Monday Morning Outlook: Long-Term Uptrend Intact, But Risks Lie Ahead

              

The Dow Jones Industrial Average (DJIA) once again played tag with the 10,000 mark last week, but headed sharply lower as the weekend drew nearer. Still, the Dow did manage to outperform its major counterparts for October, carving out a gain of 0.01% versus the S&P 500 Index's (SPX) loss of 2% and the Nasdaq Composite's (COMP) drop of 3.6%. The market remains rife with concerns, and Todd Salamone, Senior Vice President of Research, zeroes in on several of these potential hurdles in this week's commentary. In addition, Todd takes a closer look at put/call ratios for the SPX and the CBOE Market Volatility Index's (VIX) massive spike to close out the week. Next, Senior Quantitative Analyst Rocky White takes a look at the U.S. dollar, the massive amount of skepticism that has been directed toward the greenback lately, and the potential impact of this sentiment reading. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: The Hunt for Flat October
By Joseph Hargett, Senior Equities Analyst

Despite a whole month of excitement and drama, the Dow Jones Industrial Average (DJIA) has practically nothing to show for it. Traders started the week off on the right foot, with the Dow rising early on Monday due to well-received earnings reports from the likes of RadioShack (RSH) and Verizon Communications (VZ). However, analyst Richard Bove reawakened familiar fears by downgrading a trio of banks and asserting that "2010 is going to be a tough year" for the financial sector. As a result, the Dow dropped about 1% at the beginning of the week. Stocks wavered on Tuesday, after the Conference Board's index of consumer confidence fell to 47.7 this month, down from 53.4 in September. However, the Treasury drew the highest demand in two years for its auction of two-year notes. Fallout from the auction helped to push the DJIA 0.14% into the black by the close.

Wednesday was all about economic data, as the Commerce Department reported an unexpected 3.6% decline in new home sales last month. Meanwhile, September's 1% gain in durable goods orders was in line with analysts' expectations, but core shipments -- the metric used to model gross domestic product (GDP) -- declined 0.2% on a monthly basis. As a result, economists at Morgan Stanley, B of A-Merrill Lynch, and Goldman Sachs all slashed their GDP estimates for the third quarter, pressuring the Dow to a 1.21% loss on the day. However, the bulls really threw caution to the wind in the wake of Thursday's report that GDP expanded at a faster-than-expected rate of 3.5% in the third quarter, marking an unofficial end to the worst recession in 70 years. The news spurred the Dow to a gain of 200 points, or 2.1%, marking its largest single-session jump since mid-July.

However, Thursday's GDP-related momentum proved to be unsustainable. On the economic front, the Commerce Department reported that consumer spending dwindled 0.6% in September, marking the most significant monthly slide in spending since December. Elsewhere, The Wall Street Journal reported that CIT Group (CIT) is expected to file for bankruptcy protection as early as Sunday or Monday, with the plan drawing support from major bondholder Carl Icahn. Against this uneasy backdrop, the CBOE Market Volatility Index (VIX) skyrocketed 24%, and tapped its highest intraday level since July 8. The Dow, meanwhile, plunged 2.51% on the session and lost 2.6% for the week. For October, the DJIA eked out a near-imperceptible gain of 0.01%. Elsewhere, the S&P 500 Index (SPX) lost 4% on the week and 2% for the month, while the Nasdaq Composite (COMP) plunged 5.1% from last Friday's close and lost 3.6% in October.

What the Trader Is Expecting in the Coming Week: We're Watching VIX, 80-Day Trendline on SPX
By Todd Salamone, Senior Vice President of Research

Two weeks ago, I summarized a few short-term concerns for the market. It had once again run into long-term technical resistance ahead of an expected "post-expiration hangover," and short-term optimism was at risk of being flushed out. Are we seeing a repeat of the broad-market weakness of May-June 2009, which preceded another major buying opportunity, or is this a precursor of a more serious market decline?

As we enter this week's trading, the S&P 500 Index (SPX) sits more than 6% shy of the 1,100 level, a high the index achieved just a few weeks ago. This "hangover" is hurting more than others. Is the patient seriously sick, or is a recovery imminent? In order to answer this question, it might be constructive to step back and analyze what occurred a few months ago, as I see a similar technical pattern potentially materializing.

After a huge run higher, the market's momentum began to seriously wane as the SPX approached the 920 area, 38.2% above its March low. After a quick burst through this key Fibonacci resistance area in early June, resistance from the January highs came into play, leading eventually to a 7% correction. The 80-day moving average acted as support when the correction finally ended in the summer. As I've previously noted during the past several months, this trendline has been a key support and resistance level since June 2008.

Similarly, the market's momentum began to slow in September, as the SPX bumped up into the 1,080 area – 61.8% above the March low. 61.8 is another key number for Fibonacci followers. After a quick burst through 1,080, the market rallied into the 1,100 level, which is just below the site of a 50% retracement of the October 2007 peak and March trough. We enter this week's trading with the SPX trading just above its 80-day moving average, which will be sitting around 1,025 when trading begins on Monday.

In addition, the 80-day moving average coincides with October's low. Should the May-June-July pattern repeat, the 80-day moving average will again hold as support following a decline of roughly 7%. This would imply the patient will recover, just in time for what has traditionally been a positive period in the market.

In early July, the percentage of bullish retail investors, as measured by the weekly American Association of Individual Investors, was at 28%. In the most recent report, only 33% were bullish, compared to 47% just two weeks ago, which was near a 2009 high. The increasing fear among retail market players is encouraging as the SPX approaches its 80-day moving average, as they have been wrongly positioned at key turning points in the market in 2009.

The biggest risks I see are in the option activity on the PowerShares QQQ Trust (QQQQ) and in the behavior of the CBOE Market Volatility Index (VIX). The International Securities Exchange (ISE) and Chicago Board Options Exchange's (CBOE) 50-day average of the buy (to open) put/call volume ratio continues to track lower on the QQQQ, declining from extreme levels. Our interpretation is that institutional money is no longer accumulating technology stocks, as they typically buy put QQQQ options to hedge their technology exposure. If this interpretation is correct, this loss of leadership from the technology area would dampen the prospects of a strong rebound. That being said, put buying relative to call buying on the QQQQ picked up nicely in Friday's trading, which is certainly encouraging.

The VIX's close above the 30 area on Friday brings both a positive and negative interpretation. The positive is that the VIX's closing high at the early-July bottom was at 31.30. Therefore, bulls would obviously like to see yet another peak in this area. But different from July is the fact that the VIX closed above both its 80-day and 160-day moving averages. [Correction: The following wording was updated for clarity.] Bears would argue that the VIX's trend lower in 2009 is at risk of a reversal, which would be a negative for equities. The chart below depicts the importance of the 80-day and 160-day moving averages in 2009. Bulls would like to see the VIX move back below 30, sooner rather than later.

As I said at the beginning of October, if you are an aggressive short-term trader, look to add to long positions, but do so with tight stops in mind. A break of the SPX's 80-day moving average could lead to an immediate drop to the 990-1,000 area, which would equate to a 10% correction from the highs. November VIX futures are trading at a significant discount to cash VIX, which makes VIX call buying, or selling VIX put premium via spreading, a nice way to hedge your long exposure if indeed the patient is sick.

Indicator of the Week: The Dollar
By Rocky White, Senior Quantitative Analyst

Foreword: If you've been keeping up with your reading, then I'm sure you have come across articles predicting a catastrophe for the U.S dollar. We've seen predictions of hyper inflation, and that the dollar could lose its status as the world's reserve currency. "Buy gold," seems to be the common advice. I'm not an expert on macroeconomics or the fundamentals of foreign exchange. But I can tell you from articles I've read and various reports and surveys that the sentiment on the greenback is overwhelmingly pessimistic.

The chart below shows the U.S. Dollar Index, which is a measure that compares the dollar to a basket of foreign currencies, graphed along with the S&P 500 Index (SPX). The price action of the dollar shows some cause for pessimism. It has been in a free fall ever since March, when the SPX began rallying. The negative sentiment means there is a lot of bad news already priced into the dollar. If this pessimism were to unwind for any reason, then we could get a reversal resulting in a fast and furious rally to the upside.

Option Activity: Huge option purchases on the PowerShares DB US Dollar Index Bullish (UUP) caught our eye recently. Below is a graph showing the average number of calls and puts bought to open on the International Securities Exchange and Chicago Board Options Exchange. (This is proprietary data from these two exchanges; it is not publicly available.) Call buying has been steadily increasing since August, and one day recently over 140,000 calls were purchased, causing a massive spike in the call/put ratio. Why the call buying if pessimism is so rampant? We are not convinced that this is speculative call buying, but instead might be hedging. As Todd Salamone pointed out in a recent email string to traders, evidence of this is the fact that the call buying has not been accompanied by strength in the underlying.

What are they hedging? Clearly, the calls could be the hedging of short dollar positions. However, there are other possibilities. There is a strong negative correlation between the dollar and commodities, including oil. Hedge funds love trading commodities, and they may have found that hedging with these UUP calls is cheaper than other alternatives. Also, check out the graph below. It shows the correlation of five-day return of the SPX and the U.S. Dollar Index. The 21-day moving average of the correlation has been negative for about 13 straight months now. That's the longest streak we've seen, and we have data on this since the early 1970s. Due to the consistent negative correlation, it's possible that managers are using these UUP calls to hedge long stock portfolios.

Implications: As contrarians, we think there is a bullish aspect to the extreme pessimism in the dollar. However, the negative price action of the dollar lessens the bullish implications of the sentiment. An unwinding of this negative sentiment could result in a strong reversal of the decline. Remember, "the crowd is right during the trend but wrong at both ends." As far as the call buying in UUP options, we will definitely be keeping our eyes and ears open on what can be driving this. As Bernie Schaeffer said in the email string mentioned above, "This is very interesting stuff with potential implications for gold, stocks and so forth."

This Week's Key Events: A Federal Open Market Committee Meeting and October Nonfarm Payrolls
By Joseph Hargett, Senior Equities Analyst

Here is a brief list of some of the key events for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective Web site for official reporting dates.

Monday

• The economic deluge doesn't let up this week, as Monday offers up September's construction spending, the Institute for Supply Management's (ISM) manufacturing index, and pending September home sales. The earnings calendar is also packed, with Cooper Tire & Rubber (CTB), Dean Foods Co. (DF), Ford Motor Co. (F), Humana Inc. (HUM), and Chesapeake Energy Corp. (CHK).

Tuesday

• On Tuesday, the Street will be graced with September factory orders and October auto sales. In earnings, American Tower Corp. (AMT), Energizer Holdings Inc. (ENR), Marvel Entertainment Inc. (MVL), Marathon Oil Corp. (MRO), Viacom Inc. (VIA), and Yamana Gold Inc. (AUY) are scheduled to report.

Wednesday

• The Challenger, Grey & Christmas job cuts report for October, the October ADP employment report, the ISM services index for October, weekly U.S. petroleum supplies, and the Federal Open Market Committee's (FOMC) decision on monetary policy are on tap for Wednesday. On the earnings front, we'll hear from Automatic Data Processing (ADP), Baker Hughes Inc. (BHI), Devon Energy Corp. (DVN), Garmin Ltd. (GRMN), Liz Claiborne Inc. (LIZ), Pulte Homes Inc. (PHM), Time Warner Inc. (TWX), Transocean LTD. (RIG), Cisco Systems Inc. (CSCO), Evergreen Solar Inc. (ESLR), News Corp. (NWS), QUALCOMM Inc. (QCOM), and Whole Foods Market Inc. (WFMI).

Thursday

• On Thursday, preliminary third-quarter productivity will be joined by weekly initial jobless claims. Elsewhere, Cardinal Health Inc. (CAH), Coeur d'Alene Mines Corp. (CDE), CVS Caremark Corp. (CVS), MGM MIRAGE (MGM), CBS Corp. (CBS), Crocs Inc. (CROX), NVIDIA Corp. (NVDA), and Starbucks Corp. (SBUX) will report earnings.

Friday

• We end the week with a bang on Friday, as September's wholesale inventories, September's consumer credit report, and the coup de grace, October's nonfarm payrolls, unemployment rate, average work week, and hourly earnings. Finally, the Street will see earnings from Edison International (EIX), and Suncor Energy Inc. (SU).

Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insights about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.

And now a few sectors of note...

Dissecting The Sectors

Sector

Financials Bearish

Outlook: Despite logging a year-to-date rally of more than 17%, the Select Sector SPDR Financial Fund (XLF) could come under pressure in the coming weeks. Technically speaking, the XLF recently peaked at its declining 80-week moving average. We have observed that this long-term trendline sometimes serves as important support/resistance levels. On the sentiment front, we are noticing a huge uptick in call buying on the XLF. Specifically, the XLF's buy (to open) call/put ratio has turned higher. When this ratio trended higher in 2008 and early 2009, bank stocks skidded. The current behavior in this ratio may indicate that the shorts are coming back after a wave of short covering. In other words, they're buying XLF calls to hedge short positions. If this is true, the shorting activity would have a depressive coincidental impact on the group. Elsewhere, Barron's recently had a cover featuring Bill Miller, the popular Legg Mason Value Fund manager, with the exclamation, "He's Back!" This fund manager has heavy exposure to financial names, which hurt his performance badly last year. The timing of the cover may have bearish contrarian implications for the financial sector. For those of you with call positions or with big long exposure, the XLF put acts as a hedge in the event of a market pullback.

Sector

Oil Services Bullish

Outlook: Fresh signs of an improving global economy seem to be popping up on a daily basis, and energy prices have responded by trekking higher in anticipation of rising demand. Specifically, crude futures recently tagged a fresh 52-week high, and have more than doubled from their Dec. 24 low of $35.13 per barrel. What's more, the brokerage bunch has room for upgrades, as 46% of ratings on oil service stocks are currently "buys," compared to 67% in July 2008 and 61% at the end of last year. Any upgrades from these analysts could lend additional support for the oil services sector. Technically speaking, OIH closed its second week above its 80-week moving average last week, which is coincidentally the site of a 38.2% Fibonacci retracement of the trust's July 2008 peak and its December 2008 low. However, the oil services sector has wasted no time in capitalizing on this strength, with the Oil Service HOLDRS Trust (OIH) soaring more than 65% since the start of the year. Meanwhile, the trust's 50-day buy-to-open put/call volume ratio could be in the process of rolling over, which may be a concern for the sector. Typically, OIH puts are utilized by institutional investors as a way to hedge long positions on oil sector stocks or indexes.

Sector

Retail Bullish

Outlook: Technically speaking, the retail sector has come on strong since the March bottom, with the S&P Retail SPDR (XRT) rallying more than 89% during this time frame. What's more, retail remains one of the strongest sectors, and is trading above its 80-week and 160-week trendlines. However, pessimism is thick on the retail sector. In the financial media, the sector was recently hammered by a cover story in Barron's, titled "The Hard Sell" and subtitled "How Retailers Are Fighting For the Hearts & Minds of the New Consumer." Elsewhere, only 42% of the 951 analyst rankings on retail stocks are "buys," according to Zacks, leaving plenty of room for potential upgrades. That said, the XRT's 50-day buy-to-open put/call ratio has recently rolled over from a near-term peak, a development that could be a concern for the sector. However, the XRT is up about 15% since the rollover in this reading began. Within the sector, we see bullish opportunities for Expedia Inc. (EXPE), Whole Foods Market Inc. (WFMI), Green Mountain Coffee Roasters Inc. (GMCR), Polo Ralph Lauren (RL), AutoNation Inc. (AN), Starbucks Corp. (SBUX), Chipotle Mexican Grill Inc. (CMG), and Aeropostale Inc. (ARO).