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Monday Morning Outlook: Choppy Trading Ahead as Bulls and Bears Battle It Out

The VIX breached a treacherous technical level last Thursday

by 5/21/2011 11:45:03 AM
Stocks quoted in this article:

Now that the major market indexes have trudged their way to a third straight weekly loss, it's becoming more and more difficult to argue the point that seasonality is destiny. Indeed, it would seem the bulls have given up hope almost entirely in May, with one closely watched investor sentiment survey falling to a nine-month low in the latest week. But can it really be that bad out there?

Well... yes and no, according to Todd Salamone. We head into the week with stocks still pinned between key support and resistance levels, creating opportunities for both bulls and bears in the weeks ahead. That being said, Rocky White warns that traders may want to brace for more short-term losses in the immediate future, as the days leading up to the unofficial start of summer tend to be trying for the market. In fact, as Bernie Schaeffer observes, the VIX last week ventured into potentially dangerous territory, if recent history is any guide.

Finally, we wrap up with a look at the key events scheduled for this week -- including the Commerce Department's first-quarter GDP revision -- as well as a few sectors of note.

Notes from the Trading Desk: Stocks Still Churning Around Familiar Technical Levels
By Todd Salamone, Senior VP of Research

"...bulls would like to see the MID and RUT quickly rally back above resistance at 1,000 and 850, respectively, as it is important that small- and mid-cap stocks regain their leadership role. But with some investor polls showing optimism as these indexes struggle to overtake important technical levels, it isn't a slam-dunk that these sectors regain their leadership... The broad market is vulnerable to trading in a range during the next few weeks."
-- Monday Morning Outlook, May 7, 2011

After the S&P 500 Index (SPX - 1,333.27) rallied 5% from its mid-April lows into May, we have indeed entered a period of choppiness, as the first-quarter earnings season winds down and worries about European sovereign debt and Fed policy take center stage. Since we mentioned the heightened possibility of a trading range two weeks ago, the SPX quickly hit a calendar-year high, retreated, and has since bounced around key support and resistance areas. The index is down a grand total of seven points during this stretch of time.

30-Minute Chart of SPX since May 6

Throughout this range-bound period, the SPX has found support at its 80-day moving average, which is currently situated at 1,320. This trendline marked a low in mid-April, and once again earlier this week. Moreover, the March 2009 "double-low" in the 1,333 area has proven to be supportive on various occasions during the past couple of weeks, and this is exactly where the SPX is situated ahead of next week's trading.

Disturbing for bulls is the series of lower highs put in during this month, as a trendline drawn through various peaks rests in the 1,340 area -- which is also the site of the February peak that preceded a month-long, 6%-plus correction earlier this year. Also, the inverse "head and shoulders" breakout that occurred last month has so far failed to produce meaningful follow-through gains, and it is quite possible that some of the weaker hands who may have jumped into the market on this bullish technical pattern will have to be flushed out before stocks can gain traction again.

The bears, meanwhile, are fighting a series of higher lows in place since mid-March. In order for this pattern to continue, the SPX must hold support in the 1,320 area. If we see a fourth straight week of declines this week, a failure at 1,320 could set the table for a quick move down to the March calendar-year lows in the 1,250 area.

 Daily Chart of SPX since January 2011 With 80-Day Moving Average

As we mentioned a couple of weeks ago and discussed as far back as late March, small-cap equities, as represented by the Russell 2000 Index (RUT - 829.06), and mid-cap stocks, as measured by the S&P 400 MidCap Index (MID - 986.83), are encountering extremely important resistance levels. Therefore, it's not a huge surprise that the broader market has struggled to make meaningful headway as these key indexes continue to negotiate significant technical resistance.

The RUT, for example, has experienced a few closes north of its 2007 all-time high in the 850 area, but has been unable to sustain a meaningful move above this milestone. Simultaneously, the MID has struggled to overtake the 1,000 millennium mark, after first testing this level in early April.

 Daily Chart of MID since January 2011

Speaking of noteworthy technical areas, Bernie Schaeffer points out that the CBOE Market Volatility Index (VIX - 17.43) closed last Thursday at 15.52 -- just south of the 16 level. "It is pretty safe to say that nothing much good has come in the period immediately after a close by the VIX below 16," he cautions. "There were a cluster of such occurrences ahead of the May 2010 flash crash," as well as the market corrections in March and May 2011.

While the long-term technical backdrop is still firmly bullish, the short-term technical backdrop is more ambiguous at the moment. It certainly appears that something's got to give in the weeks ahead. Seasonal factors favor the bears, as Rocky notes in his commentary on the next page, but the sentiment backdrop indicates that investors are beginning to get discouraged, which oftentimes signals the beginning of a rally after extremes are met.

For example: There was another week of outflows from domestic equity funds, and the percentage of bulls in the most recent American Association of Individual Investors (AAII) weekly sentiment survey dropped to 26.7% -- the lowest reading since Aug. 26, 2010, when stocks put in a significant bottom. Moreover, equity put buying relative to call buying on the major options exchanges is at its highest level since July 6, 2010, which marked another short-term low.

Hedge funds, as far as we can tell through our analysis of put option activity on the broad-based exchange-traded funds, are showing a willingness to step up and buy on declines. However, these deep-pocketed players also seem hesitant to feed rallies once the aforementioned technical resistance levels are approached.

More choppiness could be in store, but we would keep an eye out for opportunities on both the bull and bear side. The recent pullback in gold and silver appears attractive for potential long plays, while the big banking stocks, far from living up to heightened investor expectations heading into 2011, look to be attractive shorts.

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