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Monday Morning Outlook: Despite Technical Feats, Bulls Remain at the Mercy of Europe

All eyes will be on the euro zone as EU leaders convene over the region's fiscal future

by 10/22/2011 10:28:57 AM
Stocks quoted in this article:

U.S. stocks extended their upward momentum last week, as investors clung to hope that a resolution to the euro-zone debt crisis is just around the corner. Furthermore, a relatively well-received round of big-cap earnings reports -- with Apple (AAPL) the notable exception -- also added fuel to the bulls' fire. However, as Todd Salamone notes, while the Dow Jones Industrial Average (DJIA) and S&P 500 Index (SPX) conquered significant technical hurdles, closely watched developments out of Europe will likely set the tone for the week -- and possibly even the rest of the year, as far as hedge fund managers are concerned. Meanwhile, Rocky White examines the historical significance of the Dow's recent price action, and what it could signal for the bulls. Finally, we wrap up with a preview of the notable economic and earnings events of the week ahead, as well as a few sectors we're watching now.

Notes from the Trading Desk: The Good News -- and Potential Risks -- for the Bulls
By Todd Salamone, Senior VP of Research

"The 80-day [moving average] is at 1,223, the 80-week is at 1,211, and the 80-month is at 1,225. All three trendlines have proven their significance in the past, and probably won't go down without a fight. Should the SPX manage a breakout above these pivotal levels, it would be a big boost for the bulls."
- Monday Morning Outlook, October 15, 2011

"Hedge funds hold just 45% of their assets in stocks, after subtracting their short positions from shares they own, Sarah Morgan reports at SmartMoney.com. That's well below their typical exposure and approaches levels not seen since March 2009."
- Barron's, October 14, 2011

"According to Catalpa Capital Advisors, since 1928, the stock market was down for the year in October 37 times. In 29 of those instances, they staged fourth-quarter recovery rallies."
- Barron's, October 19, 2011

We have been saying for weeks that the increasingly negative sentiment backdrop could lead to sharp gains in the market, but investors first needed a reason to cover their shorts or move from the sidelines. On Friday, the S&P 500 Index (SPX - 1,238.25) finally broke out above the 1,225 area, as investors bid stocks higher on hopes that European leaders would work out a bailout plan to address the sovereign debt issues that have been a major overhang on world markets for months. However, while European Union (EU) officials are meeting this weekend, a plan may not come forward until mid-week, which may leave the market at the mercy of rumors (both positive and negative) until clarity finally emerges. Even when clarity emerges, there are no guarantees that the plan will meet investors' expectations.

The good news for bulls is that the 1,225 level on the SPX was taken out on Friday, and the Dow Jones Industrial Average (DJIA - 11,808.79) moved back into the green for calendar year 2011. These levels -- 1,225 on the SPX, and 11,577 (the year-to-date breakeven mark) on the DJIA -- had been acting as resistance levels for weeks.

From a technical perspective, it looks a little brighter, but there is still plenty of work to be done. For example, the SPX remains in negative territory in 2011, down 1.5% year-to-date. Plus, the Nasdaq Composite (COMP -2,637.47), Russell 2000 Index (RUT – 712.42), and S&P 400 MidCap Index (MID – 861.26) are still in the red for 2011, down 0.6%, 9.1%, and 5.1%, respectively. In order to convince some investors that the worst could be over, it will be important for these benchmarks to turn green.

The next potential resistance area on the SPX is in the 1,255-1,260 zone, which is the site of both 2011's breakeven and support in March and June. Coincidentally, also in this area is the SPX's 120-day moving average -- a trendline that temporarily marked resistance in June and August 2010, after the market began its recovery from the May 2010 "flash crash." Moreover, the 1,255-1,260 area marks a 61.8% Fibonacci retracement of the SPX's 2011 high and low.


 Daily Chart of SPX since May 2010 With 120-Day Moving Average

The CBOE Market Volatility Index (VIX - 31.32) enters this week in the 31 zone, and as we've said before, ventures into this area have preceded periods of weakness in the stock market. The risk heading into next week is another pop from this region if news out of Europe disappoints investors. Bulls would like to see a clear, sustained move below 30. But, with the expiration of October options, and portfolio insurance relatively cheap, index and exchange-traded fund (ETF) put buying could act as a short-term headwind.

But, as noted in the excerpt above, hedge fund managers aren't exactly bullishly positioned, which suggests there isn't a huge need to hedge long positions via the purchase of index and ETF puts. If the market were to continue higher, fund managers could find themselves missing out -- and willing to take on more risk with only a couple months left in the year.

For example, in the fourth quarters of 2009 and 2010, we noticed that the market rallied even as the buy-to-open put/call ratio on major ETFs that we track declined. Usually, this ratio will rise in parity with stocks, as fund managers buy ETF puts to hedge long positions they are accumulating. The "seasonal divergence," in terms of the typical behavior in this ratio with respect to the market's price action, suggests to us that as portfolio managers play "catch-up," they incur extra risk and either disregard hedging or hedge less, as the hedging could be an impediment to producing sharp gains that are needed by year-end. This ended badly in the first quarters of 2010 and 2011, when short but sizable corrections eventually emerged.


20-Day BTO put-call ratio for SPY, QQQ, IWM - 4Q 2010

Another fourth-quarter seasonality statistic that we found interesting centered on where the SPX sat at its October lows. Specifically, when the SPX is in the red for the calendar year at its October lows, the market rallies 78% of the time in the fourth quarter. What's more, according to our research, when the SPX is positive on the year at its October lows, it closes the year above its October lows 96% of the time. So, while the odds are high that we'll close the year above the SPX October lows at 1,099, they're actually higher when the October lows are positive versus negative.

In conclusion, a positive outcome in Europe could produce a continued fourth-quarter rally, as fund managers aggressively accumulate long positions or short covering emerges as the technical backdrop improves. Note in the chart below how short interest is at its highest level since the market bottom in 2009 -- a positive for the bulls. But, if major benchmarks fail to make it into the calendar-year green relatively soon, or if markets react negatively to next week's news out of the euro zone, the urge to cover short positions decreases and the risk becomes a continual increase in short interest, which has proven to be a major headwind in 2011.


SPX with Short Interest

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