28/6/2014 3 Signs of Hope for Bulls

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3 Signs of Hope for Bulls
Taking a historical look at third-quarter SPX returns
by Todd Salamone 6/28/2014 8:18 AM
Keywords: SPX DJIA RUT stocks options commodities currency economy education
Escalating tensions in Iraq and hawkish comments from St. Louis Fed President James Bullard
pressured most U.S. markets last week, although bursts of late-session buying power helped ease
the blow. By the time the closing bell sounded on Friday, the Dow Jones Industrial Average and
broader S&P 500 Index were sitting slightly in the red for the week. Bucking the trend lower,
however, was the tech-laden Nasdaq Composite, which managed to notch a second consecutive
weekly win. Heading into the third quarter, Todd Salamone highlights three contrarian indicators
that could help buoy markets during a historically bearish period.
3 key benchmarks face off with critical technical levels
Why we're keeping a close eye on this indicator
Rocky White offers up 17 stocks that tend to outperform in the third quarter
Finally, we close with a preview of the major economic and earnings events for the week ahead,
plus our featured sector.
Notes from the Trading Desk: Why Complacency May Not Be as Widespread as Advertised
By Todd Salamone, Senior VP of Research
"With 1,900 on the S&P 500 Index (SPX - 1,949.44) in the rear-view mirror, and now
targeting 1,980-2,000 (1,980 is the target for the inverse head-and-shoulders
breakout pattern, and 2,000 is triple the 2009 low), traders should not lose sight of
the historical significance of half-century marks on the SPX as the index approaches
1,950 ... the SPX either hesitated for a couple weeks to a couple months around such
half-century marks (1,550 and 1,750), or became unstable after moving above a
half-century level (1,650). The 1,650 level, in fact, was first tested in May 2013, but
was not cleared for good until marking a bottom in early October, after a 4%
pullback that lasted just under a month."
-Monday Morning Outlook, June 7, 2014
"After another $22 billion in new capital was allocated to hedge funds in May, the
industry now has surpassed $3 trillion in assets under management for the first time
on record."
-24/7 Wall St., June 25, 2014
"4.5% increase in $SPX component short interest, which is far above the '12 lows -
and there is a lack of fear?"
-@ToddSalamone on Twitter, June 26, 2014
"At least five Wall Street firms on Thursday slashed their growth forecasts for the
current quarter. Among them, Goldman cut its second-quarter GDP target to 3.5%
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from 4.1%. Barclays went to 2.9% from 4.0% and RBS trimmed its target to 2.2%
from 2.7%."
-The Wall Street Journal, June 27, 2014
Despite weak economic reports -- including lower-than-expected gross domestic product (GDP)
data -- and persistent warnings from market technicians that low volatility is indicative of
complacency in the marketplace, U.S. equities displayed some resilience this past week, when
various headlines could have easily shaken market participants. This resilience suggests that
complacency is not as widespread as advertised (more on this to follow).
The S&P 500 Index (SPX - 1,960.96) has moved into another choppy pattern during the past
seven trading days. The half-century mark of 1,950 has become an important level recently, as
we speculated could happen a few weeks ago. It acted as resistance earlier in the month, and,
following a June 18 breakout above this level, it was retested on two separate days last week.
We still think a move into the 1,980-2,000 level is possible, but it will not be a huge surprise if
1,950 is revisited multiple times as we move through the summer months. As the SPX challenges
its half-century mark, other key benchmarks could be challenged by round numbers just overhead.
For example, per the study below, millennium levels on the Dow Jones Industrial Average (DJI -
16,851.84) have proven to be short-term speed bumps since 10,000 was first touched in 1999.
Since Dow 10K, the Dow Jones Industrial Average has displayed weaker-than-normal price
action in the one to two weeks after rallying to a millennium mark that has never been
touched:
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Moreover, the round 1,200 century mark on the Russell 2000 Index (RUT - 1,189.50) lingers just
overhead, after a failure at this level in March. This round number is 10% above the May lows,
which were being carved out over a two-week period. So, not only is there the potential for
sellers to emerge as the March highs are tested, but profit-taking could also surface amid those
timely traders who bought the May lows.
The RUT 1,090 level served as support in January and May, while the 1,200 area continues
to shape up as potential resistance
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A contrarian indicator that we have been following closely the past few weeks reflects the
sentiment among equity option speculators, who were at a bearish extreme ahead of the SPX's
breakout above the 1,900 century mark in late May. This group has grown increasingly optimistic
the past few weeks, as the unwinding of fear continues among these traders. Right now, the 10-
day average of buy-to-open put volume relative to call volume is nearing the levels of January,
which preceded a 5% SPX pullback. As long as the direction of this ratio continues south, the
market is likely to advance. However, if the sentiment shifts and this ratio heads higher, the
market becomes at increasing risk of another pullback. As such, we'll continue to closely monitor
this indicator.
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While equity option traders have become believers of late, there is little evidence that
complacency -- the type that usually precedes a bear market or double-digit SPX correction -- is
widespread. For example, note in the latest reporting period that SPX component short interest
increased 4.5%, and still remains far above the "complacent" levels that existed prior to the last
10% correction levels that we witnessed in 2011. The fact that short interest moved higher amid
a breakout above resistance suggests there is still a healthy dose of caution, and such caution
represents future buying power that is likely to keep pullbacks muted and/or be a driver for a
breakout above the potential resistance levels we discussed above.
Moreover, as one of the excerpts at the beginning of this report suggests, note that big dollars
continue to be directed toward the hedge fund industry, as investors seek alternative investments
outside the U.S. stock market. Whether they are directing cash to other assets, or markets
outside the U.S., or using the flexibility that hedge funds offer to make both long and short bets
against the market, the fact is that the hedge fund industry is still growing by leaps and bounds.
This is occurring in the context of performance that is not deserving of these inflows, and as the
market grinds higher in impressive fashion to new all-time highs. In other words, such flows into
hedge funds are not supportive of a "complacent" marketplace. In fact, even though $93.3 billion
has flowed into hedge funds in 2014, only $3.75 billion has flowed into U.S. equity funds --
including outflows in April, May, and June that have totaled $15.1 billion (see the table below the
short interest graph).
We continue to favor U.S. stocks, so maintain long exposure, and view pullbacks as buying
opportunities.
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Fund flows are not indicative of complacency toward U.S. stocks
Indicator of the Week: Quarterly Numbers
By Rocky White, Senior Quantitative Analyst
Foreword: With Monday marking the end of the second quarter, I'll be taking a look at how
stocks have done in the past, depending on the quarter. The S&P 500 Index (SPX) is up nearly
5% for the quarter, so I think it's safe to assume this will be the sixth straight positive quarter in
a row for the index. I'll look at past data and see if we can get a sense as to how long the streak
might last. Finally, Monday is also quarterly expiration for the major indexes. I'll see how stocks
have done historically following those events.
S&P 500 Returns by Quarter: The tables below summarize how the SPX has done in each
quarter over the past 20 and 50 years. You can see in more recent times the third quarter has
been the laggard of the group. It's the only quarter averaging a loss over the past 20 years. It
has also been the worst-performing quarter over the past 50 years, based on average return.
Looking at the standard deviation over the past 50 years, the third quarter has been the most
volatile, as well. Stocks have a tendency to underperform from July through September.
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Six in a Row: I noted earlier that this will be the sixth straight positive quarter for the SPX. That's
the longest streak since 1996. In fact, that previous streak was the longest ever for the SPX
(data back to 1928), lasting a full two more years. It finally ended when the third quarter of 1998
was negative.
The table below shows all of the previous times when the SPX had six straight positive quarters.
The index has gained about 37% during the current streak, which is the second lowest return on
the table. You can see that in the past, after six straight positive quarters, the next quarter has
typically been pretty strong -- averaging a gain of 4.09%. In addition, the streak went on to at
least seven quarters all but one time. Moreover, the next year's returns have been pretty good
compared to typical SPX returns.
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Individual Stocks: Finally, below is a list of stocks that have performed best in the third quarter
over the past 10 years. I considered all optionable stocks meeting some basic liquidity
requirements, based on average daily stock volume and open interest. These are all stocks in
which more than 80% of the returns were positive.
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This Week's Key Events: Home, Auto Sales Upcoming
Schaeffer's Editorial Staff
Here is a brief list of some key market events scheduled for the upcoming 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 Chicago purchasing managers index (PMI) and the Dallas Fed's manufacturing survey
are scheduled for Monday, along with pending home sales data. There are no significant
earnings reports scheduled.
Tuesday
The latest reports on construction spending and motor vehicle sales will come out on
Tuesday, as well as Markit's PMI and the Institute for Supply Management's (ISM)
manufacturing index. Acuity Brands (AYI) and Paychex (PAYX) will step into the earnings
confessional.
Wednesday
The regularly scheduled crude inventories update, factory orders data, and the Automatic
Data Processing (ADP) employment report will be released on Wednesday. Furthermore, Fed
Chair Janet Yellen is scheduled to speak at the International Monetary Fund (IMF) central
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banking conference. Constellation Brands (STZ) will report quarterly earnings.
Thursday
Although markets will close at 1:00 p.m. ET on Thursday, the economic calendar is chock-
full. Specifically, weekly jobless claims, international trade data, and the ISM non-
manufacturing index will hit the Street on Thursday. Additionally, Wall Street will get an
early look at the Labor Department's nonfarm payrolls report, which is being released a day
ahead of schedule due to the Fourth of July holiday. No notable names are slated to report
earnings.
Friday
Markets are closed on Friday in observance of Independence Day.
And now a sector of note...
Energy
Bullish
The Energy Select Sector SPDR Fund (XLE) reached another all-time high on Monday before
consolidating some of its gains just above the round-number $100 level to finish the week. This
wasn't unexpected, as we noted last week that the ETF's 14-day Relative Strength Index (RSI)
was in overbought territory at 85. Regardless, the ETF is still sitting with a year-over-year gain of
more than 27%. Despite XLE's technical prowess, skepticism remains evident among speculative
players. Specifically, XLE's 10-day put/call volume ratio of 9.71 on the International Securities
Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) ranks in
the 94th percentile of its annual range. This reading has popped higher from last week's ratio of
7.69 (in the 94th percentile). Simply stated, puts have been bought to open over calls at an
accelerated clip in recent weeks. What's more, a recent Merrill Lynch-Bank of America survey
found hedge funds are underweight the energy sector, relative to other sectors and historical
weightings in the group. However, the uptick in XLE put buying may indicate the firms are starting
to buy shares of the ETF -- using the options as a hedge -- which could fuel another leg higher.
At the same time, pessimism toward the energy sector is witnessed in the Market Vectors Oil
Services ETF (OIH). Over the past year, the percentage of analyst "buy" ratings toward the 37
stocks we track in this basket has declined to 52% from 62%, while short interest on the
component stocks has surged over 49%. In fact, short interest as a percentage of the stocks'
float, on average, stands at 7.1%. Meanwhile, OIH has rallied 30.5% in the same time frame --
and tagged a new five-year high of $57.36 on Friday. From a contrarian perspective, an unwinding
of skepticism in the face of continued strength in the energy sector could help OIH notch higher
highs.
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