Senior Quantitative Analyst, Rocky White, look at inflows/outflows into U.S. equity mutual funds in the three calendar years ahead of a bear market, along with the S&P 500 Index (SPX - 1,838.63) return over the same three-year period. Per the table immediately below, the sentiment among retail investors looks absolutely nothing like the years preceding the bear markets we witnessed in the 2000s.

In fact, fund flow data represents skepticism and disbelief among the retail crowd. In the context of current price action, we view this as bullish. Some might argue that you cannot look at equity mutual fund flows given the rise of exchange-traded funds (ETFs). However, the ETF world is more fully embraced by the professional investor relative to the retail investor.

Table of Index Fund Flows and SPX Returns

Other examples of a lack of euphoria:

  1. Fund managers are cautious, as evidenced by the huge portfolio protection trades seen in the options market. Last month, CBOE Volatility Index (VIX - 13.57) call open interest hit a record high. This portfolio protection does not guard against corrections or pullbacks like we saw in January, but then again, with protection in place, investors are less prone to partaking in long periods of sustained selling.

  2. Total short interest on S&P 500 component names is near three-year highs and far above the 2012 low. Meanwhile, the SPX is near all-time highs and nearly 50% above 2012's low (see chart below).

    The big outstanding short interest and performance figures suggest that the $2.8 trillion dollar hedge fund industry is underweight U.S. stocks. Hedge funds represent another source of buying power, if they increase U.S. equity exposure.

  3. Following a strong 2013, Street strategists, on average, are predicting sub-par returns of 5% to 6% for the SPX this year. To put it plainly, there is little excitement among this influential group.
QQQ price and total short interest

We are encouraged that last week's trough in the SPX occurred at a trendline that marked several lows in 2013.

In our 2014 forecast, we highlighted the potential significance of the SPX's 120-day moving average if pullbacks occur, as this trendline marked multiple troughs in 2013.

Daily Chart of SPX since December 2012 with 120-Day Moving Average

Even though "buy the dip" has worked and potential investors claim to be waiting for a dip to buy, pullbacks within the trend have actually generated spikes in fear that have marked excellent entry points. This past pullback was no different in terms of a spike in fear.

Below are just a couple pieces of evidence that suggest fear spiked yet again, giving us reason to believe that market participants continue to sell pullbacks to support, instead of taking advantage of what has worked for the past couple of years (buying pullbacks to support):

  1. "Traditional U.S. stock mutual funds and exchange-traded funds together saw withdrawals of $18.8 billion in the week ended Feb. 5, their biggest weekly withdrawals on record. The abrupt reversal, led by ETFs, comes after U.S. stock funds attracted $172 billion in 2013, the biggest inflow since the financial crisis."
    -The Wall Street Journal, Feb. 6, 2014

  2. Equity option speculators, which we use as a measure of short-term market sentiment, moved from an extremely optimistic bunch to a pessimistic bunch in only a three-week period. In other words, the five-day ratio of equity-only call buying to put buying declined from a near five-year high in mid-January to a near six-month low this week. The plunge in option speculator sentiment looks like that which has marked bottoms.
Daily Chart of ISE-CBOE-PHLX five-day BTO call put volume ratio

We have concentrated our long positions in the highly-shorted momentum names that have strong upgrade potential, along with some potential "turnaround" plays. We have a 10%-20% cash cushion in our recommended portfolio that can be used to "buy dips" when we see short-term fear enter the marketplace.

  • Yelp (YELP), Pandora (P), and Splunk (SPLK) are among the holdings in our recommended stock portfolio.

  • We like the airline sector, given its strong price action, solid earnings, and potential for short covering.

  • We are warming up to gold miners as well, with the Market Vectors Gold Miners ETF (GDX) experiencing a breakout above resistance. Many have given up on gold miners, with short interest on GDX components up 60% during the past 12 months and multiple downgrades over this time frame. Steel is another turnaround play worth considering, as price action during the past few months reminds us of the solar sector last year.
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