Monday Morning Outlook: Bloodied DJIA Stumbles into Third Quarter

              

Three straight days of disappointing jobs data and renewed fears about the strength of the economic recovery effectively extended the previous week's tailspin. The Dow Jones Industrial Average dropped below 10,000 on Tuesday, and kept on going, ending the week with a 4.5% loss. Looking ahead, Todd Salamone, Senior Vice President of Research, acknowledges the weak technical picture, but sees support on the S&P 500 Index at 1,000. Todd also remarks on the curious decline in the CBOE Market Volatility Index late in the week, even as the SPX continued to weaken. Next, Senior Quantitative Analyst Rocky White looks at the fabled "Death Cross" indicator, and its cousin, the "Golden Cross." Rocky concludes that the Death Cross is not a surefire predictor of doom ahead. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Another Jagged Pill
By Joseph Hargett, Senior Equities Analyst

Bad week, bad month, bad quarter. How bad? When the second quarter drew to a close on Wednesday, the Dow Jones Industrial Average (DJIA) recorded a loss of 3.5% for the month of June; the Dow plunged 10% during the quarter. That was the worst performance for the venerable Dow since the stomach-churning first three months of 2009. The S&P 500 Index (SPX) fared even worse, losing 5.4% for the month of June, and dropping 12% for the quarter. The Nasdaq Composite (COMP) limped into the finish as well, shedding 6.6% in June and 12% for the quarter.

Monday didn't necessarily offer a hint of what was to come. In fact, the Dow spent much of the day in the black on a mixed bag of economic developments. The Group of 20 (G20) met over the weekend and vowed to halve their respective national deficits by 2013. Meanwhile, consumer spending in May rose slightly more than expected in May. But in the final hour, the Dow settled just a little south of breakeven, down 0.05%.

The Conference Board delivered a double whammy on Tuesday. First, it downwardly revised its index of leading economic indicators for China, sending foreign markets into a nosedive. Then it reported that its consumer confidence index for the U.S. tumbled to 52.9 in June from the prior month's reading of 62.7. The market choked on this "jagged pill,'' Senior Equities Analyst Elizabeth Harrow reported in Market Recap ("Alanis Morissette is making a comeback," Elizabeth explained.) The Dow plunged 2.65%, or 268 points, to 9,870, settling beneath 10,000 for the first time since early June.

Wednesday dawned with the news that the private sector added fewer-than-anticipated jobs last month, the first of three straight days of disappointing employment data. Although the bulls fought valiantly, encouraged by a report that business activity in the Midwest expanded by more than expected in June, the Dow succumbed to another late-session sell-off, and fell 0.98% for the day.

The hits kept coming on the employment front on Thursday, as weekly initial jobless claims unexpectedly rose during the prior week. Like dominoes, the rest of the day's economic reports also fell below economists' views, with the National Association of Realtors' pending home sales index falling 30% in May and the Institute for Supply Management's manufacturing index dropping more sharply than expected in June. Despite another attempt to rally back above breakeven by the close, the DJIA fell 41.5 points, or 0.4% short.

Friday's jobs data once again disappointed. Payrolls declined by 125,000 last month, as temporary census employees exited the workforce and the private sector added just 83,000 jobs. The drop was slightly larger than predicted, though the unemployment rate unexpectedly improved to 9.5% from May's 9.7%. The Dow lost 0.5% on the day and shed 4.5% for the week. The other major indexes fared even worse. The S&P 500 Index gave up more than 5% this week, while the Nasdaq Composite dropped nearly 6%.

What the Trader Is Expecting in the Coming Week: Looking For Support at SPX 1,000
Todd Salamone, Senior Vice President of Research

"As we enter this week's trading, support for the SPX is in the 1,050 area... The bulls might be somewhat encouraged by the VIX's close below 30, as this level has marked peaks in volatility on occasion, with October 2009 and February 2010 being recent examples. However, per the chart below, note that in these months, the VIX's 80-day and 200-day moving averages were sloping lower, indicative of volatility being in an intermediate and longer-term decline. Now, these moving averages are sloped higher, indicating volatility is currently in an uptrend, increasing the risk for another pop above 30."
-Monday Morning Outlook, June 26, 2010

A CBOE Market Volatility Index (VIX) pop above 30 is exactly what occurred last week, as the VIX hit a high of 37.58 on Thursday, a 32% increase over the previous Friday's close. The spiking action began as the SPX quickly moved below support in the 1,050 area Tuesday morning. While the VIX closed the week sharply below last week's highs, the danger for the bulls is the close above 30 and its 50-day moving average, located at 29.56, which could indicate that volatility is still trending higher.

We have found the VIX's behavior during the past few days peculiar. On the chart below, note the sharp drop that began late in the morning on Thursday, even though the SPX didn't make much headway from Thursday morning into Friday's close. In fact, since the June 29 close, the SPX has lost almost 2%, and the VIX has dropped from 34.13 to 30.12 in the same four days. This is unusual. According to our research, the VIX has never declined as much, on a percentage basis, during any other four-day decline of more than 1.5% in the SPX. For what it is worth, the VIX also declined amid a retreat in the stock market in the days leading up to the March 2009 bottom, but the VIX's percentage decline then wasn't as great as we just witnessed.

Clearly, the bears have the bulls on the ropes. The technical backdrop continues to deteriorate, after a failure to move back above the 160-day moving average during a rally in June and last week's break below the recent trading range. So, while pessimism has grown during this period, given the weakening technical backdrop, the pessimism takes on less meaning from a contrarian perspective.

That being said, many technicians interpreted the breakdown below 1,050 last week as a "head & shoulders" pattern sell signal, with the breakdown creating an 880 target on the SPX. Certainly, one has to take note of the bearish development and be open to such a possibility. But the contrarian blood in us is skeptical about this emerging consensus opinion. In other words, the publicity surrounding last week's break of support may have generated a crowded short trade. Remember the publicity surrounding the SPX's move above its 200-day moving average two weeks ago? As we soon found out, the crossover was nothing more than a sell signal, even though many viewed the price action as a bullish development.

So, where is potential support after last week's breakdown? We are focusing on the 1,000 area for a multitude of reasons.

1. Per the chart below, the 1,000 area is the site of the SPX's up-sloping 80-week moving average, a trendline that has marked support and resistance in the past.
2. 1,000 marks a 38.2% retracement of the March 2009 low and the April peak.
3. 1,000 is 50% above the 666 intraday March 2009 low.
4. 1,000 is a millennium mark – it proved to be a hesitation point in the summer months of 2003 when the market began to claw back from the bear market lows.

As the proverbial "lines in the sand" continue to be redrawn amid a plunging stock market, a question we have asked is, "What is the catalyst that reverses the slide?" Amid the continued stream of bearish headlines and the weakening technical backdrop, there is little urgency for the shorts to cover and for sideline money to move into the stock market.

With the SPX down nine of the past 10 days, and the PowerShares QQQ Trust (QQQQ) down 11 consecutive days, the market could certainly experience another sharp, short-lived rally. One short-term catalyst that could push the market higher is short covering related to expiring index puts, with July expiration only nine trading days away when the market opens Tuesday morning. But the dark side of this put open interest is that if major put strikes just below currently levels get taken out on the downside, sellers of the puts will add to their short positions, creating sharp, exhaustive-like selling.

Continue to have both put and call exposure for all time horizons you are playing. The Russell 2000 Index's (RUT) close below its 200-day moving average and the 600 level is cause for concern, so think about lightening up in this area if you don't have put protection.

Todd Salamone, our Senior Vice President of Research, will talk about "Trading Strategies for Today's Market" when he hosts a live e-chat Tuesday, July 6, 2010, from 1-1:30 p.m. Sign up here for this free MoneyShow event.

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.

Indicator of the Week: The S&P 500 Index's "Death Cross"
By Rocky White, Senior Quantitative Analyst

Foreword: Two heavily watched moving averages on the S&P 500 Index (SPX) are converging. A lot of technicians are talking about the upcoming "Death Cross." That's when the 50-day moving average of the index crosses below the 200-day moving average. This is looked at as a bearish signal -- especially since the last Death Cross, which happened in late 2007. The market fell more than 40% over the next 52 weeks.

The opposite of the Death Cross is the Golden Cross, which is when the 50-day moves above the 200-day. Below is a chart of the SPX since 1998 with each Golden Cross and Death Cross marked. The Death Crosses that occurred in late 2000 and late 2007 were very good sell signals. The other four simply marked bull market pullbacks.

Quantifying the Data: Going back to 1972, there have been 18 Golden Crosses and Death Crosses. I looked at the data following these signals to see just how reliable they are at predicting the market. The first table below shows the average SPX returns after a signal from one month to one year later. The second table shows the percentage of returns that were positive. The term Death Cross is a lot scarier than the actual returns.

The table shows that the average return three and six months after a Death Cross outperform the typical SPX returns, even though there are fewer positive returns than you would typically find. However, there is underperformance one year later. The results following a Golden Cross are quite impressive relative to what the market usually returns.

Implications Death Crosses have had mixed results as an indicator, at times signaling the beginning of a painful extended decline, but at other times signaling the end of a short-term pullback. It might be a good idea to have hedges in place.

One thing to keep in mind about these widely watched technical levels is that they tend to garner a lot of media attention. A glaring media spotlight could actually have a contrarian effect on the indicator. For example, if media attention to the Death Cross strikes enough fear into traders, then they might sell before it occurs, or put on hedges so they're not forced to liquidate losing positions. In this situation, the selling pressure is exhausted by the time the Death Cross occurs. Remaining sideline money and the subsequent unwind from the hedges can then actually instigate a rally.

This Week's Key Events: A Quiet Four-Day Week
By Joseph Hargett, Senior Equities Analyst

It's a short -- and quiet -- week on both the economic and earnings fronts. Here is a brief list of some of the key events 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 market will be closed for the July 4 holiday on Monday.

Tuesday

• The Institute for Supply Management Services Index for June will be released on Tuesday. There are no major earnings reports scheduled for Tuesday.

Wednesday

• The usual weekly U.S. petroleum supplies will arrive on Wednesday. Meanwhile, Family Dollar Stores Inc. (FDO) will post its quarterly results.

Thursday

• Thursday brings weekly initial jobless claims. International Speedway Corp. (ISCA) will report earnings.

Friday

• There are no major economic reports scheduled for Friday. PriceSmart Inc. (PSMT) is the lone entry on the earnings docket.

And now a few sectors of note...

Dissecting The Sectors

Sector

Real Estate Bullish

Outlook: The real estate sector remains one of our favorites as it continues to perform well amid overwhelming pessimism from investors. The iShares Dow Jones U.S. Real Estate Index Fund (IYR) recently pulled back to its 200-day moving average and found support at this key trendline. Meanwhile, from a sentiment standpoint, the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) 50-day buy (to open) put/call volume ratio is starting to roll over. This could indicate that put traders are no longer hedging their positions on the sector, removing a potential headwind. There is also plenty of negativity from analysts. Specifically, only 36% of the 1,067 analysts covering the sector have doled out "buys." Any upgrades could provide lift for the sector.

Sector

Energy Bearish

Outlook: The Energy Select Sector Fund (XLE) suffered a major reversal on June 21, as the XLE rallied into its 200-day moving average, and was soundly rejected. The fund has since accelerated its decline, plunging below former round-number support at the 50 level last week. This region could now provide a ceiling for the XLE. Elsewhere, the Oil Service HOLDRS Trust's (OIH) recent failure at its 40-day moving average has forced the shares further below the psychologically important century mark. A continuation of this decline could send the OIH down for a retest of the 90 area. Oil prices, in particular, have been under significant pressure since the start of the oil leak in the Gulf. Combined with growing strength in the dollar, this has helped reduce the price of crude oil. In fact, the recent rally attempt in crude oil was stopped in the $79 area once again last week, sending crude futures sharply below $75 per barrel by the end of the week. The buy (to open) 50-day put/call volume ratio on XLE has been in decline since November 2009, which means stocks in this group are not likely under accumulation. In fact, they could be in distribution mode. Negative headlines in this group, along with prospects of increased regulation, have bearish implications.

Sector

Consumer Discretionary Neutral

Outlook: Wall Street continues to punish the retailing sector, with the S&P Retail SPDR (XRT) falling further below its 200-day moving average. Traders continue to doubt the sector's wherewithal, and last week's string of poor employment data threw additional uncertainty into the mix. However, we have not completely written off retail, as the shares have pulled back to the 34-35 region. This area provided stiff resistance in 2008, and a rebound from this area could represent an opportunity to enter long positions amid the current pullback. However, traders should consider hedging these positions via a married put strategy to protect against an unexpected pullback. Furthermore, it seems that the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) 50-day buy (to open) put/call volume ratio has been driven higher by unhedged put buyers, or by players simply replacing expiring hedges in the absence of coincidental accumulation, as the rising ratio was consistent with weak price action. If the headwinds from speculative/unhedged put buying are over, this could prove to be a buy signal for the sector. Within the sector, some of our favorite performers include Chipotle Mexican Grill (CMG), Netflix (NFLX), lululemon athletica (LULU), and Coach (COH). Meanwhile, some stocks to avoid due to their weak technical backdrops include Abercrombie & Fitch (ANF) and Green Mountain Coffee Roasters (GMCR).