The market staged a big-time rebound last week, thanks to a two-day 350-point rally on Wednesday and Thursday. The Dow Jones Industrial Average regained the 11,300 level, while the S&P 500 Index climbed back above 1,200. Looking ahead, Todd Salamone, Senior Vice President of Research, argues that the "possibility of a sustained upside breakout has increased," and gives five reasons why. Among them: "The market bent, but certainly did not break" after a recent onslaught of negative headlines. Next, Senior Quantitative Analyst Rocky White examines buy-to-open option data on some major exchange-traded funds and concludes that some big-money players are growing bearish on financial stocks. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Two-Day Rally Erases November Losses Schaeffer's Editorial Staff
The month of August -- the last down month prior to November -- also ended with a thud, if you recall, with the Dow Jones Industrial Average clinging precariously to the 10,000 level on Aug. 31. A 200-plus point leap on Sept. 1 then launched the fall rally. The end of November was similarly downbeat, with the Dow holding on for dear life just above 11,000. What happened on Dec. 1? The Dow again rocketed ahead more than 200 points, followed by another 100-point burst on Dec. 2. A disappointing unemployment report on Friday, Dec. 3, cooled the bulls' ardor, but by then the Dow was knocking on the door of its year-to-date highs.
The less said of November, the better. The fall rally continued through the election and the Federal Reserve's announcement of a second round of monetary stimulus, and then stumbled badly. The Dow lost 1% for the month, the S&P 500 Index (SPX) slipped 0.2%, and the Nasdaq Composite (COMP) dropped 0.4%.
Continued worries about debt issues in Ireland, Portugal and Portugal dogged the market in the early part of the week, overshadowing evidence of health in the U.S. consumer sector. All signs pointed to a robust kickoff to the holiday shopping season over the weekend, but the Dow spent much of Monday deeply in the red, falling below 11,000. However, the blue chip barometer pared its losses by the close, regaining the 11,000 mark, but losing 0.36% for the day.
Tuesday looked a lot like Monday: Euro-zone issues outweighed a mixed bag of economic news at home, including a positive reading on consumer confidence. Once again the Dow slipped below 11,000 at the open and gradually recovered throughout the day. But it all added up to an eventual loss of 0.42%, with the Dow settling at 11,006.
What a difference a new month makes. China stoked the fires overnight on Wednesday, reporting strong manufacturing data, and the U.K. similarly weighed in with a 16-year high in its purchasing managers' index. Back home, ADP reported that the U.S. added 93,000 private-sector jobs in November, while General Motors (GM) and Ford (F) reported double-digit sales gains in November compared to the previous year. The Dow leapt at the open and kept on going, skyrocketing 249 points, or 2.27%, by the close.
Much as Tuesday echoed Monday, Thursday followed in Wednesday's footsteps. Although new jobless claims climbed a little more than expected, news from the retail sector continued to be cheery. Macy's (M), J.C. Penney Co. (JCP), Target (TGT) and Limited Brands (LTD), among others, impressed with healthy same-store sales gains. That helped set a Santa mood, and the Dow rose 107 points, or 0.95%.
The Labor Department disclosed early Friday that the economy added just 39,000 jobs in November, far fewer than the gain of 155,000 that analysts expected, and helping to boost the unemployment rate to 9.8%. The Dow sulked all day, and then, in the final 30 minutes of trading, clambered above the breakeven line for a small daily gain of 0.17%. For the week, the Dow advanced an impressive 2.6%, while the SPX did even better, gaining 3%. The COMP, meanwhile, added 2.2% last week.
What the Trading Desk Is Expecting: Bulls Continue to Show Strength By Todd Salamone, Senior Vice President of Research
During the past few weeks, we have highlighted several longer-term resistance levels capping the S&P 500 Index (SPX) and evidence, via our options analysis, that hedge fund managers had mostly returned to the sidelines after a period of accumulation from late August into early November.
Our conclusion has been that while ample sideline money is a necessary condition to support a continued bullish market environment, a continued absence of hedge fund accumulation could be an inhibitor to an upside breakout, as the market is left to the mercy of the high-frequency traders and their mean-reverting activities. Therefore, the risk of a trading range similar to the end of 2009 was viewed as a growing possibility.
The SPX comes into the new week trading around the April and November 2010 peaks. After closing the month of November below the 1,200 century mark and its 80-month moving average, it has quickly rallied above these resistance areas. As we enter the traditionally strong December month, the possibility of a sustained upside breakout has increased for the following reasons.
1. The 20-day combined buy-to-open put/call volume ratio on the SPDR S&P 500 ETF Trust (SPY), PowerShares QQQ Trust (QQQQ) and iShares Russell 2000 Index Fund (IWM) has turned higher, driven mostly by a dramatic increase in put buying on IWM. The ratios on SPY and QQQQ are no longer sharply declining, but haven't yet risen as sharply as the IWM's. An increase in put buying is usually coincidental with hedge fund accumulation, suggesting strong hands are in accumulation phase again, key to continued market strength.
SPX and 20-day BTO put/call ratio for SPY QQQQ and IWM
2. IWM has pushed above its April 2010 peak. In early March, the IWM broke out above its January highs, but the Nasdaq Composite and SPX did not break out above their respective highs until one week and two weeks later, respectively. Small-cap leadership may signal an imminent breakout in larger-cap indexes.
3. Reactions to recent headlines indicate bull market conditions persist. Last week, for example, we stated that the recent price action in the U.S. market – indifferent, at best –might be considered a win for the bulls. That is, stocks showed relative resilience despite a constant stream of negative headlines that could have easily driven stocks below support levels – namely the re-emergence of the European sovereign debt crisis, the growing possibility of a Chinese rate hike, hostilities between North and South Korea, charges of insider trading brought against some hedge funds, and Friday's extremely disappointing employment report. The market bent, but certainly did not break amid these headlines.
4. Our "VIX Premium" indicator, which compares the CBOE Market Volatility Index (VIX – 17.88) to the SPX's actual volatility (15.96), is indicating lower volatility ahead, which is usually coincidental with higher stock prices. Per the chart below, note that during the past couple of years, when the VIX is trading at significant premium to SPX historical volatility (significant as defined by the VIX trading at a level that is double its actual volatility), it is a precursor to higher volatility and a market pullback. On the other hand, when the VIX is at a relatively small premium to actual SPX volatility, lower volatility has followed amid a rising SPX. In early November, this indicator correctly forecasted higher volatility and an SPX decline, as the VIX traded 140% above SPX historical volatility. The "VIX premium" has since eroded substantially, as you can see below.
VIX premium to SPX 20-day historical volatility
5. The "Black Friday" indicator, discussed by Senior Quantitative Analyst, Rocky White, in last week's Monday Morning Outlook. Rocky studied the performance of the SPX in the week after Black Friday. He found that when the market rallied in the week following Black Friday, there is a historical tendency for the market to experience a stronger-than-normal rally into year-end, compared to instances when the market experienced negative returns in the week following Black Friday. Last week, the SPX rallied, a positive omen for the rest of the year.
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Indicator of the Week: Big Money Bearish on Financials? By Rocky White, Senior Quantitative Analyst
Foreword: We have proprietary data from the International Securities Exchange (ISE) and Chicago Board of options Exchange (CBOE) that looks specifically at buy-to-open (BTO) option data. At the end of November, I used that data to see if there were any dramatic changes in the behavior of option buyers toward the major exchange-traded funds (ETF).
XLF: Below is a table of some of the major ETFs that I considered. It compares last month's BTO put/call ratio to the other months of 2010. The Financial Select Sector SPDR (XLF) really stands out in this table. The average monthly BTO put/call ratio for the XLF before November was 2.93. But November saw this number drop to 0.45. In other words, before November, traders were buying about three puts for every call, but then in November they bought two calls for every put.
ETF returns
The large number of calls purchased on XLF in November does not mean that the traders expect an increase in financials. In fact, it's probably the opposite. BTO option activity on XLF (and many ETFs) tends to be driven by hedging activity. Traders who buy puts are hedging long positions on individual equities. When they purchase calls, they are typically hedging short positions in financial stocks.
The table below shows the monthly BTO puts (red bars), calls (green bars) and the put/call ratio (black bars) for XLF each month of this year. BTO put volume has been declining for the last several months. BTO calls almost doubled from the month before, and that's how we ended up with the extremely low put/call ratio in November. This suggests that financial stocks are being shorted (with traders buying calls as hedges), which explains the underperformance of the XLF over the last few months compared to the broader S&P 500 Index.
XLF BTO put and BTO call versus put/call ratio
Implications: The big money seems to be bearish on financial stocks. They are shorting the stocks and buying XLF calls to hedge. As long as this persists it will be a significant headwind, and the XLF should continue to underperform the S&P 500. However, if this market gains any traction and begins taking out new highs, or if some good news comes out for this sector, then it could force the shorts to cover or -- even better -- completely surrender and become bullish on financial stocks. In other words, the bearish sentiment may be setting up a fierce rally in this sector. With XLF breaking above its 50-day and 200-day moving averages on the first two days of December, it may already have started. In the case of a market rally, this is a sector where traders might want some exposure.
XLF and its 20-day put/call volume ratio [chart]schaeffersresearch.com/images/commentary/2010/101203iotw3.gif[chart]
This Week's Key Events: The Calm Before Santa Schaeffer's Editorial Staff
It will be a relatively slow week on both the data and the earnings fronts. 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 * There are no major economic reports scheduled for Monday. Dollar General Corp. (DG) and The Pep Boys - Manny, Moe & Jack (PBY) will report earnings.
Tuesday * There are no major economic reports scheduled for Tuesday. AutoZone Inc. (AZO), The Talbots Inc. (TLB), AeroVironment Inc. (AVAV), Casey's General Stores Inc. (CASY), H&R Block Inc. (HRB) and The Men's Wearhouse Inc. (MW) are scheduled to issue their quarterly reports.
Wednesday * We'll get the usual weekly report on crude inventories. Scheduled to report earnings are SAIC Inc. (SAI) and Smith & Wesson Holding Corp. (SWHC).
Thursday * The Labor Department will give us its weekly look at jobless claims. Brown-Forman Corp (BF.B), Ciena Corp. (CIEN), Costco Wholesale Corp. (COST), lululemon athletic inc. (LULU), Smithfield Foods Inc. (SFD), Learning Tree International Inc. (LTRE), National Semiconductor Corp. (NSM), and Pall Corporation (PLL) plan to report earnings.
Friday * The Commerce Department will report on the November trade balance and the University of Michigan will supply its first reading on consumer sentiment in December. There are no major earnings reports scheduled for Friday.
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