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Monday Morning Outlook: S&P 500 Index Support Sets Up Bear-Market Rally

Key S&P 500 Index (SPX) support point to bounce, but CBOE Market Volatility Index (VIX) raises concerns

by 3/24/2008 6:47:59 AM
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Today's in-depth look at the week ahead begins with a recap of last week's Fed-induced market volatility and collapse in the metals and commodities markets. Next, Schaeffer's Senior Vice President of Research Todd Salamone zeroes in on the CBOE Market Volatility Index (VIX) and the bearish implications current readings have in relation to the S&P 500 Index (SPX). Joe Sunderman, Vice President of Financial Market Analytics, dives into the International Securities Exchange (ISE) Equities-Only Sentiment Index. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Fed-Rate Cut and Solid Earnings Strengthen Bulls
By Joseph Hargett, Senior Equities Analyst

It's not every week that you kick off trading with a $2-per-share fire sale of a major Wall Street brokerage house, but the J.P. Morgan Chase buyout of Bear Stearns greeted traders last Monday morning. The tension in the credit and financial markets came to a head on Tuesday, when the Federal Open Market Committee (FOMC) cut its key overnight lending rate by 75 basis points, less than the 100-basis-point cut economists expected. However, positive earnings from Goldman Sachs and Lehman Brothers bolstered the case for a positive session, and the Dow Jones Industrial Average (DJIA) finished Tuesday with a gain of more than 420 points.

However, despite the strong results from investment brokers and a record initial public offering from Visa, Wednesday saw the Dow give back most of Tuesday's Fed-induced gains. Driving the loss was an implosion by commodities and metals. Gold plunged $59 an ounce on Wednesday, while crude futures dropped about $5 per barrel due to strength in the U.S. dollar. By the end of the holiday-shortened week, gold had plunged 8.6%, crude oil was hovering just above $100 per barrel, and the Dow rebounded to gain more than 3% on the heels of a strengthening financials sector.

What the Trader is Expecting in the Coming Week: S&P 500 Index Support Sets Up Bear-Market Rally, Sentiment Points to Long-Term Concern
By Todd Salamone, Senior Vice President of Research

With the S&P 500 Index (SPX) finding support at its January low in the 1,270 area last week and then closing the week above its February low at 1,320, stocks are certainly poised for a bear-market rally. Also of interest is potential support at the SPX's 60-month, or 5-year, moving average. This support is notable because it marked the approximate site of the index's low in November 1990, the last time the U.S. was in the midst of a liquidity crisis.

Last week, we saw some interesting extremes in terms of the sentiment measures that we follow. Such extremes could be important as we move into the final week of the quarter. First, the CBOE Market Volatility Index (VIX 26.28) hit a high of 35.60, which was just shy of the August and January highs of 37.50. In last week's Monday Morning Outlook, we concluded that there was a strong possibility that the VIX was poised to revisit its highs. By Monday's trading, the index came close to doing just that. However, the fact that the VIX failed to make a new high as the SPX carved out new intraday lows is cause for intermediate- and long-term concern.

While we alluded to a big pop in VIX call open interest in last week's Monday Morning Outlook, call liquidation and put accumulation quickly followed. With March VIX options expiring last week, we will closely be following VIX option activity this week. The absence of major call accumulation would be encouraging for the bulls, while alarm bells should go off if you see a call build similar to that which occurred following February expiration.

As for the VIX, we'll be watching the 22.68 level, which is the site of its 200-day moving average. This moving average has contained all pullbacks for the VIX since March 2007. If the market were to advance strongly in the upcoming week, a VIX decline to this level might become a headwind for equities, as index option buyers accumulate put positions at perceived cheap levels.

Finally, the latest poll from the American Association of Individual Investors showed that 54.3% of those surveyed were bearish, while only 25.2% were bullish. What is striking about these numbers is that on October 11, 2007, with the SPX trading near an important market top, 54.6% of investors were bullish, while only 25.8% were bearish.

Against this backdrop, the SPX closed below its 160-week moving average for the fourth consecutive week. This trendline is located at 1,340, just 12 points above Thursday's close. With a weekly close above this trendline, the next level of potential resistance would be 1,400, site of the SPX's 80-day moving average and the February high. Meanwhile, 1,270 remains a potential support level on a resumption of the decline.

The bottom line is that we are technically in a bear market environment. However, recent price action amid short-term negative sentiment extremes suggests that the market could be in rally mode for the coming weeks. Of course, that's excluding heavy call trading among VIX option players that would suggest that another credit market accident is around the corner. The financial sector is a group short-term traders should consider on the long side, following put accumulation that were added in the face of positive earnings surprises last week.

Indicator of the Week: ISE Equities-Only Sentiment Index
~Joe Sunderman, Vice President of Financial Market Analytics

Background: In our Monday Morning Outlook on March 3, we focused our attention on the Schaeffer's Equity-Only Put/Call Volume Ratio. This indicator measures the sentiment of the options crowd by tracking the number of call contracts and put contracts that change hands in a market session. Along these lines, the International Securities Exchange (ISE) developed the ISE Equities-Only Sentiment Index. This unique put/call index uses only opening long customer transactions to calculate bullish/bearish market direction. Thus, this indicator does not include opening sell and transactions from market maker and firm. Thus, the ISE believes this ratio is a more accurate measure of true investor sentiment than traditional put/call ratios.



ISEE Index Chart

How to interpret the data: Unlike other option ratios that place the number of puts in the numerator and the number of calls in the denominator, the ISE ratios are the inverse in this relationship - call-to-put ratios. Thus, a high ISE call/put volume ratio would be seen as sign of optimism, as there are more calls than puts in volume. On the other hand, a low ISE call/put volume ratio would be a sign of pessimism. Finally, this ratio is multiplied by 100, as opposed to simply a ratio figure that falls between 0 and 1.

With this indicator, we like to study the trends of the ratio rather than the day-to-day readings, which can be volatile depending on market conditions. In particular, we like to look at the 10-day moving average to gauge the sentiment during a longer period.

Current reading: During the past 10 sessions, the ISE ratio has floated between 66 and 131 for an average 10-day reading of 99. This is the lowest 10-day reading in the entire ISE data set that dates back to January 2006. As seen by the graph, the current reading is even lower than the readings of March 2007 when this average reached a low of 101.90.

Implications: Sentiment at current levels is pessimistic, but unfortunately it has taken a very steep market decline to reach these levels. In March 2007, the market had to fall 6% for the indicator to reach the 100 level. Comparatively, the current levels of pessimism are the result of a 20% decline. Thus, even though this indicator is showing pessimism, we would like to see further drops in this 10-day reading as a sign of full capitulation.

This Week's Key Events: Consumer Confidence, Fourth-Quarter GDP, and Earnings from Homebuilders
By Joseph Hargett, Senior Equities Analyst

Here is a brief list of some of the key events for the upcoming week.

  • Monday before the market open Tiffany & Co. (TIF) is expected to report earnings of $1.21 per share, according to First Call. Walgreen (WAG) is forecast to post a profit of 67 cents per share.

  • Monday morning Existing home sales for February are seen declining by about 30,000 from the prior month to 4.86 million units.
  • Tuesday morning Consumer Confidence for March is expected to arrive flat with February's reading of 75.00.
  • Wednesday before the market open Durable goods orders for February are expected to rebound from January's loss of 5.3% to come in at a gain of 1%. Also before the open, Oracle (ORCL) is seen earning 30 cents per share for the most recent quarter.
  • Thursday before the market open Final fourth-quarter Gross Domestic Product (GDP) is expected to have grown by 0.6%, flat with the preliminary reading. In earnings, homebuilders KB Home (KBH) and Lennar (LEN) are seen reporting quarterly losses of $1.17 and $1.18 per share, respectively.
  • Friday before the market open February personal income is seen flat at 0.3%, while personal spending for February is expected to decline to 0.2% from 0.4% in January. Core PCE Inflation is expected to have moderated from January's reading of 0.3% to arrive at 0.2% in February.

And now a few sectors of note...

Dissecting The Sectors
Sector
Chemicals/Agriculture
Bullish

Outlook: While commodities and chemicals have had a rough couple weeks, the S&P Chemicals Index (CEX) rebounded sharply from its rising 20-month moving average following a brief consolidation period of the sector's recent gains. Furthermore, the Market Vectors Agribusiness (MOO) exchange-traded fund is holding at support in the round-number 50 region. This pullback and consolidation in the MOO could represent a buying opportunity before the group continues its uptrend. On the sentiment front, investors remains heavily bearish. The chemical sector's composite Schaeffer's put/call open interest ratio (SOIR) remains at an elevated reading of 0.85, above 70% of all those taken during the past year. Furthermore, just 53% of the analysts following the sector rate it a "buy" or better, leaving room for future upgrades.
Sector
Financials
Bullish

Outlook: After underperforming the broader market for the better part of the past year, financial stocks are beginning to rebound amid the current market environment. Last week's 75-basis-point rate cut from the Federal Open Market Committee (FOMC) bolstered financial institutions by making it easier for banks to lend money to each other. Furthermore, Goldman Sachs (GS) and Lehman Brothers (LEH) both bested expectations for quarterly earnings figures, painting a picture of strength among investment banks, despite the implosion of Bear Stearns (BSC). Two particular pockets of strength in the sector are Hudson City Bancorp (HCBK) and State Street (STT). HCBK has risen more than 20% so far this year along support at its 10-week and 20-week moving averages, while STT is up more than 28% during the past 52 weeks on support from its 10-month and 20-month trendlines. Sentiment toward these 2 financial concerns is heavily pessimistic, with HCBK's SOIR at an annual peak and STT's ratio falling just 4 percentage points shy of a 52-week high. With financial stocks beginning to emerge from their stigma of the past year, an unwinding of the heavy pessimism levied against the sector could help send stocks such as STT and HCBK soaring higher.
Sector
Large-Cap Technology
Bearish

Outlook: Despite last week's strength in the major U.S. market indices, the Select Sector SPDR Technology Fund (XLK) is finding resistance at its declining 160-week moving average. Furthermore, this trendline is poised for a bearish cross of its 10-week counterpart a technical development that could signal additional losses for the technology sector in the coming weeks. Meanwhile, the tech-heavy Nasdaq Composite (COMP) is underperforming its peers on Wall Street, falling under resistance at its 10-week moving average since November 2007. Despite this poor technical performance, the Nasdaq-100 Trust's (QQQQ) Schaeffer's put/call open interest ratio (SOIR) of 1.10 ranks below all such readings taken during the past year, indicating an extreme in optimism among speculative tech investors.

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