Amid Mixed Technical Signals, Three Reasons for Bulls to Keep the Faith The action in VIX since earnings season began bodes well for buyers by Todd Salamone 4/21/2012 9:30:20 AM
April expiration week was a rather haphazard one for stocks. The Dow Jones Industrial Average (DJIA) logged its first weekly gain of the second quarter, while the S&P 500 Index (SPX) barely clawed its way onto positive ground. Meanwhile, with Apple (AAPL) still in free-fall mode, the tech-heavy Nasdaq Composite (COMP) racked up its third straight weekly loss. As the major equity indexes hover around historically significant round-number levels, Todd Salamone warns that we probably haven't seen the last of these persistent technical crosswinds. However, Todd cites a few points in the bulls' favor, which suggest this lengthy chop could eventually resolve itself to the upside. Meanwhile, Rocky White shares a list of stocks have been heavily targeted by May-dated put players, in the hopes of unearthing some potential contrarian plays for the new expiration cycle. Finally, we wrap up with a preview of the key economic and earnings events for the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: Beware of Technical Crosswinds By Todd Salamone, Senior VP of Research
"We'll leave it as follows: Some technical indications are being thrown around as corrective warnings, yet our own research on these same indicators suggests a pause could be at hand, but not necessarily a correction. Sideways, choppy action within the current uptrend would not be a surprise." - Monday Morning Outlook, March 17, 2012
"A pullback like we saw in late February and early March would push the SPX down to the 1,370 area -- which we view as support, given it is the site of the 40-day moving average and last year's high. Potential resistance is in the 1,450-1,470 zone, the SPX target after the inverse 'head and shoulders' breakout above 1,260 and site of the May 2008 peak."
"...first-quarter earnings season is only a couple of weeks away, and it appears analysts aren't expecting much. Low analyst expectations set the stage for positive surprises." - Monday Morning Outlook, March 31, 2012
"Quarterly earnings this round have been surprisingly strong. Of the 113 companies in the S&P 500 that had reported quarterly results as of early Friday, 92 beat expectations, while 12 matched and just 9 came up short, according to Capital IQ. Analysts are expecting overall S&P 500 first-quarter earnings to climb 6%, with revenues edging up 5%." - CNNMoney, April 20, 2012
In mid-March, with the S&P 500 Index (SPX) at 1,404, we observed that a period of sideways, choppy action within the longer-term uptrend would not be a major surprise. Major equity benchmarks were bumping up against potential resistance, and option activity suggested professional investors were no longer in accumulation phase, with correction warnings abundant. Since that period, we have indeed experienced choppy price action, with a very mild pullback from the highs and the 1,370 area on the SPX generally being supportive.
30-Minute Chart of SPX since March 15, 2012
During the past couple of weeks, the choppy price action can be attributed to a flood of alternating negative and positive headlines -- in addition to mixed technical signals, with some indexes trading above round-number support areas, as other benchmarks trade beneath round-number levels.
The major negative headline is euro-zone sovereign debt concerns coming into play again. Worries are mounting that the European Central Bank's (ECB) emergency loans are about to run dry, even as European banks continue to utilize these funds to buy debt. As a result, yields on Spanish bonds have risen above 6%, unnerving investors. At the same time, on the domestic front, the good news is that first-quarter earnings season is off to an impressive start, thanks in part to toned-down expectations. The market is trading slightly higher since the official beginning of earnings season on April 10, which is when the CBOE Market Volatility Index (VIX - 17.44) peaked 50% above its mid-March low.
As alluded to earlier, we find it interesting that some key U.S. equity benchmarks are trading just under key round-number areas, while others trade just above key round-numbers -- creating potential crosswinds, from a technical perspective. Consider the following:
The Nasdaq Composite (COMP - 3000.45) has pulled back to the 3,000 millennium mark, which is also site of its 60-day moving average. In mid-March, the COMP broke above 3,000 after trading below this mark since November 2000.
The Russell 2000 Index (RUT - 804.05) is just above the 800 century level. This is also the site of its 80-day moving average, which was supportive during a mini-pullback in mid-December.
The S&P 500 Index (SPX - 1,378.53) is back below 1,400, after first crossing above this level in mid-March. Like the COMP, the 60-day moving average is just below current levels at 1,371.20, and this moving average roughly coincides with last year's high.
The S&P MidCap 400 Index (MID- 976.35) is trading below the key 1,000 millennium mark, which has consistently acted as a brick wall, dating back to last year's first-ever attempt to break through this level.
The above technical and fundamental crosswinds could last for several weeks, but bulls should find it encouraging that:
The price action has been somewhat muted relative to previous pullbacks induced by European sovereign debt issues. We think this is due to the fact that major players, such as hedge funds, have not been as heavily exposed to stocks, and therefore there are fewer sellers. That said, a break below this month's lows would jeopardize this bullish point.
The market was relatively resilient from mid-March up until last week, a period during which option activity suggested hedge fund managers -- who represent a tremendous source of buying power and support for the market -- were no longer in accumulation mode. At present, and as discussed last week by Senior Technical Strategist Ryan Detrick, the return of put buying on major equity exchange-traded funds (ETFs) and call buying on CBOE Market Volatility Index (VIX - 17.44) futures suggests these participants might be nibbling at current levels, providing support on pullbacks. In fact, on Friday, VIX call volume was more than four times VIX put volume. The VIX has plenty of room to move lower before retesting its March lows, even though Twitter sentiment suggests the VIX is "cheap."
The VIX peaked at 21.06 on April 10 when earnings season began, continuing a series of lower highs in place since the beginning of the year. The peak this month was 50% above the mid-March low, continuing the uncanny behavior in which the VIX tends to peak 50% above -- or double or triple -- its previous lows, and find floors at half prior highs. If the VIX would advance comfortably above 21, though, this is another bullish point that could be invalidated. (For more on the uncanny price action in the VIX over the past couple years, see the commentary I wrote in late March.)
Daily Chart of VIX since January 2012
If you are looking to add equity exposure, a sector we remain bullish on is homebuilding, and the pullback during the past month could be an opportune time to add exposure to this group.
Indicator of the Week: The May Expiration Cycle By Rocky White, Senior Quantitative Analyst
Foreword: Option traders like us don't often look at the calendar the same way others do. Rather than looking at calendar months, option traders tend to look from one monthly expiration cycle to the next. Last week marked the expiration of April-dated options, so now we're starting the May expiration cycle. The table below shows that since 2006, April has been the most bullish expiration month for the S&P 500 Index (SPX), based on average return -- and December is the only month without a losing expiration cycle since 2006 (April was actually the same way, until this last cycle). May, you'll see, has been a rather weak expiration cycle for the market, with the SPX averaging a loss of 0.75%. However, this has been skewed by a couple of very poor months -- specifically, an 8.8% loss in 2010 and a 3.4% loss in 2006. Most of the time, in fact, the May cycle has been positive (67% of the time).
S&P 500 Returns by Expiration Cycle since 2006
Front-Month Put/Call Ratio: One thing I noticed is that the May series is quite heavy in puts on the SPDR S&P 500 ETF Trust (SPY), which is the tracking ETF for the SPX. Going back to 2010, this has been a bad sign for stocks. There have been 28 expiration cycles since then. If you split up the expiration cycles from highest put/call ratios to the lowest, then you arrive at the data set below. When the front month put/call ratio is very high, you get an average loss of 0.47%, with only 57% positive. However, if the expiration cycle starts off with a very low put/call ratio, then you get an average gain of 2.32%, and almost 80% are positive.
SPY Returns
This is why May being very put-heavy is a cause for concern. In fact, the current put/call ratio for SPY options when looking at May expiration is 3.09. There have only been four other times when the ratio has been above three. Three of those four times were negative, including the 14% loss suffered during the August 2011 cycle.
SPY Expiration Cycle Returns
Individual Stocks to Watch: Since options are often used to speculate on individual stocks, we look for equities with high put/call ratios as potential contrarian trading opportunities. Below are stocks with sufficient May open interest that have at least twice as many puts as calls in the newly front-month series, despite the shares outperforming the market. The heavy put open interest indicates pessimism -- and, therefore, a lot of sideline money. If these stocks continue to outperform, a capitulation by these bears could create a sudden and powerful rally.
Individual Stocks to Watch
This Week's Key Events: All Eyes on Fed Decision, First-Quarter GDP 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
There are no major economic reports scheduled for Monday. Netflix (NFLX), Texas Instruments (TXN), Hasbro (HAS), ConocoPhillips (COP), D.R. Horton (DHI), SunTrust Banks (STI), and Zions Bancorporation (ZION) are all due to take their turns in the earnings confessional.
Tuesday
Tuesday features the S&P/Case-Shiller home price index, new home sales, and the Conference Board's latest consumer confidence report, while the Federal Open Market Committee (FOMC) will kick off its two-day meeting. Companies scheduled to report earnings include Apple (AAPL), 3M Company (MMM), AT&T (T), Amgen (AMGN), AK Steel (AKS), U.S. Steel (X), Baidu (BIDU), Juniper Networks (JNPR), Questcor Pharmaceuticals (QCOR), ARM Holdings (ARMH), and Reynolds American (RAI).
Wednesday
The FOMC will announce its latest policy decision at 12:30 p.m. Eastern on Wednesday, to be followed by a 2:15 p.m. press conference with Fed Chairman Ben Bernanke. Durable goods data and the regularly scheduled crude inventories report will also hit the Street. Earnings results are due out from Caterpillar (CAT), Boeing (BA), Eli Lilly (LLY), Corning (GLW), Sprint Nextel (S), Cirrus Logic (CRUS), Citrix Systems (CTXS), Cliffs Natural Resources (CLF), Harley-Davidson (HOG), Cheesecake Factory (CAKE), Lorillard (LO), Ryland Group (RYL), Zipcar (ZIP), and Xilinx (XLNX).
Thursday
Thursday's round-up will include weekly jobless claims and pending home sales. Wall Street can expect earnings reports from Exxon Mobil (XOM), Amazon.com (AMZN), Starbucks (SBUX), PepsiCo (PEP), Kellogg (K), United Parcel Service (UPS), Aetna (AET), Bristol-Myers Squibb (BMY), Colgate-Palmolive (CL), Dow Chemical (DOW), Coinstar (CSTR), JetBlue Airways (JBLU), Zynga (ZNGA), Meritage Homes (MTH), PulteGroup (PHM), Potash Corp. of Saskatchewan (POT), and Tyco International (TYC).
Friday
The week wraps up on Friday with the advance report on first-quarter GDP, and the final Thomson Reuters/University of Michigan consumer sentiment index for April. Procter & Gamble (PG), Chevron (CVX), Merck (MRK), Goodyear Tire & Rubber (GT), American Axle & Manufacturing (AXL), and Newmont Mining (NEM) are slated to reveal their quarterly earnings.
And now a few sectors of note...
Dissecting The Sectors Sector Leisure/Retail Bullish
Outlook: The jobs market appears to have hit a soft patch lately, with March payrolls falling short of expectations. However, the four-week moving average of first-time jobless claims remains near a four-year low, and consumer-level inflation edged up at a slower pace last month -- pointing to an improving fundamental backdrop for shoppers, and, by proxy, consumer discretionary stocks. In fact, retailers managed a composite same-store sales gain of 6.9% for March, surpassing the 5.3% improvement predicted by analysts. What's more, overall retail sales improved 0.8% last month, blowing past the consensus analyst estimate of 0.3%. On the charts, the SPDR S&P Retail ETF (XRT) is still a technical outperformer, with the fund reclaiming a foothold above its 10-week moving average by Friday's close. For those seeking a bullish play in the retail/leisure space, we recommend focusing on stocks in solid technical uptrends that are surrounded by negative sentiment, which creates the potential for upside surprises -- especially with a number of restaurant stocks due to report earnings over the next several weeks. A few of our current favorites include retailers AutoZone (AZO), Advance Auto Parts (AAP), Macy's (M), Limited (LTD), and Whole Foods Market (WFM), along with restaurateurs Chipotle Mexican Grill (CMG) and Domino's Pizza (DPZ). With skepticism still lingering toward these consumer-dependent stocks, contrarians can continue to capitalize on situations where sentiment has yet to catch up with the bullish technical performance. Sector Homebuilding Bullish
Outlook: Housing data continues to come in hot-and-cold, with a surprise drop in housing starts offset by an unexpected surge in building permits. However, a batch of coolly received reports in recent weeks gave the SPDR S&P Homebuilders ETF (XHB) a chance to fill in its bullish gap from Feb. 3. In fact, XHB on Friday notched a seventh consecutive weekly close above the $20 level, which previously marked the fund's May 2010 peak. The shares have also established a foothold near the site of their February highs, in the $20.50 area. From here, the fund still has room to rally up to $23.25 -- which is half its all-time high, reached only three months after XHB was launched in 2006. Despite the improving price action in the sector, analysts remain overwhelmingly negative. With 91% of builders trading above their 200-day moving averages, these names have attracted only 42% "buy" ratings from brokerage firms. However, a recent preponderance of put buying on XHB suggests that hedged players are starting to dip their toes into housing stocks, which could be a boon for the group during the near term. In fact, the 50-day buy-to-open put/call volume ratio for the fund is now resting near its highest level since 2007, which indicates that big-money investors are actively acquiring shares of sector components. As further evidence, Goldman Sachs is launching a fund to buy home-loan bonds, with the investment giant asserting that "stabilization in U.S. housing fundamentals is creating an attractive investment opportunity." Some of our preferred names in the sector are Lennar (LEN), Toll Brothers (TOL), Meritage Homes (MTH), PulteGroup (PHM), and D.R. Horton (DHI), all of which sport relatively high short-to-float ratios. Going forward, these stocks could benefit from upgrades or short-covering activity as the technical and fundamental performance continues to surpass the Street's low expectations. As a point of caution, Barron's just featured an optimistic cover story titled "Home Prices Ready to Rebound" -- suggesting some optimism may be priced in, and the XHB could pull back in the short term. However, a pullback that is contained above $20 would be healthy, in our view, as we still believe in the potential reward in this sector. What's more, the bullish cover is not out of touch with the positive price action, making the contrarian implications less relevant. Sector Gold Bearish
Outlook: Lately, we've been seeing several danger signs that point to potential short-term weakness for the SPDR Gold Trust (GLD). First, as Jim Paulsen of Wells Capital Management recently observed, valuations for the underlying metal relative to stocks, bonds, and other assets have soared off the charts lately, hinting that a correction may be overdue -- particularly as gold sheds its "fear premium" in the face of recovering consumer confidence. Looking at the options markets, total buy-to-open option volume on the ETF imploded recently, and continues to decline. This occurrence has previously coincided with periods of range-bound or negative price action for GLD. Meanwhile, the fund's front-month put/call implied skew has recovered from its recent lows, but this has yet to provide any kind of meaningful bid for the shares -- marking a deviation from past trends. From a technical perspective, the outlook is similarly unsettling. The fund turned lower in late February after an unsuccessful test of resistance in the $175 area, and GLD has since plummeted through its 140-day moving average. This trendline has played a key role as both support and resistance in the past, and it's currently serving as a stubborn technical ceiling. Plus, the fund finished each of the past three sessions below the $160 level, suggesting that support here is weakening. Even more troubling, we've started to see some bullish coverage on gold in the financial media. From a contrarian perspective, this optimism in the face of deteriorating price action has distinctly bearish implications. That said, we're keeping a close eye on GLD's 320-day moving average, which could limit downside during the short term.
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