Here's Why the Bulls Have Staying Power Right Now

It was a solid week on Wall Street, despite a couple of earnings disappointments in the tech sector and the Fed's official swan song for quantitative easing. A well-received earnings report from Visa Inc (NYSE:V) put some wind in the bulls' sails, while a surprise stimulus package from the Bank of Japan sent the Dow back into record-high territory, and the S&P 500 north of a key level. So, can we sustain the momentum? Schaeffer's Senior VP of Research Todd Salamone thinks so.

• The re-emergence of round numbers
• Why we could see the bears deflate in the coming weeks
• Good news about midterm elections (aside from no more campaign ads)

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: Round Numbers Still Rule
By Todd Salamone, Senior VP of Research

"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."
-Monday Morning Outlook, Oct. 25, 2014

"Important levels being taken out this am- $QQQ round # $100, $SPY above round $200 & $201.30 (triple '09 low), $IWM above YTD B/E 115.36"
-@ToddSalamone on Twitter, Oct. 31, 2014

"The S&P 500 has averaged a 15.3% gain during the November-through-April period in midterm election years and rises 94% of the time, according to Mr. Stovall."
-The Wall Street Journal, Oct. 31, 2014

Last week, our message was that many equity benchmarks had some room to rally, but potential technical resistance levels were beginning to come into play, which could slow the momentum off the mid-October lows. We added that the sentiment backdrop was one that is supportive of stock prices, and speculated that there was a plethora of sideline cash that would "eventually" drive stocks through the resistance levels that we discussed in detail.

Well, "eventually" came last week, with some market participants aggressively moving off the sidelines and/or covering short positions. Stocks took the Fed's official announcement that quantitative easing would end in stride, followed by a sharp rally on the last trading day of the week and month after Japan's central bank unexpectedly announced new stimulus measures, which apparently eased concerns about weakness in overseas economies.

Even though the market rallied last week, this coming week sets up similarly. For example, the S&P 500 Index (SPX - 2,018.05) and the related exchange-traded fund (ETF), the SPDR S&P 500 ETF Trust (SPY - 201.66), are back to their respective August-September highs that preceded the near 10% correction that unnerved many market participants. So, from this perspective, with a sharp pullback still fresh on the mind of investors, it is possible that those who are currently invested and stayed invested through the recent downturn will look at the quick rebound as a second opportunity to lighten their exposure. And as we cautioned a couple of months ago, this is a big area from a round-number perspective, especially given the fact that 2,000.37 and $201.30 on the SPX and SPY, respectively, represent 200% gains from 2009's intraday lows. Additionally, these round-number levels are 10% above the mid-October lows.

While on the subject of round-number percentage gains, should equities continue higher, it is worth mentioning that a 10% year-to-date (YTD) gain on the SPX is at 2,033, and a 10% YTD gain on the SPY is at 203.16. Remember -- and this is a topic we have observed before -- round numbers and round-number percentage gains have been extremely important in terms of identifying potential short-term pivot levels. The Russell 2000 Index (RUT - 1,173.51), for example, recently bottomed at a level that represented a 10% YTD loss, whereas the SPX closing low was just above its 2013 close, or YTD breakeven (round-number 0%). That said, the RUT is barely above its 2013 close at 1,163 heading into this week.

Moreover, the Dow Jones Industrial Average (DJI - 17,390.52) began a short-term topping pattern in the vicinity of the 17,000 millennium mark in August-September, but also "V-bottomed" in the 16,000 area two weeks ago. And the PowerShares QQQ Trust (QQQ - 101.40) peaked at the $100 mark in early September, found support at $90 two weeks ago, and is now back above the September peak and in the $100 area again.

But, similar to last week, the sentiment backdrop continues to be supportive of the equity markets, which was NOT the case when these benchmarks first rallied up to these potential resistance levels in August and September. The biggest difference in the sentiment landscape is that in the late August/early September topping period, market participants were becoming increasingly negative on stocks, which made it all the more difficult for equities to overcome resistance levels.

For example, check out the direction of the buy-to-open, equity-only put/call volume ratio (the chart immediately below). As the SPX was at 2,000 in the late August/early September time frame, equity option buyers were buying puts (downside bets) at an increasingly higher rate than calls (upside bets). To the degree that the growing negativity was representative of the general market crowd, the rising pessimism pressured stocks.

But this negativity hit an extreme similar to the early August bottom, and this extreme marked a bottom two weeks ago. The good news for bulls is that the pessimism is giving way to increasing optimism, which was not the case the last time equity benchmarks were trading at these levels. Bulls are hoping that the unwinding of the extreme in pessimism logged two weeks ago continues, as they would like to see the equity put/call volume ratio drop below the previous low.

Similarly, note in the graph below how active investment managers -- as measured by the weekly National Association of Active Investment Managers (NAAIM) survey -- were reducing equity allocations as the SPX was pushing 2,000 in late August/early September. By the time they were finished, at the market bottom two weeks ago, this group had its lowest allocation to equities since October 2011. However, they are now in accumulation mode instead of distribution mode, which could be supportive of stocks at these levels.

There is another major difference that we are currently monitoring with respect to when the SPY was trading in the 200 area back in late August/early September: how options are priced on the SPY. Specifically, we track the implied volatility of SPY put and call options that are 5% out of the money (OOTM), and compare them by creating a ratio ("OOTM p/c skew," as labeled in the chart below). A couple of months ago, prior to the pullback, puts (downside bets) were much more expensive than usual relative to calls (upside bets). As we cautioned at the time, when such a pricing disparity occurs during a rally, weakness usually follows -- and it did. This time, we are not seeing a disparity like we saw a couple of months ago, suggesting that this move higher is more likely to have staying power.

Finally, whereas two months ago we were entering a period of historically negative seasonality, we now enter a period of positive seasonality, with midterm elections right around the corner (more on those from Rocky White on page 2) and overseas central banks in stimulus mode. Positive seasonality and the prospect of more overseas stimuli could deflate the bears and embolden the bulls in the coming weeks. That said, market participants have been very quick to switch course when certain headlines hit the wires, so a risk is one of those "unknown, unanticipated" headlines generating a sudden and abrupt change in the sentiment landscape that is currently supportive of equities.

Indicator of the Week: Midterm Elections
By Rocky White, Senior Quantitative Analyst

Foreword: Midterm elections are coming this week, so it will be interesting to see how Wall Street reacts to the new Congress. To get an idea of what to expect this week, I took a look back at how stocks have done in the past around election time. I look at short-term time frames (the next day) and longer-term time frames (six months).

Elections Since 1950: Elections are held on the Tuesday after the first Monday in November. I went back to 1950 on the S&P 500 Index (SPX) and looked at how the market did around this time. I break it down by midterm election years (like this year), presidential election years, and off-years when there is no regularly scheduled election.

This first table below shows how the SPX has done the day after the election. This might be a gauge of Wall Street's immediate outlook on what the elections mean for stocks. If that's the case, then Wall Street typically has high hopes for the new Congress. Since 1950, the day after midterm elections has been positive 75% of the time, averaging a gain of 0.57%. Traders seem to react to midterm results much better than presidential election results. In the years a new president is elected, the SPX has been positive just 38% of the time, averaging a loss of 0.55%.

Rest-of-Year Returns: Below is a similar table showing how the SPX has done for the rest of the year after Election Day. The midterm election years are more bullish than other years, looking at the average return. The index is positive more often than presidential election years, but not as often as off-years.

Here's some more good news. I broke down the 16 midterm election rest-of-year returns by whether the market was up or down heading into Election Day. When the market was positive for the year heading into Election Day, the rest of the year was positive seven out of eight times, averaging a gain of 5.49%. The SPX is up more than 9% this year -- as of now -- which has historically led to more gains over the last two months of the year.

The Next Six Months: Do the strong gains continue from there, or does the hope fade as the new Congress begins to act? The table below looks a little further out -- summarizing SPX returns over the next six months after Election Day. Since 1950, the six months after midterm elections have been off-the-charts bullish. As you can see in the table below, the SPX averages almost 15% over the next six months, and has never been negative. Furthermore, 13 of the 16 returns are above 10%! In other words, in midterm election years, the next six months have yielded double-digit returns 81% of the time. That's a higher percentage than other years that simply have positive results.

This Week's Key Events: Alibaba's Earnings, Nonfarm Payrolls Take Top Billing
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

• The week will start off with the release of auto sales data, Markit's flash purchasing managers manufacturing index (PMI), the Institute for Supply Management's (ISM) manufacturing index, and construction spending. Herbalife (HLF), MannKind (MNKD), Sprint (S), American International Group (AIG), Arena Pharmaceuticals (ARNA), Marathon Oil (MRO), and Sysco (SYY) will release earnings.

Tuesday

• On Tuesday, the international trade balance will be released, along with factory orders. Stepping up to the earnings plate will be Alibaba (BABA), Activision Blizzard (ATVI), AK Steel (AKS), Becton, Dickinson and Co. (BDX), Burger King (BKW), CVS Health (CVS), FireEye (FEYE), Michael Kors (KORS), Priceline (PCLN), TripAdvisor (TRIP), Twenty-First Century Fox (FOXA), Valero Energy (VLO), and Zulily (ZU).

Wednesday

• The monthly ADP employment report, the ISM services index, and the regularly scheduled crude inventories update are on Wednesday's docket. For earnings, Tesla Motors (TSLA), Time Warner (TWX), Whole Foods Market (WFM), CBS (CBS), Chesapeake Energy (CHK), Level 3 Communications (LVLT), Molycorp (MCP), Mondelez International (MDLZ), Qualcomm (QCOM), Skullcandy (SKUL), VIVUS (VVUS), and Zillow (Z) will report.

Thursday

• Weekly jobless claims and productivity and labor costs come out on Thursday. Walt Disney (DIS), AOL (AOL), El Pollo Loco (LOCO), First Solar (FSLR), King Digital Entertainment (KING), Lions Gate Entertainment (LGF), Melco Crown Entertainment (MPEL), Monster Beverage (MNST), NVIDIA (NVDA), Sarepta Therapeutics (SRPT), Skyworks Solutions (SWKS), SunEdison (SUNE), Tekmira Pharmaceuticals (TKMR), Transocean (RIG), and Zynga (ZNGA) will present earnings.

Friday

• Friday's docket will feature the Labor Department's nonfarm payrolls report and unemployment figures. Cooper Tire & Rubber (CTB) and Humana (HUM) will report earnings to close out the week.

And now a sector of note...

Pharmaceuticals
Bullish

Pharmaceutical stocks have easily outperformed the broader market over the long term. Of the 38 names we track in this sector, the average year-to-date return is 30.6% -- and going out to a 52-week time frame, that gain expands to 52.9%. Despite this impressive price action, these equities, on average, sport a short interest-to-float ratio of 8.7%, potentially paving the way for a short-covering rally.

Meanwhile, the SPDR S&P Pharmaceuticals ETF (XPH) soared to a new record peak of $113.15 on Friday -- confirming the significance of a recent bounce off its 40-week moving average, as similar bounces in April and August translated into two-month surges of 25% and 16%, respectively. If the same pattern persists after XPH's most recent rebound from this trendline, the fund could be trading around $118 by year's end. The strength of the sector is also witnessed in the Market Vectors Pharmaceutical ETF (PPH), which is in the process of challenging its own all-time highs, just two weeks after experiencing a head-fake below its 200-day moving average -- a move that likely generated selling among technicians. Among individual equities, Bristol-Myers Squibb Co (NYSE:BMY) jumped to a 13-year peak of $59.03 on Thursday, after positive results for its lung cancer treatment were met with a price-target hike at Leerink Swann.