The Week Ahead for the Stock Market
October 31st, 2011

This week will be a huge test for the rally, climaxing with Friday's jobs report. The Federal Reserve holds an important meeting. Earnings are due from MasterCard, News Corp., Pfizer, Apache, Kraft Foods and American International Group.

It was a great week last week -- and an even better month -- for investors.

The major indexes scored solid performances for the week, boosted by major signs of progress out of the debt-laden euro zone. The Standard & Poor's 500 Index (SPX) and the Nasdaq Composite Index (COMP) are enjoying their best October performances since 1974. The Dow Jones industrials (DJIA) are looking at their best October ever. Best of all, the major averages are back in the black for the year.

The Dow was up more than 3.5 percent at 12,231 and the S&P 500 up 3.8 percent at 1285. The Dow's 12 percent monthly gain puts it on track for the best October since 1987, and the S&P, up more than 13.5 percent, is headed for its best monthly performance since 1974.

While there are still plenty of details left to hammer out, the united front, presented by European leaders was sufficient to send the major market indexes north of significant technical levels. The rally was broad-based, with both small- and large-cap stocks scoring meaningful victories on the charts. Since big-money players have some ground to make up before year-end, it's not unreasonable to think the positive momentum could continue.

But, there are still several risks to the bullish case before wrapping up the month of October.

Bond investors may not have been too happy during the past week. Stocks rose four days out of five and pulled money away from bonds. To compete, yields had to rise and they did. The iShares Barclays 20+ year Treasury Bond exchange-traded fund (TLT) dropped 2.5% on the week and is down 10% since Oct. 3 -- as the big stock market rally erupted.

And short-sellers -- sure that the Dow was headed to 10,000 or worse -- had to cover their positions quickly, especially on Thursday, when the Dow soared as much as 415 points before settling back to a 340-point gain.

Bears may get another opportunity, but they'll need a solid catalyst. Momentum has moved to the bulls. The Dow, S&P 500 and Nasdaq ended the week trading above their simple 200-day, 50-day and 20-day moving averages. That hasn't occurred since April.

The domestic economy still has some strength –looking at the economic data -- consumer spending, durable-goods sales, auto sales and even new-home sales – have presented good sound arguments. (When the economists finally study this year, they'll point to the big rise in gasoline prices, the Japanese earthquake and the summer's bitter budget battles as catalysts for the summer slowdown.)

Trading is expected to remain volatile as investors close the books on October's record setting double-digit stock market gains, which reversed much of the summer's steep losses. But importantly, investors are turning their attention away from Europe's tortuous sovereign debt drama and back to the U.S. economy, which while sluggish, is showing a little more resilience than economists had expected.

European leaders in the past week finally showed progress toward a plan to enhance their bailout fund and resolve the Greek debt restructuring. They were expected to take the plan to the G-20 leaders meeting in Cannes on Thursday and Friday. The European Central Bank also holds a rates meeting Thursday, the first to be presided over by new ECB President Mario Draghi. Investors will be watching to see if the ECB will tweak interest rates though analysts see that as unlikely.

Major Occurrences in the Week Ahead

The week ahead is another big week for earnings reports – with some 116 members of the S&P 500 Index reporting results. So far, the third-quarter earnings season has been strong with 71% beating Street estimates, Thomson Reuters says, despite complaints about lack of demand, regulation and other woes.

Earnings reports are also expected from major companies like Pfizer (PFE) and Kraft Foods (KFT), and the IPO market is showing signs of life with e-commerce discount site Groupon planning a 30 million share offering.

The jobs report, expected to show the addition of 100,000 nonfarm payrolls in October, is the big data point traders are watching, but there is also ISM data on manufacturing and service sector activity.

Therefore, the week ahead, or so, should divulge some consolidation, with the next big milestone, this week, being payrolls being put-forward ... and the next milestone after that one is the Super Committee.

The Congressional Super Committee is the bipartisan committee working to find $1.5 trillion in deficit reduction by its Nov. 23 deadline, and analysts worry that the partisan feuding that characterized the debt ceiling negotiations will lead to a weak resolution, and then potentially another downgrade of the U.S. credit rating.

Maybe the market will stumble around the time the Super Committee reports, especially if it does not make a real effort to trim spending and instead relies on spending cuts that were already expected. However, the stocks could then move higher into year end.

Hedge Funds Playing Year-End Catch-Up?

“A positive outcome in Europe could produce a continued fourth-quarter rally which would be great for the week ahead, as fund managers aggressively accumulate long positions or short covering emerges as the technical backdrop improves. Note in the chart above how short interest is at its highest level since the market bottom in 2009 -- a positive for the bulls. But, if major benchmarks fail to make it into the calendar-year green relatively soon, or if markets react negatively to the week ahead news out of the euro zone, the urge to cover short positions decreases and the risk becomes a continual increase in short interest, which has proven to be a major headwind in 2011.”
- The Week Ahead, October 24, 2011

Judging by the price action this past Thursday, when the S&P 500 Index (SPX - 1,285.09) rallied 3.4% and the Russell 2000 Index (RUT - 761.00) jumped 5.2%, European leaders' plan to address the sovereign debt issues in their region was well-received. While Europe stole the headlines, a respectable third-quarter U.S. GDP report also soothed wary investors. The 2.5% increase was driven primarily by solid consumer spending as inventory building came in less than expected, brightening the economic landscape ahead for the week ahead.

On the heels of the news, volatility indexes dropped sharply as stocks roared higher, with the Dow Jones Industrial Average (DJIA - 12,231.11) climbing above the 12,000 millennium mark for the first time since Aug. 1, and the PowerShares QQQ Trust (QQQ - 58.94) once again challenging its 2011 highs.

Leadership came from the small- and mid-cap equities, continuing a long trend in which large-cap, defensive names outperform only in weak market environments, while small- and mid-cap stocks lead the charge during bullish runs. Encouraging for the bulls is that the SPX, RUT and S&P 400 MidCap Index (MID - 910.64) advanced above key levels that have been identified in the past, and the CBOE Market Volatility Index (VIX - 24.53) fell below a key mark.

For example:

• The SPX advanced above the 1,255-1,260 zones -- site of its 2011 breakeven point, the 61.8% Fibonacci retracement of this year's high and low point, and its 120-day moving average.

• The RUT took back the 750 mark, which is where it was trading right ahead of the Lehman Brothers collapse in 2008 and the flash crash of 2010. But work remains, as the RUT is still 23 points away from making a run at its 2010 year-end close of 783.65.

• The MID closed the week back above the critical 900 century mark, an area that acted as resistance for months in 2007 before the index experienced a 55% haircut into the 2009 trough. Furthermore, the MID moved barely back into the green for 2011 as of Friday's close, after rallying above its breakeven at 907.25 to settle at 910.64.

• The VIX fell below the 30-31 zone, which is an area that has spelled trouble for the equity market since September and represents double the 2011 low. The VIX's failure to advance above 50 in August, a multi-year resistance level going back to 1997, plus the subsequent break below the 30 mark is encouraging for bulls for the week ahead. The next key level on the VIX is 24, which is Augusts’ half-high.

That said, three short-term risks to the bullish case, in the week ahead, include:

1. 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.

2. Another technical risk relates to the QQQ, a benchmark driven by many large-cap technology stocks. While outperforming impressively, it still has not taken out the 60 level, which is half its all-time high and has marked multiple peaks in 2011.

The Nasdaq 100 suffered through some volatility last week as high profile stocks like Netflix, Inc. (Nasdaq: NFLX) and Amazon, Inc. (Nasdaq: AMZN) suffered through post earnings declines. However, by the end of the week, the Powershares QQQ ETF (Nasdaq: QQQ) ETF was back at new weekly highs and is amazingly poised just under multi-year highs. The fact that this index has been able to shrug off some high profile stock’s, profit taking reveals wide participation in this rally. This bodes well for future strength and for the week ahead. The $59 level remains a key resistance level to watch and could cause QQQ to pause soon.

3. A third risk is that much of the short covering related directly to the huge build-up of put open interest in exchange-traded fund (ETF) and index options is likely expended, as heavy put strikes that will expire in a few weeks are far out of the money and less sensitive to market gyrations. That said, short covering is still possible on individual equities, and those that are highly shorted with a strong technical and fundamental backdrop are likely to lead if the market continues to rally in the week ahead.

"The selloff in most of the global markets in the third quarter heavily impacted a large number of hedge funds. In fact, not only did it put many funds into the red for the year, it pushed a huge number of hedge funds below their high water mark. According to HFR, at the end of the third quarter just 19.3 percent of all hedge funds were above that critical level that determines whether their investors' accounts are in the black."
- Institutional Investor, October 21, 2011

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 -- even though some market players may choose to forgo such a strategy in order to try and capture quick gains in a short period.

Conclusion for the Week Ahead

The markets continued to surprise market bears with its strength towards the end of last week. The inability for the mid week reversal to gain momentum was revealing of the underlying strength supporting this move. Regardless of what is fundamentally pushing this move, the strength has been readily apparent. Even though last week’s stock-market gains were pretty impressive, a further rally, in the week ahead, that can last until the end of the year would be greatly appreciated.

There has also been a recent change in character from selling rallies to buying dips. This was once again very apparent and may be the pattern to watch moving forward. The market structure has certainly improved to a point where dips should be expected to find support.

Patience is the best strategy for those now in the market, particularly for the week ahead. There should be plenty of good buying opportunities in the week ahead. Start to work on your buy list now, while the market is completing a short-term top, so you will be prepared once the correction unfolds – buy the dips!.