Monday Morning Outlook: After a Blisteringly Hot July, 1,000 Now Looms on SPX

              

Although last week cooled off just a little bit, the Dow Jones Industrial Average (DJIA) finished its best month since 2002, soaring 8.6% in July. The major market indices traded flat for the better part of last week, only to rally sharply heading into the weekend on a General Electric Company (GE) upgrade and stronger-than-expected economic data. Looking ahead to next week, Todd Salamone, Senior Vice President of Research, zeroes in on resistance at the 1,000 level for the S&P 500 Index (SPX), as well as the Russell 2000 Index's (RUT) 80-week moving average. Todd also checks in with the 10-day moving average for the buy (to open) call/put ratio on the International Securities Exchange (ISE). Then, Senior Quantitative Analyst Rocky White explains why conventional wisdom surrounding a recent "overbought" signal from the SPX's relative-strength index might be off the mark. We wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: The Dow's Best Month Since 2002 Ends with a Sigh
By Joseph Hargett, Senior Equities Analyst

Following the intense rallies of the prior two weeks, last week's 0.8% gain by the Dow Jones Industrial Average (DJIA) was quite the snoozer. Mediocre earnings from Verizon Communications (VZ) and mixed housing data set the tone on Monday. The Commerce Department reported that new home sales jumped 11% in June. However, the median sales price slumped to $206,200, down 12% on a year-over-year basis. The theme continued into Tuesday, with BP Plc (BP) offering up a disappointing earnings report, while the Conference Board reported that consumer confidence fell to 46.6 in July from June's reading of 49.3, marking a steeper-than-expected decline. In response, the Dow inched up 0.17% on Monday and then back down 0.13% on Tuesday.

Wednesday started off horribly, as a sell-off in Shanghai spread to the U.S. market on fears that the Chinese government might take steps to tighten credit. Matters worsened when the Commerce Department reported a steep 2.5% drop in June durable goods orders. However, a cautiously optimistic Beige Book from the Fed helped erase the worst of the day's losses. According to the report, the recession's pace appears to be slowing, with the economy even beginning to stabilize in some regions. The Dow held the 9,000 level, and closed down 0.29%. Optimism picked up as the weekend neared, with better-than-expected earnings from Motorola (MOT) and Dow Chemical (DOW) contributing to the rebound. General Electric (GE) surged after scoring an upgrade from Goldman Sachs, and investors were relieved to hear that initial jobless claims rose by just 25,000 in the prior week. All three major indices tagged fresh 2009 highs before the closing bell sounded on Thursday, and the Dow logged a gain of 0.92% on the session.

Stocks traded in a narrow range on Friday, as investors didn't know whether to laugh or cry at the government's latest gross domestic product (GDP) report. The data showed that the economy contracted at a 1% annual pace in the second quarter, which was less than economists expected and an improvement over the 6.4% contraction in the first quarter. However, the data also indicated that the economy has slowed down by 3.9% during the past year, marking the heftiest four-quarter pullback since the 1930s. Stocks eventually decided to trudge higher, and the Dow finished with a gain of 0.19%. For the week, the DJIA and the S&P 500 Index (SPX) both added 0.8%, while the Nasdaq Composite (COMP) rose 0.6%.

What the Trader Is Expecting in the Coming Week: Worries About Resistance and Volatility
By Todd Salamone, Senior Vice President of Research

We saw the market break out to the upside two weeks ago, and a continuation of that advance last week. So far the S&P 500 Index (SPX) has rallied 13% from the July 8 intraday low. So now what? A steep sell-off?

Let me begin with a comment that Ryan Detrick, who did an outstanding job covering the market in my absence, made last week. While outlining a few bullish supporting factors for the market, Ryan said, "A logical place for potential resistance for the SPX lies at the round-number 1,000 level. This, of course, would amount to approximately a 50% rally off of the index's March lows near 666."

Indeed, the 1,000 target was nearly achieved last week thanks to a strong rally on Thursday. The SPX reached 996.68 on Thursday morning, just shy of the short-term target Ryan highlighted. With the 1,000 level immediately overhead, and the SPX coming into this week "overbought" (the nine-day relative-strength index reached an "overbought" reading above 80 last week), the question is, "Are we just around the corner from the widely anticipated correction?"

Certainly, this combination of technical resistance, an overbought condition, evidence of short-term optimism creeping into the marketplace (which I'll discuss in a moment), and professional traders bracing for a surge in volatility is cause for concern. Driving the expectation for a surge in volatility is a growing thirst for CBOE Market Volatility Index (VIX) calls. For more on volatility expectations among the professional traders and our take on this, see Bernie Schaeffer's most recent edition of Schaeffer on Charts.

With professionals looking for a sharp pullback, this could very well become a self-fulfilling prophecy. I'll throw in the fact that August is one of only three months to average negative returns during the past 20 years. That said, I think a trading range much like we witnessed in May and June could be a higher probability during the next few weeks. As Rocky White writes in this week's Indicator of the Week, although the market may be "overbought" according to the traditional definition, this does not mean a sharp pullback is on the immediate horizon. In fact, "overbought" using these parameters is a falsehood, according to Rocky's research, although it may indicate that the market is due to digest some of the sharp gains.

The above being said, key resistance levels lie just overhead on some major indices, which could dampen the velocity of the current rally. Aside from the 1,000 level on the SPX, the Russell 2000 Index (RUT) is trading just below its declining 80-week moving average, which acted as resistance in September 2008. This trendline is currently situated at 583.54. Should the 583 level get taken out, there is room for a rally up to the 600 level, which would be a 50% retracement of the index's October 2007 high (around 850) and its March low (near 350).

So, while we have some room to the upside, let's take a look at a couple of sentiment indicators that lead me to believe a hesitation is possible. First, per the chart below, consumer equity call buying on the International Securities Exchange (ISE) has become popular again. This is evident by the 10-day moving average of the buy (to open) call/put ratio. Since January 2008, when this ratio has reached extremes near current levels, it has generated "sell" signals three times, while one such reading foreshadowed a trading range environment (May 2008).

With the technical backdrop in better shape now than the last time we saw the buy (to open) call/put ratio produce "sell" signals, I think a case can be made for a repeat of May 2008. So, what is the caveat to the current reading being predictive of a more difficult market environment in the days ahead? Consider this: this same ratio peaked at levels between 225-243 prior to the bear market in late 2007. In other words, we have seen even higher levels of optimism among option traders preceding the bear market, offering a risk to my outlook.

Moreover, retail investors are getting more comfortable with the market's outlook, and they have tended to be very reactive and wrong at key points throughout 2009. For example, according to the latest American Association of Individual Investors weekly survey, nearly 48% of investors are bullish. This is the highest percentage of bulls since June 4, which preceded a mild pullback in the SPX during the course of the following month. For what it is worth, only 28% of those surveyed were bullish ahead of the SPX's breakout two weeks ago.

For the short term, the contrarian trade would be to bet against a sharp rise in volatility in the days and weeks ahead. A decline in volatility may certainly occur within the context of a market that goes through the process of consolidating the gains it experienced during the past month, similar to that which occurred in May and June. We continue to favor the technology sector. If professional traders end up being correct, a long position in the unpopular U.S. bond market is a nice hedge to a sharp pullback in the stock market.

Indicator of the Week: The Nine-Day Relative-Strength Index (RSI)
By Rocky White, Senior Quantitative Analyst

Foreword: The third straight positive week for the S&P 500 Index (SPX) has placed the broad-market indicator up nearly 50% from its March lows. Should we be getting nervous? Are we going to see a pullback? To answer these questions, I'm going to look at a short-term overbought/oversold indicator. I'm talking about the nine-day Relative-Strength Index (RSI). The RSI is an oscillator that ranges from zero to 100. When technical analysts use an RSI, they typically interpret high readings (usually around 70) as bearish, indicating a market that is overbought. Conversely, low readings (usually around 30) are seen as bullish, meaning that a market is oversold.

When J. Welles Wilder first wrote about the RSI in the late 1970s, he suggested using 14 periods. Since then, the nine-day RSI has gained some popularity. The nine-day RSI will be a bit more volatile than the 14-day, and should be better for looking at shorter time frames. Below is a graph of the SPX and its nine-day RSI. The pullback at the beginning of July took the RSI down to the mid-30s. The index has since rallied during the past few weeks, pushing the RSI to 80.

Is 80 Overbought?: As I mentioned earlier, high RSI readings are usually interpreted as indications that a market is overbought: 80 is a pretty high level for the RSI. When I looked at past instances when the RSI has reached a reading of 80, however, they did not show that the market is overbought. In fact, the results are quite bullish for the market in the two months following such a reading.

For this analysis I tracked the SPX and its nine-day RSI dating back to 1972. The top table below shows returns for the SPX after its nine-day RSI crosses above 80. The lower table displays typical SPX returns since 1972. The tables show that RSI has reached this high level 59 times. Those 59 returns outperform the typical market returns across all time frames shown. One month following a signal, the SPX has an average return of 1.66% compared to a typical return of only 0.60%. Furthermore, the market is up 69% of the time following a signal, which is also better than how the market has typically performed.

Implications: Since the RSI is hitting the extreme level of 80, you can assume that these signals occur during very strong rallies. In fact, the average market return in the month heading into one of these signals is 5.63%. The market has returned far less than this after a signal, but it still returns a solid 1.66% during the following month (seen in the table above). So, the RSI hitting 80 might be a sign that the rally is slowing down, but selling on this signal alone would have caused a trader to miss out on some gains.

This Week's Key Events: Unemployment Rate on Tap Friday
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

• June's construction spending report, July's auto sales, and the Institute for Supply Management's (ISM) manufacturing index for July are slated for release Monday. On the earnings front, Humana Inc. (HUM), MGM Mirage (MGM), Chesapeake Energy Corp. (CHK), and Pulte Homes Inc. (PHM) are slated to release their quarterly reports.

Tuesday

• June's personal spending/income reports and pending homes sales figures will arrive on Tuesday. Elsewhere, D.R. Horton Inc. (DHI), Marvel Entertainment Inc. (MVL), BMC Software Inc. (BMC), Kraft Foods Inc. (KFT), and Whole Foods Market Inc. (WFMI) are among those reporting earnings.

Wednesday

• The ADP employment report provides a sneak peak at July's jobs data on Wednesday, followed by June's factory orders, the ISM's services index for July, and the weekly report on U.S. petroleum supplies. Meanwhile, Garmin Ltd. (GRMN), Transocean Ltd. (RIG), Activision Blizzard Inc. (ATVI), The Allstate Corp. (ALL), and Cisco Systems Inc. (CSCO) are scheduled to report earnings.

Thursday

• Only the weekly initial jobless claims report is scheduled for release on Thursday. The earnings calendar includes Canadian Solar Inc. (CSIQ), Comcast Corp. (CMCSA), MBIA Inc. (MBI), Sirius XM Radio Inc. (SIRI), Beazer Homes USA Inc. (BZH), and NVIDIA Corp. (NVDA).

Friday

• The economic calendar rounds out the week with July's non-farm payrolls report, the unemployment rate, and June's consumer credit report. There are no major earnings reports slated for release on Friday.

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

Technology Bullish

Outlook: The technology sector has been hot in 2009, with the PowerShares QQQ Trust (QQQQ) gaining roughly 33% since the beginning of the year. Despite this outperformance, investors continue to overlook and to bet against the shares. Specifically, a recent survey of 127 institutional investors by TheMarkets.com revealed, "Surveyed investors expect that key sectors of focus over the next 12 months will be energy, financials, healthcare and basic materials." We find it extremely odd that technology was not listed among those key sectors, especially given QQQQ's strong technical performance in 2009. Elsewhere, the QQQQ's 50-day buy-to-open put/call ratio has entered a major uptrend, a development that has been bullish for the sector in the past. Finally, net shares in Fidelity Select tech funds are currently low compared to the past few years. This means that retail investors are not crowding the tech sector, and suggests that sideline money from this group could spur demand for tech stocks. Within the sector, our favorites include Palm Inc. (PALM), Western Digital Corp. (WDC), Juniper Networks Inc. (JNPR), Atheros Communications Inc. (ATHR), and priceline.com Inc. (PCLN).

Sector

Gold Bearish

Outlook: On July 21, Federal Reserve Chairman Ben Bernanke reassured Congress and Wall Street that he will pull excess liquidity from the financial system in time to avoid a boom in inflation. As gold is typically utilized as an inflationary hedge, this news has been negative for the malleable metal. Furthermore, the U.S. dollar is beginning to gain strength once again, despite a wealth of negative sentiment. Such a development would have negative implications for dollar-denominated gold prices. Technically speaking, the SPDR Gold Trust (GLD) has settled into a series of lower highs dating back to a near-term peak in February. The trust is in danger of setting yet another peak in this decline, having stalled at long-term resistance in the 94-95 region. This area capped GLD in mid-March, and was a major technical hurdle for much of May. A rejection here, combined with a continued unwinding of inflationary hedging, could send the trust sharply lower.

Sector

Treasurys Bullish

Outlook: Treasurys are getting quite the bad rap lately. There has been talk in the financial media of a bursting bubble, a sentiment that was highlighted by a bearish Barron's cover story several weeks ago. Furthermore, a recent survey of investment managers indicated that optimism in regard to government debt is at its lowest level in quite some time. However, last week saw strong demand for several large bond auctions, including the revival of seven-year notes. And, even though Wednesday's auction of five-year Treasury notes saw demand slip to a 10-month low, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) actually finished the day higher. Technically speaking, the TLT is currently in the process of rebounding off support near its 80-month moving average and the round-number 90 level. Finally, the U.S. Dollar Index is holding firm near support in the 80 region, which could be bullish for Treasurys. Should these support levels hold, we could see an unwinding of pessimism on both fronts, potentially sending bonds steadily higher.