Sector Investing

[ReturntoSender]

Monday Morning Outlook: Beware the Mean-Reverting Market
One major buy signal -- and four possible risks to the bullish case
by Todd Salamone 7/2/2011 1:30 PM

http://www.schaeffersresearch.com/commentary/observations.aspx?ID=106980&trackback=recapezine

It was a remarkably efficient week on Wall Street, as traders celebrated positive developments out of Greece and a much-needed round of reassuring domestic data. In fact, after five straight days of nonstop gains, it was almost as though the past two months of miserable market action never even happened. So, wonders Todd Salamone, what's not to like, from a contrarian perspective?

Well... at least four things, as it turns out. While several sentiment indicators are pointing to healthy amounts of cash on the sidelines, Todd highlights a few possible risks investors need to be aware of during the short term. Next, Rocky White takes a look back at second-half seasonality, and explains why President Obama's third year in office could ultimately be a boon for the bulls. Finally, we wrap up with a preview of the holiday-shortened week ahead, as well as a few sectors of note.

Notes from the Trading Desk:
By Todd Salamone, Senior VP of Research

"The good news for the bulls, as we discussed last week, is that the widespread pessimism we are seeing is very similar to that which has existed at various correction lows since the market bottomed in early 2009. Said another way, the risk to the bears is the tremendous unwind potential from short-covering activity, or sideline money suddenly reemerging. This risk is heightened as long as the major market indexes stay in the black on a year-to-date basis, and hold above their respective long-term moving averages."
-- Monday Morning Outlook, June 18, 2011

"On the sentiment front, numerous indicators are displaying the kind of heavy-handed pessimism that has coincided with previous buying opportunities. Now, this doesn't count for much until the overall price action improves -- but it does suggest we have some wood for the fire should we start to bounce."
-- Monday Morning Outlook, June 25, 2011

The Fed's "QE2" bond-buying program and the first half of the 2011 calendar year are now behind us. Actions to address the sovereign debt issues in Europe and a stronger-than-expected ISM report in the U.S. drove stocks to five consecutive days of impressive gains. In the blink of an eye, the Nasdaq Composite (COMP - 2,816.03) moved comfortably back into the black for 2011, while the S&P 500 Index (SPX -1,339.67) rallied strongly from the powerful combination of support at its 200-day moving average and its year-to-date breakeven level.

Plus, as we move into the second half of 2011, seasonality is very favorable for market participants (be sure to see Rocky White's commentary on the next page).

So, if you're a contrarian investor, what's not to like? After all, the major market indexes pulled back to (successfully) test technical support -- creating a lot of anxiety among investors in the process -- and the ensuing rally has been so sharp, and so sudden, that you have to believe many have been left behind.

In fact, the benchmark indexes enter the week trading just below areas of resistance that we have been highlighting since April, when the S&P Midcap Index (MID - 995.05) made its first-ever run at the 1,000 millennium mark. At that time, we also noted that the SPX was knocking on the door of its 2009 "double low" in the 1,333 area, and the Russell 2000 Index (RUT) was revisiting its June 2007 all-time high in the 850 area.



And here we are again, near these same resistance areas. But what we find interesting, as described in the table below, is that the sentiment backdrop is one that suggests there is enough sideline money and short-covering potential to drive a sustained move through these areas relative to two months ago. Said another way, there was more money betting on a breakout above these key areas on the SPX, MID and RUT three months ago than there is now.

For example, one tool we use to measure hedge-fund positioning in the equity market is the 20-day buy-to-open put/call volume ratio on the major exchanged-traded funds (QQQ, IWM, and SPY). The higher this ratio is, the more invested hedge fund managers are, as they typically buy puts on these broad-based exchange-traded funds to hedge long equity positions as they accumulate shares. In late April, this ratio stood at 3.70, and was beginning to roll over. Admittedly, at this point, the ratio was not very high with respect to previous peaks, which might provide a clue as to why the ensuing correction was more modest than prior pullbacks. At present, this ratio is at 2.37 and beginning to turn higher. Our interpretation is that hedge fund managers are moving back into equities from an underweight position, and that relative to April 2011, there's more cash for these hedge funds to put to work at present.



Another tool we use to measure sentiment is the 10-day customer-only, equity-only, buy-to-open put/call volume ratio, using data from the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). When this ratio is high, it's evidence that there is persistent negativity, and a sign of growing bearish speculation in the marketplace. We've found that it's best to buy stocks when this ratio hits a relative high and begins to turn lower, as this rollover is a sign that the heavy pessimism has hit a climax -- which can precede powerful rallies. After hitting a near two-year high last week, this ratio has started to turn lower, which could be a major buy signal.



Below is a table that summarizes the sentiment backdrop at present relative to the end of April, including indicators described above. Certainly, you can make a case that there's more cash on the sidelines at present to drive stocks through overhead resistance levels.



So, what are the near-term risks to the bullish case we discussed above?

1. We enter the holiday-shortened week with MID just below 1,000, the RUT right below 850, and the SPX above 1,333 but squarely at 1,340 -- the site of peaks in February, April and June. As of yet, these indexes have not been able to sustain a convincing move above these levels.

2. The market is fresh off five consecutive up days -- which, in a mean-reverting market environment, suggests an increased risk of a downside move as technical traders take profits around resistance levels.

3. The CBOE Market Volatility Index (VIX - 15.87) closed below the significant 16 level on Friday. The VIX has tended to bounce higher after pulling back to this area in 2011, as investors view this as a good time to acquire portfolio insurance at a "cheap" cost. Should the VIX rally, stocks will likely move lower. Then again, there may not be as many investors looking to hedge this time around as compared to previous trips down to this level, given there is a lot of sideline cash and more shorts in the market relative to the recent past.

4. The first session after a three-day weekend can be volatile. Given the super-low-volatility uptrend in the market this past week, an added dose of volatility would support the case for a trend reversal.

Have a safe and fun-filled Fourth of July weekend.

Indicator of the Week: Second Half of the Year & Third Year of the Presidential Cycle
By Rocky White, Senior Quantitative Analyst

Foreword: We are now halfway through 2011 -- and for the first time since 2007, the Dow Jones Industrial Average (DJIA) was positive through the first six months of the year. This bullish price action isn't too surprising, considering this is the third year of the Presidential cycle. The table below reveals that the third year has an amazing streak of 15 straight positive years, going all the way back to 1950.



One theory for the positive price action is increased campaign efforts during the third year of the cycle, as incumbent politicians start passing legislation to boost the market, which (theoretically) helps them in their re-election bids. The average return in those years is 17.7%, which is far better than the average returns in any other year of the cycle. This week, let's take a look at the historical data to see what we can expect in the second half of this year.

The Second Half & the Presidential Cycle: Below is a table that breaks down the annual data by first and second half. One interesting note is that the third year -- unlike each of the others -- typically has more bullish returns during the first half, with the second-half returns falling more in line with other, more typical years. In fact, out of the 15 returns, only twice has the second half of the year outperformed the first half (1951 and 2003).





When the First Half is Positive: Below is a table showing how the second half of the year has played out historically, depending on whether the first half of the year was positive or negative. A positive first half has typically correlated with more bullish returns in the second half. In fact, the returns in the second half of the year are significantly better when the first half is positive, as opposed to when the first six months are negative.



Finally, here is a table showing the first- and second-half breakdown for every third year of the Presidential cycle since 1951. While 2007 was negative in the second half, look at the prior five instances of the third year of a Presidential cycle. On two occasions, there were double-digit gains during the second half, and on one other occasion, there was a gain of 9%. That's pretty much the kind of market action we're hoping for in the second half of 2011.



This Week's Key Events: Traders Brace for an Onslaught of Jobs Data
Schaeffer's Editorial Staff

Here is a brief list of some of the key events this 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 equities market is closed Monday in observance of Independence Day.

Tuesday
* The economic calendar kicks off Tuesday with factory orders for May, while Gravity Co. (GRVY) is expected to report earnings.

Wednesday
* On Wednesday, the ISM services index for June is due out, along with the regularly scheduled weekly report on mortgage applications from the Mortgage Bankers Association (MBA). On the earnings front, we'll hear from A. Schulman (SHLM), DragonWave (DRWI), Ocz Technology Group (OCZ), and Unify Corp. (UNFY).

Thursday
* Employment data takes the spotlight on Thursday, with the day's docket featuring ADP's private-sector payrolls report for June, as well as the Labor Department's usual update on weekly jobless claims. Crude inventories will also hit the Street one day later than usual, due to the July 4 holiday. Quarterly earnings are expected from Helen of Troy (HELE), International Speedway (ISCA), Semileds Corp. (LEDS), WD 40 Co. (WDFC), and Zep Inc. (ZEP).

Friday
* Ahead of Friday's opening bell, all eyes will be on the Labor Department's nonfarm payrolls report for June. Later in the session, traders will also hear about May's wholesale inventories. PriceSmart (PSMT) and Greenbrier Companies (GBX) are slated to wrap up the week's roster of earnings reports.