Monday Morning Outlook: A Strong Month, A Strong Quarter, And Then A Slowdown

              

Despite posting back-to-back weekly losses, Wall Street still finished September and the third quarter with solid gains. In fact, the S&P 500 Index (SPX) logged its seventh consecutive monthly gain. Still, the tone on the economic front was somewhat somber last week, as traders confronted weaker-than-expected data on the manufacturing and the jobs fronts. Looking for a leg up on the coming week, Todd Salamone, Senior Vice President of Research, revisits key levels for the CBOE Market Volatility Index (VIX) and the SPX, while examining the possibility of a sharper pullback due to three potential risks to the bullish case. Then, Senior Quantitative Analyst Rocky White takes a closer look at the SPX's seven-month winning streak, similar historical occurrences, and the potential implications for the current market environment. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Wall Street Stumbles on Weak Economic Data
By Joseph Hargett, Senior Equities Analyst

The Dow Jones Industrial Average (DJIA) fell for the second week in a row last week, the first time it has suffered a two-week stumble since the second week of July. The venerable average started last week on the right foot, gaining 1.28% on Monday in low volume trading following a bout of corporate deal-making, as companies including Xerox (XRX), Johnson & Johnson (JNJ), and Abbott Laboratories (ABT) announced new merger-and-acquisition developments. The bulls were notably absent the rest of the week, however. On Tuesday the Dow shed 0.48% after the Conference Board's consumer confidence index backpedaled to 53.1 from its previous reading of 54.5. "Consumers remain quite apprehensive about the short-term outlook and their incomes," reported Lynn Franco, head of the Conference Board's consumer research group. "With the holiday season quickly approaching, this is not very encouraging news."

The Dow started off in positive territory on Wednesday due to a stronger-than-expected final second-quarter gross domestic product revision, but a round of discouraging manufacturing data and a larger-than-expected decline in private-sector payrolls kept the bulls from making a comeback. For the session, the DJIA shed 0.31%. The situation worsened on Thursday, with the Institute for Supply Management's (ISM) manufacturing index falling to 52.6 in September from 52.9 in August and initial jobless claims soaring by more than forecast in the prior week. With September's nonfarm payrolls report and the unemployment rate less than 24 hours away, traders ran for the exits, sending the Dow more than 2% lower.

Battered and beaten by unexpectedly weak economic data, Wall Street limped into the close on Friday, only to face more grim news. The Labor Department said the private sector shed a steeper-than-expected 263,000 jobs in September, elevating the unemployment rate to 9.8% -- the highest level since June 1983. On that same sour note, the Commerce Department reported that factory orders fell 0.8% in August, defying economists' expectations for a 0.7% rise. The Dow shed 0.23% on the day. For the week, the Dow dropped 1.9%, while the S&P 500 Index (SPX) gave back 1.8% and the Nasdaq Composite (COMP) fell 2.1%.

What the Trader Is Expecting in the Coming Week: Three Risks to the Bullish Case
By Todd Salamone, Senior Vice President of Research

"...Technical barriers are not necessarily giant warning flags in our view. Rather, they represent speed bumps within the uptrend that may serve as yet another battleground for market players... We continue to expect that pullbacks will be mild, with the 1,000 area serving as support on the SPX. "
-- Monday Morning Outlook, Sept. 12, 2009

"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."
-- Monday Morning Outlook, Sept. 26, 2009

The technical barriers referred to above pertain to the S&P 500 Index's (SPX) 80-week moving average, a trendline that acted as support in much of 2007 and provided a key peak in May 2008. With talk growing louder about world stimuli being removed amid poor employment and manufacturing numbers, the technical speed bumps referred to during the past several weeks have become quite noticeable. The pullback can be labeled "mild" so far, since the SPX continues to trade above the 1,000 millennium mark and, for that matter, above its 50-day moving average, which is currently situated at 1,021.80. The retreat can be viewed as an opportunity to go long stocks that were overbought just a few weeks ago. But set your stops tight, as a break below these support levels could lead to sharper pullback. We view potential opportunities, for example, among the high-beta, high short interest names (retail, leisure, real estate).

We are open to the possibility of a sharper pullback based on three observations that piqued our interest last week. They can be considered risks to the bullish case.

The first is the 50-day moving average of the buy-to-open put/call ratio on the PowerShares QQQ Trust (QQQQ). Hedged players tend to buy puts on this technology-related, exchange-traded fund to hedge long positions they are accumulating in the technology area. These stocks have displayed leadership in 2009, but as this ratio moves higher, it is a sign that more and more investors are gaining long exposure to this area.

Note, for example, that the buy-to-open put/call ratio is approaching levels that occurred in October 2007 (as denoted by the blue line and the peak above 3.0 in the chart below). It is certainly possible that this ratio could peak at the October 2007 level and once again coincide with a major top in technology. This is something to be open to or, at the very least, be on guard against. However, as long as this ratio continues to trend higher, the technology area should continue to be an area of leadership.

At the same time, we think it is important to realize that this trade is becoming more and more popular. So, if you are overexposed to the technology area, you might want to consider hedging in the event that a repeat of October 2007 occurs. That is, if a rollover in the ratio occurs, it could be indicative of hedged players no longer being in accumulation mode, leaving the sector vulnerable.

Above being said, we are encouraged that the buy-to-open put/call ratio is rising and still a long way from peak levels on other major exchange-traded funds that we track, such as the S&P SPDR Retail Fund (XRT), the Select Sector SPDR Financial Fund (XLF), the Select Sector SPDR Energy Fund (XLE) and S&P Despositary Receipts (SPY). In fact, our analysis is consistent with the theme that hedge funds are relatively under-invested, although they do have a large and growing exposure to technology stocks. Hedge funds and retail investors are a potential source of buying power on pullbacks of the nature that we are experiencing now, which gives us increased confidence that support levels will hold.

The second item of interest that we observed last week was the CBOE Market Volatility Index (VIX) trading at twice the 20-day historical volatility of the SPX. Last Wednesday, for example, the SPX's 20-day historical volatility was at 12.49%. Meanwhile, the VIX closed at 25.61, a 105% premium to historical volatility. This was a somewhat common occurrence throughout in the 1990s and had bullish implications. But in the 2000s, it has been a rare occurrence with bearish implications, per the tables below.

Again, we have to be mindful of the negative returns that have been produced this decade when the VIX was trading at such a large premium to historical volatility. We cannot say with certainty why there is such a divergence between the 1990s and the 2000s. It could be pure randomness, or it could be a sign of more informed players making up a bulk of the trading activity now versus then.

Finally, the VIX has experienced two consecutive closes above its 80-day moving average, a trendline that has contained peaks and marked important market troughs this year. The last time it closed above this trendline was early September, ahead of a market rally. So, while the advancing VIX is not a "slam dunk" sell signal, it is a risk worth noting and another reason to set your stops tight and/or hedge long positions if you are overexposed. The 30 level could be important on the VIX too, as there was a lot of "dancing around" this strike in May and June.

With the SPX lower in seven of the last eight trading days, the most oversold since late June and early July (according to the nine-day Relative Strength Index and TRIN readings), and trading just above intermediate-term support levels, a move higher would be expected in the near term. However, if stocks cannot rally or at least stabilize by the end of this week, the recent peak around the 80-week moving average could prove to be more than a speed bump. We would consider a SPX break of 1,000 followed by a break of 980 as a sign of increasing vulnerability to the downside. The 980 area is the site of the SPX's 80-day moving average, a trendline that has marked both resistance and support dating back to September 2008.

Indicator of the Week: Seven Straight Monthly Gains for the S&P 500 Index
By Rocky White, Senior Quantitative Analyst

Foreword: September 2009 passed into history last week, and Wall Street watched the S&P 500 Index (SPX) log its seventh consecutive positive month by posting a gain of 3.6%. The last time the SPX posted a monthly decline was way back in February. Despite this strong performance, there is still quite a bit of chatter that the market has rallied too far, too fast, and that the uptrend must come to an end soon. In order to see if these mutterings hold any credence, let's take a look at how common such extended market rallies are and how such winning streaks typically end.

Seven Straight: As the first table below shows, the SPX has posted gains in seven consecutive months 11 times since 1950. Compared to the index's anytime returns for this period, shown in the second table, one-month returns following a seven-month winning streak are pretty strong, with positive returns realized 73% of the time. In other words, the market was positive 73% (eight of 11) of the time after the SPX saw gains seven months in a row. So, don't let the monthly winning streak make you uneasy.

Looking further out, the SPX continues to outperform, with an average six-month return of almost 8% and positive returns more than 90% of the time.

Conclusion: The table below highlights individual occurrences when the SPX posted gains for seven straight months. Notice that the end of 2006 was the last time that this phenomenon occurred. What's more, the last three times the Street saw such a winning streak, the SPX was positive once again in the eighth month, though the streak ended there.

Implications: This market has been very strong this year, and the SPX has seen seven straight months of gains. However, no one knows when this streak will end. By the same right, each month that the SPX closes with a gain does not lead to a higher probability of a pullback. More important than the market's historical performance is the crowd's opinion where we're headed. We still see a lot of pessimism despite the fact that we are currently in the midst of one of the strongest market rallies in decades. As a result of this pessimism, there are plenty of people sitting on cash. This combination of strong technicals and sideline cash places the market in a favorable position, as it's just a matter of time before this untapped capital gets back in the game. Make sure you're there before it does.

This Week's Key Events: Alcoa Inc. Kicks Off the Third-Quarter Earnings Season
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

• The Institute for Supply Management's services index for September is the lone economic report slated for release on Monday. On the earnings front, the only report of note comes from The Mosaic Company (MOS).

Tuesday

• There are no economic reports scheduled for Tuesday. Elsewhere, The Pepsi Bottling Group Inc. (PBG) and Yum! Brands Inc. (YUM) are among those reporting earnings.

Wednesday

• Weekly U.S. petroleum supplies, August's consumer credit report, and the September Treasury budget are on Wednesday's docket. Meanwhile, Costco Wholesale Corp. (COST), Family Dollar Stores Inc. (FDO), Monsanto Company (MON), and Alcoa Inc. (AA) are scheduled to report earnings.

Thursday

• Weekly initial jobless claims will be followed by August's wholesale inventories report on Thursday. The earnings calendar includes Marriott International Inc. (MAR), and PepsiCo Inc. (PEP).

Friday

• We round out the week's economic calendar with the August trade balance. 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 37% 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 level 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 trust'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 two weeks ago.

Sector

Gold Neutral

Outlook: Gold prices continued to see-saw around the $1,000 an ounce mark last week, though the malleable metal's finish above this psychological level is a mark in the bulls' favor. Gold also benefited from a pullback in the U.S. dollar last week. 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 in 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 121% 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).