Monday Morning Outlook: Consumers Are Fearful, and DJIA Backpedals

              

The bulls tried their best to extend the previous week's rally, but Friday's sell-off sent the Dow Jones Industrial Average skidding to a 1% loss for the week. The S&P 500 Index likewise fell 1.2%. Looking ahead, Senior Technical Strategist Ryan Detrick is sitting for Todd Salamone this week. Ryan sees the potential for continued churning in the market over the coming weeks, particularly with next week being the first week of a five-week expiration cycle. Longer term, the contrarian in Ryan is encouraged by the pessimism he continues to see among retail investors. Next, Senior Quantitative Analyst Rocky White tells us about the CBOE's Correlation Index, a measure of whether the market expects all stocks and sectors to move in a pack (which they often do in a market crash.) Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Weak Consumer Sentiment Report Sparked Plunge
By Joseph Hargett, Senior Equities Analyst

We were about to celebrate the July rally, until the consumer sentiment report arrived on Friday, revealing a continued and deep-seated wariness about the direction of the economy. The week's gains disappeared in the blink of an eye.

Earnings season kicked off on Monday, and anticipation ahead of Alcoa Inc.'s (AA) unofficial start to this quarter's round of reports held Wall Street largely in check. Traders were concerned about poor economic data out of China, but the Dow Jones Industrial Average (DJIA) still managed to end the day in (barely) positive territory, adding 0.18%.

Patient bulls were rewarded on Tuesday, as in-line earnings and a cautiously positive earnings outlook by Alcoa provided the impetus for a triple-digit gain for the Dow. Wall Street was in such a good mood that it even shrugged off news that Moody's downgraded Portugal's sovereign debt ratings. When the dust finally cleared, the DJIA had added 146 points, or 1.44%, to close above the 10,300 level for the first time since June 21.

On Wednesday, the blue-chip barometer extended its winning streak to seven sessions in a row, but only by the skin of its teeth, advancing 3.7 points, or a tiny 0.04%, on the session. Weak June retail data set an early tone, as the Commerce Department reported that sales at U.S. retailers declined 0.5% in June. Furthermore, minutes from the latest meeting of the Federal Open Market Committee revealed the Fed's lowered outlook for U.S. economic growth, including the group's "need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably." Eek.

The Fed's worries about the slow recovery, along with weak manufacturing data out of the New York and Philadelphia areas, weighed heavily on the market on Thursday. JPMorgan Chase & Co. (JPM), the first of the big banks to report earnings, offered up a report that exceeded expectations, but CEO Jamie Dimon was less than upbeat in his comments about the economy's health. The Dow spent much of the day as much as 100 points or more in the red. However, last-minute rumors -- later confirmed -- that Goldman Sachs (GS) reached a settlement with the Securities and Exchange Commission reinvigorated the bulls, and stocks pared most of their losses by the close. The Dow ended its seven-session winning streak, but closed down only 0.07%.

The Goldman settlement, and the news Thursday that BP plc (BP) had finally managed to cap the Gulf oil leak, might ordinarily have provided a jumpstart to trading on Friday. But consumer sentiment fell off a cliff in July, reaching its lowest level since August 2009. The consumer sentiment index, which is a survey conducted by Reuters and the University of Michigan, fell to 66.5 in early July from 76 in late June. Analysts had expected a much smaller drop-off. Traders were also clearly disappointed by earnings in the financial sector, particularly by Bank of America (BAC) and Citigroup (C.) The Dow responded by sinking like stone. By the close, the Dow had dropped 261.41 points, or 2.52%, wiping out the week's gains and then some. The Dow lost about 1% on the week, while the S&P 500 Index slipped 1.2%, and the Nasdaq Composite fell 0.8%.

What the Trader Is Expecting in the Coming Week: Don't Panic (But Fasten Your Seatbelts)
Ryan Detrick, Senior Technical Strategist

Todd is out on vacation the next two weeks, so I'll be filling in for him.

How about that? Second-quarter earnings might not be so bad after all. Quarterly profits thus far have been solid. Alcoa Inc. (AA) kicked things off in the right direction and Intel Corp. (INTC) actually had its most profitable quarter ever, making $2.9 billion. Although Friday's big drop left a sour taste in everyone's mouth, taken in context, a slight pullback this week is acceptable. Coming on the heels of the best week in a long time, and concerns that retail sales were weak for the second month in a row, housing data is dropping off a cliff, consumer sentiment is weakening, and jobs are not coming back as quickly as we'd all like to see – the SPX finished down only 1.2% for the week.

Speaking of AA, we've found that over the last five years, when the stock is up the day after reporting earnings (remember, they report earnings the night before) this is actually a very good sign for the market in the near term. And vice versa, if AA is down – it could be signaling rough times ahead (which it did last quarter ahead of a big market sell-off). Given AA was up more than 1% on Tuesday, the day after earnings, this is a good sign.

Turning to the charts, the S&P 500 Index (SPX) rallied up to nearly 1,100, its 50-day moving average and the site of a trendline connecting recent highs. This was a logical place for a break and Friday's large sell-off confirmed this.

Another chart we are watching closely is the CBOE Market Volatility Index (VIX) and its 200-day moving average. As Todd mentioned last week, this trendline was support last June and it once again served as support. Higher volatility is usually bearish for the overall market, so if you're bullish, you'd want to see this trendline eventually break.

To quote Mark Twain, "History doesn't repeat itself but it does rhyme." Over the past month we've seen various bearish technical formations take shape. From "death crosses" to "Dow theory sells" to "broken spread triple bottoms" to "bearish head-and-shoulders" formations, the technical crowd has a lot of reasons to be bearish. As Todd put it last week, "...suffice it to say that there was (and could still be) a crowded short trade among many chart technicians."

Out of all of the technical patterns above, none were as widely covered as the bearish head-and-shoulders pattern. What does this have to do with the Mark Twain quote? We heard the exact same thing last July on another well publicized head-and-shoulders top before a huge end-of-year rally.

Last year, during the second week of July, the SPX broke its neckline around 880. This break projected a move down to about 820. What happened? The SPX bottomed around 870 and rallied uninterrupted until the end of the year. You can read what I had to say about last year's head-and shoulders-formation here.

Earlier this month, the SPX broke its neckline around 1,040 with a projected move of 860 as the ultimate target. What has happened so far? The SPX made it down to 1,010, before a massive spike higher up to near 1,100, before Friday's sell-off.

Now this isn't meant to be a shot at technical analysis, because I do think price action is important. But what you also need to add to your trading arsenal is sentiment. When everyone agrees on something, you might strongly consider taking the contrarian view. Last year at this time, with the SPX trading at 980, I gave reasons why you should remain bullish. It wasn't a popular call at the time, as nearly everyone was bearish, but was ultimately proven correct as the SPX made it clear up to 1,220 this past April.

Speaking of which, in late April I discussed how sentiment was getting a little over-the-top bullish and we could be due for a pullback. I had no clue we'd pull back as much as we have; nonetheless, sentiment was the key for predicting future price action. Not price action by itself.

So once again, now that we have the technical community in agreement that stock prices are headed lower, what is the sentiment telling us? As Todd pointed out last week, investor polls are getting near past levels of extreme skepticism, thus areas that coincide with major market bottoms. Another potentially bullish development in this area is the Investors Intelligence poll just saw more bears than bulls for the first time since April 2009. And the bulls came in at only 32.6% percent, the lowest level since late March 2009. As this chart shows, pullbacks near the 0% area (in other words the same amount of bulls versus bears) have marked some nice buying opportunities during previous bull market pullbacks.

After dropping nine of 10 days, the Dow recently gained seven straight days. You might think this would be bearish in the near term – as it suggests the market is overbought. This line of thinking actually couldn't be further from the truth. Since 1990, there have been 18 times that the Dow was up seven straight days. As you can see, this is actually extremely bullish going out 10, 21, and 42 market days versus the typical Dow returns since 1990.

Not to be outdone, the VIX recently dropped seven days in a row, ending on Tuesday. Similar to the Dow up seven days in a row – this is very bullish going out two months. And this is even rarer than the Dow study, as this has happened only nine times since 1990.

Finally, turning to next week, we have noticed a definite bearish slant to the first week of a new expiration cycle. Our thinking is this weakness occurs as institutions and other large traders buy portfolio protection in the form of puts on exchange-traded funds (ETFs) – thus putting downward pressure on the overall market. Given last week was July expiration, that opens the door for some weakness next week as we enter the August cycle. Finally, August is a five-week cycle. Most monthly option cycles are four weeks. Per below, we've noticed that things are especially troublesome for the first week of a five-week cycle.

So next week we could see a continuation of Friday's weakness, but looking out a few months, this overall bounce very well could continue after some more weakness.

Looking at a long-term chart of the SPX, I think it does pay to keep things simple. On a monthly chart, you can't like the double failure earlier this year at the 80- and 160-month moving averages. It's tough to be extremely bullish until we get above those two trendlines.

At the same time, we like to look at the 80-week moving average. As you can see, this trendline held all pullbacks during the last bull market and once it was violated in late 2007, it was time to sell. In the near term, as long as we stay above this trendline, to me, you still have to side with the bulls, given the overall negative sentiment we are seeing.

Nonetheless, as Todd has been stressing, with as much volatility as we've been seeing, it is prudent to shorten your time frames and if you are trading longer term, be sure you are properly hedged.

I'll leave you with a few stats that caught my eye this week. First, the bad news: two-year yields fell to a record low, suggesting the bond market isn't buying the economic recovery. There is nothing nice about this for the stock market, and we'll need yields to begin to trend higher for a meaningful market rally to form.

Now for some good news, from a contrarian point of view: there have been net redemptions for three straight years from equity-based mutual funds. The last time we saw three straight years similar to now was 1979-1981. Looking back, not a bad time to be accumulating stocks ahead of one of the greatest bull markets ever. I'm not saying we'll see another 20-year rally like that, but no one wants to own equity mutual funds and that is exactly why you should want to. Secondly, hedge funds' net exposure to equity markets (measured as long minus short as a percentage of capital) is 18%. This is the lowest level since March 2009, and a big drop from June's 29%. Anytime I see something that is at a similar level to March 2009, you have to pay close attention.

Good luck trading and I'll be back next week.

Free Webinar: Why You Should Consider Options

Are you intrigued by the idea of options trading, but also a little frightened by the market in general these days? Are you confused by options jargon, which can be a little scary for rookies? We have a free new Schaeffer's webinar just for you. Put a circle around Tuesday, July 20, 1 p.m. on your calendar and let Senior Equities Analysts Elizabeth Harrow and Andrea Kramer give you "Four (Really Good) Reasons to Try Your Hand at Options." Elizabeth and Andrea will explain in clear, easy to understand language why options should be part of your portfolio. Sign up here for this free Schaeffer's webinar.

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: CBOE Correlation Index
By Rocky White, Senior Quantitative Analyst

Foreword: Most traders are familiar with the Chicago Board of Options Exchange (CBOE) Volatility Index, which is simply known as the VIX. The VIX uses options on the S&P 500 Index (SPX) to calculate the implied volatility that the market is predicting in the near future. A little less known is the CBOE's Correlation Index, which computes the expected future correlation between the stocks in the SPX.

I'll describe the Correlation Index since it's still a mystery to some traders. It is the expected average correlation of price returns of the individual stocks in the S&P 500. In other words, if the market expects all stocks and sectors to move together (which they often do in a market crash), then the S&P Implied Correlation Index will have a high reading. If the market expects sectors and stocks to move independently of each other (this would be "normal" times, when a well-diversified portfolio will naturally be hedged), then the S&P Implied Correlation Index will have a lower reading. Currently, there are two indexes for the implied correlation. One is the JCJ, which uses options that expire in January 2011, and the other is the KCJ, which uses options that expire in January 2012.

An Extreme Reading: The chart below shows the JCJ along with the SPX since 2009. It's extremely interesting that this index is higher now than at any other time. The beginning of 2009 was the climax of a market crash that lasted more than a year and saw the index fall by nearly 60%. The current pullback is about 15%, but that's after the market rallied by 80% off the bottom.

I think the graph below gives us more perspective on the Correlation Index. The chart below shows the ICJ (the Correlation Index using options that expired in January of this year) going back to mid-2008. Before the crash accelerated in late 2008, the Correlation Index commonly traded below 50. This index reached 75 at the market bottom before it began falling in the latter part of 2009.

Implications: The CBOE's S&P Correlation Index is trading at an extreme high right now. If this was symptomatic of investor fear, then it would make us contrarians pretty excited. However, if that were the case then you would also see an extremely high VIX. The VIX closed at a relatively high level of 26.7 on Friday but that is nowhere near an extreme. It seems as though investors aren't necessarily expecting a crash scenario, but they are expecting heightened correlation going forward. It suggests to me that maybe investors are buying and selling based on news-driven events that affect the entire market. Instead of focusing on company fundamentals, maybe they are focused on some of the things below.

• Economic data such as inflation or employment figures

• What will the Fed do on interest rates

• Congressional action on the expiring tax cuts, health care or cap and trade

• The health of Europe

• Escalations in the wars in Iraq and Afghanistan or conflicts with Iran

We would suggest keeping a close eye on developments in these areas as they can trigger huge moves in the entire market. This is especially true overnight and even more so over the weekends.

This Week's Key Events: Earnings Season Picks Up the Pace
By Joseph Hargett, Senior Equities Analyst

Earnings season unofficially kicks off each quarter with the report from Alcoa Inc. We also heard last week from JPMorgan Chase & Co. (JPM), Google Inc. (GOOG), Bank of America Corp. (BAC), Citigroup Inc. (C), and General Electric Co. (GE). But that was just the beginning of the fun. 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

• There are no economic reports slated for release on Monday. Delta Air Lines Inc. (DAL), Halliburton Co. (HAL), Hasbro Inc. (HAS), IBM Corp. (IBM), Noble Corp. (NE), Texas Instruments Inc. (TXN), and Zions Bancorporation (ZION) will release their quarterly earnings reports.

Tuesday

• June's building permits and housing starts will hit the Street on Tuesday. Biogen Idec Inc. (BIIB), Goldman Sachs Group Inc. (GS), Harley-Davidson Inc. (HOG), Johnson & Johnson (JNJ), PepsiCo Inc. (PEP), Boston Scientific Corp. (BSX), Juniper Networks Inc. (JNPR), Seagate Technology (STX), VMware Inc. (VMW), and Yahoo! Inc. (YHOO) are scheduled to report earnings.

Wednesday

• The market will be graced with the weekly report on U.S. petroleum supplies on Wednesday, while Abbott Laboratories (ABT), The Coca-Cola Co. (KO), EMC Corp. (EMC), Wells Fargo & Co. (WFC), Baidu Inc. (BIDU), CA Inc. (CA), eBay Inc. (EBAY), Netflix Inc. (NFLX), QUALCOMM Inc. (QCOM), Starbucks Corp. (SBUX), Western Digital Corp. (WDC), and Xilinx Inc. (XLNX) will post their quarterly results.

Thursday

• Weekly initial jobless claims will be joined by June's existing home sales and June's leading economic indicators. Akeena Solar Inc. (AKNS), AT&T Inc. (T), The Blackstone Group LP (BX), Bristol-Myers Squibb Co. (BMY), Caterpillar Inc. (CAT), Continental Airlines Inc. (CAL), Eli Lilly & Co. (LLY), Fifth Third Bancorp (FITB), Nokia Corp. (NOK), PNC Financial Services (PNC), Travelzoo Inc. (TZOO), Amazon.com Inc. (AMZN), Capital One Financial Corp. (COF), The Cheesecake Factory Inc. (CAKE), E*Trade Financial Corp. (ETFC), The Mosaic Co. (MOS), SanDisk Corp. (SNDK), and Xerox Corp. (XRX) will report earnings.

Friday

• Friday ends the week as it began, with no reports slated for release. Joining the earnings parade will be Honeywell International Inc. (HON), Johnson Controls Inc. (JCI), Schlumberger Limited (SLB), Verizon Communications Inc. (VZ), and Kimberly-Clark Corp. (KMB).

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) once again pulled back to support near its 200-day moving average. This trendline provided key support for the fund during May's flash crash and again in June. Furthermore, the fund has outperformed the S&P 500 Index (SPX) despite the recent market pullback. Last week, the IYR's half-high at $47.50 held as support, while investors seem reluctant to allow the trust to slip into negative territory on the year. 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 38% of the 1,107 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. What's more, last week, the fund suffered its second rejection at its 50-day moving average since the beginning of June. Furthermore, despite the news that BP has capped the oil leak in the Gulf, and a slouching U.S. dollar, oil prices remain under significant pressure. In fact, crude prices were once again stopped in the $79 area last week, forcing crude prices to contend with turmoil near the $75 per barrel level. 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

Euro Bullish

Outlook: The euro has taken a bit of a beating during the European sovereign debt crisis, but the sell-off may have been overdone. Bearish investor sentiment has certainly gotten out of hand, with financial pundits from both print and broadcast media speculating on the collapse of the seven-nation currency. Furthermore, investors have levied heavy short interest against euro futures, betting on additional declines in the currency. However, the CurrencyShares Euro Trust (FXE) is in the process of rebounding from record lows. In fact, the trust has reclaimed key support at the $125 level, which provided a floor for the FXE in 2008 and 2009, as well as its 80-day moving average. Finally, the trust's nine-day RSI is rebounding off a double-bottom low, indicating that buying pressure should return to FXE. However, there is still a lingering risk of a bigger-picture decline, and FXE is facing potential resistance at its 200-day moving average. As such, we could recommend hedging any bullish positions.