Why Fear Ahead of Earnings Could Favor Bulls

The S&P 500 Index (SPX) is sitting just above two potential layers of support

Senior Vice President of Research
Apr 6, 2015 at 8:11 AM
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"As we move into this week's trading, the 'keeping it simple' model is now saying 'buy.' In other words, loyal readers of Monday Morning Outlook are fully aware of how round-number, year-to-date percentage returns have generally marked key pivot areas. With that said, multiple equity benchmarks, including the DJIA enter this week at potential year-to-date (YTD) support levels, which could be opportunistic for short-term traders ... If the SPY manages to stay above the 205 strike early in the week, there could be a bit of a tailwind from short covering related to expiring options that are at strikes below the SPY level."
-- Monday Morning Outlook, March 30, 2015

Our short-term "buy" signal in last week's commentary got off to a tremendous start last week, as the S&P 500 Index (SPX - 2,066.96) and SPDR S&P 500 ETF Trust (SPY - 206.43) rallied over 1% on Monday. However, the sharp rally pushed the SPY into a "call wall" at the March 31 expiry 208 strike, from which stocks noticeably reversed direction. In fact, on Wednesday, the SPX dipped back below its December 31 close at 2,058.90 intraday, only to close back above this key level in the last minutes of trading. In the interest of keeping it simple, the short-term outlook continues to favor the bulls, with the SPX's 2014 close continuing to act as support in the near term.

DJIA and SPY since January 2015 with YTD Breakeven
"Wall Street analysts to make their deepest cuts to earnings forecasts since the financial crisis ... Analysts, citing the dollar's strength as a key factor, are predicting that profits at S&P 500 firms for the first quarter will show their biggest annual decline since the third quarter of 2009."
-- The Wall Street Journal (subscription required), March 22, 2015
"With economic data missing the mark, analysts predicting three straight quarters of falling profits and speculation shifting about when the Federal Reserve will boost interest rates, investors are taking steps to protect profits ..."
-- Bloomberg, April 1, 2015
"'In companies with stretched valuations, I've seen customers buy protection or reduce positions going into earnings,' said Jeffrey Yu, head of single-stock derivatives trading at UBS."
-- The Wall Street Journal (subscription required), April 1, 2015
"What (if any) upside is there to the coverage the U.S. dollar is getting? In other words, might lower earnings expectations work in favor of the bulls, in terms of a lower bar to hurdle when earnings season rolls around again?"
-- Monday Morning Outlook, March 16, 2015

Market participants continue to fret over a multitude of uncertainties and headlines that continue to stoke volatility. This past week, for example, many economic reports missed forecasts, and coincident with these releases, voting Federal Open Market Committee (FOMC) members opined that rate hikes were coming. Weaker-than-expected economic data combined with potential upcoming rate hikes did not sit well with investors, causing volatility to spike and equities to erase Monday's gains.

In addition to uncertainty both here (Fed, economy) and abroad (Greece, Middle East), earnings reports will come into focus, with Alcoa Inc (NYSE:AA) marking the unofficial beginning of earnings season with its Wednesday, April 8 release.

Expectations appear to be low heading into earnings season, with a lot of blame being placed on the strong dollar. In fact, downward revisions to earnings expectations during the course of the quarter may be putting a lid on stock prices. However, while the market has not made any headway to the upside, there hasn't been any meaningful downside either, suggesting resilience amid news that could be very capable of pushing stocks lower (negative earnings revisions, Fed fears, weak economic data).

The takeaway is that poor earnings reports are likely factored into the market, as analysts have reacted to earnings-related headwinds, such as a stronger dollar. For bulls, the good news is that companies have a lower earnings bar to hurdle. Undoubtedly, there would be more risk to these earnings reports if analysts stood firm in their estimates, even as negative earnings drivers gathered steam. During this earnings season, look for some companies to attempt to add clarity to their respective earnings releases by presenting data absent currency factors. This is what we saw at the back end of the earnings season that just passed, and those companies' stocks tended to react favorably.

Whether it's earnings season or the Fed, it appears professional investors are indeed taking steps to protect their portfolios, as the ratio of buy-to-open put volume to buy-to-open call volume on exchange-traded funds such as the SPY, PowerShares QQQ Trust (QQQ - 105.12), and iShares Russell 2000 (IWM - 124.65) is increasing. When professional traders are in accumulation mode and stocks push higher, we have sometimes observed that this ratio coincidentally rises too, as put demand (bought as a hedge) increases as equity exposure increases.

At present, the combined buy-to-open put/call volume ratio on these exchange-traded funds is rising, but stocks have not coincidentally rallied. Therefore, we are concluding that steps are indeed being taken to protect portfolios, perhaps due to a perceived risk that earnings could wreak havoc on the market. If this is indeed the case, stocks are being "pre-sold" ahead of earnings, and this could eventually tilt the risk-reward in the bulls' favor, especially if analysts' earnings revisions are proven to be worse than the actual results.

Hedging activity picking up pre-earnings?

SPY, QQQ, IWM Combined BTO put call ratio since January 2013 with SPX

Finally, we are keeping our eyes on the bigger picture. If YTD breakeven support is broken on the SPX, another potential support area is close by at 2,030, home to the index's 10-month moving average. As we have said in a previous report, in the context of the daily headlines that have created volatility by the day, a monthly graph of this index displays an orderly uptrend that has rewarded patient investors.

Monthly Chart of SPX since January 2012 With 10-Month Moving Average

Read more:

Indicator of the Week: The Importance of a Positive YTD Return Right Now

The Week Ahead: Fed Minutes and Alcoa Inc. Earnings


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