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Monday Morning Outlook: Small-Cap Sentiment and a Significant VIX Move

Levels and indicators to watch in the week ahead

by 10/8/2007 7:10:10 AM
Stocks quoted in this article:

The broad market continued to rally last week despite ongoing concerns about weakening economic conditions, subprime woes, and earnings warnings from a number of banks. The tech-laden Nasdaq Composite (COMP) jumped 2.9% last week, hitting a 6.5-year high. Elsewhere, the Dow Jones Industrial Average (DJIA) charged 1.2% higher while the S&P 500 Index (SPX) gained just over 2%; both indices tagged new all-time highs during the week. Furthermore, the SPX finally closed above the 1,553.11 level, which marked the March 2000 high for the index.

The Russell 2000 Index (RUT) sprinted nearly 5% higher last week, moving firmly above former resistance at the 800 level. The index's next major challenge from a chart perspective is the 850 level. This region, which is now only 0.61% above the index, halted the RUT's rally in June and July.

However, the small-cap sector could receive a significant lift from the continued unwinding of bearish sentiment. With only a small percentage of hedge-fund managers bullish for September, and only 5% of hedge fund managers in a recent survey proclaiming themselves bullish for the month of October, it wouldn't surprise me if many have positioned themselves net short the small-caps. After all, the RUT has tended to take it on the chin more so than larger caps during the various the corrective phases in the market we have seen in 2006-2007 and many hedge funds have reined in their risk profile. But should the small-caps continue to lead the way as they did last week, we could see some hedge funds take a major hit from a repositioning that was actually designed to reduce their downside exposure. Furthermore, as they unwind their shorts on the small-cap sector, the increase in buying pressure will help to lift the group even higher.

One key component needed to put this rally on solid ground would be for the RUT to begin to seriously outperform the SPX. This would blow away the "bad breadth" concerns as well as discredit the comfortable consensus that "safety in the form of large cap U.S. multinationals is the place to be." I would very much like to see the RUT's relative-strength measure versus the SPX reverse into a sustained uptrend. Keep in mind that this measure's rally was quite tepid off its first-quarter bottom before just imploding in July, a signal that trouble was just ahead.

Another key component to helping keep uptrend on solid ground could be the CBOE Market Volatility Index's (VIX) close this past week below its 32-week moving average. As I pointed out in the October edition of the Option Advisor newsletter (published September 27):

" Note the [VIX] rally above the 32-week in May 2006 as the market began experiencing difficulties, and that the 32-week held as support in June and July 2006 as the market continued to struggle. But then the convincing break by the VIX below its 32-week in August 2006 was followed by an off to the races market rally. In other words, the market "fever" was signaled by the rise in the VIX above its 32-week moving average, and the "break" in this fever by the break below the 32-week. And at that point, it was "safe" to be long again."

I believe the VIXclose below this trendline last week could have very similar implications to that of August 2006, which in hindsight signaled an "all clear" for stocks during the final months of that year. I'd like to see additional VIX weekly closes below the 32-week to accentuate the contrast to the period following the March 2007 bottom when the VIX pullbacks following the spike in February and March did not penetrate below the 32-week moving average which signaled trouble ahead.

What's more, the VIX generated a signal last Friday when it dropped by less than 10% (specifically, 8.3%) while the SPX rose by more than 0.85% (it gained 0.96% during the session). This phenomenon with the SPX rallying more than 0.85% while the VIX drops less than 10% - has had historically bullish implications dating back to 1990. Specifically, after 20 days the market is higher 69% of the time; the average gain in the SPX over this period is 1.65%.

As we head into a new week, we are faced with the official start of a new earnings season. The impact of credit and liquidity concerns as well as continued problems within the housing sector are widely expected to weigh heavily on third-quarter earnings. As a result, the consensus estimate for earnings growth has been sharply lowered from roughly 6.2% in July to a gain of 3.8%, according to Thomson. The earnings growth rate expected for the S&P 500 Index has dropped even further to 1.4% for the quarter, which would effectively be the worst performance in more than 5 years. These sharply lowered expectations leave the door wide open for positive surprises across the Street, which could keep this rally alive throughout the next couple of months.

Also weighing on the market this week will be the Federal Open Market Committee (FOMC) minutes from the latest meeting. This report will thoroughly dissected by analysts for possible clues as to what the Fed will do at its meeting at the end of this month. In addition, September retail sales are due out at the close of the week, which could give a good look in the health of consumer spending.

And now a few sectors of note...

Dissecting The Sectors
Base Metals/Copper

Sentiment: Three of our favorite copper names - Southern Copper (PCU), Freeport McMoRan Copper & Gold (FCX), and BHP Billiton (BHP) continue to trend upward into new-high territory. But the trio still stands to benefit from upgrades on Wall Street. Currently, there are 13 total "buy" ratings among the 3 stocks, 12 "holds," and 1 "strong sell." Additionally, options players have assumed a relatively bearish position on BHP and FCX, while short sellers are active on FCX and PCU. The grouping of stocks remains attractive from a contrarian perspective as it epitomizes the combination of strong price action against a backdrop of skepticism.

Outlook: We are staying the course with our positive take on the copper group PCU, BHP, and FCX continue to look impressive from an overall Expectational standpoint. All 3 stocks have been steadily appreciating along 10-day-moving-average support, all have potential buying power waiting on the sidelines in the form of short covering, bearish options unwinding, and prospective analysts' upgrades. Meanwhile, copper futures are near a historical high after clearing triple-top resistance near the $3.70-per-pound level.
Small-Cap Stocks

Sentiment: As I pointed out above, I think that small caps stand to benefit from the unwinding of bearish sentiment, as skepticism continues to run high in the press and among hedge-fund managers. The unwinding of large short positions and a gradual move out of the bearish camp can help power the small-cap group forward during the near term. There is also additional room for increased optimism on Wall Street. The latest information from Zacks shows that just 46.6% of all analysts' ratings on Russell 2000 stocks are "buys," leaving 45% "holds" and 8% "sells." A trend toward upgrades in the small-cap sector could perceptibly impact the group by stirring up positive attention among buyers.

Outlook: Last week was led by the small-caps; the Russell 2000 Index rallied 4.9% compared to the 1.2% gain in the Dow and the 2% increase in the S&P 500 Index. The group has jumped above intermediate-term resistance at its 32-week moving average and is near a 3-month high. The one technical challenge facing the RUT is the 850 level, which thwarted the index's rallies in June and July. An unwinding of bearish sentiment in the small-cap arena could be the impetus required to clear this technical threshold.

Sentiment: The Schaeffer's put/call open interest ratio (SOIR) for the Select Sector SPDR Financial Fund (XLF) continues to reflect a sense of complacency among the speculative crowd. Currently, the indicator weighs in at 2.03, a new annual low. The composite SOIR for the brokerage sector, meanwhile, stands at 0.17, lower than 91% of the past year's readings. The banking group's composite SOIR is closer to the pessimistic end of the spectrum at 0.94 (the 89th annual percentile). Short interest on both the banking and brokerage groups has declined in recent months, pointing to building optimism among equity investors.

Outlook:While the rising tide of the market has helped lift the XLF in recent weeks, the group isn't out of the woods yet with regard to subprime exposure and the overall credit crunch. The ETF continues to underperform the broader market on a relative-strength basis and faces an area of technical congestion around the 36 mark. With earnings season now in focus, reports from banking and brokerage names will provide more of a clue into the true bottom-line impact of the recent credit-market woes.

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