The Week Ahead - Coping with Europe's Chaos – an Increase in Portfolio Insurance!
The RUT and MID will Face Crucial Tests on the Charts!
Stay on Track – Earnings – More Big Names Ahead!
The European financial drama will continue, with the spotlight perhaps moving to Italy. The week ahead features results from big retailers like Macy's and Ralph Lauren as well as General Motors, Cisco Systems and Walt Disney.
Investors could be forgiven for failing to realize that last week's notable economic news included a downwardly revised growth forecast from the U.S. Fed, as well as a fair-to-middling three-day gauntlet of jobs data. For the better part of the past five days, perennial bankruptcy candidate Greece dominated the headlines almost entirely, after Prime Minister George Papandreou decided to surprise his euro-zone comrades with a bailout referendum. On the plus side, Papandreou's gambit didn't actually send Greece spiraling into the abyss -- but it didn't exactly inspire confidence among global investors, either.
European officials in the past week wrestled with Greece on its bailout, which helped drive stocks to their first weekly loss in six weeks. Europe, particularly the creeping worries about Italy, will stay at the top of the list for investors in the week ahead.
European finance ministers meet Monday and Tuesday, after G20's leaders meeting fell short of expectations. The summit failed to generate support from countries outside Europe to participate in the bailout, and a role for the IMF was left unclear.
Leading up to the summit, European leaders were dealing with a threat from Greek Minister George Papandreou to hold a public referendum on the bailout, an idea later dropped. As Papandreou's government teetered on collapse, he survived a confidence vote by the Greek parliament Friday evening.
Italy also became an important concern for markets this past week, as it agreed to accept IMF scrutiny of its fiscal reforms. Yields on 10-year Italian bonds topped 6.4 percent. Italy holds a bill auction on Thursday.
As investors watch Europe in the week ahead, the news from Washington may start to become an increasing source of market anxiety.
As Washington edges towards a Nov. 23 deadline, traders are likely to start handicapping the work of the bipartisan Congressional Super Committee, tasked with reducing the deficit by $1.5 trillion.
Analysts have been concerned that as the Super Committee comes down to the wire on its plan, tensions will run high and the acrimonious tone surrounding the debt ceiling debate last summer could again dominate headlines. They blame that public wrangling, which led to the downgrade of U.S. debt, for a clear falloff in business and consumer confidence.
There were reports last week that a six-member subset of the 12-member Super Committee is working to find a solution, since the two parties are so far apart on taxes and spending. If the committee does not reach a deal by the deadline, there are $1.2 trillion in spending cuts that will automatically be triggered across government agencies, starting in 2013.
After snapping their weekly winning streaks, the major market indexes are now planted beneath key levels of resistance. There are plenty of potential buyers camped out on the sidelines, but be warned that stocks still have more ground to cover before winning over the holdouts.
Before this past week, stocks had recovered about 17 percent of their summer and early fall losses.
The past week was a turning point for markets, as it held so many major events, including a Fed meeting and the October employment report. The jobs report showed a net increase of 80,000 nonfarm payrolls, but upward revisions for the past two months encouraged economists that the trend is improving.
The past week was crucial psychologically, for the potential upside for the balance of the year and will influence the move forward for the week ahead. If we had gone through the past week and it had been all about the U.S. data, we'd probably be above 1300 (on the S&P 500) right now.
The CBOE Volatility index (VIX) fell 1.1 percent to close at 30.16 on Friday, but is well above levels from just last summer. It was trading near 20 in early August.
On the week, the VIX rose 22.9 percent following wide market swings in four of five trading sessions.
By taking a longer-term approach, though, some investors have been able to see the current situation as a buying opportunity. Even for the short-term, the buying opportunities are quite apparent in options trading!
Stock valuations are cheap, so if earnings hold up, investors are likely to be better positioned in stocks than in bonds or cash.
The S&P 500 forward price-to-earnings ratio is now at 12 – its’ lowest in years.
Savvy investors are using the dips and the highs within a fairly well-defined trading-range to put some money to work, particularly in the options market.
With results in from some 433 of the S&P 500 companies, 70 percent have beaten forecasts on third-quarter earnings, defying views that growth would be hit by the problems in Europe and a slower economy in China.
Analysts have said earnings growth has helped to support the market and has taken some of the focus away from Europe, even if just momentarily.
More reports are expected in the week ahead, and the focus may be pulled back to earnings -- what's supposed to be the most important determinant in stock prices -- including several retailers like Macy’s, whose results could shed some light on how the holiday shopping season may go.
The week ahead is, in fact, one of the busier weeks for earnings. Some 18 stocks in the Standard & Poor's 500 Index (SPX) report results. Two members of the Dow Jones Industrial Average (DJIA) -- Walt Disney (DIS) and Cisco Systems (CSCO) -- weigh in.
Obstacles to be Encountered in the Week Ahead
“The RUT is still in the red for 2011, and the MID is barely in the green, with the index's first-half lows just overhead at 920. The fact that the MID is trading around a key round number with historical significance, which also happens to coincide with its year-to-date breakeven, is perhaps the No. 1 risk from a technical perspective. It will be of importance for the MID to make a more convincing move above 900 in order to squeeze more shorts."
“The bottom line is, the equity market's backdrop continues to improve, even as many hedge funds have been significantly underinvested and are in the red this year. With more clarity on how Europe plans to address their issues amid an improved technical backdrop, risk-taking could increase significantly and drive stocks higher in the coming months, as fund managers look to play "catch-up" with the year winding down. Risks do remain, so it's still prudent to hedge your long positions..."
- The Week Ahead for the Stock Market, October 31st, 2011
Well, we thought we had a little more clarity on the European sovereign debt issues and -- surprise, surprise -- Prime Minister George Papandreou decided early last week that Greek voters should decide whether they wanted to accept the bailout package tailored by European leaders the prior week. The rescue deal included austerity measures that were already unpopular among Greek voters, leaving market participants doubtful of a positive outcome to the proposed referendum. Ambiguity once again became the order of the day with respect to Europe, and key equity indexes -- such as the S&P 400 MidCap Index (MID – 898.78) and PowerShares QQQ Trust (QQQ - 57.82) -- sharply retreated from the resistance levels. However, both the MID and QQQ picked up steam during the week to stay above their support levels and should recover further in the week ahead.
The Nasdaq 100 as represented by the Powershares QQQ ETF (Nasdaq: QQQ) ETF continues to basically consolidate under key resistance near $59. While there has certainly been an increase in volatility over the past few weeks, QQQ has not given up much ground overall. This is a positive, and QQQ remains one of the key indicators for the health of the markets, particularly for the week ahead. Any strength that carries QQQ over $59 would be worth acting on, as it could signal a key breakout. Looking below, the $56 level has held as support on a few occasions, and QQQ should remain above this level in a benign environment.
If there is anything we have learned during the past few months, it is that "surprises" have become commonplace, suggesting directional exposure should be hedged, as noted in the excerpt above. The ongoing uncertainty and constant surprises have kept volatility gauges, such as the CBOE Market Volatility Index (VIX - 30.16), relatively elevated compared to their historical averages.
With other world leaders -- including the familiar duo of French President Nicolas Sarkozy and German Chancellor Angela Merkel -- pressuring the Greek government to accept the bailout package, under threat of exile from the euro (another unpopular notion among the disgruntled citizenry), Papandreou spent the rest of the week backpedaling, right up to a narrowly won vote of confidence late Friday. Equities recovered from Tuesday morning's low, and the sell-off was relatively contained by week's end.
The equity market's prospects into the week ahead and also to year-end still appears to be constructive, as it would seem that a huge build-up in pessimism is still in the early stages of unwinding. For example, an indicator which is the 10-day equity-only, customer-only, buy-to-open put/call volume ratio on the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX), which is essentially a measure of investor sentiment, gives some evidence that a rally is eminent.
When the ratio rises from low levels (extreme optimism giving way to pessimism), the market has historically struggled. Moreover, when the ratio peaks at high levels and moves lower (extreme pessimism giving way to optimism), equities have historically advanced. As you can see on the chart below, the ratio recently peaked at its highest level since early 2009 and has turned lower. This could be evidence that the shorts are becoming less bold, and are covering their positions, which -- as we said last week -- could sustain a rally in the week ahead. The bulls should find it encouraging that this ratio has plenty of room to fall, based on historical data.
However, there are several overhead obstacles, or resistance levels, that continue to pose a challenge for the bulls in the week ahead, and are worth keeping in our view. Specifically:
1. The 1,260 region on the S&P 500 Index (SPX - 1,253.23) represents its year-to-date breakeven, as well as significant lows in March and June. SPX 1,253, by the way, is the average year-end target among money managers, as cited in the latest Barron's Big Money poll.
2. QQQ 60 is half the all-time high, and has acted as an area of resistance on four trips up to this area in 2011.
3. MID 900 is a round-number area that marked the 2007 peak, and the 2011 breakeven is just seven points north of 900.
4. The Russell 2000 Index (RUT - 746.49) comes into the week ahead trading in the 750 area, site of its peak ahead of the 2010 "flash crash" and it 320-day moving average, an uncommon long-term average that has been significant in the past. If this trendline is taken out, which the SPX and MID managed to do late last month, the 780 area becomes the next speed bump, site of its 2011 breakeven and support in February, March, and June.
There is a continued belief that any advances will be led by small-cap and mid-cap equities and, in fact, small- and mid-cap stocks have been leading the big caps since the lows in early October. In order for this leadership to continue, the MID must sustain a move above 900, and the RUT must get over the 750 mark.
The bottom line is, there appears to be short-covering activity and money moving in from the sidelines as we transition out of an extreme in negative sentiment. With the major equity indexes back in the red, or still in the red, for 2011, some would-be investors may need a little more convincing, especially for the week ahead. That said, there is sufficient buying power available to push equities through the various resistance levels that have been pinpointed as we move into year-end. Hedging of long exposure is still prudent -- although premiums on portfolio insurance are 23% higher than they were the last time this recommendation was made, with the VIX moving from 24.53 to 30.16 over the course of the past week.