Start the Week Examining Last Week's Bullish Signal

Why the January Barometer may be little help to an investor

Senior Vice President of Research
Jan 24, 2015 at 2:59 PM
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The Dow Jones Industrial Average (DJI) and S&P 500 Index (SPX) both ended their weekly losing streaks on Friday, despite giving back some gains from earlier in the week. Of course, the big lift came on Thursday, courtesy of the European Central Bank's (ECB) monetary stimulus decision, which powered the aforementioned benchmarks to matching 1.5% daily gains. Despite these (and other) indexes now trading near resistance, Schaeffer's Senior VP of Research Todd Salamone explains why there's reason to believe these levels could be taken out.

  • One historically bullish signal from last week.
  • Why long-term investors shouldn't disturb their long positions.
  • Rocky White takes a look at the January Barometer theory.

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: Why It's Still Smart to Be Hedged
By Todd Salamone, Senior VP of Research

"... the SPX must break important support areas that are in play now before the October lows can be tested. For instance, the index comes into this week around the 2,000 millennium mark and its 120-day moving average -- a trendline we discussed last week as being supportive during multiple pullbacks since 2013 (exception being the October decline)."

"Additionally, SPX 1,980 could prove important as we enter the second half of the month, as it is the site of the index's 10-month moving average ... [T]he SPX has not experienced a monthly close below its 10-month moving average since January 2012 ..."


- Monday Morning Outlook, Jan. 17, 2015

"$DJIA YTD B/E = 17,823. Yesterday's close = 17,813...$COMP YTD B/E = 4,736. Yesterday's close=4,750."

"As major benchmarks, such as $SPX, $QQQ, $DJIA trade around 2015 B/E levels, $RUT getting set to do battle with round number 1,200 (again)"


-@ToddSalamone on Twitter, Jan. 23, 2015

On the heels of the European Central Bank's (ECB) decision to buy sovereign bonds on Thursday morning, world markets rallied. The S&P 500 Index (SPX - 2,051.82) began its ascent early last week -- ahead of the ECB's decision -- as buyers emerged with the index sitting on major support, which we've discussed previously.

Thursday's ECB decision propelled the SPX higher into positive territory for 2015 by Thursday's close. The move north of breakeven was short-lived, however, with the SPX moving back into the red by Friday's close. Perhaps investors are moving to the sidelines ahead of the Federal Open Market Committee's (FOMC) scheduled meeting next week -- and as indexes trade at resistance.

Moreover, the PowerShares QQQ Trust (QQQ - 104.26) and S&P 400 MidCap Index (MID - 1,455.79) rallied from round-number levels at 100 and 1,400, respectively. And the Dow Jones Industrial Average's (DJI - 17,672.60) low for the year remains barely above the 17,000 millennium mark.

Key Levels on DJI, SPX, QQQ, and MID

Despite equities trading at resistance, there is an encouraging sign for bulls that short-term resistance levels will be taken out. Coincident with the ECB decision and subsequent market rally, the 10-day average of the equity-only, buy-to-open put/call volume ratio experienced a relatively sizable decline on Thursday. A single-day decline in this ratio of the magnitude we saw on Thursday has proven to be bullish historically. It is a sign that short-term traders are in the early innings of moving from an environment filled with caution and/or skepticism to one that is more optimistic. This transition typically lasts a few weeks and is supportive of stocks.

Specifically, the 10-day, equity-only, buy-to-open put/call volume ratio declined by 2.7% from a reading above 0.60, which is historically high. Since June 2012, it has done this 16 other times. On 14 of those occasions, the SPX was higher one week later by an average of 1.10%, or three times its anytime average over the same time period. Moreover, the SPX has advanced 88% of the time one week after this signal, more than the expected 61%.

Returns After a Drop in the 10 Day Equity Only Buy to Open Put/Call Volume Ratio
ISE CBOE PHLX 10 Day Equity Only Buy to Open Put/Call Volume Ratio Since November 2014 with SPX

Volatility expectations also remain on our radar. On the volatility front, the fact that single-day volatility is almost twice 2015's daily volatility is getting a lot of play on blogs and in various media.

One potential reason for the high single-day volatility could be the effects of a previous topic in this report -- extremely low SPDR S&P 500 ETF Trust (SPY - 204.97) put open interest and extremely low CBOE Volatility Index (VIX - 16.66) futures call open interest, which some investors purchase for portfolio protection.

If the low levels of VIX call open interest and SPY put open interest are indicative of market participants giving up on hedging -- after such activity proved to be a performance headwind throughout most of 2014 -- there may be more knee-jerk reactions to perceived negative headlines now, relative to last year, when portfolio protection was extremely popular. But the wide daily fluctuations have, so far, proven to be noise within the bigger picture. For example, the SPX's 10-month historical volatility is at its lowest reading since May 2013. On balance, monthly historical volatility continues to track lower since its peak in 2009.

If you are a longer-term investor, the longer-term, low-volatility trend suggests not disturbing your long positions, unless and until you see a significant break of longer-term support. After all, as the environment stands now, there is some rationale for portfolio-protection trades to lose their popularity from the perspective of a major decline in volatility during the past few years.

Note the tight, low-volatility trend that has occurred within the context of scary geopolitical headlines, in addition to Fed fears and shaky political headlines

Monthly Chart of SPX since September 2011 with 10-Month Moving Average

"Hedge funds' use of borrowed money, or leverage, to amplify the effect of their bets dropped last week to the lowest level in more than two years, Morgan Stanley told clients in a confidential memorandum. The drop in leverage signals a dwindling conviction that markets will push ever higher."

- The Wall Street Journal (subscription required), Jan. 11, 2015

We don't have a definitive reason as to why VIX call open interest and SPY put open interest have plunged in recent months. Another theory could be hedge funds have chosen to play in other areas -- currencies, commodities, emerging markets, bonds, for example. Or, as a recent Wall Street Journal article suggested (see excerpt immediately above), reduced leverage among hedge funds could be limiting demand for portfolio protection, which may ultimately prove bullish if leverage again increases.

All things considered, we reiterate what we said last week. That is, it is not a bad idea to be hedged or at least make preparations to hedge when necessary, as one risk to the market is a break of support potentially causing panic selling among unhedged longs and/or a sudden demand for portfolio protection, which could coincidentally push indexes lower than expected. And the cost of the hedge may prove to be very small in the context of the potential rally that we could witness if hedge funds begin increasing their leverage once again.

VIX call open interest -- the plunge

VIX Daily Open Interest
Chart courtesy of Trade-Alert

Indicator of the Week: The January Barometer
By Rocky White, Senior Quantitative Analyst

Foreword: Heading into the last week of January, the Dow Jones Industrial Average (DJIA) is right around breakeven on a month-to-date basis. Does it really matter if it finishes the month positive or negative? It might if you subscribe to the January Barometer theory. That's the idea that the direction of the market in January sets the tone for the rest of the year. This week, I'm taking a look to see if January has actually been a good predictor for the rest of the year, and if there is anything we should do knowing that information.

Is January a Barometer?: First, I wanted to see if January was in fact a decent barometer for the rest of the year. Looking back to 1950, the table below summarizes the returns of the dow depending on whether January was positive or negative. Looking at this table, the January Barometer theory does seem to have some validity. When January has been positive, then 83% of the time the index has gained points from February through the end of the year -- averaging a return of 9.68%. When January was negative, then the average return was only 2.54%, with barely half of the returns positive.

DJIA Feb-Dec Returns Since 1950

This year, January is pretty flat -- so, barring a huge move next week, this next table isn't really relevant. It's still pretty interesting. It shows the larger the move in January, the more prophetic the January Barometer. When January has gained 4% or more, then the rest of the year has averaged a gain of almost 12%. When the first month of the year has been down at least 4%, then the rest of the year doesn't even average a 1% gain, and has been positive just half the time. When looking at this table and the table above, it seems January has tended to set the tone for the rest of the year.

DJIA Feb-Dec Returns Since 1950

Trading and the January Barometer: Okay, so we know that January has been a pretty good predictor for the rest of the year. Is there anything we can do? Well, knowing what we know now, let's go back to 1950 and pretend we had $100 to invest. How would we have done trading the January Barometer? The chart below shows what that $100 would be worth today using three different strategies (I begin the chart in 1990 since the lines were pretty even up to then, and it makes the chart a lot easier to read).

The first strategy (the black line) is simply buying the Dow on Jan. 1, 1950, and holding it through 2014. Today, it would be worth about $8,900. The red line is if we bought the index on Jan. 1 of each year, then sold it if January was down. Otherwise, we held it for the entire year. In that case, our $100 would have grown to just $6,300. Knowing that underperformance was coming didn't help us much. Typically, the market still gained, so we'd be better off owning it. The last strategy is based off the last table, and, in that case, we bought the index on Jan. 1, and sold it at the end of January -- only if January was down at least 4%. In that case our $100 would be worth $9,100, barely beating a simple buy-and-hold strategy.

3 Ways to Trade the January Barometer

This last table just shows the annualized return realized from each of the strategies above. I would conclude that knowing about the January Barometer would not help an investor. Using that last strategy of selling the index when January was down big gained less than half of a percent in annualized return. However, this analysis does not take into account dividends or trading costs. Add those in, and I'm sure the buy-and-hold strategy is superior.

DJIA Annualized Return Since 1950

Editor's Note: The charts and commentary above originally cited the S&P 500 Index (SPX), but the data was compiled using the Dow Jones Industrial Average (DJIA). We regret the error.

This Week's Key Events: FOMC in Focus; Blue-Chip, Tech Earnings Roll In
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 Dallas Fed's manufacturing survey will kick off the week. Microsoft (MSFT), Ashland (ASH), D.R. Horton (DHI), Seagate Technology (STX), Texas Instruments (TXN), and Zions Bancorporation (ZION) will release earnings.

Tuesday

  • Tuesday's packed docket includes durable goods orders, the S&P/Case-Shiller home price index, new home sales, and the consumer confidence index. Additionally, the Federal Open Market Committee (FOMC) will begin its two-day policy setting meeting. 3M (MMM), AT&T (T), Caterpillar (CAT), DuPont (DD), Pfizer (PFE), Procter & Gamble (PG), United Technologies (UTX), Apple (AAPL), Yahoo (YHOO), AK Steel (AKS), American Airlines (AAL), Amgen (AMGN), Bristol-Myers Squibb (BMY), Coach (COH), Corning (GLW), Electronic Arts (EA), Freeport-McMoRan (FCX), Illumina (ILMN), Juniper Networks (JNPR), Lockheed Martin (LMT), Novartis AG (NVS), Peabody Energy (BTU), U.S. Steel (X), VMware (VMW), and Western Digital (WDC) will step under the earnings spotlight.

Wednesday

  • Crude inventories and the FOMC policy announcement come out on Wednesday. Boeing (BA), Facebook (FB), AmerisourceBergen (ABC), Anthem (ANTM), Biogen Idec (BIIB), Cirrus Logic (CRUS), Citrix Systems (CTXS), EMC Corporation (EMC), Fiat Chrysler (FCAU), General Dynamics (GD), Hess (HES), International Game Technology (IGT), International Paper (IP), Las Vegas Sands (LVS), Meritor (MTOR), Progressive (PGR), QUALCOMM (QCOM), Steel Dynamics (STLD), T. Rowe Price (TROW), Tractor Supply (TSCO), and Vertex Pharmaceuticals (VRTX) will report earnings.

Thursday

  • On Thursday, weekly jobless claims and pending home sales are slated for release. Visa (V), Alibaba (BABA), Amazon (AMZN), Google (GOOGL), B/E Aerospace (BEAV), Blackstone (BX), Broadcom (BRCM), Celgene (CELG), Colgate-Palmolive (CL), ConocoPhillips (COP), Deckers Outdoor (DECK), Dow Chemical (DOW), Ford (F), Gigamon (GIMO), Harley-Davidson (HOG), hhgregg (HGG), InvenSense (INVN), JDS Uniphase (JDSU), JetBlue Airways (JBLU), Microchip Technology (MCHP), NetSuite (N), Nokia (NOK), Potash Corp./Saskatchewan (POT), PulteGroup (PHM), QLogic (QLGC), Ryland (RYL), Sherwin-Williams (SHW), Stanley Black & Decker (SWK), Thermo Fisher Scientific (TMO), Time Warner Cable (TWC), and Viacom (VIAB) will step into the earnings confessional.

Friday

  • Friday's economic calendar includes the advance reading on fourth-quarter gross domestic product (GDP), the employment cost index, the Chicago purchasing managers index (PMI), and the University of Michigan's consumer sentiment survey. Chevron (CVX), AbbVie (ABBV), Altria Group (MO), Eli Lilly (LLY), ImmunoGen (IMGN), Ingersoll-Rand (IR), MasterCard (MA), Mattel (MAT), Novo Nordisk (NVO), NuStar Energy (NS), Tyson Foods (TSN), Weyerhaeuser (WY), and Xerox (XRX) will release earnings.

And now a sector of note...

Utilities
Bullish

The utilities sector has been a strong performer on the charts, as evidenced by the record peak the PHLX Utility Sector (UTY) tagged just last week. Additionally, of the 10 utility stocks we follow, eight are currently trading above their 80-day moving average. Even more impressive, these securities have gained, on average, nearly 28% over the last 52 weeks. Nevertheless, just 37% of covering analysts rate these stocks a "buy." With bonds rallying in the wake of the European Central Bank's (ECB) stimulus announcement, utilities could benefit from a lower-rate environment -- and a round of upgrades could create additional tailwinds.

In a similar vein, the Utilities SPDR ETF (XLU) has advanced more than 29% over the last year -- and hit an all-time high last Thursday -- and is currently sitting atop several layers of potential support. Specifically, the exchange-traded fund (ETF) is north of the $45 level, which corresponds with its 2007 peak. Also, the same area is roughly double XLU's March 2009 low and triple its October 2002 low, hinting at possible triple-barreled technical support. If the shares can sustain their momentum, additional buying power could result from short sellers and/or option bears throwing in the towel. After all, 31.8% of XLU's float is sold short, and its SOIR of 5.14 ranks in the 92nd annual percentile.

Monthly Chart of XLU since December 2007

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