Monday Morning Outlook: Dow Jones Industrial Average Clings to 10,000

              

That was a close one! It came down to the wire on Friday, but the Dow Jones Industrial Average (DJIA) managed to rally back nearly 200 points and eke out a close above 10,000 for the week. Growing concerns about European sovereign debt and a less-than-inspiring January nonfarm payrolls report were at least partly to blame for last week's turmoil. Looking ahead to next week, Todd Salamone, Senior Vice President of Research, examines key technical support and resistance levels for the S&P 500 Index (SPX). He also drills down on several sentiment indicators, and explores the potential for a buying opportunity in the current market environment. Next, Senior Quantitative Analyst Rocky White takes a look at the December lows indicator, and examines the theory that the market is in for a rough year if the prior December's lows are taken out. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Dow Survives the Showdown at 10K, Barely
By Joseph Hargett, Senior Equities Analyst

After getting soundly trounced in January, it appeared that the Wall Street bulls were set to wipe the slate clean and resume their control of the market in February. Monday certainly started off on the right foot, as a stronger-than-forecast fourth-quarter report from Exxon Mobil (XOM) helped rouse the bulls from their slumber. What's more, the Institute for Supply Management (ISM) noted that its manufacturing index improved to 58.4% in December, outpacing consensus estimates. The Dow Jones Industrial Average (DJIA) gained 1.19% on the session, and seemed to be on its way toward reclaiming some of the prior month's losses.

Tuesday picked up where Monday left off, with the National Association of Realtors' pending-home sales index unexpectedly rising in December, while home builder D.R. Horton (DHI) reported that it swung to a profit for the first time since 2007 in its fiscal first quarter. Against this backdrop, the Dow rallied 1.09%, marking the best two-session winning streak in three months.

The rally hit a wall on Wednesday, as traders were underwhelmed by a weaker-than-expected ISM services index and an uninspiring ADP employment report. Elsewhere, Toyota Motors (TM) accelerated into the red amid more engineering issues, while a weaker-than-forecast fourth-quarter earnings report from Pfizer (PFE), and President Obama's vow to crack down on big banks, helped stifle an eleventh-hour rebound attempt. For the day, the Dow slipped 0.26%.

The floodgates were opened on Thursday, with dismal data overshadowing a strong earnings report from Cisco Systems (CSCO). The mood soured even before the open, as Spain hiked its budget deficit forecasts through 2012 -- becoming the latest member of the euro zone to confess to crippling debt issues. Meanwhile, the Labor Department reported that initial jobless claims unexpectedly rose in the latest week, spooking traders ahead of Friday's nonfarm payrolls report for January. By the close, the Dow had plunged 2.61%, finishing at its lows for the year.

Stocks spent most of Friday's session wallowing in the red, as economic trouble in Europe and an ambiguous January jobs report weighed on the Street. In the euro zone, Portugal passed a bill allowing the country's autonomous government to keep spending at will – exacerbating fears about lofty deficits in both Greece and Spain. Elsewhere, the highly anticipated January nonfarms payroll report sent mixed signals to investors, with some cheering an unexpected decline in the unemployment rate, while others bemoaned negative revisions to prior statistics. However, thanks to a dramatic eleventh-hour coup by the bulls, the major market indexes pared all of their losses by the close, as the Dow gained 0.10% on the day. For the week, the DJIA fell 0.5%, while the S&P 500 Index (SPX) surrendered 0.7%. The Nasdaq Composite (COMP), meanwhile, backpedaled only 0.3% for the week.

What the Trader Is Expecting in the Coming Week: A Potential Buying Opportunity for Hedged Investors
By Todd Salamone, Senior Vice President of Research

In last week's report, I concluded with the following market summary:

"There has been a bullish tone lately when flipping the calendar to a new month. Amid signs of increasing fear and an oversold condition, this combination sets the stage for a bounce into resistance around 1,100. But take note that the technical backdrop has deteriorated relative to the other pullbacks that we have witnessed during the past several months, suggesting there is more risk in the market now. Therefore, keep your long positions hedged with protective puts. Short-term resistance for the SPX is in the 1,100-1,110 range... Support is in the 1,040 area, site of the 160-day moving average and the lows in October that preceded the November advance."

As you can see in last week's chart of the S&P 500 Index (SPX) below, the anticipated "bounce" lasted only two days, beginning with the traditional Monday morning strength that has followed the usual Friday weakness, a pattern in 2010. Sure enough, the rally stalled in the 1,100-1,110 range and, by Friday afternoon, support in the 1,040 area was being tested. For the bulls, the good news is that the 160-day moving average and the August highs and October lows proved to be solid support, as the SPX rallied 22 points off its Friday afternoon lows. Meanwhile, while the headline Dow Jones Industrial Average (DJIA) dipped below 10,000 during the week, it did not experience a daily close below this millennium mark. Amid the roller-coaster ride and the gut-wrenching decline from Wednesday morning through most of Friday, the SPX only fell seven points during the week, or less than one percentage point. From the intraday high on Jan.19 to Friday's low, the SPX has declined 9.2%.

From a technical perspective, we continue to have concerns about the SPX's breach of its 80-day moving average and the subsequent unsuccessful attempt to rally back above this trendline early last week. That being said, from a bigger-picture perspective, we find it intriguing that many investors have quickly soured on the market's prospects. For new readers, buying opportunities usually occur when investors become fearful, as this is a sign that most of the selling pressure has been exhausted. Yes, there may be logic in this sentiment within the context of the magnitude of the pullback and the break below an important trendline. But, for those with a four- to six-month time horizon, or longer, we strongly recommend evaluating and acting upon opportunities on the long side. You can hedge these plays with short-term put options in case the current situation continues to deteriorate beyond our expectations.

Where are we seeing evidence of the souring mood among investors, as described above?

1. The American Association of Individual Investors weekly survey showed that less than 30% of those surveyed describe themselves as bullish on the market. This is the first time since November 2009 that the percentage of bulls fell below 30%. The percentage that describe themselves as bearish rose to 43%, also the highest since November 2009.
2. The International Securities Exchange's (ISE) customer-only, equity-only 10-day call/put volume ratio has plummeted to its lowest level since December 2009. The current 1.58 reading is on the heels of a very low 1.28 reading on Thursday.
3. Investors seeking portfolio protection drove the CBOE Market Volatility Index (26.11) to a high of 29.22 on Friday afternoon. Since early September, this index has peaked in the 30 area. Bulls should take note, however, that the VIX closed the week above its 200-day moving average, which might suggest that we are moving toward a higher period of volatility in the market, which would translate into additional selling.

Many major indexes are trading just above strike prices with major put open interest, as expiration is only two weeks away. For example, there is significant put open interest at the 105 strike on the SPY, which equates to SPX 1,050. Should this level break, delta hedging by those players that sold the puts could create significant selling. But if the indexes hold above these major put strikes in the days ahead, short covering related to the expiring put open interest could drive the market higher in the days ahead.

Our theme remains the same -- hedge your long positions. The current pullback could be a major buying opportunity within the context of the advance since March 2009 and the bigger-picture fears about the economy (which leaves room for positive surprises in the future). But the SPX's failure at the 160-month moving average in January, and the subsequent break below the 80-day moving average, still leaves cause for concern.

On a final note, the below table lists the SPX's return on the first day of the week since September 2009. Consider this some food for thought when planning for Monday morning.

• The previous eight occurrences have been positive.
• The previous 13 of 14 occurrences have been positive.
• In the table below, the last 19 of 22 occurrences have been positive for an average of return of 0.78%.

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: Breaking December's Lows
By Rocky White, Senior Quantitative Analyst

Foreword: Last week, the Dow Jones Industrial Average (DJIA) fell to its lowest price of the year. In fact, the last time the market was as low as Friday's close was early November 2009. I have heard that if the Dow breaks below its December lows in the first quarter of a year, it bodes ill for the market going forward. This week, I'm taking an in-depth look at the numbers to see for myself if this assertion is correct.

December Low Indicator: Using the Dow as a benchmark, I gathered data from instances where the average took out its December lows at any time during the first quarter of the following year. Then I found the market returns for those years and compared them to years when the previous December's lows held. Of course, years when the December lows were eclipsed are naturally at a disadvantage, since by definition they had an early loss for the year. Therefore, I also look at the returns of the final three quarters of the year.

The table below contains the aforementioned data dating back to 1950. According to the data in the last two columns, there appears to be some credibility to this indicator. In the 26 individual years that the December lows were broken in the first quarter, the Dow averaged a return of 3.1% in the last three quarters. What's more, those quarters were positive 58% of the time. These returns significantly trail the years when the December lows were not broken, which showed an average return of 8.1% and positive returns in more than 80% of the instances.

Don't Sell Yet: The table above shows that this has been a pretty reliable indicator in the past, and it definitely makes for a good media sound bite. However, as I dig deeper into the numbers, especially the more recent data, the conclusions drawn from the table above become a bit murkier.

The table below is similar to the one above, except the data only dates back to 1980. Again, we see some underperformance in the years when the December lows were breached. However, the gap in returns is not nearly as wide the one present in the table with data dating back to 1950. Also, returns for the final three quarters are not bad by any means.

Digging Deeper: Since three quarters is a long time for option players to hold a position, I looked at returns over shorter time frames immediately following the breach of the December lows. I show each year that the lows were broken, and the returns for different time frames, ranging from two weeks to the full year. The table below details individual returns since 1980, including the average and median returns. Finally, for comparison, I show average and median returns at any time since 1980.

There definitely does not seem to be any immediate cause for panic due to the December lows being broken. In the short term, the returns are pretty close to typical market returns. Also, average returns for the rest of the year following a breach of the December lows are for a gain of 9.9%, with a median of 16%. Finally, looking at those rest-of-year returns on an individual level, we see that four of the past five instances have been positive, and that three of those gains were in the double digits. I think that when we really get into the data with this indicator, you can conclude that the breach of the December lows is nothing to be afraid of going forward.

While I'm not saying that there is nothing to be afraid of, I am stating that this indicator is not to be feared.

This Week's Key Events: January Retail Sales and Consumer Sentiment on Tap
By Joseph Hargett, Senior Equities Analyst

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 Web site for official reporting dates.

Monday

• There are no economic reports slated for release on Monday. Hasbro Inc. (HAS), Loews Corp. (L), Electronic Arts Inc. (ERTS), and Evergreen Solar Inc. (ESLR) will enter the earnings confessional.

Tuesday

• December's wholesale inventories are scheduled for release on Tuesday. BJ Services Co. (BJS), Biogen Idec Inc. (BIIB), The Coca-Cola Co. (KO), Pulte Homes Inc. (PHM), Baidu Inc. (BIDU), and The Walt Disney Co. (DIS) are slated to release earnings.

Wednesday

• The December trade balance, weekly crude inventories, and the January Treasury budget will hit the Street on Wednesday. Computer Sciences Corp. (CSC), Elan Corp. (ELN), Sprint Nextel Corp. (S), Allstate Corp. (ALL), and Boston Scientific Corp. (BSX) will report earnings.

Thursday

• Traders will see weekly initial jobless claims, January's retail sales, and December's business inventories on Thursday. Akeena Solar Inc. (AKNS), AutoNation Inc. (AN), JA Solar Holdings Co. Ltd. (JASO), PepsiCo Inc. (PEP), Agilent Technologies Inc. (A), Buffalo Wild Wings (BWLD), Cheesecake Factory Inc. (CAKE), McAfee Inc. (MFE), and Panera Bread Co. (PNRA) are scheduled to report earnings.

Friday

• Friday brings a quiet close to the week, with only February's University of Michigan consumer sentiment index on tap. PepsiAmericas Inc. (PAS) and Duke Energy Corp. (DUK) are releasing their earnings reports on Friday.

And now a few sectors of note...

Dissecting The Sectors

Sector

Real Estate Bullish

Outlook: From a technical perspective, the real estate sector has shown resilient price action amid the current economic conditions. Specifically, the iShares Dow Jones U.S. Real Estate Index Fund (IYR) has soared more than 41% during the prior 52 weeks. By comparison, the S&P 500 Index (SPX) has risen just 31% for the same time frame. Last week's continued grind lower was a minor blow to the bulls, but the IYR is clinging to support in the 43-43.50 region. Meanwhile, there is plenty of negativity levied against the real estate sector that could unwind sharply in the wake of a rebound from technical support. There have been quite a few negative pieces centering on risks to commercial real estate in the financial media, including a recent article on the front page of The Wall Street Journal. Meanwhile, Wall Street analysts have little nice to say about the group, with more than 67% of the ratings doled out on IYR holdings coming in at "holds" or worse. What's more, short sellers are also betting heavily against the sector, as the composite short-to-float ratio for IYR holdings comes in at 8.75%. With the ETF in a solid uptrend, an unwinding of this negativity should provide a serious tailwind for the sector.

Sector

Internet Bullish

Outlook: Internet stocks have been standouts within the market-leading technology sector. This impressive price action can be seen in the Internet HOLDRS Trust's (HHH) 128% surge off its November 2008 low of $23.20. What's more, the trust is currently hovering near support in the 53 region. This area capped the trust from July through September 2008, and should now provide support, with the HHH holding steady above this region since late October. Short sellers are beginning to react to the sector's technical strength, as the number of shares sold short plunged by more than 26% during the past month. A continuation of this short covering could provide a tailwind for the sector. The group has also put in a solid performance in the earnings confessional so far this season. Specifically, Amazon.com Inc. (AMZN) rocketed higher after reporting that sales spiked 42% during the most recent quarter, while Netflix (NFLX) shares soared as much as 22% after the company topped Wall Street's expectations. NFLX is of particular interest, as more than 21% of its float is sold short. From a contrarian perspective, the rampant pessimism amid HHH's technical prowess has bullish implications.

Sector

Retail Bullish

Outlook: Despite the recent market turmoil, the retail sector remains an outperformer. In fact, the SPDR S&P Retail (XRT) exchange-traded fund (ETF) has rallied more than 71% during the past 52 weeks. More recently, the trust has consolidated above support at the 34.50 level, which is just below the trust's 10-week and 20-week moving averages. Additionally, the ETF has support at its 120-day moving average rising into the area, a trendline that has provided a technical lift since early July. Despite the group's resilience, pessimism blankets the retail sector. BusinessWeek recently featured a negative cover on the employment outlook, while many analysts remain skeptical of the sector due to persistent doubts regarding consumer spending. What's more, a healthy portion of the Street remains skeptical, as less than half of the 965 analyst rankings on retail stocks are "buys" or better. Such fears should keep expectations low for this group, which sets the table for disappointing developments to result in only minor setbacks, while positive surprises could spark sharp rallies.