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Monday Morning Outlook: Have Stocks Come Too Far, Too Fast?

The S&P 500 Index enters expiration week trading just below previous resistance

by 2/12/2011 10:59:04 AM
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Following two straight weeks of positive price action for stocks, our benchmark indexes are hovering near multi-year highs. So, perhaps it's only natural that Senior Vice President of Research Todd Salamone is wondering whether we're on the cusp of a potential pullback. However, his analysis of a key technical indicator leads to some reassuring conclusions. Meanwhile, Senior Quantitative Analyst Rocky White takes a look back at expiration weeks past, to see what kind of action investors should brace for in the five days ahead. Finally, we wrap up with a quick preview of some key economic and earnings events slated for this week, as well as a few sectors of note.

Recap of the Previous Week: Amid Global Turmoil, Another Round of Multi-Year Highs
Schaeffer's Editorial Staff

The major market indexes ended last week solidly higher, even though the day-to-day progress was fairly modest. In fact, the Dow Jones Industrial Average (DJIA), S&P 500 Index (SPX), and Nasdaq Composite (COMP) all rose to a string of new multi-year highs, despite ongoing uncertainty in the Middle East and another rate hike out of China. In the end, traders were encouraged by the long-awaited resignation of Egyptian President Hosni Mubarak -- announced during Friday's session -- as well as the U.S. government's plan to scale back the size of the Federal Housing Administration (parent organization to the gruesome twosome of Fannie Mae and Freddie Mac).

Summing up the week's performance, the Dow (12,273.26) tacked on 1.5% to notch its second consecutive weekly win, after finding a new two-year high of 12,285.94. In the process, the blue chip barometer scored a Friday finish above 12,200 for the first time since June 13, 2008. The Dow has rallied 3.2% so far in February, and is now trading some 146 points above its rising 10-day moving average.

As for the SPX (1,329.15), the broad-market bellwether topped out at 1,330.79 Friday, representing its own two-year peak. The SPX gained 1.4% for the week, strengthening its foothold above former resistance in the 1,300 region. Month-to-date, the SPX has added 3.3%.

Finally, the COMP (2,809.44) sailed to a three-year high of 2,810.56 on Friday, and collected its first weekly close above 2,800 since November 2007. This round-number level kept a tight lid on the index's progress throughout the week, but finally gave way to persistent buying pressure. The COMP kept pace with its broad-market brethren by ending the week up 1.4%, bringing its February advance to 4.1%.

What the Trading Desk Is Expecting: Measuring the Odds for a Pullback
By Todd Salamone, Senior Vice President of Research

"... while bulls are encouraged by the SPX action and .INDU's latest venture above 12,000, it would be even more encouraging if the RUT sustains a meaningful move above 800..."

"We remain bullish, with hedge funds apparently in accumulation mode and short-term speculators turning more pessimistic within the context of strong price action. Keep a close eye on SPX 1,333.58 as overhead resistance, as it represents double the March 2009 low."
-- Monday Morning Outlook, Feb. 5, 2011

Another week has passed, but this time we enter the week with the Russell 2000 Index (RUT) above the 800 century mark, and less than 5% away from its all-time high at 856.48. And now it's the S&P 500 Index (SPX) that enters the week trading just below its next potential area of resistance -- 1,333.58 -- after moving above potential round-number resistance at 1,300 earlier this month.

As noted last week, 1,333.58 on the SPX is double the index's March 2009 low. We point this out because the SPX ran into its "double October 2002 low" in May 2007, before a major topping process took place during the next several months. The SPX went on to experience only one monthly close above 2002's double low at 1,537.26, before ultimately peaking in October 2007.

For short-term traders, 1,333.58 is worth noting as a potential resistance or hesitation area. But longer term, we think the sentiment backdrop is one of much more investor caution and worry relative to 2007, implying the "double-low" resistance could be a speed bump, at worst, and not a major inflection point like four years ago.

If you are looking for an index without any immediate previous resistance overhead, check out the S&P 400 Midcap Index (MID – 969.50), which is now comfortably above its all-time highs in the 925 area. The round-number 1,000 level could be viewed as a potential resistance area. Note that since the SPX peaked in March 2000 -- the beginning of the "lost decade" for large-cap investors -- MID has nearly doubled. Over this period and at present, Wall Street analysts have generally shunned these so-called "higher risk" stocks in favor of the "higher quality" large-cap equities. This skeptical attitude continues to make the small- and mid-cap sectors an appealing contrarian play.

 Monthly Chart of MID since January 2000

A risk factor that we identified in early January was the comparison of the CBOE Market Volatility Index (VIX) and actual SPX volatility. We noted that the VIX was trading at more than double SPX historical volatility, and the difference between the two had just begun to narrow once again. History suggests that when this occurs, a rise in historical volatility will usually follow, which is coincident with falling stock prices. So, while historical volatility rose as predicted, stock prices advanced, too -- which has happened before, but is unusual.

Daily Chart of SPX since December 2010 With Historical Volatility

We were curious to see past instances when the market advanced 25 days after a "VIX premium" sell signal amid an increase in historical volatility. How did the market go on to behave in the aftermath of this unusual combination of rising historical volatility and rising stock prices?

Per the study below, bullish price action followed, with the SPX higher 94% of the time 21 days later, well above the at-any-time expectations of 61% higher over a 21-day period. The average return over the 21 days was far above the at-any-time average return, too. So, at a time when everyone is looking for a pullback because we have come "too far, too fast," this research suggests the elusive pullback may be far into the future.

Past SPX Performance Amid Rising Volatility and Stock Prices

Past SPX Performance

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