Schaeffers<>Monday Morning Outlook: Two Signs of Trouble for Small- and Mid-Cap Stocks The RUT and MID ended September beneath historically significant technical levels by Todd Salamone 10/1/2011 11:59 AM
The uniformly dismal third quarter is finally over -- but with burning questions about the state of the global economy still unanswered, what do investors have to look forward to? Friday's session ended with a thud, as Wall Street weighed softer manufacturing activity out of China and higher consumer prices in the euro zone, which raised questions about the European Central Bank's ability to accommodate the region's dicey fiscal situation. Plus, we're on the cusp of three solid days' worth of U.S. jobs data, which seems an unlikely source of inspiration, at best.
From a technical standpoint, Todd Salamone notes that the S&P 500 Index still remains well within the confines of its recent trading range. On the other hand, an apparent breakdown for small- and mid-cap stocks gives the bulls cause for concern -- particularly as sentiment continues to deteriorate among big-money players. Meanwhile, Rocky White weighs the historically bearish implications of the Dow's five-month losing streak against typically sunny fourth-quarter seasonality. Finally, we wrap up with a preview of the key economic and earnings events for the week ahead, featuring Friday's nonfarm payrolls report for September.
Notes from the Trading Desk: Hedge Fund Managers Grow Increasingly Gloomy By Todd Salamone, Senior VP of Research
"With equities pulling back to potential long-term support areas as negative sentiment continues to grow, now is a good time to add equity exposure to your portfolio for a potential rally back to the resistance areas discussed last week. But be careful if there is a break of support, as short-covering activity or a shift from other assets will not be as urgent, undermining the potential reward for the risk you are taking." - Monday Morning Outlook, September 24, 2011
Coming into last week's trading, the major market indexes were sitting just above significant support areas -- and buyers stepped up to the plate quickly, with the S&P 500 Index (SPX - 1,131.42) rallying 5% by Tuesday afternoon. Unfortunately, that rapid surge higher brought technical resistance levels back into play, and the advance was over almost as soon as it started. The SPX ran up near the top of the recent range, to the 1,200 area, but the index was once again turned back, as sellers proved to be just as powerful as the early-week buyers. For bulls, it was a disappointing end to the week, as Thursday's much-anticipated German vote to approve the expansion of the European Financial Stability Facility (EFSF) failed to provide lasting inspiration for investors.
As we enter this week's trading, the SPX remains locked in the same volatile trading range that has been in place since early August. The sideways channel formed after the SPX had experienced a two-week, 17% decline from its calendar-year highs. 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.
From a technical perspective, other concerns include the continued deterioration in the technical backdrop of small- and mid-cap stocks, as evidenced by the following developments:
The Russell 2000 Index (RUT - 644.16) closed below 650, which was the site of resistance in 2005 prior to acting as support in early 2008.
For the first time since September 2010, the S&P 400 MidCap Index (MID - 781.26) experienced a monthly close below 800, which is double its 2009 low. The index remains above its 80-month moving average, situated at 766.80 -- a trendline that marked major lows in 2002 and 2010.
As we move into the final quarter of the year, there is not a strong consensus as to whether or not this range will resolve itself to the upside or the downside. However, a recent Reuters poll of global strategists indicated that the SPX would be modestly lower by year's end. In fact, our analysis of option activity on major exchange-traded fund (ETF) options suggests that hedged players could be looking for weakness immediately ahead -- which marks a change from the past few weeks, when we saw evidence that this group was split.
For instance, we are now seeing a roll-over in the 20-day combined buy-to-open put/call ratio on the SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 Index Fund (IWM) and PowerShares QQQ Trust (QQQ), after a period in which this ratio turned higher. When the ratio is advancing, it is usually evidence that hedge fund managers are buying stocks, as they simultaneously purchase these puts to hedge the long equity positions they're accumulating.
Another hedging tool for those accumulating equities are call options on the CBOE Market Volatility Index (VIX - 42.96), as the VIX will usually advance sharply in the event of a correction. Thus, the profit from the call options could cushion equity losses. But, during the past 20 days, VIX puts have been in heavier demand than VIX calls. During the past several weeks, the VIX's buy-to-open call/put ratio has fallen below 1.0, due to a surge in put buying and a significant decrease in call buying. This could be a signal that the hedge fund world is positioning for a weaker market ahead, and using VIX puts to hedge growing short positions. The market has tended to struggle as this group turns negative, which they appear to be at the moment.
The only piece of good news in the chart below 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 (second chart below).
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.
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