Monday Morning Outlook: Despite Long-Term Uptrend, Bearish Sentiment Prevails

              

Housing data, the Federal Open Market Committee (FOMC), and the Group of 20, oh my! Last week's data deluge nearly sent the Dow Jones Industrial Average (DJIA) careening into the 10,000 level for the first time since Oct. 7, 2008, but the bulls quickly ran out of steam following the FOMC's policy statement. As a result, the DJIA peaked less than 100 points shy of 10K on Wednesday, and spent the rest of the week careening lower. Looking for a leg up on the coming week, Todd Salamone, Senior Vice President of Research, reviews key sentiment indicators, including the CBOE Market Volatility Index (VIX) and the 20-day historical volatility for the S&P 500 Index (SPX). Todd zeroes in on key support and resistance levels for the SPX and the Russell 2000 Index (RUT), offering levels to keep an eye on heading into next week. Then, Senior Quantitative Analyst Rocky White drills down on historical data concerning fourth-quarter seasonality for the Dow, revealing that Santa Claus may yet be paying a visit to Wall Street. 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 Fails to Inspire Bulls
By Joseph Hargett, Senior Equities Analyst

It was a roller coaster week for the Dow Jones Industrial Average (DJIA), with the Federal Open Market Committee (FOMC) providing the lift hill for a plunge heading into the weekend. Stocks surrendered to widespread selling pressure right out of the gate on Monday, as lackluster leading economic indicators and profit taking ahead of the FOMC and Group of 20 (G20) meetings drove the Dow to a loss of 0.42%. On Tuesday, a round of solid earnings reports and rising commodities prices (due to a falling U.S. dollar) more than negated Monday's losses, as traders turned cautiously optimistic heading into the FOMC statement on monetary policy. The DJIA rebounded 0.52% as a result.

Wednesday marked the beginning of the end for the bulls on the week. The Fed reported that economic activity had "picked up" since its last meeting, but that it would maintain rock-bottom interest rates near zero for some time, and announced plans to extend its purchase of mortgage-backed securities into early 2010. Furthermore, the Fed said it expects inflation to remain "subdued." The Dow looked poised to challenge the 10,000 level shortly after the statement, but an eleventh-hour sell-off plunged the blue-chip barometer 0.83% into the red. Stronger-than-expected weekly jobless claims promised to send stocks back the other direction on Thursday, but a disappointing report from the National Association of Realtors quickly spoiled the mood on the Street. According to the data, existing home sales staggered 2.7% lower in August, reversing course after a 7.2% rise in July. The Dow fell 0.42% on the day.

Stocks slid into the red for the third straight session on Friday, as investors digested disappointing earnings from Research In Motion Limited (RIMM) and a wave of dismal economic data. Specifically, durable goods orders fell by a steeper-than-expected 2.4% in August and new home sales all but flatlined for the month, although consumer sentiment sprinted past economists' predictions to approach 21-month highs. Still, the Dow fell 0.44% on the day, ending the week with a loss of 1.6%. Elsewhere, the S&P 500 Index (SPX) dropped 2.2% last week, while the Nasdaq Composite (COMP) fell 2% on a week-over-week basis.

What the Trader Is Expecting in the Coming Week: Battling Conventional Wisdom
By Todd Salamone, Senior Vice President of Research

"The odds are stacked against the market for the upcoming week when looking at quadruple-witching week-after returns since 2006. However, we remain bullish in the context of an improving technical backdrop and a sentiment landscape that suggests 'disbelief.'"
- Monday Morning Outlook, Sept. 19, 2009

Stocks behaved as expected in the week following quadruple-witching expiration, with the market suffering the typical post-expiration hangover by trading lower in four of the five days. Put demand was predominant on broad-based indexes and exchange-traded funds (ETFs), especially the S&P 500 Index (SPX), the iShares Russell 2000 Index Fund (IWM), and the Standard & Poor's Depositary Receipts (SPY). Furthermore, the CBOE Market Volatility Index (VIX) rose, as demand for portfolio protection grew.

Conventional wisdom thinks that stocks are overdue for a big pullback and that portfolio protection is cheap, so growing put demand was not a huge surprise. What's more, as I discussed last week, the mechanics of growing demand for portfolio protection usually has a depressive effect on stocks. This effect usually occurs immediately following expiration, as investors replace expired put hedges. If you combine the bearish mechanics of index and ETF put buying, last week's short-term "overbought" condition, the prospects of stimulus removal as suggested by the G20 and Fed meetings, and disappointing reports on housing and durable goods, you are left with difficult market headwinds.

However, the pullback may generate another buying opportunity, as the indexes retreated to potential support areas. The "buying opportunity" view is consistent with the current trend in the market, but inconsistent with the outlook of many traders and investors.

In addition to the common view that a sharp pullback could be on the horizon, many professionals agree that portfolio protection (a la the VIX) is "cheap and headed higher." While it is true that the VIX is trading near its 52-week lows, it should also be noted that the 20-day historical volatility of the SPX is only 14.8%. In other words, the VIX can easily be considered expensive when compared to SPX historical volatility. In fact, the VIX is currently trading more than 75% above SPX historical volatility. During the past five years, the VIX has typically traded at a 25% premium to historical volatility, suggesting that a reading of 18 might be considered normal relative to current historical volatility. Finally, the VIX comes into the week just below its 80-day moving average, a trendline that has marked peaks dating back to mid-January. This trendline could mark yet another top in the near future. As I stated in early September, "The contrarian bet for the months of September and October is a neutral-to-bearish trade on volatility."

We are still intrigued by the skepticism or, put another way, the vast sideline money that exists within the context of the huge rally off the March lows. Last weekend, Barron's summed up the sentiment landscape perfectly, with a cover and byline that read, "THE NEW INVESTOR – Even with shares up sharply, millions of Americans remain fearful and may stay that way for years, clinging to cash, bonds and dividend-paying stocks."

Meanwhile, the American Association of Individual Investors' (AAII) poll continues to reflect prevalent fear and defensive posturing. In the last AAII survey, only 39% of retail investors surveyed were bullish on stocks, compared to nearly 45% bearish. The fact that there are more bears than bulls is astonishing. Moreover, the market rally has coexisted with anxiety among retail investors for the past 10 weeks. During this 10-week period, in which the SPX rallied nearly 8%, the average bullish percentage was only 39%, while the average bearish percentage was 40% – again, more bears than bulls.

The SPX moved out of its short-term "overbought" condition, but now sits back below its 80-week moving average as we enter the week ahead. Last week, I raised the possibility that this trendline could serve as short-term support in the event of a pullback. If a move back above the important 80-week moving average is not achieved in fairly short order, expect buyers to emerge around the 1,000 area. This region is home to a trendline connecting the March and July lows. A move up to 1,120 would mark a 50% retracement of the SPX's October 2007 high and its March trough, so this would be the next upside target for the bulls.

Finally, the RUT pulled back to the 600 area last week. As I have previously discussed, 600 is significant, as it is the site of the RUT's March 2000 high and a 50% retracement of the index's July 2007 peak and March low. The RUT's 80-month moving average is situated at 634.52, and could be a challenge, having provided support on a monthly closing basis in October 1998 and in September/October 2001.

Indicator of the Week: Fourth Quarter Seasonality
By Rocky White, Senior Quantitative Analyst

Quarterly Returns: The third quarter comes to an end this week, so I thought it would be appropriate to see what history tells us about the final three months of the year. If history holds true, then we should be in for a very enjoyable fourth quarter. Below is a table showing the data for the Dow Jones Industrial Average (DJIA) since 1950. The fourth quarter is, hands down, the best quarter for the market, with an average return of 3.50%. Furthermore, the fourth quarter returns positive results three times out of four.

Below is the same data, but focusing on more recent times. Since 1980, the Dow has seen even better fourth-quarter returns. For this time frame, the Dow's median return is slightly more than 5%, with positive returns occurring 83% of the time.

The 10 most recent fourth-quarter returns are below. We just noted that there is a bullish bias for the end of the year, but the past two years have seen negative fourth quarters.

Too Far Too Fast? With the Dow up more than 25% since the end of the first quarter, many Wall Street pundits are saying that we have come too far too fast and that the market is due for a pullback. This skepticism is a confidence booster for contrarians, signaling that there is plenty of potential upside for the market by the end of the year. The table below only increased our confidence. It shows the Dow's performance since 1900 when the market gained at least 25% in the second and third quarters. You can bet that in each of these instances there was a chorus pontificating that the market was overbought and we were due for a reversal. But the returns are phenomenal. The table shows that in an overwhelming majority of cases momentum carries through to the next quarter. We see average quarterly returns of more than 15% when the market is up at least 25% in the six months leading into a quarter. In nearly nine out of 10 occasions, the market was higher the following quarter.

Conclusion: We're hearing a lot of claims that the market is overbought and will suffer a pullback by the end of the year; it's music to our ears. As contrarians, we'd much rather hear a crowd warning everyone of an overhead market as opposed to one focusing on the unmistakably bullish historical tendency for the coming fourth quarter.

This Week's Key Events: September Nonfarm Payrolls on Tap
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

• There are no economic reports or major earnings reports slated for release on Monday.

Tuesday

• July's Case-Shiller housing price index and the September consumer confidence index will arrive on Tuesday. Elsewhere, Walgreen Co. (WAG), Darden Restaurants Inc. (DRI), Jabil Circuit Inc. (JBL), and Nike Inc. (NKE) are among those reporting earnings.

Wednesday

• The September ADP employment report, the final second-quarter gross domestic product (GDP) reading, and weekly U.S. petroleum supplies are on Wednesday's docket. Meanwhile, Actuant Corp. (ATU) is scheduled to report earnings.

Thursday

• August's personal income and spending reports, weekly initial jobless claims, August's construction spending index, pending August homes sales, September auto sales, and the Institute for Supply Management's manufacturing index for September will arrive on Thursday. The earnings calendar includes Constellation Brands Inc. (STZ), Accenture Plc (ACN), and Immucor Inc. (BLUD).

Friday

• We round out the week's economic calendar with September's hourly earnings, average workweek, nonfarm payrolls, the unemployment rate and August's factory orders report. There are no earnings reports scheduled for release.

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 41% since the beginning of the year. Despite this outperformance, investors continue to overlook and to bet against the shares. Specifically, 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. Meanwhile, the QQQQ's 50-day buy-to-open put/call ratio continues to climb, and could be viewed bullishly, especially with many of the contributing puts being possible hedges against accumulated long positions. One risk to this rising ratio is that it is at its highest levels since November/December 2007, which was essentially the top of the QQQQ's bull market rally. Also in the options pits, call open interest above the trust is extremely thin, virtually eliminating potential overhead options-related resistance. Traders should continue to keep an eye on the 40 level, as it is home to a 50% retracement of the security's June 2008 high and its November low. Within the group, our favorites include Palm Inc. (PALM), Western Digital Corp. (WDC), Juniper Networks Inc. (JNPR), Atheros Communications Inc. (ATHR), and priceline.com Inc. (PCLN). Traders should avoid Research In Motion Limited (RIMM), especially following the company's lackluster earnings report last week.

Sector

Gold Neutral

Outlook: Gold prices took quite a hit last week, with the front-month contract dropping back below the $1,000 an ounce mark. Even more disturbing is the fact that gold declined in the midst of a pullback in the U.S. dollar. As gold is typically utilized as an inflationary hedge, this technical weakness is quite bearish for the malleable metal. Technically speaking, gold has once again rallied into long-term resistance near the $1,000-an-ounce region. Gold has challenged this millennium mark five times since March 2008, and has been soundly rejected on each instance. Elsewhere, the SPDR Gold Trust (GLD), which tracks the performance of gold bullion, has been stymied by round-number resistance at the 100 level. The trust created a double top near the century level earlier this month, and it has since pulled back sharply. Meanwhile, gold's 14-day Relative Strength Index (RSI) has turned lower from overbought levels seen before the precious metal broke above the $1,000-an-ounce region. What's more, short interest has spiked on GLD, a development that could be related to hedge funds buying gold futures. We saw a similar development in last 2008 and early 2009, which turned out to be bullish for GLD.

Sector

Retail Bullish

Outlook: The retail sector has come on strong since the March bottom, with the S&P Retail SPDR (XRT) rallying more than 87% during this time frame. What's more, the exchange-traded fund (ETF) has extended its rally along key support at its rising 10-week and 20-week moving averages. However, pessimism is thick on the retail sector, as only 41% of the 960 analyst rankings on retail stocks are "buys," according to Zacks, leaving plenty of room for potential upgrades. That said, the XRT's 50-day buy-to-open put/call ratio has reached high levels, but has not given an indication of moving higher or turning lower. While we remain bullish toward the retail sector, a major decline in this ratio would change our position. Within the sector, we see bullish opportunities for Expedia Inc. (EXPE), Whole Foods Market Inc. (WFMI), Green Mountain Coffee Roasters Inc. (GMCR), Polo Ralph Lauren (RL), AutoNation Inc. (AN), Starbucks Corp. (SBUX), Chipotle Mexican Grill Inc. (CMG), and Aeropostale Inc. (ARO).