Civil unrest in Egypt brought the January rally to a dead stop last week, and at least temporarily ended the Dow Jones Industrial Average's flirtation with the 12,000 level. Looking ahead, Todd Salamone, Senior Vice President of Research, notes that the Russell 2000 Index and the S&P 500 Index are also trading near key round-number levels, and he reviews some of the short-term risk factors he's written about in recent weeks. Next, Senior Quantitative Analyst Rocky White reports that the so-called January barometer is bullish both for February and the remainder of the year. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Egyptian Riots Break the Spell Schaeffer's Editorial Staff
Earnings and economic reports were mixed. The Fed was cautious. Still, the Dow Jones Industrial Average stubbornly marched on 12,000, and the S&P 500 Index (SPX) briefly tagged 1,300, defying a bearish January bias and the talking heads on TV who insisted that the market was overbought and due for a correction. Then, after major rioting broke out in the streets of Cairo and several other Egyptian cities late in the week, the bulls decided to wait for the smoke to clear, and not just figuratively.
The Dow burst out of the starting blocks on Monday to its first triple-digit advance of the year. Alcoa predicted global demand for aluminum will double by 2020, led by China. Meanwhile, the tech sector got a boost when Intel Corp. (INTC) increased its dividend and stock buyback plan, and Barron's saluted Nvidia Corp. (NVDA) with a bullish rave. The Dow soared 109 points, or 0.92%, bringing 12,000 tantalizingly within view.
Traders took it easy as they waited for the president's State of the Union address Tuesday night and the Federal Open Market Committee's pronouncement on Wednesday. Tuesday's action initially headed south, after Great Britain reported that fourth-quarter gross domestic product (GDP) shrank 0.5%, and the Case-Shiller index showed U.S. housing prices are still in retreat. Blue chips 3M Company (MMM), American Express (AXP), and Johnson & Johnson (JNJ) also weighed in with disappointing earnings. But the Dow fought its way nearly back to breakeven by the end of the day, slipping just 0.03%.
The Fed checked in Wednesday with its first policy statement of the year, and sang a familiar tune: The central bank is cautiously optimistic about the economic recovery, but dismayed that it's not strong enough to reduce unemployment significantly. Therefore, the Fed will stay the course with its bond-buying program, and interest rates will remain near zero for an extended period. The Dow made a brief trip above 12,000, but settled for a smaller advance of 0.07%.
Thursday followed the pattern of the previous two days. Economic reports provided mixed signals, with both jobless claims and pending home sales recording gains. The corporate sector didn't provide much guidance either: Caterpillar (CAT) and Netflix (NFLX) took victory laps in the earnings spotlight, but both AT&T (T) and Procter & Gamble (PG) disappointed. The Dow eked out a tiny gain of 0.04%.
It wasn't enough that earnings from the likes of Ford Motor (F), Microsoft (MSFT), and Amazon.com (AMZN) were found wanting on Friday, along with the Commerce Department's first reading on fourth-quarter gross domestic product. Egyptian President Hosni Mubarak sent troops into the streets of several major cities as protests against the regime grew increasingly violent, and traders took their chips off the table ahead of the weekend. The Dow plunged 166 points, or 1.39%, with all three major market indexes slipping into the red for the week. The Dow fell 0.4% last week, while the SPX lost 0.5%, and the Nasdaq Composite dropped just 0.1%.
What the Trading Desk Is Expecting: Reviewing the Risk Factors By Todd Salamone, Senior Vice President of Research
With the Russell 2000 Index (RUT), Dow Jones Industrial Average (DJIA) and S&P 500 Index (SPX) all trading around key century, or in the case of the Dow, millennium marks, stocks took a hit Friday, as army tanks entered crowded streets in Egypt, after a fourth consecutive day of protests. Friday's sell-off was also driven by an earnings miss by Ford, a tepid forecast by Amazon.com, and a negative reaction to Microsoft's upside earnings surprise, as earnings season continues to be both a positive and negative driver on a day-to-day basis.
The chart below gives you a nice flavor of the past couple weeks' price action, in terms of the robust technical resistance in play at the aforementioned 1,300 century mark on the SPX, and the Dow's failure at the 12,000 millennium mark. In fact, the SPX's price action on Friday looks very similar to the Wednesday and Thursday morning action of the previous week, when the SPX made a quick retreat from the 1,300 area to the 1,270 zone.
The good news for bulls is that hedge fund managers still appear to be under accumulation, as evident by the heavy buy-to-open put volume relative to buy-to-open call volume on major exchange-traded funds that are used as hedging vehicles. When these players purchase index portfolio protection, events like Friday are less apt to create a "sell first and ask questions later" mentality among this particular group.
But a short-term market risk, in addition to those identified last week, is heavy put open interest below current levels acting as "magnets" due to delta-hedge selling, which occurs when sellers of the puts short futures to hedge their own exposure to further declines.
For example, on the SPDR S&P 500 ETF Trust (SPY – 127.72), huge put open interest resides around the 125, 126, and 127 strikes. A break of 127 would likely lead to an immediate decline to 125, at which point we would expect stabilization to occur in the context of option traders squaring their positions. Coincidentally, the 125 area corresponds to the index's rising 50-day moving average.
SPY total call and put open interest
While we are on the SPY, a note of encouragement could be the huge SPY volume on Friday, which was on par with levels that have marked bottoms during declines going back to mid-July 2010. These specific instances are marked with circles, and must occur within the context of an extended short-term decline or big down day.
Here is a quick review of the risk factors that we have identified during the past couple of weeks, with parenthetical updates:
1. January has not been seasonally strong during the past 10 years, marking various corrections or beginning of corrections... (Days like Friday make one wonder if this is the start of another January correction, as major indexes get rejected at key psychological round-number resistance. Friday's action pushed small caps into the red for the year, while the SPX remains in the black, albeit barely.)
2. The CBOE Market Volatility Index (VIX) is trading at a significant premium to SPX historical volatility, and this premium has rolled over from its highs. Such high premiums amid a rollover have preceded setbacks.... (Historical volatility on major indexes has risen since the rollover of the VIX premium at the end of last year, but rising historical volatility occurred within the context of advancing stock prices – until Friday's setback. Implied volatility is still double that of historical volatility, which means this indicator continues to dictate caution).
3. Equity option players hit an extreme in call buying relative to put buying two weeks ago ... (these players continue to become a little less enthusiastic, but the continued unwinding of optimism remains a risk factor).
Short-term risk-reward seems to be balanced from a chart perspective, but there is a lot riding on how hedge fund managers will react to this pullback. For now, pullbacks should be viewed as buying opportunities, but we continue to strongly urge that you have portfolio protection in place to weather short-term setbacks.
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Indicator of the Week: The January Barometer By Rocky White, Senior Quantitative Analyst
Foreword: The January Barometer is a well-known stock market indicator. The principle behind it is that the market's performance in January sets the tone for the rest of the year. Below is data on the Dow Jones Industrial Average since 1950. Look at the huge difference in returns when January is positive compared to when it is negative. The first month of the year has been a very good guide for the rest of the year. When January is positive the rest of the year has been positive 82% of the time, averaging a return of 9.76%. If January is negative, then the average return is just about 2% and is positive only half the time.
Average Dow return since 1950 through the rest of the year
January Barometer for February: For option traders like us, a year is a pretty long holding period. So I looked to see if the January Barometer works for predicting February. This table shows how the Dow has performed in February depending on January's return. Again, January's momentum carries forward. When January is positive, February averages a gain of 0.51%. If it's negative, then January averages a loss of about 1%.
Average Dow return in February since 1950
Implications: The January Barometer has been a good indicator in the past, and hopefully the trend will continue. The Dow is up over 2.1% so far this year, with one more trading day to go in January. Below shows Dow data for each year that had a positive January since 1990. We see 12 occurrences, with 10 of those leading to a positive return for the rest of the year. In that table, the rest of the year averages a return of more than 11%. I think we can live with that.
Dow returns in January and February since 1991
This Week's Key Events: Earnings Parade Continues, and Jobless Figures Are Due 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 Commerce Department will issue personal income and spending figures for December, and the Chicago purchasing managers' index will offer some insight into manufacturing health in that area in January. Exxon Mobil Corp. (XOM), Gannett Co. Inc. (GCI), Illinois Tool Works Inc. (ITW), Sohu.com Inc. (SOHU), Anadarko Petroleum Corp. (APC), Baidu.com Inc. (BIDU), Eastman Chemical Co. (EMN), and McKesson Corp. (MCK) will report earnings.
Tuesday * The Commerce Department will report on construction spending in December and the Institute for Supply Management (ISM) will provide a snapshot of manufacturing activity nationally in January. We'll also get auto sales figures for January. Scheduled to report earnings are Archer Daniels Midland Co. (ADM), ArvinMeritor Inc. (ARM), Cummins Inc. (CMI), Patriot Coal Corp. (PCX), Pfizer Inc. (PFE), Tupperware Brands Corp. (TUP), United Parcel Service Inc. (UPS), AFLAC Inc. (AFL), Boston Scientific Corp. (BSX), Broadcom Corp. (BRCM), Electronic Arts Inc. (ERTS), Massey Energy Co. (MEE), and MEMC Electronic Materials Inc. (WFR).
Wednesday * Challenger Gray & Christmas and ADP will give us separate looks at the employment picture. We'll also get the usual weekly report on crude inventories. AOL Inc. (AOL), Cincinnati Financial Corporation (CINF), Convergys Corp. (CVG), Genworth Financial Inc. (GNW), The Hershey Company (HSY), Magellan Midstream Partners L.P. (MMP), Manpower Inc. (MAN), Marathon Oil Corp. (MRO), Mattel Inc. (MAT), Time Warner Inc. (TWX), Whirlpool Corp. (WHR), ACE Limited (ACE), AvalonBay Communities Inc. (AVB), Bally Technologies Inc. (BYI), BMC Software Inc. (BMC), GT Solar International Inc. (SOLR), Hanesbrands Inc. (HBI), Hartford Financial Services (HIG), NetLogic Microsystems Inc. (NETL), Visa Inc. (V), and Yum! Brands Inc. (YUM) plan to report earnings.
Thursday * The Labor Department will give us its weekly look at jobless claims. Meanwhile, the Commerce Department will report on factory orders in December and the ISM will report on January activity in the service sector. AutoNation Inc. (AN), Cardinal Health Inc. (CAH), CIGNA Corp. (CI), CME Group Inc. (CME), CVS Caremark Corp. (CVS), Diamond Offshore Drilling Inc. (DO), The Dow Chemical Company Inc. (DOW), The Estee Lauder Companies Inc. (EL), Goodrich Corp. (GR), International Paper Company (IP), ITT Corp. (ITT), Kellogg Company (K), MasterCard Inc. (MA), Starwood Hotels & Resorts Worldwide Inc. (HOT), American Financial Group (AFG), Fiserv Inc. (FISV), Las Vegas Sands Corp. (LVS), and Sunoco Inc. (SUN) will report earnings.
Friday * The Labor Department will conclude the week with the always anticipated nonfarm payrolls report and the unemployment rate. Aetna Inc. (AET), Aon Corp. (AON), The Clorox Company (CLX), Fortune Brands Inc. (FO), PPL Corporation (PPL), PulteGroup Inc. (PHM), Tyson Foods Inc. (TSN), and Weyerhaeuser Company (WY) will report earnings.
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