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Monday Morning Outlook: The Two SPX Levels You Really Need to Know
Don't buy the hype about bearish technical patterns
by Ryan Detrick 7/23/2011 10:30 AM

http://www.schaeffersresearch.com/commentary/observations.aspx?ID=107261&trackback=recapezine

It was another week of partisan gridlock on the federal budget debate, even as euro-zone leaders hammered out a plan meant to prevent a Greek domino effect. However, traders shook off lingering uncertainty over the looming U.S. debt ceiling, with an onslaught of corporate earnings reports ultimately driving the action. The major market indexes netted healthy gains by Friday's close, but -- as Ryan Detrick points out -- stocks are still just drifting between all-too-familiar support and resistance levels. The range-bound action could continue over the short term, but Ryan sees plenty of reasons to believe a breakout to the upside is in the market's future. Fortunately, Rocky White has already crunched the numbers to come up with a list of contrarian-friendly stocks to consider for the second half of 2011. Finally, we wrap up with a few sectors of note, as well as a preview of the week ahead.

Notes from the Trading Desk: Bearish Technical Patterns Spark Media Buzz
By Ryan Detrick, Senior Technical Strategist

Todd Salamone is out on vacation this week, so I'll be filling in with my take on the market action. First of all, what a difference a week makes! At this time last week, rising concerns over sovereign debt crises in Europe and the U.S. had pressured stocks to one of their worst weeks of the year. Fast-forward seven days, and the S&P 500 Index (SPX - 1,345.02) is just a few solid sessions away from another multi-year high.

So, what exactly changed? Well, there's been significant progress on the Greek bailout, even as the debt debate here in the U.S. has been inching along -- but the big market mover has been earnings. On the whole, second-quarter earnings have been very strong so far. In fact, all that talk of a double-dip recession last month is looking more and more like investors just continuing to scare themselves out of an ongoing, powerful bull market. But this is nothing new, as investors have been finding reasons to doubt this market for nearly 28 months now.

Just take a look at the following chart of the SPX. From late August to the early May peak, the index gained more than 30%. But, bigger-picture, the SPX has simply been trading in a 100-point range from about 1,260 to 1,360 since January.

Weekly Chart of SPX since September 2010


Back in late June, when all the talk was about how we were going to break down to new lows, I noted the significance of support at 1,260, as well as the extreme degree of negative sentiment:

Don't follow the rest of the retail crowd by panicking in the face of bearish headlines. Overall, the price action remains strong, and sentiment continues to be downright dire.

As of this writing, not much has changed. The market is still technically strong, yet no one seems to believe in the uptrend.

Speaking of technicals, we've noticed the media picking up on some bearish chart formations. Few contrarian indicators are more powerful than this. As we've noted time and time again, once the media starts talking about bearish technical analysis patterns, it could be time to get long, or vice versa. For example, back in late April, the media was buzzing about a bullish "inverse head-and-shoulders" pattern, which -- as contrarians -- we would have preferred to see slip under the radar. Sure enough, the market peaked for the calendar year shortly thereafter.

However, this past week, we saw dire warnings about bearish head-and-shoulders patterns, as well as "island reversals," being thrown around in the media. If the past two years have taught us anything, it would be to get ready for a rally soon.

Turning from technicals to fundamentals, earnings are coming in solid for yet another quarter, but I'm more impressed with the strong merger-and-acquisition activity we've seen. Just last week, Carl Icahn upped his bid to acquire Clorox (CLX), while Express Scripts (ESRX) bought Medco Health Solutions (MHS) for more than $29 billion. Continued M&A activity is very bullish for the overall market.

I'm not a huge valuation guy, but let's take a second to look at just how reasonable valuations really are. We are looking at record SPX earnings of about $100 per share this year. This translates to a price/earnings ratio of 13.5. When you consider inflation is less than 2%, and 10-year yields are less than 3%, this confirms just how low valuations really are. Historically, with inflation and yields that low, you'd expect a P/E ratio closer to the low 20s. In other words, stocks are potentially trading at a 30% discount, simply due to all of the well-known fears out there.

With that in mind, just imagine if the European issues are resolved without any more major snags. Yes, the situation could get much worse -- but so much of the bad news is already priced in at this point, I think the bigger concern for investors would be missing out on a huge second-half rally -- potentially to new highs, as Bernie Schaeffer noted recently.

Turning to the sentiment backdrop, we continue to see money flow out of equity mutual funds, as there have now been 12 straight weeks of equity mutual fund outflows -- bringing the year-to-date outflows to $18 billion. Incredibly, we've seen $22 billion flow out during just the past five weeks. With the SPX less than 3% from a new multi-year high, the bullish implications are very clear: There's still a lot of money on the sidelines that could push us much higher.

I read this week that as of the second quarter, hedge funds have more than $2 trillion in assets -- a new record. As Todd has mentioned over the last few weeks, we're seeing signs that hedge-fund managers are accumulating equities, as they often purchase puts on broad-focused exchange-traded funds (ETFs) to hedge their long stock positions. The 20-day buy-to-open put/call volume ratio for the SPDR S&P 500 ETF (SPY), PowerShares QQQ Trust (QQQ), and iShares Russell 2000 Index Fund (IWM) continues to move higher, which is a good sign that big-money players are scooping up equities. Even better, the ratio has more room to run before reaching a level that has coincided with previous peaks.

20-day BTO put/call volume ratio for SPY, QQQ, IWM


Elsewhere, the Investors Intelligence poll is showing a little bullishness entering the picture, but we are nowhere near past major peaks. The current difference between bulls and bears is 25%, while the 40% area has caused some trouble in the past. Again, this would suggest we have room to run higher from current levels.

II bulls-bears with OEX


Overall, the powerful combination of low expectations, solid earnings, modest valuations, and strong price action remains firmly in place. For the time being, we could very well continue to trade in that aforementioned 100-point range on the SPX -- but longer-term, the odds highly favor an eventual breakout and a strong year-end rally. Best of luck in your trading.

Finally, my thoughts go out to all those affected by the senseless violence that took place in Norway on Friday.

Indicator of the Week: Positive Price Action, Negative Sentiment, and Stocks to Watch in the Second Half
By Rocky White, Senior Quantitative Analyst

Foreword: This week, I'll be using a couple of basic technical and sentiment analysis metrics to create a list of stocks to watch for the rest of the year. For those not familiar with our philosophy here at Schaeffer's, we are contrarian investors. That means we look for situations where the prevailing sentiment on Wall Street runs counter to a stock's technical and fundamental performance.

When an uptrending stock is surrounded by negative sentiment, this can be bullish for a couple of reasons. First of all, investors are clearly expecting bad things for the stock -- perhaps an earnings miss, or some other kind of negative development. If the investing crowd is expecting bad news, then it's surely already priced in. So, if something bad does happen, the resulting sell-off is typically muted, as the majority of investors have already exited their positions or hedged in preparation. However, if the expected downturn doesn't come to pass, the prevailing negative sentiment can lead to a fast and furious rally in the stock, as all that sideline money suddenly rushes in to buy.

Timing the Rush: So, how do we know when all that sideline money is going to rush into the stock? Well, we don't know exactly when it will happen (if only it were that easy!), but we do know investors can only watch a stock go higher and higher for so long before they finally capitulate and buy into the rally. That's why we keep an eye on solidly uptrending stocks that are surrounded by bearish sentiment from investors and analysts.

Using a couple of very simple metrics, I put together a study that highlights our contrarian philosophy. Going back to the year 2000, and looking at all equities that met some minimum liquidity criteria, I put the stocks into four groups based on their price returns during the first half of the year. Group 1 had the worst returns, and Group 4 had the best returns. To quantify sentiment, I looked at the percentage of "buy" recommendations from Wall Street analysts. Group 1 is stocks that were looked at favorably on Wall Street, and Group 4 are stocks that the analysts hated.

Below is a table showing the average first-half returns and the average percentage of "buy" ratings for the different groups. (Note that Group 1 for the average return is not the same subset of stocks for Group 1 of average percent "buys.") However, do you see what we're looking for in the second half of the year? If we focus on the stocks that arrived in Group 4 for both metrics, we'll have found a combination of positive price action and negative sentiment. According to our theory, these stocks will have a tendency to outperform.

First-Half Returns and Analyst Ratings by Group


Study Results: The table below shows the average returns for all of these stocks during the second half of the year. Looking at the groupings on the left side of the table, those in Group 4 boasted the highest first-half returns overall. Scanning across the top of the table, the stocks with the best first half-returns and the least "buy" ratings from analysts (Group 4 price and Group 4 analyst ratings) collected the best average return out of all the subsets, up 8.7%.

It's interesting to note, though, that the worst subset of second-half returns also originated from the generally outperforming Group 4. However, the underperformers were the stocks that were actually the most loved on Wall Street (Group 4 price, Group 1 analyst ratings -- up just 1.1% for the second half).

First-Half Performance with Analyst Rating Breakdown


In other words, after looking at the high-flyers from the first half of the year, how do we know which rallies will continue through the end of the year, and which are starting to run out of gas? We suggest you look at what Wall Street thinks of those stocks. When equities are enthusiastically loved by analysts, there's a greater possibility that buying pressure has been exhausted and the uptrend is near its end. But if Wall Street hates the stock, it's evidence that there's still sideline money that could flow into the stock and support future gains.

Stocks to Watch: Following the analysis above, the natural thing to do is list some stocks that are in Group 4 of both metrics through the first half of 2011. Below is a list of the 20 most liquid stocks that have racked up a substantial gain so far this year, yet get no love from Wall Street. Be forewarned, though: We don't advocate blindly playing the stocks on the list. Gaining an edge in stock/option trading requires a lot of legwork, but this list should serve as a solid starting point to research potential bullish plays for the rest of the year.

Second-Half Stocks to Watch


This Week's Key Events: Second-Quarter GDP Punctuates a Busy Week
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

*

No major economic reports are scheduled for Monday. Earnings are due out from Baidu (BIDU), Broadcom (BRCM), Netflix (NFLX), RadioShack (RSH), Texas Instruments (TXN), BE Aerospace (BEAV), and Lorillard (LO).

Tuesday

*

The economic calendar kicks off Tuesday with new home sales for June, the S&P/Case Shiller 20-city home price index for May, and the Conference Board's consumer confidence index for July. On the earnings front, we'll hear from 3M Company (MMM), Amazon.com (AMZN), Ford Motor (F), GlaxoSmithKline (GSK), AK Steel (AKS), U.S. Steel (X), ARM Holdings (ARMH), JetBlue Airways (JBLU), Juniper Networks (JNPR), Regions Financial (RF), and Under Armour (UA).

Wednesday

*

Wednesday features the Federal Reserve's Beige Book, along with June's durable goods orders and the regularly scheduled weekly report on petroleum inventories. Boeing (BA), ConocoPhillips (COP), Delta Air Lines (DAL), Visa (V), Corning (GLW), Akamai Technologies (AKAM), Level 3 Communications (LVLT), Green Mountain Coffee Roasters (GMCR), Whole Foods Market (WFM), and Ryland Group (RYL) are expected to report earnings.

Thursday

*

On Thursday, we'll hear the usual update on weekly jobless claims, as well as pending home sales for May. Sharing the earnings spotlight will be Exxon Mobil (XOM), Chesapeake Energy (CHK), Starbucks (SBUX), Sprint Nextel (S), Automatic Data Processing (ADP), Bristol Myers Squibb (BMY), Boston Scientific (BSX), DR Horton (DHI), and M/I Homes (MHO).

Friday

*

The week's marquee economic report -- the advance estimate of second-quarter gross domestic product (GDP) -- hits the Street on Friday. Also on the day's docket are the Chicago PMI and the final Reuters/University of Michigan consumer sentiment index for July. Rounding out the week's slate of earnings reports are Amgen (AMGN), Meritage Homes (MTH), Newmont Mining (NEM), American Axle (AXL), Arch Coal (ACI), and Weyerhaeuser (WY).

And now a few sectors of note...

Dissecting The Sectors
Sector
Leisure/Retail
Bullish

Outlook: Despite ongoing concerns about consumer spending habits, headline retail sales edged higher in June, defying expectations for a modest decline. On the charts, the SPDR S&P Retail ETF (XRT) remains in a longer-term uptrend. The fund is up 13.6% since the start of 2011 -- easily outperforming the major market indexes -- and XRT found a new all-time high of $56.44 earlier this month. Plus, XRT's 50-day buy-to-open put/call volume ratio is turning higher, which has previously been consistent with periods of technical strength. Nevertheless, plenty of pessimism is still levied against the consumer discretionary group. Our data reveals that restaurants boast the largest percentage of stocks above their 200-day moving average, yet less than half of the cumulative analyst ratings are "buys." With so much negativity surrounding this outperforming sector, it seems there's plenty of cash still on the sidelines that could flow in to support additional upside. A few retail/leisure stocks we favor include Chipotle Mexican Grill (CMG), Crocs (CROX), and Green Mountain Coffee Roasters (GMCR), all of which have excelled on the charts in 2011. Despite the positive price action, all three equities are heavily shorted -- raising the possibility of short-covering support amid continued technical strength. Among Internet-based discretionary stocks, both Amazon.com (AMZN) and Netflix (NFLX) are appealing. This duo has been exploring all-time highs in 2011, yet we still see evidence of lingering skepticism. As these equities continue to outperform, a shift in sentiment toward the bullish camp could contribute to future gains.
Sector
Real Estate
Bullish

Outlook: Real estate is Wall Street's perennial underdog, but the robust price action in this sector demands a second look from contrarians. The iShares Dow Jones U.S. Real Estate Index Fund (IYR) is up more than 12% this year, comfortably surpassing the major market indexes. In fact, 80% of stocks in the real estate sector are trading above their benchmark 200-day moving averages -- the fifth-highest percentage among the sectors we track. Despite this broad-based technical strength, only 41% of analyst ratings on real estate stocks are of the "buy" variety -- which happens to be the third-lowest percentage among the more than 40 industry groups we follow. As IYR continues to climb the charts, a round of upgrades could help to attract some buying interest to this underappreciated sector.
Sector
Large-Cap Tech
Bearish

Outlook: Big-cap tech continues to underwhelm, despite enthusiasm over stronger-than-forecast earnings reports from sector stalwarts such as Google (GOOG), Intel (INTC), and IBM (IBM). Within the group, Dow component Cisco Systems (CSCO) is one of the most high-profile underperformers. Many Wall Street pundits cited the stock as a "bargain" following a bearish gap in February -- but the stock has since tumbled to a string of new multi-year lows. CSCO has regained some ground after bottoming just south of the $15 level in mid-June, but the stock's longer-term downtrend remains firmly intact. Meanwhile, fellow Dow member Microsoft (MSFT) received a warm welcome for its fiscal fourth-quarter earnings report on Friday, but is now trading just below all-too-familiar resistance in the $28-$30 area. Nevertheless, MSFT's average 12-month price target stands at an ambitious $32.64, in territory the shares haven't explored in more than three years -- opening the door for potential price-target cuts in the event of continued stagnation on the charts.
Sector
Financials
Bearish

Outlook: A troubling trend has emerged in the big-cap financial sector this earnings season, with a number of banking heavyweights failing to capitalize on "well-received" quarterly reports. Stocks such as Citigroup (C) and JPMorgan Chase (JPM) have seen their post-earnings gains evaporate all too quickly, leaving the shares locked in their respective year-to-date downtrends. Even Morgan Stanley (MS), which gapped dramatically higher after its Thursday report, backpedaled to end the week south of resistance at $24. In fact, the Financial Select Sector SPDR (XLF) is down 4% year-to-date, having missed out entirely on the broad market's advance. Checking out the sentiment backdrop, the 50-day buy-to-open put/call volume ratio for the XLF remains depressed, suggesting that big-money players are still on the sidelines. Plus, data from Zacks indicates that 59% of analyst ratings on finance stocks are of the "buy" or better variety, despite the dismal price action. Going forward, these underperforming bank stocks look vulnerable to additional downside as this remaining optimism is shaken out.