How Key Technical Levels Factored Into the Recovery

Following a choppy week in which the Dow Jones Industrial Average (DJI) and S&P 500 Index (SPX) logged some huge losses, both indexes came back over the past five sessions. In fact, the SPX posted its best single-week percentage gain of 2014, while the DJI snapped its streak of four consecutive weekly losses. Looking ahead, traders are eagerly awaiting the Federal Open Market Committee's (FOMC) two-day policy-setting meeting, which commences on Tuesday. While this event may lead to increased volatility, Schaeffer's Senior VP of Research Todd Salamone explains why the technical and sentiment pictures should, for the most part, be encouraging to bulls.

• A look at how the sentiment backdrop favors bulls
• Why we would avoid small-caps for the time being
• The sentiment signal that's at a 30-year high, and what that could mean going forward

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: Encouraging Signs On the "Road to Recovery"
By Todd Salamone, Senior VP of Research

"It is worth noting that the year-to-date (YTD) breakeven for the SPY is 184.69 -- a psychological level that certainly coincided with the incoming demand mid-week ... With the big bounce to end the week, the 190 level overhead could once again become short-term resistance ... other major indexes also broke below important technical levels ... The Russell 2000 Index (RUT - 1,082.33) -- a barometer of small-caps -- fell below the 1,090-1,100 area and found support near 1,047, which is 10% below last year's close."

"... the sentiment backdrop is definitely in the bulls' favor. The National Association of Active Investment Managers (NAAIM) survey asks active investment managers what their current equity exposure is on a weekly basis. Historically, when they have low exposure, it indicates there is a lot of cash that could flow into the market. This week, the exposure index nose-dived to 9.97%, which is the lowest level since Oct. 12, 2011."
-Monday Morning Outlook, Oct. 18, 2014

"$VIX settlement price 15.92- 87% of Oct. $VIX call options expire worthless, despite near 10-percent $SPX correction $VRO"

"Interesting low in $VIX today, after many Oct. calls expired. Low of day was 15.56 (15.53 is half last week's high of 31.06"

"$VIX call open interest the lowest since Oct. '13"
-@ToddSalamone on Twitter, Oct. 22-23, 2014

Last week, we discussed the sharp selling that gripped equity markets, sparked by Ebola headlines and global growth concerns. We suggested that the magnitude of the selling may have been exacerbated by option expiration week, as sellers of equity index and exchange-traded fund (ETF) put options were feeling more and more pain as heavy put open interest strikes on the SPDR S&P 500 ETF Trust (SPY - 196.43) and S&P 500 Index (SPX - 1,964.58) were violated. This forced them to hedge, which is usually done via shorting SPX futures.

While the sharp selling baffled many who were at a loss for explanation, the selling generated a tremendous amount of fear -- fear which has been present at many major bottoms within the impressive longer-term uptrend since the 2009 bottom.

While some short- and intermediate-term technical levels were violated on key indexes and equity benchmarks during the expiration-week "delta hedge" sell-off, other key levels held, such as the year-to-date (YTD) breakeven mark and 320-day moving average on the SPX. This set this week's "road to recovery," as pessimism was not as sour as the climactic fear ahead of the previous week's trough. That said (and encouraging for bulls), despite a pretty impressive rally from the lows, sentiment is not nearly as optimistic as it was in early September, when the SPX was doing battle with the 2,000 millennium mark that preceded the most recent pullback.

Not only did the SPX rally back above the round 1,900 level, but it also closed the week above the 1,950 half-century mark and its 120-day moving average, which we viewed as potential resistance areas. Half-century marks have been significant on multiple occasions on the SPX, and the 120-day moving average has supported SPX pullbacks since mid-2013.

That said, there is work to do, as the flattening 80-day moving average and declining 40-day moving average are just overhead, two trendlines that have acted as support on different occasions. Plus, July resistance at 1,990 is just overhead, with the formidable 2,000 millennium mark reinforcing this resistance area.

Additionally, the Russell 2000 Index (RUT - 1,118.82) reclaimed the round 1,100 level, an area that has marked multiple bottoms this year. Moreover, large-cap technology stocks, as measured by the PowerShares QQQ Trust (QQQ - 98.62), climbed back above 96.75, which represents its 10% YTD return, and an area of resistance in late July. But, like the SPX, both indexes have major resistance overhead, whether that be the round 100 level on the QQQ, or the 320-day moving average on the RUT -- which marked a bottom in December 2012 following a correction, and is situated around the August lows.

In fact, despite a nice bounce from last week's lows, the RUT looks the most vulnerable from a technical perspective, given the longer-term moving average resistance overhead, and the fact that it is still trading in the red for 2014. So, if you are looking to hedge your long holdings, puts on the iShares Russell 2000 ETF (IWM - 111.07) could be worthwhile, as they are about 25% less expensive than they were a couple of weeks ago.

In addition to the continued risk posed by small-cap stocks, there is also a risk that volatility is on the rise (rising volatility is usually associated with falling stock prices). While the CBOE Volatility Index (VIX - 16.11) peaked during expiration week around triple its 2014 closing low, beware that the VIX trough this past week was at 15.56, which is roughly one-half the recent peak, and 50% above the 2014 closing low. In fairness, the VIX is inflated ahead of the Federal Open Market Committee (FOMC) meeting next week, and this is not anything unusual. FOMC meetings are known calendar events that could spur additional volatility, which means more expensive option premiums.

Plus, as a result of the expiration of October VIX futures options, VIX call open interest is now at its 2013 low. Therefore, those that usually hedge may not be hedged, and if surprising negative headlines hit the wires, a rush to buy portfolio protection could pressure stocks. Or those that are long but not hedged may be more prone than usual to panic-sell.

There is a potential upside to the low level of VIX call open interest, and also the extremely low put open interest on the SPY. That is, such low levels of open interest could mean that hedging demand is relatively low because equity allocations are lower than usual. It is no secret, for example, that active investment managers sharply reduced their exposure during the latest market melee.

If low equity exposure is indeed the case, it would only take an absence of negative headlines to push equities higher, as sideline money slowly re-enters the equity market amid less expensive portfolio protection, relative to the past couple of weeks. Such sideline money could eventually power the aforementioned indexes above their respective resistance levels. In fact, when VIX call open interest was this low in October 2013, a powerful fourth-quarter rally emerged. Bulls would like to see strong price action accompanied by a build in VIX call open interest, as a sign that the deep-pocketed hedged players are increasing their equity exposure and buying portfolio protection along the way.

As you can see on the first chart below, active investment managers still have relatively low exposure to equities, but are showing signs of coming back to the market after reaching extremely low levels of exposure the week prior to last. Bulls would like to see these market participants continue to add exposure, which would be supportive of the market. Also, per the second chart below, the typically wrong equity option buyer crowd is still at a bearish extreme, similar to the bearish extreme that preceded the August-September rally.

The sentiment backdrop remains in favor of the bulls, but the momentum off the bottom could slow as technical resistance comes into play. We would still avoid the small-cap sector, given the potential technical shortcomings, relative to other sectors of the market.

Indicator of the Week: Poll Calling for a Correction
By Rocky White, Senior Quantitative Analyst

Foreword: Not too long ago I wrote about the lack of bears in the Investors Intelligence poll. What we're currently seeing in that poll is not only a lack of bears, but a lack of bulls.

Recall that the poll is a survey of over 100 published newsletters that the editors at Investors Intelligence collect, to determine the number that are bullish, bearish, or expecting a correction. That third designation (labeled "Correction" in the graph below) is for newsletters that are bearish in the short term, but bullish over the long term. I guess you could say they're currently nervous, but hopeful for gains at some point. Perhaps it's even advisors who are bearish but don't want to convince their subscribers stocks are heading lower, because it's bad for business when people shun stocks. Either way, the percentage of newsletters calling for a correction, according to Investors Intelligence, is at the highest level in over 30 years!

This week, I'm going to look back to see what happened other times investor newsletters were so heavily predicting a correction.

40% Call for Correction: Looking at the chart above, the 40% level seems to mark pretty high spikes for the "Correction" group. Going back to 1970, I looked at other times the "Correction" group moved above 40%. I only counted times when it was the first move above this level over a three-month period. I then calculated S&P 500 Index (SPX) returns following those times.

The first table below summarizes the returns after these signals. The second table is for comparison and shows typical index returns since 1970. In the prior instances of the "Correction" group moving above 40%, the returns after were not very impressive. Two months later, the SPX averaged a loss and was negative over half the time. Three months after a signal, the index was also down over half the time, but averaged a slight gain. When you get out to six months, the average returns are pretty close to typical returns, though the average return still shows some underperformance.

We've Seen This Before: These occurrences have happened three times during the current bull market that began in 2009. Each time was during about a 2% drop in the SPX, and the increase in the "Correction" group came mostly from the "Bullish" group.

Below are a table and a chart showing how the SPX fared after the recent occurrences. The last two times the bulls jumped ship resulted in pretty good returns going forward, while the 2012 occurrence was followed by more weakness. You can see the first couple of weeks this time followed the 2012 pattern.

This Week's Key Events: Fed Decision and Facebook, Twitter Earnings in Focus
Schaeffer's Editorial Staff

Here is a brief list of some key market events scheduled for the upcoming week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.

Monday

• Monday's docket contains pending home sales and the Dallas Fed's manufacturing survey. Revealing earnings will be Merck (MRK), Twitter (TWTR), Amgen (AMGN), Buffalo Wild Wings (BWLD), Cliffs Natural Resources (CLF), Crocs (CROX), EXACT Sciences (EXAS), and T-Mobile US (TMUS).

Tuesday

• On Tuesday, durable goods orders, the S&P/Case-Shiller home price index, and consumer confidence figures will be released. Additionally, the Federal Open Market Committee (FOMC) will kick-off their two-day policy-setting meeting. DuPont (DD), Pfizer (PFE), Facebook (FB), BP (BP), Coach (COH), Electronic Arts (EA), Freeport-McMoRan (FCX), Gilead Sciences (GILD), Marriott (MAR), Panera Bread (PNRA), Sherwin-Williams (SHW), Sirius XM Holdings (SIRI), TD Ameritrade (AMTD), UBS AG (UBS), U.S. Steel (X), Whirlpool (WHR), and Wynn Resorts (WYNN) will step up to the earnings plate.

Wednesday

• The FOMC will announce its latest policy decision on Wednesday afternoon, followed by a press conference from Fed Chair Janet Yellen. The regularly scheduled crude inventories will also be released. For earnings, Visa (V), Akamai Technologies (AKAM), Allstate (ALL), Avis (CAR), Baidu (BIDU), Barrick Gold (ABX), Cirrus Logic (CRUS), Dreamworks Animation (DWA), F5 Networks (FFIV), Garmin (GRMN), Glu Mobile (GLUU), Kraft Foods (KRFT), RF Micro Devices (RFMD), SodaStream (SODA), Shutterfly (SFLY), SunPower (SPWR), and Take-Two Interactive (TTWO) will report.

Thursday

• The advance reading on third-quarter gross domestic product (GDP) comes out on Thursday, along with weekly jobless claims. GoPro (GPRO), Groupon (GRPN), LinkedIn (LNKD), Starbucks (SBUX), Time Warner Cable (TWC), Alcatel Lucent (ALU), Altria (MO), Avon Products (AVP), CME Group (CME), Expedia (EXPE), hhgregg (HGG), Kellogg (K), Marathon Petroleum (MPC), MasterCard (MA), MGM Resorts (MGM), Microchip Technology (MCHP), Mosaic (MOS), New York Times (NYT), TASER (TASR), Teva Pharmaceutical (TEVA), and World Wrestling Entertainment (WWE) will release earnings.

Friday

• Friday's docket shows personal income and spending numbers, the employment cost index, the Chicago purchasing managers index (PMI), and the Thomson Reuters/University of Michigan's final reading on consumer sentiment for October. Stepping into the earnings spotlight will be Chevron (CVX), Exxon Mobil (XOM), Anheuser-Busch InBev (BUD), Clorox (CLX), Hilton Worldwide (HLT), Sony (SNE), and Weyerhaeuser (WY).

And now a sector of note...

Pharmaceuticals
Bullish

Pharmaceutical stocks have easily outperformed the broader market over the long term. Of the 39 names we track in this sector, the average year-to-date return is 26.4% -- and going out to a 52-week time frame, that gain expands to 50.4%. Despite this impressive price action, these equities, on average, sport a short interest-to-float ratio of 8.9%, potentially paving the way for a short-covering rally.

Meanwhile, the SPDR S&P Pharmaceuticals ETF (XPH) is back above its July peak, and is now trying to take out its late-September high at $109.56. The fund's 40-week moving average held last week's low (at $97.75), as it did in April and again in August, which translated into two-month rallies of 25% and 16%, respectively. If the same pattern persists after XPH's most recent pullback, the fund could be trading around $118 by year's end. Among individual equities, Bristol-Myers Squibb Co (NYSE:BMY) enjoyed a post-earnings jump of 2.2% on Friday, and is in positive year-to-date territory for the first time since March, breaking out above May/September resistance.