Indicators Offer Uplift to the Stock Market

Indicators Appear to Favor the Bulls!

Junk Bonds and Housing Could Push the Stock Market Higher!

by Ian Harvey

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July 23, 2012

Introduction

“.....Stocks finished near session lows Friday, breaking a three-day winning streak, sparked by fresh fears over the euro zone sovereign debt crisis and after a batch of mixed earnings reports.
The Dow and Nasdaq slid back into negative territory for the month, but all three major averages still posted modest gains for the week.
Stocks had rallied for most of the week thanks to gains in techs, and after Federal Reserve Chairman Ben Bernanke said the central bank stands ready to act if needed.....”

- The Past Week Stock Market Results – July 23, 2012


It was a winning week for U.S. stocks -- even if it didn't really feel like it on Friday. But while familiar euro-zone concerns are still flaring up, last week also brought a number of well-received earnings announcements, along with a few resoundingly upbeat reports on the housing sector. Another flood of quarterly earnings is set to hit the Street this week, including the latest results from Apple (NASDAQ AAPL) and a number of other heavy hitters.

So, now that July options expiration is behind us, it is possible that stocks can finally gather enough positive momentum to tackle looming resistance levels – below we will discuss several indicators which should offer the bulls some uplifting glimpse of the future.

Will Stocks Catch Uplift as the Shorts Falter?

“.....option sellers would love to see the SPY close above 135.00 and below 137.00, which would allow them to pocket the premiums collected from the sales of these options….The 137 strike would correspond to the 1,370 level on the SPX, which is where the SPX recently ran into resistance.....”
- Options Expiration Expectations , July 16, 2012

There was a nice bounce going until the S&P 500 Index (SPX - 1,362.66) ran into resistance near the 1,370 area on Friday. As obvious from the excerpt above, there were heavy calls on the S&P 500 SPDRS (ARCA: SPY - 136.47) at the 137 strike, and this was already an area the SPX had trouble with back in early July -- so it was a logical place for stocks to hit a roadblock, and that's exactly what happened. Still, looking at the bigger picture, the lows from early June are still intact, and the overall uptrend is firmly in place.

The Fundamental Outlook

“.....Many analysts said earnings could start to be a negative factor for stocks because of the high number of misses on the top line. A closer examination of earnings season shows that 40 percent of the companies are beating on the revenue side -- which is the worst performance since the recession. It is apparent that earnings growth is slowing, and revenue growth is slowing..... It appears that many investors are becoming too negative in regard to the stock market – they are viewing the economy today through a distorted lens -- with the feeling that the economy can be tipped into recession by any little thing – however, taking a more positive view.....”
- The Stock Market in the Week Ahead - July 23, 2012

Turning to the fundamental outlook, there continues to be signs that the economic recovery is slowing. Overall, earnings are coming in better than the Street's much-lowered expectations, yet revenue is missing the mark in a lot of cases. The big question on everyone's mind is whether this is just a slowdown in the recovery, or the beginning of a major recession.

As mentioned in the excerpt above – “however, taking a more positive view -- there are still two areas holding up well that support the fact that the economy won't surrender to recession, and could very well improve drastically during the second half of the year.....housing and junk bonds....both are showing some major improvements, and this is definitely sound indicators providing an encouraging sign.

- The majority of the housing data over the past two months has been very positive. In fact, housing starts in June came in at their highest level in three years.

- Junk bonds can be a very good gauge of economic growth -- these are bonds on the riskiest of companies, and improvements here show an appetite for risk. Why would anyone buy bonds if you think the company paying would just default? Right now, various junk bonds are breaking out -- suggesting the economy could be on much better footing than most give it credit for.

The Psychology of Round Numbers

“.....Tuesday, last week, saw the Dow Jones Industrial Average (DJIA) touch the 13,000 level for the first time since the 2008 market crash. Crashing through psychological milestones usually makes for a good headline but rarely means anything to the professional traders on Wall Street. The DJIA 13,000, though, could be different.....”
- Dow 13,000 – The Psyche of Round Numbers, February 27, 2012

With further discussion regarding the technical indicators -- that 1,370 area previously mentioned -- was definitely a trouble spot. Not to be outdone, though, the Dow Jones Industrial Average (DJIA - 12,822.57) is close to 13,000, and the Russell 2000 Index (RUT - 791.54) is flitting around the 800 mark. Study has found that these psychologically significant big, round numbers can indeed act as sticking points – as discussed in the excerpt above. As long as the SPX is above its double low of 1,333, the stock market is still firmly bullish -- but it would be great if all of these other areas -- indicators -- could be cleared sooner rather than later.

Internals High for the NYSE

“…..The chart of the NYSE Composite shows the lower close Friday, but it is still above its uptrend (line c). A break of the uptrend would not be surprising in the week ahead…..The WMA of the A/D line is still rising, which is a positive sign….”
- The Past Week Stock Market Results – July 23, 2012

Below is a chart that suggests new highs could be coming soon. If you look at the cumulative new highs versus new lows at the New York Stock Exchange (NYSE), it has just made another new peak. This shows that there are many more new highs than lows, and anytime you get a lot of stocks breaking out to new highs, the overall market will normally follow suit. This indicates that internals remain very strong here – this is an acceptable fact!

Sentiment Indicators – Short Interest

Many of the various sentiment indicators are showing skepticism – which, if you are a contrarian investor, is a good sign – however, there are some indicators that are definitely showing positive signs for the stock market. One definite positive is that when the news is bad and expectations are extremely low, it is much easier to surprise to the upside.

One sentiment indicator that appears to be proving positive is in short interest. Since April, there’s been a huge spike in short interest on all optionable stocks. In fact, the number of shares sold short recently climbed above the peak seen last September. What is extremely encouraging here for the bulls is that short interest just ticked lower, suggesting the shorts could be covering. The last time short interest was this high and rolled over; there was a 30% rally in the SPX over the next six months. Whether this likely to happen again is anyone’s guess, but it's another sign that siding with the bulls is probably a wise move.

Put/Call Volume Ratio Indicator

Another indicator that continues to bode well for the bulls is the 10-day, equity-only, buy-to-open put/call volume ratio on the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). This ratio recently peaked at its highest level since March 2009, but has since rolled over. In consideration to this fact – there was a 10% pullback in the SPX, yet there was similar put buying to what we saw at a major generational panic bottom. This is quite interesting as it sums up the overall level of fear that is in the market place. This ratio is still firmly pointing lower, and as you can see, a lower ratio has historically been rather bullish for equities.

Mutual Fund Flows

Looking at domestic equity mutual funds, there has been a record outflow over the past 12 months of around $175 billion -- historically, the 12-month flows tends to move with the overall market. Yet, what has happened since the lows last summer is an increase in outflows, along with a steadily higher stock market. This could be an extremely powerful market lift, as it shows how much more potential there is for higher prices should any flows make their way back to equities.

Bond Fund Flows

“…..The Investment Company Institute estimates that $540 million moved out of stock funds in the week ending July 11. This was better than the prior week, when the outflow was $2.87 billion.
Bonds continue to be the big winner, as they had net inflows of $6.39 billion, with the majority in taxable bonds. The prevailing concern of investors is still on the return of their capital, not the return on capital…..”

- The Week Ahead in the Stock Market - July 23, 2012

And here's a chart that also plots bond fund flows. This isn't a huge surprise, but there has been about $200 billion in bond fund inflows during the past 12 months, trouncing the record outflows from domestic equity funds. Bonds are now becoming quite traded which should make the investor wary. The potential for money to shift out of the popular bond trade and into the much-less-popular equity trade is a very real possibility as equity prices continue to move higher.

AAII Sentiment Indicator - “More Bears Than Bulls”

“…..The AAII survey of individual investors shows that only 22% are now bullish, with 41.8% bearish. These are levels that are often seen near important market lows.
In contrast, the financial newsletter writers are still too bullish, at 43.6%, with just 24.5% bearish. The number of bulls often drops below 30% at market bottoms…..”

- The Past Week Stock Market Results – July 23, 2012

Expectations of investors are very low due to such incidents as the flash crash, the ill-fated Facebook IPO, and various scandals at banks (led by JPMorgan's "London Whale" mess) – and further proof of just how low expectations are came in the form of the American Association of Individual Investors (AAII) sentiment poll that came out last week. This showed that there were just 22% bulls, which is the lowest reading since August 2010. Plus, this marks the 11th straight week of more bears than bulls.

More detailed information on indicators from the AAII can be found at "Pessimism in the Stock Market", July 24, 2012

With further study of the historical data it was found that this is the sixth-longest such streak since 1987. Looking at the previous five times this has occurred, after 10 straight weeks of more bears the bulls, the SPX is up an average of more than 5% over the next 30 trading days -- and it was higher all five times over the next 30-day period. Below is a chart of the 10-week moving average of the AAII bulls since 2002. As you can see, this is the lowest it's been since March 2009, and it's down near previous major buying points going back over the last 10 years – this certainly indicates that the rally might continue!

Conclusion to Indicators

When taking into consideration the facts above and the positive indicators mentioned, the odds of higher prices are still very good. Therefore, it is worth bearing in mind that financials and select Chinese Internet names look rather weak, and bearish positions on some of these names could very well be a decent hedge, should the market stall out for any reason.

The uptrend appears to be firmly in place when you consider the accommodative Fed, low valuations, and historically low sentiment -- it all adds up to a strong likelihood of higher prices at least through the remainder of this year, if not further out.

Further Articles Relating to the Week Ahead

1. The Week Ahead in the Stock Market - July 23, 2012

2. The Economy and Earnings in the Week Ahead – July 23, 2012

3. The Past Week Stock Market Results – July 23, 2012

4. The Major ETFs in the Week Ahead – July 23, 2012


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