Monday Morning Outlook: Rally Continues in Face of Broad Skepticism

              

Driven by another solid round of economic data and a surprise quarterly profit from Alcoa Inc. (AA), the bulls stampeded back onto Wall Street last week. Well-rested from their two-week hiatus, bullish investors found renewed hope for the global economic recovery in better-than-expected manufacturing and sales data, as well as an interest-rate hike from the Land Down Under. While earnings are all the rage on the Street, next week is expiration week, and Todd Salamone, Senior Vice President of Research, revisits this volatile topic and its potential implications for the week ahead. Todd also examines the bearish tone in a lot of recent financial commentary. Lest we forget about earnings, Senior Quantitative Analyst Rocky White takes a closer look at Alcoa as the starting gun to earnings season, and whether the pace the aluminum giant sets has any impact on the rest of the market. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: The Bulls Are Back in Town
By Joseph Hargett, Senior Equities Analyst

After a rough couple of weeks, the bulls are back in town. And judging from the Dow Jones Industrial Average's (DJIA) week-over-week return, they're not hanging down at Dino's. The Dow resumed its uptrend with fervor, soaring 1.18% on Monday in the wake of upbeat economic data and positive analyst notes. The embattled financial sector emerged as a leader, as Goldman Sachs upwardly revised its view on major domestic banks from "neutral" to "attractive." Meanwhile, the Institute for Supply Management (ISM) reported that its non-manufacturing index improved to 50.9 in September, up from 48.4 in August. The Dow extended its upward trajectory on Tuesday, thanks to a growing hope for economic recovery. Driving the latest round of optimism, the Reserve Bank of Australia became the first G20 member to boost interest rates since the economic downturn. The move also pressured the U.S. dollar lower and sent gold futures to the first in a string of record highs. For its part, the DJIA added 1.37% on the session.

Wednesday snapped the Dow's string of triple-digit gains, as hot and cold sentiment ahead of Alcoa Inc.'s (AA) date in the earnings confessional kept the major U.S. market indexes flirting with breakeven for most of the session. The Dow dropped a fractional 0.06% for the day. The bulls shifted back into high gear on Thursday, as investors cheered a surprise profit from Alcoa and a string of positive same-store sales figures from the retail sector. Overall, sales rose 0.1% for the month, compared to analysts' expectations for a drop of 2%, according to the International Council of Shopping Centers (ICSC). Elsewhere, the Labor Department reported that initial and continuing jobless claims fell to their lowest levels since January, helping to push the Dow to a gain of 0.63%.

Interest-rate chatter from Federal Reserve Chairman Ben Bernanke set the market on edge early on Friday, as the central bank bigwig vowed to raise key rates and ease stimulus measures when the economy's path to recovery becomes more pronounced. Nevertheless, the major market indexes eventually journeyed to the north side of breakeven, after the Commerce Department reported that the U.S. trade deficit narrowed for the first time in four months in August. By the close on Friday, the Dow rose 0.80% for the session, gaining 4% for the week. Elsewhere, the S&P 500 Index (SPX) and the Nasdaq Composite (COMP) both jumped 4.5% for the week.

What the Trader Is Expecting in the Coming Week: Gloom and Doom in the Financial Press
By Todd Salamone, Senior Vice President of Research

"The pullback can be labeled 'mild' so far, since the SPX continues to trade above the 1,000 millennium mark and, for that matter, above its 50-day moving average, which is currently situated at 1,021.80. The retreat can be viewed as an opportunity to go long stocks that were overbought just a few weeks ago... With the SPX lower in seven of the last eight trading days, the most oversold since late June and early July (according to the nine-day Relative Strength Index and TRIN readings), and trading just above intermediate-term support levels, a move higher would be expected in the near term. However, if stocks cannot rally or at least stabilize by the end of this week, the recent peak around the 80-week moving average could prove to be more than a speed bump."
-- Monday Morning Outlook, Oct. 3, 2009

The long-awaited sharp pullback expected by many professional and retail investors remains elusive, as better news on the economy (namely jobless claims and retail sales) and a stronger-than-expected earnings report from Alcoa set a more positive tone for stocks. In the immediate days ahead, the bulls have in their favor expiration week, which has historically had a bullish bias. And in the weeks ahead, the bulls can look forward to the potential for a repeat of a pattern that has existed in 2009 -- skepticism ahead of earnings season followed by positive surprises and a surging stock market.

So, as we look to the week ahead, the SPX comes into the week trading near the top of a recent range in the 1,070-1,075 area. With that being said, it wouldn't be a huge surprise if the first day of expiration week begins on a sour note. That sour note sounded in May, June, July (morning weakness), August, and September expiration weeks.

If mean-reversion continues to be the order of the day, stocks may stumble out of the gate yet again as the week gets started. But, as long-time readers know, expiration weeks tend to have a bullish bias, as the unwinding of short positions related to the hedging of expiring index put positions occurs. The table below compares expiration-week returns to non-expiration week returns. The positive weekly returns stand out amid a period in which the SPX has declined. So, while probabilities are on the side of the bulls this upcoming week, one should also note that the low-probability declines during expiration week have been more violent than a typical non-expiration week decline, which suggests hedging some of your bullish plays.

The skepticism that has accompanied the rally is amazing, as market watchers continue to be concerned about the market coming "too far, too fast." This doubt represents sideline money that can potentially support pullbacks and propel stocks higher. Consider some of the anecdotal evidence of skepticism that our analysts shared with each other over the course of last week:

1. Analysts at Bank of America/Merrill Lynch believe a correction in the SPX "appears under way," with key support at 870-920, which would equate to 15-20% decline from the recent 1,080 high.
2. BusinessWeek, Oct. 1, 2009 – "Fund Managers Bracing for a Sell-Off."
3. The Vice Chairman and Director at BlackRock Investments wrote in Barron's last week that he is bullish, but with an SPX year-end target of only 1,000-1,050, and with caution that "investors should be prepared for corrective action at any time."
4. It was noted on CNBC.com on Oct. 6 that Jim Cramer does not expect a meltdown, but expects another 3-5% correction.
5. CNBC.com also reported last week that the Chief Investment Officer at Wells Fargo Advisors is telling investors to prepare for a 10-20% pullback.
6. Several articles in the Oct. 1, 2009 The Economist, including one article entitled, "A Rally Too Far."
7. Worries about third-quarter earnings – the common denominator is second-quarter earnings surprises were driven purely by cost-cutting, a driver that won't be in place for third-quarter reports, and doubt that companies can deliver on top-line growth.
8. The latest American Association of Individual Investors' weekly survey indicated the percentage of bulls dropped from 43% to 35% -- the 10-week moving average of the percentage bulls and percentage bears is even at 40%. I'd expect more bulls in the context of the current uptrend.
9. Finally, Bernie Schaeffer also commented on this wealth of downbeat commentary in Friday's Schaeffer's Media Outtake .

The doom and gloom amid rising stock prices is especially interesting in light of reports from the Economic Cycle Research Institute (ECRI). The ECRI's Weekly Leading Index (WLI) hit an all-time high last week and comments from the institute were interesting. "We are in the early stages of the recovery and it looks to be a lot stronger" than the consensus for modest 2%-3% GDP growth, said Lakshman Achuthan, managing director of the Economic Cycle Research Institute (ECRI). The recovery will be "V-shaped" and is now "virtually unstoppable" -- at least through the first half of 2010 -- Achuthan says, citing a "positive contagion" in the economy right now, based on leading economic indicators.

Turning back to the technicals, the bad news is that the SPX's 80-week moving average proved to be a major speed bump, a possibility that we discussed during the past few several weeks. The "chop" around this trendline is similar to that of the SPX's struggle around the 1,000 millennium mark in August and September. The good news is that unlike May 2008, the rally up to the 80-week trendline has not been immediately rejected. In other words, a "pause" is preferential to the alternative, a violent pullback that some are hoping and preparing for as alluded to earlier. The 80-week moving average is currently sitting at 1,040.70, which we view as a support area. The 1,040 area acted as resistance in late August and was a brief support area in late September. Should another setback occur, we see big support in the 990-1,000 region. The SPX's 80-day moving average is now sitting at 991.07 and the 1,000 level is 50% above the March low, a resistance area in October 2008 and a speed bump more recently. Resistance lies at 1,080, the late September peak. Meanwhile, the big level that bulls are eyeing is 1,121.44, which is the 50% retracement of the October 2007 peak and March 2009 trough.

Finally, a few follow-ups from last week:

1. The PowerShares QQQ Trust (QQQQ) buy-to-open put/call volume ratio turned sharply lower last week. This may indicate that hedged buyers are giving up on technology and rotating into another group. Therefore, we recommend that you hedge long technology exposure if you are heavy in this area.
2. The CBOE Market Volatility Index (VIX) has again turned lower, unable to sustain a move above its 80-day moving average. This index has been range-bound between 22 and 29 since early-September. The VIX comes into this week nearer the lower end of this range – bulls would like to see the VIX break below 22 in the days ahead.
3. We added the oil service group to our bullish list. While gold is grabbing all of the headlines and admittedly has a bullish technical backdrop, the long gold trade is crowded. Meanwhile, the Oil Service HLDRS (OIH) Trust has vastly outperformed the SPDR Gold Trust (GLD), plus we are seeing evidence of some investors betting against the oil service sector. Therefore, we view the oil services group as attractive from the perspective of a strong technical backdrop amid evidence of skepticism.

Indicator of the Week: Alcoa Inc. Kicks Off Third-Quarter Earnings Season
By Rocky White, Senior Quantitative Analyst

Foreword: Each earnings season, Alcoa Inc. (AA) is one of the first major companies to report. Last Wednesday, AA reported a profit of 4 cents per share, faring far better than the 9-cent loss many analysts were expecting. But Wall Street had seen this act before in the second quarter, with earnings topping consensus views largely due to heavy cost-cutting instead of top-line revenue growth. Continued cost-cutting is obviously not sustainable over the long term, and analysts' chief concern about the upcoming earnings season is whether that top-line growth will return. But AA's quarterly report flew in the face of this skepticism, as revenue growth, not cost-cutting, was the major factor in the company's earnings report.

Specifically, AA reported that revenue grew by 9% for the quarter, easily topping analyst estimates. Consequently, Alcoa saw a very positive reaction on Thursday with AA shares gaining more than a percentage point. Does this tell us anything about what to expect for the rest of earnings season? Is it setting up a series of positive surprises or are we just getting our hopes up so that the rest of earnings season will likely disappoint? I looked back over the last five years of earnings reports to see what Alcoa's positive earnings could tell us about the next few months.

The Past Five Years: The following tables detail the S&P 500 Index's (SPX) returns following Alcoa's earnings reports for the past five years. I broke down the returns depending on whether AA had a positive earnings reaction or a negative earnings reaction. As you can see from the tables below, a positive reaction to AA's earnings is very bullish for the SPX, compared to the index's returns in the wake of a negative reaction. In other words, based on last week's AA earnings reaction, we should be pretty excited about the market moving forward, at least until the fourth-quarter earnings season begins.

Digging into the data, let's take a closer look at the one-month return, as it places the SPX in the heart of earnings season. When there is a positive reaction to AA's earnings, the market returns a very impressive 2.35% during the ensuing month. Only two of the eight such signals detailed below show a declining market for this period. Comparatively, a negative reaction to Alcoa's earnings results in an average market return of 0.34%, with positive returns following seven of the 12 signals.

The Past 20 Returns: In the table below, I show the past 20 earning reactions for Alcoa and the ensuing SPX returns. Note that the pattern mentioned above did not hold true following the prior reporting period, as reactions to AA's earnings report were negative, yet the SPX still put together an impressive return. Also, I notice that the most recent report marked only the second time in the past seven earnings releases that AA had a positive reaction.

Implications: Alcoa's positive reaction has been a good omen in the past, signaling very bullish returns in the following months. Just like last earnings season, we see a lot of negative sentiment heading into these third-quarter reports. With expectations this low, we see more potential for a surprise to the upside rather than the downside. Alcoa's big surprise profit only strengthens our conviction that more positive earnings results can cause a major unwinding of the negative sentiment and propel this market higher. The past two earning seasons saw major double-digit market gains within a month (see the table above). We still see the negative sentiment; all we need is a few more surprises. I would recommend being positioned to take advantage of this.

This Week's Key Events: Fed Minutes and Consumer Price Index 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. On the earnings front, Fastenal Company (FAST) is scheduled to release its quarterly report.

Tuesday

• The economic calendar is devoid of reports for a second consecutive day on Tuesday. Elsewhere, Johnson & Johnson (JNJ), Altera Corp. (ALTR), CSX Corp. (CSX), and Intel Corp. (INTC) are among those reporting earnings.

Wednesday

• September's import/export prices, retail sales, and August's business inventories will be joined by minutes from the most recent Federal Open Market Committee meeting on Wednesday. Meanwhile, Abbott Laboratories (ABT), JPMorgan Chase & Co. (JPM), and Xilinx Inc. (XLNX) are scheduled to report earnings.

Thursday

• Weekly initial jobless claims, the consumer price index (CPI), the core CPI, weekly U.S. petroleum supplies, and the Philadelphia Fed's manufacturing index for October will arrive on Thursday. The earnings calendar includes Citigroup Inc. (C), Cypress Semiconductor Corp. (CY), Fairchild Semiconductor International (FCS), Goldman Sachs Group Inc. (GS), Harley-Davidson Inc. (HOG), Nokia Corp. (NOK), Southwest Airlines Co. (LUV), Advanced Micro Devices Inc. (AMD), Google Inc. (GOOG), and IBM Corp. (IBM).

Friday

• We round out the week's economic calendar with September capacity utilization and industrial production reports, as well as the preliminary University of Michigan consumer sentiment index for October. Reports from Bank of America Corp. (BAC), General Electric Co. (GE), Halliburton Co. (HAL), and Mattel Inc. (MAT) are scheduled for release.

Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insights 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.

And now a few sectors of note...

Dissecting The Sectors

Sector

Technology Bullish

Outlook: The technology sector has been hot in 2009, with the PowerShares QQQ Trust (QQQQ) gaining some 42% since the beginning of the year. Despite this outperformance, investors continue to overlook and to bet against the shares. For instance, net shares in Fidelity Select tech funds are somewhat low when compared to previous years, indicating that retail investors are not crowding the tech sector. As such, there could be sideline money available that could spur demand for tech stocks. In the options pits, call open interest above the trust is extremely thin, virtually eliminating potential overhead options-related resistance. However, the QQQQ's 50-day buy-to-open put/call ratio has rolled over from its highest level since November/December 2007 (the top of the QQQQ's bull market rally). This could be a sign that hedge funds are not longer in "accumulation mode" where technology stocks are concerned, thus posing a risk to the tech sector's momentum. Traders should also continue to keep an eye on the 40 level, as it is home to a 50% retracement of the trust's June 2008 high and its November low. Within the group, our favorites include Palm Inc. (PALM), Western Digital Corp. (WDC), Juniper Networks Inc. (JNPR), Atheros Communications Inc. (ATHR), and priceline.com Inc. (PCLN). Traders should avoid Research In Motion Limited (RIMM).

Sector

Oil Services Bullish

Outlook: Fresh signs of an improving global economy seem to be popping up on a daily basis, and energy prices have responded by trekking higher in anticipation of rising demand. Specifically, crude futures have nearly doubled from their Dec. 24 low of $35.13 per barrel. The oil services sector has wasted no time in capitalizing on this strength, with the Oil Service HOLDRS Trust (OIH) soaring more than 67% since the start of the year. The OIH has gained momentum since the market bottom in March, rallying nearly 90% off its March 6 low of $64.65. Meanwhile, it appears that hedge funds may be in the process of accumulating oil sector stocks, as the OIH's 50-day buy-to-open put/call volume ratio has rocketed higher in recent weeks and now rests at its highest reading of 2009. Typically, OIH puts are utilized by institutional investors as a way to hedge long positions on oil sector stocks or indexes. What's more, the brokerage bunch has room for upgrades, as 46% of ratings on oil service stocks are currently "buys," compared to 67% in July 2008 and 61% at the end of last year. Any upgrades from these analysts could lend additional support for the oil services sector.

Sector

Retail Bullish

Outlook: September same-store sales data has been solid, with 69% of those reporting sales data topping Wall Street's expectations, according to a recent Thomson Reuters report. What's more, the Financial Times said that "Leading U.S. retailers on Thursday reported their first monthly sales gain since the financial collapse of September 2008," as Retail Metrics' September comparable sales index rose 1.1%. Technically speaking, the retail sector has come on strong since the March bottom, with the S&P Retail SPDR (XRT) rallying more than 97% during this time frame. What's more, the exchange-traded fund (ETF) has extended its rally along key support at its rising 10-week and 20-week moving averages. However, pessimism is thick on the retail sector, as only 42% of the 951 analyst rankings on retail stocks are "buys," according to Zacks, leaving plenty of room for potential upgrades. That said, the XRT's 50-day buy-to-open put/call ratio has reached high levels, but has not given an indication of moving higher or turning lower. Within the sector, we see bullish opportunities for Expedia Inc. (EXPE), Whole Foods Market Inc. (WFMI), Green Mountain Coffee Roasters Inc. (GMCR), Polo Ralph Lauren (RL), AutoNation Inc. (AN), Starbucks Corp. (SBUX), Chipotle Mexican Grill Inc. (CMG), and Aeropostale Inc. (ARO).