Q2 STOCKS TO BUY

Why This Market Could Surprise Investors

While charts and headlines might suggest upside is limited for the stock market, the sentiment backdrop could help stocks break out to new highs

Senior Vice President of Research
Jul 11, 2016 at 9:20 AM
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"While the charts say limited reward versus risk, the sentiment backdrop paints a different story, one that suggests more reward in the market than the charts are currently implying… a potential tailwind could be found in short covering related to the expiring put open interest. It is interesting that since the 'Brexit' referendum, put open interest on SPY options expiring in the next three months has increased by about 1.5 million contracts, compared to just over 600,000 call contracts."

-- Monday Morning Outlook, July 5, 2016

Bulls set off fireworks during the Fourth of July holiday-shortened week, pushing equity benchmarks above round-number resistance levels. The Dow Jones Industrial Average (DJIA - 18,146.74), S&P MidCap 400 Index (MID - 1,520.42) and S&P 500 Index (SPX - 2,129.90) closed the week above round numbers that were in play at the end of June and, early in the week, gave the impression that they would put a ceiling on the post-"Brexit" recovery. Whereas the DJIA closed above the 18,000 millennium level, the underperforming Nasdaq Composite (COMP - 4,956.76) remains below 5,000.

Fed uncertainty and concerns about economic growth have been among the worries unsettling investors this year. In fact, the market responded negatively immediately following a worse-than-expected May employment number released in early June and a Federal Open Market Committee (FOMC) meeting in mid-June. But the first week of July's trading was highlighted by a positive reaction to better-than-expected June employment data and a warm response to minutes from June's FOMC meeting.

The move above round numbers is a step in the right direction for bulls. But as we have seen since early 2016, advances above the round numbers in play currently have proven to be false breakouts, since the MID, SPX, and DJIA have been unable to anchor themselves above these levels for a meaningful time period. For example, the longest consecutive daily streak that the DJIA was able to hold above 18,000 on both an intraday and closing basis was eight sessions in May 2015. For the SPX, the longest daily streak above 2,100 on both an intraday and closing basis was seven consecutive days.

Moreover, while Friday's SPX close was a high for 2016 at 2,129.90, it was less than a point shy of its record high close in May 2015 of 2,130.82. In other words, many benchmarks enter the week above round-number resistance, but also at or just below previous highs -- suggesting there is work to be done in terms of making new highs and putting the round numbers behind us for good.

DJIA 18000 July 11

"The second-quarter earnings season is shaping up to be another disappointing affair. S&P 500 companies are expected to report a 5.2% decline in earnings from the second quarter of 2015, according to FactSet. That would mark the first time since the height of the financial crisis that the index has endured five straight quarters of profit contraction."

-- The Wall Street Journal, June 28, 2016

From a contrarian perspective, a sustained breakout above resistance would surprise many investors. And anyone around the market long enough will find that it is full of surprises.

As recently as the last week of June, CNBC was flashing headlines about indexes trading below their 200-day moving averages, which to some investors is a "sell" signal. In the immediate aftermath of "Brexit," many market watchers told us to prepare for a prolonged period of higher volatility.

Moreover, political uncertainty both in the U.S. and overseas has been a major distraction to investors, not to mention the consensus opinion that slowing economic growth will continue to be a drag on already depressed earnings.

And after downgrading equities for the next 12 months in mid-May, Goldman Sachs last week said that it expects a 10% drop in the SPX before ending the year at 2,100. Keep in mind that in mid-January, J.P. Morgan was advising us to "sell rallies" and RBS told us to "sell everything."

Meanwhile, the most recent weekly survey from the National Association of Active Investment Managers (NAAIM) showed that equity exposure among this crowd fell to its lowest level since late May. And after coming into June at a multi-month high in optimism and getting burned with this bet, equity option buyers grew more pessimistic heading into this month, which puts the market in a better position to surprise to the upside.

"For bulls, the good news is we are less at risk of a volatility explosion, relative to when we entered the month of June. Large speculators on VIX futures, for example, have been dead wrong on the direction of volatility when moving into an extreme position. While they are net short, the short position on a net basis is about half of what it was in the weeks ahead of the 'Brexit' referendum."

-- Monday Morning Outlook, July 5, 2016

Looking back, the last time the SPX was trading above 2,100, in early June (ahead of both the aforementioned FOMC meeting and the Brexit referendum), large speculators were net short more than 100,000 CBOE Volatility Index (VIX) futures contracts, according to Commitments of Traders (COT) data. With the SPX back above 2,100, following a 100-point SPX decline between early June and now, this net short position has been cut by more than half. As we said last week, since large speculators are no longer in an extreme short position, we find it less likely for a volatility shock relative to early June.

VIX Futures Bets July 11

Our message from last week remains the same: the charts and various new headlines indicate limited upside. But the sentiment backdrop suggests there is more upside potential in the market than the charts and headlines reveal.

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