Week Recap from Schaeffer research

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Forward

The Dow Jones Industrial Average is stuck below breakeven for the year following last week's 3.3% slump. Looking ahead, Todd Salamone, Senior Vice President of Research, sympathizes with traders frustrated by the choppy action of the last several months, and advises caution, especially in the upcoming expiration week. Next, Senior Quantitative Analyst Rocky White looks at the Moving Average Convergence Divergence (better known as the MACD), which calculates the difference between two moving averages of a stock's price. Rocky gives you a contrarian take on the "sell" signals this indicator delivered last week. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Slip Sliding Away
By Joseph Hargett, Senior Equities Analyst

The D word -- as in double-dip -- began as a whisper and turned into a full-throated roar last week. Fears that the U.S. economy would slip back into recession grew with every successive economic report. Employment remains weak. Growth prospects are dimming around the globe. Manufacturing was weaker than expected in both Japan and China, and the Bank of England cut its outlook for the British economy. Everyone from Goldman Sachs to the Federal Reserve agreed that economic recovery is progressing more slowly than expected. The Dow Jones Industrial Average reacted by slumping back below its June highs, reversing the gains of late July and early August.

At least the week started off on an entertaining note, as traders considered the surprise Friday resignation of Hewlett-Packard Co. (HPQ) CEO Mark Hurd, following a sexual-harassment claim. As details unfolded -- did they? didn't they? -- Hurd critics and defenders laid out their cases. Meanwhile, back on Wall Street, Goldman Sachs cut its year-end target for the S&P 500 Index (SPX) from 1,250 to 1,200. Nonetheless, the Dow recorded a solid 0.42% gain for the day.

The Dow sank at the open on Tuesday, dropping 150 points, thanks to disappointing reports on U.S. productivity and Chinese imports. But the big news of the day came from the Federal Open Market Committee (FOMC). The Fed committee reported that economic recovery is progressing, albeit very slowly. It also reiterated the Fed's longstanding pledge to keep interest rates at record-low levels for an extended period and announced plans to invest in longer-term U.S. Treasurys. The Dow pared most of it losses by the end of the day -- dropping 0.51% -- but a gloomy tone had been established.

Wednesday's sell-off began overseas, and financial terminals around the world displayed a sea of red. Both China and Japan released data revealing a slowdown in manufacturing activity, and the Bank of England forecast slower growth for Great Britain -- echoing the Fed's statement of a day earlier. Meanwhile, here in the U.S., the trade deficit unexpectedly widened in June. The Dow tumbled out of the gate and drifted lower throughout the day, finally settling near the session's lows. When the dust cleared, the Dow dropped 265 points, or 2.49%, and slipped below the support of its 200-day moving average.

Any hopes for a Thursday bounce were probably dashed Wednesday night when blue-chip tech titan Cisco Systems (CSCO) confessed to weaker-than-anticipated revenue. CSCO also tempered its outlook for the next quarter and year; CEO John Chambers told analysts that the company is seeing "mixed signals" and an "unusual uncertainty" from customers. Then, to seal the bearish deal, the Labor Department announced a surprise increase in first-time jobless claims. The Dow dropped another 0.57%.

On Friday, inflation hawk Thomas Hoenig, the president of the Kansas City Fed, delivered a major speech in which he criticized near-zero interest rates as "a dangerous gamble." Hoenig has long been dissenting from the Fed's pledge to keep interest rates near zero for an "extended period." Elsewhere, July retail sales inched up 0.4%, and the Reuters/University of Michigan consumer confidence index climbed to 69.6 in August, surpassing expectations. The Dow settled for a slim loss of 0.16%. The Dow ended the week 3.3% lower, while its major market brethren fared even worse. The SPX lost 3.8% for the week, while Nasdaq Composite dropped an ouch-worthy 5%. All three major market indexes are below breakeven for the year.

What the Trader Is Expecting in the Coming Week: Hedge Funds Lack Conviction
Todd Salamone, Senior Vice President of Research

"... it is encouraging if you are a market bull to see the 20-day, buy–to-open put/call volume ratio turn higher from low levels earlier this month, as it suggests that hedge fund managers with heavier-than-normal cash positions are in accumulation phase once again. The big question is whether or not they'll remain in buying mode for a sustained period, like 2009....investors continue to fret over the slowdown in economic growth amid a regulatory environment that is far from 'business friendly' and tax reform that may not be 'investor friendly' in the year ahead. Throw in the upcoming midterm elections in November, and such uncertainty could drive hesitancy among potential investors."
-Monday Morning Outlook, July 31, 2010
"Present price action suggests that the bears are continuing to lose their grip on the market. At the same time, the June highs linger above, and the SPX still has not yet made what might be defined as a bold move above resistance."
-Monday Morning Outlook, Aug. 7, 2010
"U.S. Treasury bonds, often a top choice for risk-averse investors, are attracting more interest from hedge funds now, according to a study released Wednesday by consulting firm Greenwich Associates... Hedge-fund trading volume in U.S. government bonds surged by more than 70% in the past year. In 2009, hedge funds generated about 3% of trading volume in this market."
-MarketWatch, Aug. 11, 2010
Before addressing the above excerpts, note that the end of the coming week coincides with the expiration of August options. Expiration weeks produced generally bullish returns from 2006-2008, but more negative returns since 2009. With trading volume thin, options expiration could influence market action this week. For example, more negative headlines could spark a "delta-hedge" decline, as heavy put open interest below current levels on index and exchange-traded fund (ETF) options act a "magnet" when the market is in distress, due to sellers of portfolio insurance hedging their exposure by shorting futures. But in the absence of negative headlines, short covering related to expiring put open interest could act as a tailwind for the market. For those with time frames of a week or shorter, be open to both possibilities this week, and structure your portfolios accordingly.

Let's get back to the excerpts that preceded the expiration week notice. They are important for establishing who exactly is driving this market, identifying the risks and opportunities, and structuring your trades with this information at hand.

In the first excerpt, the 20-day, buy-to-open put/call volume ratio referred to puts being purchased at a higher rate than calls on the iShares Russell 2000 Index Fund (IWM), SPDR S&P 500 ETF Trust (SPY) and PowerShares QQQ Trust (QQQQ). The idea is that when this ratio is rising, hedge funds are buying puts on these vehicles to hedge long positions that they are accumulating, and the market tends to advance.

As in 2009, it is apparent that hedge funds are the predominant force in driving sustainable trends. Unlike 2009, it is becoming increasingly apparent that hedge funds are not yet committed to long periods of accumulation necessary to sustain a long rally in equities. With that said, the QQQQ/IWM/SPY 20-day, buy-to-open put/call volume ratio has turned lower once again (see the chart below). Should the decline persist, the best-case scenario is a range-bound stock market, as the high-frequency, mean-reverting players dominate the day-to-day action. If high-frequency traders simultaneously step aside, the market becomes vulnerable.





Equity market players with longer-term time frames are likely frustrated with periods like this, as cash-rich hedge fund buying emerges and then suddenly disappears in only a matter of days or weeks. The low conviction and shortening of holding periods among fund managers has been especially apparent in 2010. In fact, judging by the charts, there is little interest among hedge fund managers to accumulate stocks once the SPX moves into the 1,120-1,130 zone. This area defined the highs in late 2009, and continues to define the top of the range at present.

Finally, let's address the surge of hedge fund volume in U.S. government bonds. The iShares Trust Barclays 20+ Year Treasury Bond Fund (TLT) is up 14% year-to-date, easily outperforming the U.S. stock market, oil, and even gold. With deep-pocketed players continuing to plow money into these assets, there could be opportunity to play the TLT on pullbacks. But as we learned in the most recent equity bear market, when hedge funds get too one-sided in a trade, the rush for the exits can be extremely dangerous.

Therefore, the risk is the popularity of the long Treasury bond trade, so hedge any long plays that you enter on a pullback.

How long will hedge fund investors tolerate fund managers tying up assets in risk-free government bonds? If and when investors demand more in return, the equity markets could be a major beneficiary of this firepower. The big question for bulls continues to be, "When will this firepower finally be unleashed?"

Our advice is to shorten your holding periods, have exposure to both sides of the market, and hedge your directional plays. If you are an options player, premium selling has certainly been rewarded during the ongoing chop since mid-May, and this strategy will continue to be rewarded if the trading range continues. Traders with short-term time horizons and an eye for playing both sides of the market can profit too, assuming they have the necessary tools and strategies in place to profit from the short-lived, sharp directional movements we have experienced from time to time in 2010.
Foreword: The Moving Average Convergence Divergence (better known as the MACD) is a very common technical indicator. The indicator calculates the difference between two moving averages of a stock's price. A moving average of the difference is then used to determine buy and sell signals. We track the number of stocks each day that give a "buy" or "sell" signal.

The S&P 500 Index (SPX) tumbled 2.8% last Wednesday and this led to a whole slew of stocks giving sell signals, according to their MACD indicators. That day there were 594 MACD sell signals, which is the most we have ever recorded in a single day (we have been tracking this data since 2000). Below is a chart of the SPX and daily MACD sell signals going back to 2006. The red dots mark times when we saw more than 300 sell signals in a single day.





Quantifying the Results: I'm calling these sell signals because that is the way the MACD is usually interpreted. The results below tell us they haven't been sell signals at all. At least in the short term, maybe we should start referring to these as oversold buy signals.

I went back through our data and found instances when there were at least 300 MACD sell signals on a single trading day. Then I tracked the SPX going forward out to two months. The days after a signal strongly outperform typical market returns. For example, one month after a signal the SPX has been positive 69% of the time, averaging a return of 2.58%. Since 2002 (the year of the first signal) the SPX has averaged just 0.11% in a typical month. The first table below shows results after a 300-sell signal day. The second table summarizes the SPX returns since 2002 for comparison.





Implications: Even though we refer to these as sell signals, the market has had a tendency to go up following an abundance of them. A lot of charts are looking as if they are breaking down technically, but don't let that scare you off. Especially in these times when mean reversion is customary, it could be a good time to have exposure to the market. If the zigzags get you nervous, then there is nothing wrong with hedging your position.

This Week's Key Events: Housing Starts on Tap Tuesday
By Joseph Hargett, Senior Equities Analyst

Earnings season is winding down. 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 New York Fed will release its Empire State Manufacturing Survey for August on Monday. Agilent Technologies Inc. (A), Lowe's Companies Inc. (LOW), Sysco Corp. (SYY), and Urban Outfitters Inc. (URBN) will release their quarterly earnings reports.

Tuesday

Traders will have a lot of economic data to consider on Tuesday. The Commerce Department will release reports on housing starts and building permits for July, while the Labor Department will supply July readings on the Producer Price Index (PPI) and the core PPI. Meanwhile, the Federal Reserve will report on industrial production in July. Abercrombie & Fitch Co. (ANF), The Home Depot Inc. (HD), Saks Inc. (SKS), Wal-Mart Stores Inc. (WMT), and Analog Devices Inc. (ADI) are scheduled to report earnings.

Wednesday

The usual weekly report on U.S. petroleum supplies is due on Wednesday. BJ's Wholesale Club Inc. (BJ), Chico's FAS Inc. (CHS), Target Corp. (TGT), Applied Materials Inc. (AMAT), Brocade Communications Systems Inc. (BRCD), Hot Topic Inc. (HOTT), and Limited Brands Inc. (LTD) will post their quarterly results.

Thursday

The weekly report on initial jobless claims will be released on Thursday, along with the Conference Board's Leading Indicators Index for July, and the Philadelphia Fed Index for August. Dick's Sporting Goods Inc. (DKS), Dollar Tree Inc. (DLTR), GameStop Corp. (GME), Stein Mart Inc. (SMRT), Yingli Green Energy Holding Co. Ltd. (YGE), Aeropostale Inc. (ARO), Blue Coat Systems Inc. (BCSI), Dell Inc. (DELL), The Gap Inc. (GPS), Hewlett-Packard Co. (HPQ), Intuit Co. (INTU), Marvell Technology Group Ltd. (MRVL) and salesforce.com inc. (CRM) will report earnings.

Friday

There are no major economic reports scheduled for Friday. Rounding out earnings for the week will be AnnTaylor Stores Corp. (ANN) and Hormel Foods Corp. (HRL).

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