Why a Short-Term Pause May Be in Order

U.S. stocks could be due for a breather, as several key market benchmarks approach technical crossroads

Apr 25, 2016 at 9:40 AM
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Earnings and oil, with a bit of technical analysis tossed in. If you're wondering what that means, let's just say it's a quick description of last week. Last weekend, Iran decided to stand other global oil producers up at the Doha Oil Summit. Saudi Arabia didn't like that, so none of the nations agreed to freeze the supply of oil. This initially sent oil prices down sharply ahead of last Monday's open. Well, about 500 miles away, workers in Kuwait weren't happy with their pay, and decided to stop producing oil themselves. The strike might have helped oil prices rebound, because by the close on Monday, oil prices and U.S. stocks had reversed sharply off their lows and moved much, much higher.

The surge only lasted a couple of days, as the strike ended Wednesday and a U.S. government report showed a 2.1-million-barrel build in weekly inventories. This seemingly marked the mid-week top for oil prices and U.S. equities, as both slid lower through the end of the week.

As you can tell, the past week was a tale of two halves, with the SPDR S&P 500 ETF Trust (SPY - 208.97) surging higher early and falling late. Besides the underlying move in energy prices, it was one of the busiest earnings weeks of the season. Most companies continued to beat the lowered analyst expectations, but the reactions were quite mixed and didn't provide a major catalyst for a continuation of higher prices.

In the context of how far U.S. equities have come during the past few months, this type of jittery price action is not too surprising. The SPY is also running up against its November 2015 high and trading ever so close to its former all-time high, which is now sitting just a few points above its current level. The $210 area has been a real thorn in the side of the SPY for more than a year, so don't expect it to just open the door for higher prices without a little fight.

SPY daily chart April 22

During the past 50 trading days, the S&P 500 Index (SPX - 2,091.58) has advanced more than 13%. Schaeffer's Quantitative Analyst Chris Prybal produced a good study highlighting the typical returns of the S&P 500 after such a strong rally. This is only the 29th time since 1972 -- and the first time since February 2012 -- this has happened. So, what happened next? Below are the results, but basically the market took a pause for a couple of weeks before continuing its uptrend. This doesn't guarantee anything, but still good information to have.

SPX returns after big moves

There have been some interesting developments related to sector rotation since the February bottom. With oil more than 70% off its lows, it makes sense that energy stocks have led the rally, netting a nearly 30% gain. Industrial and basic material stocks have also done very well, which has coincided with weakness in the U.S. dollar. Finally, on the back of a pretty strong earnings season so far, financial stocks -- as evidenced by the Financial Select Sector SPDR ETF (XLF - 23.55) -- are officially back in bull-market mode, after rallying +20% off their low.

XLF daily chart April 22

One thing to keep an eye on in relation to energy, materials, and industrials is the U.S. dollar. Most of the products related to businesses are denominated in the U.S. dollar, so when it gets weak, these products get cheaper for customers. Lower prices usually mean higher demand, and it's not a coincidence that the U.S. dollar has been getting hit during this rally. Take a look at the chart below of the PowerShares U.S. Dollar Index (UUP - 24.65). It's currently bouncing off its lower channel, which coincides with price level support -- and it's showing strength to end the week. For the strength in these sectors to continue, most will want to see a break down below this support area.

UUP daily chart April 22

On the flip side, the leaders in early 2016 -- utilities and consumer staples -- have underperformed, and have done so in a big way the past week. Each were down significantly during the past five trading sessions and broke below their intermediate-term uptrends. These charts of the Utilities SPDR ETF (XLU - 47.35) and the Consumer Staples Select Sector SPDR ETF (XLP - 51.96) are starting to look a little worrisome to me on a relative basis.

XLU daily chart April 22

XLP daily chart April 22

Checking in on a few sentiment readings, we have seen optimism come back to the market since the February bottom, but it's far from extreme at this point. Below is a chart based on data from the Investors Intelligence (II) sentiment survey, which compiles the market outlooks of more than a hundred newsletters. The blue line represents the percent of respondents who are bullish minus the percent that are bearish. Historically, we look at this figure to rise above 40% to mark extreme optimism, but it's only at about 25% right now.

Bulls minus bears April 22

The most recent BofA-Merrill Lynch fund manager survey was also interesting. Respondents to this survey are asked to contribute information about current holdings and it has traditionally been used as contrarian indicator. Allocations to U.S. equities remain near an eight-year low, even though they have outperformed international equities during the past 12 months.  

In addition, managers are still overweight cash and utility stocks and underweight energy, materials, and industrials. The main takeaway is that sentiment toward U.S. equities has improved relative to February, but is far from optimistic at this point.

Given the overhead technical worries and strong price action in recent months, a little speed bump or pause in action may be in order. With that said, this is the eighth rally to the $210 area by the SPY in the last 13 months. With the current sentiment backdrop and resiliency of the market, one would think eventually these previous highs have a good chance of being taken out.

Looking forward to this week's action, we can expect another steady dose of earnings reports, most notably from 3M (MMM), Lockheed Martin (LMT), Procter & Gamble (PG), AT&T (T), Chipotle Mexican Grill (CMG), Twitter (TWTR), Facebook (FB), MasterCard (MA), and Amazon.com (AMZN).  On the economic front, the Federal Reserve rate decision will be unveiled on Wednesday, along with the weekly crude oil inventory report. In addition, the advance reading on first-quarter gross domestic product (GDP) and inflation-related data will be released on Thursday and Friday, respectively.

Read More:

Indicator of the Week: Why Sentiment Matters After the Dow's Defeat of 18K

The Week Ahead: Fed in Focus; Apple, Facebook Earnings Due

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