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The Dow Jones Industrial Average managed another close above the 11,100 level last week, but traders were evidently holding their fire ahead of the midterm elections and anticipated new Fed stimulus. Still, despite the flat action in the final week, the major market indexes all sported solid gains for the month of October. Todd Salamone, Senior Vice President of Research, looks ahead to the week's big headlines and cautiously concludes the rally has more room to run. Next, Senior Quantitative Analyst Rocky White takes a look at what stock price action prior to a company's earnings report might tell you about how traders will react to that report. (Hint: Think like a contrarian.) Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: New Stimulus May Be Nudge, Rather Than Shove
Schaeffer's Editorial Staff

The fall rally stalled in a week-long pre-election funk as October wound down. The market had spent two months riding a blissful wave of anticipation of more monetary stimulus, with the Dow Jones Industrial Average rising 12% since Federal Reserve Chairman Ben Bernanke first raised the prospect in late summer. That bliss was punctured Wednesday when The Wall Street Journal, in a curiously sourced story widely believed to be a Fed plant, reported that the additional stimulus would amount to a "few hundred billion dollars over several months." That relatively modest figure was a disappointment to many on the Street.

But the sulk set in even before the Journal carried the tablets down from Mount Bernanke. Despite a weekend pledge by the Group of 20 to avoid a currency war, and an upbeat report on existing home sales in September from the National Association of Realtors, the Dow inched ahead just 0.28% on Monday.

Tuesday was more of the same. Earnings reports from U.S. Steel Corp. (X) and Kimberly-Clark Corp. (KMB) disappointed, and housing prices, as measured by Case-Shiller, remained weak. However, Ford Motor Co. (F) blew away estimates. The Dow managed a close in the black by a tiny 0.05%.

The Journal report on the Fed cast a pall on Wednesday, overshadowing strong durable goods numbers and relatively healthy new home sales. The Dow slumped 0.39%.

The Dow received an early boost Thursday when new jobless claims came in much lower than expected, but 3M Company (MMM) offered a soft forecast not only for its own full-year earnings, but for global economic prospects in general. And traders still fretted over the Fed. The Dow spent time on both sides of the breakeven line during the course of the session, but eventually settled for a tiny loss of 0.11%.

Friday was a microcosm for the week: a mixed bag of economic and earnings reports (way to go Microsoft!), resulting in another desultory, wait-and-see session of trading. Gross domestic product increased 2% in the third quarter -- up from 1.7% in the second quarter, but nowhere near enough to supercharge jobs growth. Meanwhile, the University of Michigan sentiment index reported a decline in consumer confidence. The Dow traded in a tight 55-point range, slipping 0.04% by the close. The Dow fell 0.1% for the week, but recorded a healthy 3.1% gain for October. The S&P 500 Index, meanwhile, added 0.02% for the week, and 3.7% in October, while the Nasdaq Composite added 1.1% for the week, and easily outpaced its brethren for the month, climbing 5.9%.

What the Trading Desk Is Expecting: Are Expectations Sinking?
By Todd Salamone, Senior Vice President of Research

"From 1922 to 2006, the average gain of the Dow Jones Industrial Average over the 90 trading days following midterms (roughly November until mid-March) was 8.5 percent, according to a new study authored by Brian Gendreau, market strategist for Financial Network. That's almost 5 percent higher than the Dow's gains in non-election years... Gendreau is the first to admit that he's not the first economist to release a survey like this... He also notes that given the ever-increasing wealth of information available to traders today, the effects of this trend may be somewhat weaker going forward."
U.S. News & World Report
, Oct. 25, 2010

"The central bank is likely to unveil a program of U.S. Treasury bond purchases worth a few hundred billion dollars over several months, a measured approach in contrast to purchases of nearly $2 trillion it unveiled during the financial crisis. The announcement is expected to be made at the conclusion of a two-day meeting of its policy-making committee next Wednesday... Stock prices have rallied since Mr. Bernanke broached the idea of bond buying in late August. But investors and analysts are divided on whether the gambit will work."
The Wall Street Journal
(front page), Oct. 26, 2010

"Most leading economists expect the Federal Reserve to buy between $80 billion and $100 billion worth of assets per month under a new program to bolster the struggling economy, according to a Reuters poll."
, Oct. 28, 2010

A few weeks ago, I was anticipating that the market could be setting itself up for a "buy the rumor, sell the news" situation at month's end, ahead of two potential market-moving events in the first trading week of November: the outcome of the midterm elections and a two-day Federal Open Market Committee (FOMC) meeting that ends Wednesday. In other words, I was expecting investors would be enthusiastic, looking for the midterm elections and additional quantitative easing (QE2) to spark a year-end rally, and thus setting themselves up for disappointment.

According to The Wall Street Journal, Democrats will likely maintain the majority in the Senate, but the balance of power will shift, with projections of 51 Democrats and 49 Republicans after the elections compared to the current make-up of 57 Democrats and 41 Republicans. In the House, Republicans are expected to be the majority party, with projections of 230 Republican seats and 205 Democratic, seats from the current 265 Democratic seats and 178 Republican seats.

Moreover, Fed Chairman Ben Bernanke hinted at QE2 in late August, creating an unwinding of the pessimism that had built up in the market before to his comments.

Recently, and much to my surprise, there seems to be a bit of caution as to the sustainability of the rally from the late-August lows, amid slightly lower expectations heading into these events. While certain outcomes are expected, it does not appear that traders expect these outcomes will actually produce a positive reaction in the stock market. Said another way, there is a growing consensus that QE2 and Republican control of the House are already factored in, creating a perception that there is little upside, and an unfavorable risk-reward scenario for stock investors.

In addition, the Journal article referenced above seemingly dampened expectations on the outcome of the FOMC meeting; some observers had expected to Fed to intervene more aggressively than the article suggested it would.

The lower expectations with respect to QE2, and a growing consensus that there is little post-event upside for stocks, could have bullish implications, to the extent that traders have acted on this perception by moving to the sidelines. Such actions coincidentally put a cap on the market, which we have witnessed during the past couple of weeks. But they also generate a lower probability of a "buy the rumor, sell the news" scenario developing and, in turn, increase the chances of a "buy the news" situation if the expected outcomes come to fruition.

Where are we seeing evidence of caution entering the marketplace?

  • The National Association of Active Investment Managers' (NAAIM) weekly survey indicates that money managers have significantly reduced their exposure to the equity market since early October.
  • Option activity continues to suggest that hedge funds are in the early innings of moving back into equities. A Bank of America/Merrill Lynch hedge fund report suggested that as of Oct. 20, long/short hedge funds had net long exposure of 21%, far below the historical net long range of 35%-40%.
  • Since early October, the 10-day, all-equity buy-to-open put/call volume ratio on the Chicago Board Options Exchange and International Securities Exchange has risen, indicating relatively more buy-to-open put volume on individual equities.
  • The public remains wary, as last week was the 25th consecutive week of outflows from domestic equity funds
  • Various headlines suggest caution, including a piece in the Journal this past Thursday entitled, "Doubts Surround Rally's Vigor."

In light of the bullish historical tendencies following midterm elections and the bullish technical developments that we have discussed in prior weeks -- the inverse "head and shoulders" breakout above the 1,130 level on the S&P 500 Index (SPX), and last week's "golden cross," in which the SPX's 50-day moving average crossed above its 200-day moving average -- the cautious tone among some investors may set up a year-end rally in the absence of a major disappointment next week.

Do not interpret this outlook as zero or little risk in the market, as there is still uncertainty with respect to next week's outcomes. While the sentiment backdrop is not as euphoric as we initially anticipated, it isn't as pessimistic as it was in August either. If midterm elections swing in the Democrats' favor, or the Fed disappoints in some manner, sellers will emerge.

In that scenario, there is the potential of a "delta-hedge" decline from the heavy put open interest on various index and exchange-traded funds. In a "delta-hedge" decline, the heavy put open interest at various strike prices acts as a magnet; that is, as the risk of a particular strike getting penetrated increases, sellers of the puts tend to hedge their positions by shorting equity futures. The iShares Russell 2000 Index Fund (IWM) stands out as a fund most vulnerable to a delta-hedging decline if there is a disappointing outcome (see IWM open interest configuration chart below).

IWM open interest configuration

Quickly turning to the charts, the 1,200 area on the SPX, site of the April high and its 80-month moving average, continues to hover just above Friday's close. If the current consolidation between 1,170 and 1,190 resolves itself to the downside, the 1,120 area could provide support, as the 80-day, 160-day and 200-day moving averages are converging around this level.

Daily SPX chart with 80-day, 160-day, and 200-day moving averages

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