Monday Morning Outlook: Uncertainty Is in the Air as Wall Street Prepares for Change

              

Today's in-depth look at the week ahead begins with a recap of last week's short-lived rally ahead of an historical Presidential election, and the subsequent sell-off heading into the weekend. Next, Schaeffer's Senior Vice President of Research, Todd Salamone, examines technical support and resistance levels for the S&P 500 Index (SPX), as well as several key sentiment indicators for the broad market. Joe Sunderman, Vice President of Financial Market Analytics, drills down on the CBOE Market Volatility Index (VIX) and its relationship with the SPX's 20-day historical volatility. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: An Historic Week Ends on a Sour Note
By Joseph Hargett, Senior Equities Analyst

Despite a strong finish, last week marked a return to the bear market, as all 3 of the major U.S. indices plunged about 4%. The first week of November started off benignly on Monday, as the Dow Jones Industrial Average (DJIA) dropped a mere 5.8 points, despite a report from the Institute for Supply Management (ISM) that its manufacturing index plunged to its lowest level since 1982. Tuesday saw the end of a nearly 2-year campaign for the office of President of the United States, as voters turned out in droves for the chance to make history by voting for the first African-American president, or the first female vice president. The market was in high spirits, as the Dow surged 305 points after lawmakers on Capitol Hill hinted that they may invest in a broader range of financial firms, such as GE Capital.

But Tuesday's election anticipation gave way to a "sell on the news" event on Wednesday, with the Dow falling 486 points following worse-than-expected results from the ADP National Employment jobs report and the ISM's non-manufacturing report. The sell-off extended into Thursday; the DJIA plunged 443 points as traders dealt with another round of negative employment data from the Labor Department, which indicated that continuing jobless claims hit a 25-year high. A poor earnings report from Cisco Systems (CSCO) didn't help matters, either. The maelstrom had blown itself out by Friday, as not even a 14-year high in the unemployment rate and a larger-than-expected drop in nonfarm payrolls could keep the major U.S. indices from rebounding sharply. The Dow added 248 points on Friday, but closed the week with a loss of more than 4%. Meanwhile, the S&P 500 Index (SPX) lost 3.9% last week, while the Nasdaq Composite (COMP) gave back 4.3% on a week-over-week basis.

What the Trader Is Expecting in the Coming Week: Support, Resistance, and Sentiment for the S&P 500 Index
By Todd Salamone, Senior Vice President of Research

On October 27, the S&P 500 Index (SPX) entered the week just above chart support near its mid-October lows and rallied. The index entered last week just below resistance from its October 17 highs and ended the week in the red. This week, the SPX starts out sitting smack in the middle of a month-long trading range between 1,010 and 850, which are levels to pay close attention to this week.

Meanwhile, the 900 strike is home to heavy put open interest in the November option series, and could also provide an area of potential support. Since the SPX entered its current trading range last month, the index has closed below the 900 strike only twice. This region also marked the SPX's lows last week.

Last week, I discussed the powerful high-volume rally on the S&P Depository Receipts (SPY) on October 28 and the short-term bullish implications for the 2 weeks following the signal. This signal "shuts off" on Tuesday. For those of you keeping track, the SPY closed at 93.76 on October 28, and we'll know tomorrow if this signal preceded another bullish 10-day period.

Last Thursday, however, was somewhat of a mirror image of October 28. In other words, the SPY lost 5.5% on a day in which volume exceeded its previous 10-day average. In each of the previous 37 instances where this has occurred, it has essentially been a coin-flip probability as to whether the SPY finished higher or lower in the 10 days following such an event. However, the signal has bearish implications, since the average loss of 4.2% compares to only a 3.7% average gain.

We are also closely watching the behavior of the CBOE Market Volatility Index (VIX – 56.10) from 2 perspectives. First, the VIX continues to trade at a steep discount to the SPX's 20-day historical volatility, which has begun to level off just above 80% during the past few weeks. Our interpretation of this development is that there is little fear of another major setback in the market. Typically, such fear leads to major market bottoms. If fear and panic were elevated, the VIX would be trading above the actual volatility of the SPX.

Second, we are keeping an eye on the 44-45 area in regard to the VIX. We think this area is important, as it marked last week's low, and represents the VIX's "half-high" achieved on October 24. Moreover, this area is currently home to the VIX's rising 50-day moving average.

Even though we are in a period that has traditionally been strong for the market, investors should be cautious. Specifically, hedge funds remain a dominant force in the market, and are apparently still going through periods of de-leveraging. We saw more evidence of this de-leveraging on Wednesday and Thursday, as "forced selling" emerged with energy and steel stocks leading the market lower.

Along these lines, we've heard of several dates by which hedge fund investors must redeem their holdings. One such date is November 15, while the others lie at the end of November and December. Perhaps hedge-fund managers began raising cash last week in anticipation of the November 15 deadline. These deadlines may continue to plague the market in the weeks ahead, as hedge-fund managers use any signs of market strength to raise cash. Therefore, we recommend that you continue to avoid the sectors that hedge funds are heavily long, namely energy and technology.

Indicator of the Week: Is the VIX Showing Enough Fear?
By Joe Sunderman, Vice President of Financial Market Analytics

Background: The Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX) is a sentiment tool that measures the market expectations for near-term volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 Index (SPX) options. This volatility is intended to be forward-looking, and is calculated from both calls and puts. The VIX is often referred to as an investor "fear gauge," as it provides insights to how the investor community views future volatility. During challenging market periods, the VIX will tend to rise, as investors brace for higher levels of volatility. On the other hand, during quiet market periods, a low VIX is a sign that investor fear is subsiding.

In past commentaries on the VIX, I have either focused on the absolute level of the index or its trend. Today, I will take a closer look at the disparities between the SPX's historical volatility and the VIX.

Data Interpretation: The accompanying graphs offer 2 different depictions of the VIX and the 20-day historical volatility of the SPX. The first graph shows the VIX's trend and the action of the SPX volatility since the beginning of the year. There are a couple of noteworthy developments to point out. First, until August 2008, the VIX traded at a premium to SPX historical volatility. In fact, going back 18 years, the VIX has traded at a premium to SPX volatility more than 90% of the time. Thus, the natural spread is for the VIX to trade at a premium to SPX volatility. Second, there has been an unusual development since August in the relationship between the VIX and the SPX's volatility - a discount. Such a development is abnormal, as it has occurred less than 10% of the time in the past 18 years, but has occurred in 25 of the past 36 sessions.

The graph below shows the difference between the VIX and SPX volatility. This graph is more revealing in terms of the spread between these 2 related indicators. When the difference between the indicators is above zero, the VIX is trading at a premium to the SPX's volatility. On the other hand, when this indicator goes below zero, the VIX is trading at a discount to the SPX's volatility.

Historically, there have not been many occurrences when the VIX premium traded at a 30% discount or more - aside from the past month. Below are the dates of such occurrences:

11/7/2008 -30.22%
11/5/2008 -35.96%
11/4/2008 -42.51%
11/3/2008 -36.25%
10/21/2008 -33.92%
10/20/2008 -34.15%
10/14/2008 -38.44%
3/23/2007 -34.71%
3/22/2007 -36.97%
3/21/2007 -41.32%
8/16/2002 -37.03%
8/15/2002 -37.50%

Implications: It is difficult to draw a quantitative conclusion when there are so few historical references to draw upon. I do feel that this discount in the spread is a troublesome development. I remain concerned with the complacency I am seeing among option players. Bulls would want to see the VIX trading at a steep premium to SPX volatility, as a sign that fear is rampant among the investing community.

This Week's Key Events
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 the respective company websites for official reporting dates.

Monday

• There are no economic reports scheduled for Monday. In earnings, Energy Conversion Devices (ENER), Tyson Foods (TSN), Midway Games (MWY), Starbucks (SBUX), and Sirius XM Radio (SIRI) are scheduled to release their quarterly reports.

Tuesday

• There are no economic reports scheduled for Tuesday. In earnings, Fossil (FOSL), Liz Claiborne (LIZ), Tyco International (TYC), and TJX Companies (TJX) are scheduled to release their quarterly reports.

Wednesday

• The weekly release on U.S petroleum supplies is the lone report slated for Wednesday. In earnings, JA Solar (JASO), Applied Materials (AMAT), Computer Sciences (CSC), NetApp (NTAP), and Sina (SINA) are scheduled to release their quarterly reports.

Thursday

• On the economic front, the latest report on U.S. weekly initial jobless claims is on tap, as well as September's trade balance and October Treasury budget reports. In earnings, Pan Am Silver (PAAS), Urban Outfitters (URBN), Wal-Mart Stores (WMT), and Kohl's (KSS) are scheduled to release their quarterly reports.

Friday

• The economic calendar ends the week with a bang, with the release of October's import/export prices and retail sales, September's business inventories, and November's preliminary University of Michigan consumer sentiment index. In earnings, Abercrombie & Fitch (ANF), Agilent (A), and J.C. Penney (JCP) are scheduled to release their quarterly reports.

And now a few sectors of note...

Dissecting The Sectors

Sector

Insurance Bearish

Outlook: The government bailout of insurance giant American International Group (AIG) sharply adjusted the perception that the credit crisis was limited solely to the financial sector. Ever since, the group has come under heavy fire, with the S&P Insurance Index (IUX) falling more than 36% since September 16 - the day before the U.S. Federal Reserve Board approved the bailout loan. But trouble existed even before the AIG bailout, as IUX has fallen more than 60% since January, easily outpacing the S&P 500 Index's (SPX) drop of about 36% for the same time frame. The insurance index is now trading at multi-year lows, as it battles overhead resistance at the 150 level. However, investors have yet to fully capitulate to this poor performance, as the KBW Insurance SPDR's (KIE) Schaeffer's put/call open interest ratio (SOIR) of 2.06 ranks below 61% of all those taken during the past year. Furthermore, 7 of the 14 analysts following Aflac (AFL) rate the shares a "buy" or better, while 12 of the 14 brokerage firms following MetLife (MET) issue "buy" ratings. Should this elevated bullish sentiment begin to unwind, it could provide additional selling pressure for the sector.

Sector

Gold Bearish

Outlook: Gold remains an unreliable safe-haven investment, as the December gold futures contract plunged 18% during October, logging its largest monthly percentage loss since February 1983. Metals traders continued to fear government efforts to rescue the ailing financial industry in the U.S. and Europe. As such, gold has plunged more than 27% from its March 2008 highs above $1,000 an ounce. What's even more conspicuous is that gold prices reached that high level following the Bear Stearns debacle. But the failure of Lehman Brothers, Washington Mutual, American International Group, Fannie Mae, and Freddie Mac has failed to elicit the same kind of panicked safe-haven buying in gold. Along these lines, sentiment toward gold remains heavily bullish. Specifically, the SPDR Gold Trust's (GLD) Schaeffer's put/call open interest ratio (SOIR) of 0.38 indicates that calls outnumber puts by a ratio of about 3 to 1. Should this wealth of optimism for a rebound in the malleable metal begin to unwind, it could provide additional selling pressure, thus sending gold steadily lower.

Sector

Large-Cap Technology Bearish

Outlook: The tech-laden Nasdaq Composite (COMP) was the hardest-hit last week, dropping 4.3%, compared to lesser declines by its Wall Street brethren. Furthermore, the index was rejected by overhead resistance in the 1,800 region once again last week. In addition, the Select Sector Technology SPDR Fund (XLK) is trading below resistance at its declining 10-week and 20-week moving averages and is battling long-term resistance in the 17-17.50 region. On the sentiment front, there are still a number of overloved names within the technology sector. Microsoft (MSFT) has garnered 15 "buys," 5 "holds," and no "sells," while Google (GOOG) has acquired 20 "buys," 2 "holds," and no "sells." Even Apple (AAPL), with its year-to-date decline of more than 50%, remains a heavy bullish favorite. Currently, AAPL's SOIR of 0.76 rests in the lower quarter of its annual range, while 14 of the 20 analysts following the shares rate them a "buy" or better. With losses mounting, and confidence in the sector declining in the current economic environment, we could see this bullish sentiment unwind in the form of added selling pressure.