Sector Investing

[ReturntoSender]

Monday Morning Outlook: With Anxiety Running High, Stocks Fight to Find Purchase
Sentiment surveys are pointing to near-peak levels of gloom and doom on Wall Street
by Todd Salamone 10/8/2011 12:15 PM

http://www.schaeffersresearch.com/commentary/observations.aspx?ID=108248&trackback=recapezine&am...

Stocks scored a win last week, thanks in part to a series of stronger-than-anticipated U.S. employment reports. Despite a rocky start to the fourth quarter, easing concerns about a potential double-dip helped the major market indexes recover from their mid-week lows and settle back into the confines of the recent trading range. The bulls' victory tour ended on a less-than-convincing note, though, as more negative headlines out of Europe resulted in modest losses on Friday. While Todd Salamone is encouraged that the benchmark indexes are still holding steady above historically significant support levels, he also cites evidence to suggest that we haven't yet seen the last of the market's choppy sideways ride. Rocky White echoes that cautious tone after surveying the latest round of Wall Street sentiment polls. Bearish sentiment is running high, and with just cause -- but Rocky warns that there may still be some panic left to be shaken out of this market. Finally, we wrap up with a few sectors of note, as well as a preview of the major economic and earnings reports for the week ahead.

Notes from the Trading Desk: Will Third-Quarter Earnings Provide a Much-Needed Catalyst?
By Todd Salamone, Senior VP of Research

"While the SPX is still trading above the key 40-month moving average, situated at 1,108, bulls should take note of the lower highs that have occurred on the last two rally attempts... "The only piece of good news... is that the VIX's call/put ratio is approaching extreme lows. A turn higher in the ratio from these levels has been associated with major advances in the equity market on previous occasions. For now, though, bulls should be on guard, as this ratio continues to decline alongside a bearish roll-over in the 20-day combined SPY/QQQ/IWM put/call ratio."
- Monday Morning Outlook, October 1, 2011

"The hedge-fund industry just had its fourth-worst quarter on record, according to one industry watcher. Hedge funds lost 5.5% in the quarter, according to Hedge Fund Research Inc., 'trailing only the third and fourth quarters of 2008 and the third quarter of 1998.'"
- The Wall Street Journal's MarketBeat blog, October 7, 2011

Bulls got quite the scare last week, as major benchmarks we follow -- including the S&P 500 Index (SPX - 1,155.46), S&P 400 MidCap Index (MID -799.18), and Russell 2000 Index (RUT - 656.21) -- fell below major areas of potential support that we have been highlighting over the past few weeks. These levels are as follows:


SPX 1,100: Site of its 40-month moving average, a round number, and a 38.2% Fibonacci retracement of the March 2009 low and May 2011 peak.
MID 768-800: 768 is its 80-month moving average, and 800 is double the 2009 low.
RUT 650: Resistance in 2004 and support before Lehman Brothers collapsed in 2008.

Moreover, a benchmark we haven't discussed like the others above is the Dow Jones Industrial Average (DJIA - 11,103.12), which fell below the 11,000 millennium mark. The 11,000 area marked resistance from May 1999 through May 2001 before a bear market took hold, and resumed its role as resistance in 2005 and ahead of the "flash crash" in 2010.

After the above levels were broken, it was a "sell now, ask questions later" mentality on the "risky" small- and mid-cap stocks, as the RUT traded 7.6% lower after 650 was broken, and the MID shed 8.8% after 800 gave way to the bears. Likewise, after 11,000 on the DJIA was breached, it led to an additional 6% haircut.

But equally impressive was the rebound rally that quickly carried these benchmarks back above their respective levels of support within only a couple of days, and back into the range that has been in place since early August. While the sell-off was sharp and quick, we found the respective lows last week to be of interest.

For example, the RUT bottomed near 600. This area carries significance in that:

It is double the low at the height of the Russian ruble and Long-Term Capital Management crisis in 1998;
It was a resistance area in March 2000, and again in 2003-2004;
It is a 50% retracement of the March 2009 low and May 2011 peak; and
600 corresponds with the 60 level on the iShares Russell 2000 Index (IWM) exchange-traded fund (ETF), which is 1/10 the value of the RUT. The 60 strike was the last area of significant put open interest in the October series, and the glut of put contracts at this strike -- and immediately above -- may have accelerated the RUT's downside move, due to delta-hedge selling.





Meanwhile, SPX 1,100 was barely penetrated, as the index traded near 1,075 at its lows last week. The MID bottomed at 731, which was also a low in January 2008, and experienced only one daily close below its important 80-month moving average last week.





So, while it was quite the scare for bulls early last week, benchmark equity indexes continue to cling to longer-term levels of support. However, equally important resistance areas lie just overhead, creating a range-bound environment. Potential near-term catalysts that could move the market out of this range are third-quarter earnings, which get underway next week, and a European Union summit in two weeks.

We found the 5.5% loss that hedge funds experienced in the third quarter as an interesting statistic. On one hand, the third-quarter loss could be a disappointment to those investing cash in strategies that can make money in difficult environments, due to the wide range of strategies and assets available for hedge fund managers to utilize. On the other hand, the 5.5% loss was much better than the 14% loss that the SPX encountered.

With the hedge fund industry's more than $2 trillion in assets, another potential conclusion is that their net exposure to U.S. equities is low, given how correlations among stocks rose during the quarter. Other potential takeaways from the third-quarter performance is that they are investing in other assets, such as currencies, gold, silver, and other commodities, and/or have an above-average short position to offset long equity positions. This is something we have been noting for weeks via our analysis of the options markets, and we still feel that hedge fund managers could dictate the next directional move in the market.

While we did see the buy-to-open call/put ratio on the CBOE Market Volatility Index (VIX - 36.20) tick a little bit higher last week, suggesting some fund managers may be dipping their toes back into the market, the put/call ratio on major equity-based ETFs we follow is still mired in a decline. This suggests rallies will continue to be sold by some fund managers, thereby heightening the odds of a continued sideways chop.



Our advice from last week hasn't changed. That is: Keep tight stops on your long equity positions -- especially those in the consumer-discretionary area, as we are seeing some breakdowns among former leaders in this group. Large-cap banks continue to be the biggest area of vulnerability, and these are names to consider if you are actively shorting. Treasury bonds should remain in your portfolio, and utilities are a sector worth adding, given the attractive dividend yields, strong price action, and the low percentage of "buy" ratings from analysts, hinting at future upgrade potential.

Indicator of the Week: Scanning the Various Sentiment Polls
By Rocky White, Senior Quantitative Analyst

Foreword: As experts on sentiment analysis, we track a whole host of sentiment polls. This week, we'll take a look at a few of these surveys, compare their methodologies, and see what they're telling us about how investors feel right now. Keep in mind that, as contrarians, we consider high levels of pessimism to have bullish implications for the market. Negative sentiment signals the presence of sideline money, as well as the potential for quick, big gains when that money begins buying into the market. Of course, the bullish implications are most valuable when the widespread pessimism runs counter to the market's direction.

Investors Intelligence: I've written about the Investors Intelligence (II) poll before. They've been around a long time; we actually have data from them dating back to the early 1960s. To conduct this poll, II gathers various publications on the market and determines their stance. Then, they show the percentage of financial advisers who are bullish, bearish or expecting a correction (i.e., short-term bearish, but longer-term bullish).

Below is a chart of the percentage of bulls and bears from the II poll going back to 2009. It shows the bears are currently at their highest level since the March 2009 bottom. Accordingly, the bulls are low -- but the percentage was actually lower in August 2010. That August pullback in the S&P 500 Index (SPX) was actually a higher low, as the market was up from a month earlier. However, it really freaked out investors, which was a sign that pessimism was rampant and a rally possible.

Again, we like the pessimism that is evident in the latest II poll -- but at the time the survey was conducted, the market was hitting fresh lows. So, that diminishes the bullish implications.



AAII: AAII stands for the American Association of Individual Investors. Each week, they ask their membership where they think the market is heading in the next six months. Then, they group those responses into three categories -- bullish, bearish, and neutral -- and report the percentage for each.

As you can see from the chart below, this poll is a lot more volatile than the II poll. That makes sense, as those who actually publish their market outlooks would probably be more stubborn about changing their opinion than those who are informally asked every week, "Where are we headed?" In fact, the poll was so volatile from about April 2009 through mid-2010 that it was nearly useless. In late 2010, the bulls climbed to pretty high levels, while the bears fell to very low levels. The market still had some room to the upside at that point, and continued to rise through February 2011. After that, the SPX pulled back significantly and became quite choppy. The index then hit an annual high in May, and we're down significantly since then. Currently, the bears are at a pretty high level, but the bulls are not at their annual lows, and are actually rising.



NAAIM: This is a newer survey, which has data going back to only July 2006. NAAIM stands for the National Association of Active Investment Managers. What sets this poll apart from the rest is that this poll does not simply ask, "Are you bullish or bearish?", but instead asks money managers how their money is actually positioned in the market. They can answer anywhere from -200 (leveraged short) to +200 (leveraged long). This is valuable information, because the fundamental goal of our sentiment analysis is to see where money is positioned. Is it all crowded into the market, or all on the sidelines (or somewhere in between)? This poll asks that direct question.

There are some drawbacks to this poll, which NAAIM acknowledges on their site. For starters, it's not easy for some money managers to sum up their position in one simple number. Also, the sample size for this poll is growing, but it's not very big as of right now.

That being said, below is the chart of the NAAIM survey. It is currently at its lowest reading of all time, and is negative for just the second time ever (the first time was in October 2008, around the peak of the financial crisis). This suggests that money managers are short the market -- so any positive news that comes out, or any signs of life in the market, could spark a fast and furious short-covering rally.



Implications: Each of the polls I mentioned above is showing significant pessimism at the moment. This is to be expected, with the SPX down almost 15% since July. A positive catalyst could change the hearts of these bears, and the market could make a significant move higher. However, the overall price trend is lower, which diminishes the contrarian bullish connotations of the polls. Also, as far as the II and AAII polls go -- while bearish, they're still not as bearish as they were at the March 2009 bottom. This suggests panic could still lead to climactic selling, and another substantial decline.

This Week's Key Events: Alcoa Earnings, Fed Minutes on Deck
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 economic calendar is bare on Monday, as government offices are closed in honor of Columbus Day. Mistras Group (MG) headlines a quiet day on the earnings front.

Tuesday

On Tuesday, the central bank will take the spotlight, with the release of the Federal Open Market Committee's (FOMC) latest meeting minutes on tap. Earnings season unofficially kicks off with Alcoa's (AA) post-close report, with quarterly results also expected from Joe's Jeans (JOEZ), Synergetics USA (SURG), and WD-40 Co. (WDFC).

Wednesday

The weekly MBA mortgage index is the only report of note on Wednesday, but Fed officials Charles Plosser and Sandra Pianalto are both scheduled to deliver speeches. Earnings are expected from PepsiCo (PEP), Adtran Inc. (ADTN), Infosys (INFY), ASML Holding (ASML), and Host Hotels and Resorts (HST).

Thursday

Thursday's calendar includes the August trade balance, the Treasury budget, and the weekly report on jobless claims, as well as the government's holiday-delayed crude inventories update. Google (GOOG), JPMorgan Chase (JPM), Fastenal (FAST), Lindsay Corp. (LNN), Safeway (SWY), and Fairchild Semiconductor (FCS) will share the earnings stage.

Friday

The week wraps up with a flurry of economic data, as September retail sales, import/export prices, August business inventories, and the preliminary Reuters/UMich consumer sentiment index for October are all scheduled to hit the Street. The earnings calendar concludes with reports from Mattel (MAT) and Webster Financial Corp. (WBS).

And now a few sectors of note...

Dissecting The Sectors
Sector Utilities
Bullish
Outlook: The utility sector is often preceded by its "defensive" reputation, and it has indeed emerged as a pocket of technical strength, even amid the recent broad-market turmoil. The PHLX Utility Sector Index (UTY) pulled back this past week, but rebounded after finding support at its 200-day moving average. In fact, the electric utility group currently boasts the highest percentage of stocks trading above their 200-day moving averages among all sectors we follow, at 58%. Plus, the sector sports some attractive dividend yields, which are certainly a selling point in the context of a tumultuous market environment. However, Wall Street hasn't exactly jumped on the bullish bandwagon just yet. Electricity stocks have attracted only 38% "buy" ratings from brokerage firms, which is one of the most bearish ratings configurations around right now. Within the group, Duke Energy (DUK) and Consolidated Edison (ED) have racked up double-digit percentage gains in 2011, and both stocks have recently tagged new annual highs. Nevertheless, there's not a single "buy" endorsement between the two. Going forward, a round of well-deserved upgrades could draw a fresh wave of buyers to the table, helping these stocks extend their positive price action.

Sector Leisure/Retail
Bullish
Outlook: The SPDR S&P Retail ETF (XRT) remains in technical limbo on the charts, with the fund hovering between familiar support and resistance levels. XRT closed last week beneath the round-number $50 level and its year-to-date breakeven at $48.36, but wrapped up the month of September just north of support in the $45 region -- which previously served as resistance in 2007 and 2010, and is currently home to major put open interest of more than 35,000 contracts in the October series. Despite the technical stagnation here, we remain upbeat on select outperformers within the group, and recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism. Amazon.com (AMZN) is one such example, with the shares up nearly 25% year-to-date -- despite a 45% surge in short interest over the course of the past month. Whole Foods Market (WFM) also holds contrarian appeal, as the stock has enjoyed a years-long uptrend atop the support of its 10-month moving average. With WFM attracting a significant amount of speculative put buying in recent weeks, there could be some skepticism yet to unwind toward this technical standout. Heavily shorted Sturm Ruger (RGR) is another one to watch, after the stock last week found support near former resistance at the $25 level. As these high-flying discretionary names continue to outperform on the charts, a capitulation by the skeptics could provide an influx of buying pressure.

Sector Large-Cap Tech
Bearish
Outlook: From a broad perspective, the tech-rich Nasdaq Composite (COMP) now seems to be struggling with resistance in the 2,500 area, shortly after the index suffered a rejection at the formerly supportive 2,600 level. In similar fashion, the PowerShares QQQ Trust (QQQ) spiraled lower after an unsuccessful late-July test of the $60 level -- which represents exactly half its all-time high of $120, set back in March 2000. Within the tech sector, semiconductor stocks are among the more notable laggards, as analysts remain surprisingly upbeat on this underperforming group. The percentage of "buy" ratings on components of the Semiconductor HOLDRS Trust (SMH) peaked at 58.2% in late July, hitting its highest level since May 2010, and remains at an elevated 57.0%. Meanwhile, the percentage of "sells" is resting near an annual low, at 5.4%. In fact, a few upbeat analysts have recently flagged the poor price action in chip stocks as a buying opportunity. However, with a seemingly endless string of semiconductor names slashing their financial guidance in the face of sluggish demand trends, the outlook for this struggling group seems unlikely to improve anytime soon. With SMH faring even worse than the broader QQQ in 2011, the semiconductor sector as a whole could be vulnerable to a shift in sentiment toward the bearish end of the spectrum as the weak technical performance continues.

Sector Financials
Bearish
Outlook: Bad news continues to roll in for the banking sector, with credit default swap (CDS) costs soaring this past week amid ramped-up concerns over a potential European debt contagion. In fact, CDS costs for Morgan Stanley (MS) and Goldman Sachs (GS) jumped to their highest point since the October 2008 financial crisis. Nevertheless, analysts continue to hold these troubled stocks in high regard. Among sector heavyweights MS, GS, Bank of America (BAC), JPMorgan Chase (JPM), Citigroup (C), and Wells Fargo (WFC), Zacks reports a total of 66% "buy" ratings from brokerage firms -- despite the fact that these six stocks have averaged a year-to-date loss of 40.8%. Taking a broader look at the group, the technical backdrop for the Financial Select Sector SPDR (XLF) remains bearish, with the fund sitting on a steep year-to-date decline of nearly 26%. XLF tumbled lower in late August after an unsuccessful test of the $13.50 level, which previously served as major support during 2010. Going forward, this area could prove to be a troublesome resistance level. XLF is also now lingering near a few other crucial technical areas, including $11.76 (double its 2009 low) and $11.62 (a 50% retracement of the 2009 low and 2011 high). Going forward, a breach of these levels could spell serious trouble for financial stocks.

Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insight about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.