| With Hedge Funds on Edge, Are Stocks Doomed to Drop? |
Our options analysis suggests hedged players are losing their appetite for equities
by Todd Salamone 3/24/2012 9:55:14 AM
It was a rocky week for stocks, as traders were preoccupied by signs of an economic slowdown in China. As a result, the S&P 500 Index (SPX) closed lower for the first time in five weeks, while the Dow Jones Industrial Average (DJIA) gave up about 1% by the time the dust settled. However, as Todd Salamone notes, the market remains north of key support levels, suggesting that stocks are simply taking a breather from their breakneck year-to-date surge. According to Todd's analysis, there could be more choppy trading ahead, as a few option-based indicators are pointing to a case of cold feet among big-money players. Meanwhile, Rocky White explains how you can use contrarian analysis to find out which stocks have the muscle to keep climbing in the suddenly wobbly market environment -- complete with a list of potential bullish and bearish picks. Finally, we wrap up with a preview of the major earnings and economic events for the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: Round Numbers and Retracements Come Into Play
By Todd Salamone, Senior VP of Research
"... 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, as the SPX battles the round-number 1,400 area concurrent with the S&P MidCap 400 Index (MID) making its second run in as many years at the 1,000 millennium mark. Overall, we still see a favorable environment for the bulls."
- Monday Morning Outlook, March 17, 2012
"Thirty-four percent of respondents to Bloomberg's monthly consumer expectations survey said the economy was improving, the largest share since January 2004. The pickup boosted the monthly expectations index to the highest in a year. Figures from the Labor Department today showed jobless claims decreased by 5,000 to 348,000 in the week ended March 17, the fewest since February 2008."
- Bloomberg, March 22, 2012
Stocks retreated slightly last week, digesting impressive year-to-date gains so far, as key benchmarks -- such as the Dow Jones Industrial Average (DJIA - 13,080.73), S&P 500 Index (SPX - 1,397.11) and the S&P 400 MidCap Index (MID - 990.93) -- simultaneously battled round-number areas. For example, the DJIA broke out above the 13,000 millennium mark in mid-March, and advanced to nearly 13,300 by expiration Friday, but pulled back to the 13,000 level in last week's trading. The 13,000 area is a 50% retracement of this month's low and high. Meanwhile, the SPX slipped back below 1,400, while the MID enters Monday's trading south of the important 1,000 millennium mark once again. Like the DJIA, the MID's low in the 980 area this past week was at a 50% retracement of the March low and high, while the SPX's low at 1,387 was a 38.2% retracement of the calendar month peak and trough.
As we stated last week, our research on various technical indicators suggests a pause within the uptrend could be at hand, even though some technicians view the same indicators as signs of an imminent correction. The pullback over the past five days was mild, as the SPX continues to trade comfortably above last year's high at 1,370, following a breakout above this level in mid-March.
As major benchmarks trade at key century and millennium marks, one risk we see is that a few institutional players, who had been accumulating stocks earlier this year, have now backed off -- perhaps taking a "wait and see" approach as to how the market behaves, given the numerous calls for a correction.
Evidence that some hedge fund managers are shying away from equities comes from our analysis of option activity, as put buying on major exchange-traded funds has declined, in turn driving put implied volatilities on the SPDR S&P 500 ETF Trust (SPY) lower relative to call implied volatilities (first chart below). As you can see on the second chart below, cumulative put buying at the recent peak never reached the levels of late July 2011, when hedge funds were overweight equities ahead of a 20% decline. But recent put buying on major exchange-traded funds (ETFs) did reach the levels of spring 2011, which preceded a 7% pullback in the SPX.
In the absence of a technical breakdown, the decrease in put buying and the plunge in out-of-the-money put implied volatilities relative to call implied volatilities is not yet alarming, but it remains on our radar, nonetheless. If the market remains in good shape from a technical perspective, we'd expect to see more fund players actively accumulating equities, which would correspond with another increase in put buying.
Whatever materializes over the course of the next few weeks, we remain bullish, and any pullbacks should be used as opportunities to buy your favorite equities. While some fund managers are backing off of equities at present, this group is far from an overweight equity position, even as the market displays strength. Moreover, retail investors are still yanking money out of equity mutual funds, driven by disbelief in an economic recovery. Retail investors still represent enormous buying power, despite the market's surge from the 2009 lows and, more recently, the October 2011 trough.
Resistance for the SPX is in the 1,440-1,450 area, its target after the inverse "head and shoulders" breakout above 1,360. The 1,450 area was also the site of a peak in May 2008. Support lies in the 1,360 area, site of its 40-day moving average and area of the 2011 high. For what it is worth, some traders are keying on the 14-day moving average, which has supported multiple pullbacks since the middle of January, with the exception being the early March decline. The rising 14-day moving average on the SPX is currently sitting at 1,386.40, which corresponds with the 38.2% Fibonacci retracement level referred to earlier.
We still favor homebuilders and the retail/restaurant group, where price action is strong amid skepticism. Financials are another area you can dip your toes into, as we are seeing evidence of these stocks rallying on good news, and holding their own on bad news. For example, Bank of America (BAC) rallied 2.6% on Friday amid a brokerage house downgrade, while Morgan Stanley (MS) surged almost 4% on a broker upgrade
Indicator of the Week: Lessons in Contrarian Trading
By Rocky White, Senior Quantitative Analyst
Foreword: This week I'm going to give a little summary of our contrarian philosophy, along with some simple indicators we use to determine the sentiment surrounding a stock. Finally, I'll use these indicators to create somewhat of a "watch list" for stocks to keep an eye on.
The Basics: Our contrarian strategy is not as simple as taking the opposite side of the public's widely held viewpoint. A stock that goes higher and higher for an extended amount of time will naturally gain a lot of positive sentiment. That does not mean we immediately hate that stock. Going against the price trend is always a tough way to play. We look for stocks where the sentiment is counter to the established trend. In other words, we look for stocks going higher despite a significant amount of pessimism.
Our reasoning is that the pessimism indicates a lot of investors have been avoiding that stock, and are therefore sitting on the sidelines. If that stock continues higher, then at some point, the sentiment will change and that sideline money will (hopefully, all at once) begin to flow into that stock, thereby driving it higher in a short amount of time. The fast and furious rally is especially beneficial to us as option traders.
Indicators: We are constantly monitoring the markets and reading about stocks here at Schaeffer's. We tend to get a feel for the sentiment simply by reading the news and keeping an eye on other media outlets. However, it helps to be able to quantify sentiment, and we do that in a few different ways.
Analyst ratings, for example, are pretty straightforward. Analysts give a buy/hold/sell recommendation on stocks, depending on what they think investors should do. If a stock is trekking higher, but has little to no "buy" recommendations, then the potential is there for upgrades -- which can influence those on the sidelines to buy the stock.
Shorting a stock or buying put options are two ways for investors to profit when a stock falls in price. Therefore, monitoring the changes in short interest and the amount of put buying are ways to quantify negative sentiment on a stock. If there's a large amount of these negative bets being placed on the stock, while it's still moving higher and higher, then we assume there is significant sideline money that can still be deployed to keep the rally going.
Contrarian Stock Plays: As promised, below are some stocks to keep an eye on using some of the indicators mentioned above. I looked over the past six months to see which stocks, despite outperforming the S&P 500 Index (SPX), saw fewer analyst "buy" recommendations, an increase in short interest, and more puts bought to open than calls bought to open. There's more homework to be done on the stocks below, but this may be a good place to start for some contrarian bullish stock plays.
Using the same indicators as above, this next table shows stocks that could be compelling from the short side. In other words, these stocks have been moving lower over the last six months, but analysts and investors keep making bullish predictions. If the underperformance continues, and the bullish investors change their minds on these stocks, you might see a sudden outflow of money -- driving the prices even lower. Specifically, the table shows stocks that are lower over the previous six months, even as short interest has decreased, the percentage of analyst "buys" has increased, and there have been more call options bought compared to put options.
This Week's Key Events: Consumer Confidence Data Rolls In
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.
- The week kicks off on Monday with the pending home sales index, and earnings reports from Cal-Maine Foods (CALM) and Apollo Group (APOL).
- Tuesday's economic calendar features the S&P/Case-Shiller home price index, as well as the Conference Board's latest consumer confidence report. On the earnings front, we'll hear from Charming Shoppes (CHRS), Lennar (LEN), McCormick (MKC), Neogen (NEOG), Walgreen (WAG), Christopher & Banks (CBK), Robbins & Myers (RBN), Sealy (ZZ), and Synnex (SNX).
- On Wednesday, durable goods data and the regularly scheduled crude inventories report will hit the Street. Earnings are due out from AuRico Gold (AUQ), Commercial Metals (CMC), Family Dollar (FDO), Lindsay Corp (LNN), Progress Software (PRGS), Mosaic (MOS), Paychex (PAYX), Red Hat (RHT), Teavana (TEA), and Resources Connect (RECN).
- Thursday's docket includes weekly jobless claims and the final report on fourth-quarter GDP. Best Buy (BBY), Finish Line (FINL), SeaChange (SEAC), Shaw Group (SHAW), Research In Motion (RIMM), TIBCO Software (TIBX), and Xyratex (XRTX) are expected to report earnings.
And now a few sectors of note...
- The week wraps up on Friday with personal income and spending data, the Chicago purchasing managers index (PMI), and the final March reading of the Thomson Reuters/University of Michigan consumer sentiment index. There are no major earnings reports due for release.
Dissecting The Sectors
Outlook: The trend of improving jobs data has continued, with February payrolls surpassing expectations, and the unemployment rate holding steady at its lowest point in nearly three years. In addition to the positive employment news, consumer-level inflation remains relatively tame -- pointing to an improving fundamental backdrop for shoppers, and, by proxy, consumer discretionary stocks. On the charts, the SPDR S&P Retail ETF (XRT) is still a technical outperformer, with the fund tagging a new all-time best of $61.90 last week. Since the March 2009 market bottom, in fact, XRT has rallied an impressive 245%. For those seeking a bullish play in the retail/leisure space, we recommend focusing on stocks in solid technical uptrends that are surrounded by skepticism, which creates the potential for upside surprises. A few of our current favorites include retailers AutoZone (AZO), Advance Auto Parts (AAP), and Whole Foods Market (WFM), along with restaurateurs Chipotle Mexican Grill (CMG), Domino's Pizza (DPZ), and P.F. Chang's China Bistro (PFCB). 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.
Outlook: Housing data continues to come in hot-and-cold, with a major surge in building permits offset by weakness in new and existing home sales. 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 another weekly close above the $20 level, which previously marked the fund's May 2010 peak. Plus, after an earnings miss from KB Home (KBH), XHB found a foothold near the site of its 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 94% 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. 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 names could benefit from upgrades or short-covering activity as the technical and fundamental performance continues to surpass the Street's low expectations.
Outlook: Lately, we've been seeing several danger signs that point to potential short-term weakness for the SPDR Gold Trust (GLD). Looking at the options markets, the fund's front-month put/call implied skew has taken a significant dive from its late-2011 highs. Historically, downturns in this indicator have correlated with weakness in GLD. Along the same lines, total buy-to-open option volume on the ETF has imploded recently -- an occurrence that has previously coincided with periods of range-bound or negative price action for GLD. Meanwhile, 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. 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.
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.