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SCHAEFFER'S MONDAY MORNING OUTLOOK

Prepared by Shaeffer's Investment Research

DJIA Bulls Defend 10,000; Jobs Report Due Friday
Institutional And Retail Investors Alike Are Skeptical

(August 30, 2010) The Dow Jones Industrial Average fell for the third week in a row, closing below 10,000 on Thursday, before clambering back above that closely watched psychological level on Friday. The Dow slipped 0.6% last week. Looking ahead, Todd Salamone, Senior Vice President of Research, explores two themes. First, retail investors are highly skeptical and reluctant to put cash in this market. Second, hedge funds continue to favor bonds over stocks. As such, there is major firepower for a longer-term market rally, but it's unclear when this firepower might be unleashed. Next, Senior Quantitative Analyst Rocky White compares presidential approval ratings to Dow performance and wonders whether a contrarian market indicator might lurk in the data. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week The big news this week will be the jobs numbers on Friday.

Recap of the Previous Week: Soothing Words From Bernanke
By Joseph Hargett, Senior Equities Analyst

Here's the summer of 2010 in a nutshell: The Dow Jones Industrial Average slips the first week of June, rallies for two weeks, then slumps for two weeks. That's followed by an up week, which in turn is followed by a down week. The Dow then rallies three weeks in a row, a stretch that includes a sizzling 7% one-week gain at the end of July, only to plunge for three weeks in August. The Dow has explored a 1,000-point range during June, July and August, falling below 9,700 at its depths, and threatening 10,700 at its heights. For all the drama, and several trips below 10,000 last week, we're now settled just slightly below the midpoint of that range.

With summer winding down, and relatively slow activity on the news front, the weak economic recovery continued to dominate traders' concerns all week. The Dow battled the breakeven line all day Monday, but late selling pressure eventually forced it to a modest loss of 0.38%.

Traders began the day Tuesday waiting for the July existing home sales report. Expectations were not high, given the expiration of the federal home-buyer tax credit, but it seems no one expected a plunge of 27.2%, the largest-ever monthly decline. The Dow briefly dipped below 10,000 for the first time in over a month. By the close, the Dow managed to hold onto the 10,000 level, but dropped 134 points, or 1.3%.

The gloom persisted early Wednesday when existing home sales for July, like their new home counterparts, came in weaker than expected, sinking 12.4%. Moreover, durable goods orders for July increased by a sickly 0.3%. The Dow again slipped below 10,000, at which point the bulls evidently decided enough was enough, and that the 10,000 level was worth defending. The Dow finished on a slim gain of 0.20%.

Thursday was the day the bulls failed to defend 10,000. Actually, the news was, if not good, then not terrible either. Initial jobless claims dropped far more than expected, although manufacturing in the Fed's Kansas City region turned extremely weak. But the drumbeat of negativism over the last several weeks took its toll again, and the Dow fell to 9,985.81, for a loss of 0.74%.

Federal Reserve Chairman Ben Bernanke rode to the rescue Friday, reassuring investors that the Fed would not ignore the threat of deflation, even as he insisted the recovery is continuing, "albeit at a relatively modest pace." In a major speech at a Fed symposium, Bernanke said, "I expect the economy to continue to expand in the second half of this year," and that "the preconditions for a pickup in growth in 2011 appear to remain in place." Bernanke's soothing words were underscored by the revised second-quarter gross domestic product report. The government lowered its estimate of economic growth in the quarter to an annual rate of 1.6%, down from its original estimate of 2.4%. Even so, the revised rate was still stronger than many economists expected. Traders cheered, sending the Dow to a gain of 165 points, or 1.65% on the day. That pared the Dow's weekly loss to 0.6%. The S&P 500 Index, meanwhile, dropped 0.7% for the week, and the Nasdaq Composite surrendered 1.2%.

What the Trader Is Expecting in the Coming Week:
When Will Hedge Funds Make Their Move?
By Todd Salamone, Senior Vice President of Research

Thanks to Senior Technical Analyst Ryan Detrick, who did an outstanding job covering the stock and bond markets last week. After attending the San Francisco Money Show, I can assure you that Ryan hit the nail on the head when he said, "...we continue to see a very skeptical crowd." For instance, in two of my workshops that centered around option strategies for the current market environment, very few hands were raised when I asked, "How many of you are bullish through year end?"

Above being said, allow me to review some additional statistics that measure the pulse of the investor and that "hit us between the eyes" this week.

One poll that I have discussed in this forum during the past several months is the weekly American Association of Individual Investors (AAII) survey. We have found that when this crowd is negative on the market, it usually marks bullish short-term trading opportunities. In the poll released on Thursday, only 21% surveyed were bullish, while 49% were in the bearish camp. This was the lowest percentage of bulls since March 5, 2009, when only 19% were bullish. So, in terms of the low percentage bulls, we are at an extreme. However, keep in mind that in March 2009, 70% were bearish, whereas 49% are bearish now. So, in that context, we are not quite at a bearish extreme.

Other polls that we found interesting were the Spectrem Affluent Investor Confidence Index and the Spectrem Millionaire Investor Confidence Index, released on Monday, August 25. (The former index measures the investment confidence and outlook of households with $500,000 or more in investable assets; the latter is self-explanatory.) The Spectrem Millionaire Investor Confidence Index fell 11 points in August to minus 18, its biggest drop since June 2009, pushing it to the lowest level since that date. While one might interpret this as bearish for the market, contrarians should note that June 2009 proved to be an excellent buying opportunity.

Last week, Ryan touched on the enormous outflow from equity funds and into bond funds, and the potential bullish implications for equities longer term. I'll add that the Investment Company Institute reported that there were 15 consecutive weeks in which investors pulled money out of U.S. equity funds. This is another extreme that short-term market participants should note, as it too may have contrarian implications.

We find it of interest that the "Hindenburg Omen," an indicator that is designed to predict market crashes, and which has flashed multiple times recently, has created quite the buzz in the investment community. It may be of no surprise that technicians have discussed this development, but it is yet another technical indicator that has made its way into mainstream media, including financial websites and even a general interest local radio station here in Cincinnati, Ohio.

If it isn't enough that the economic and political backdrop are scaring the living daylights out of retail and institutional investors, a multitude of chart patterns ("death cross," bearish "head and shoulders," "Hindenburg Omen") have added to the building "wall of worry." We cannot say for certain the long list of concerns is fully factored into the market, but to the extent that they are, the headline risk may not be as great as advertised.

On the other hand, the bullish implications of a potential "inverse head and shoulders" pattern on the S&P 500 Index (SPX) is not being advertised. The May/June lows would make up the "left shoulder," with the July low at 1,010 the "head." If support holds at 1,040, this would make up the "right shoulder" in the pattern, with the neckline in the 1,130 area. A bullish "inverse head and shoulders" play would offer technicians the most reward versus risk, as the possibility of this bullish pattern playing out does not seem to be on the radar of many traders.

Moreover, the SPX is currently trading just above support from its rising 80-week moving average, a trendline that marked lows in November 2009 and last month.

With retail investors in cash-raising mode, the risk is continued evidence at present that hedge funds continue to favor bonds over stocks. Note that it was a combination of short covering and stock accumulation among hedge funds that drove the market higher in 2009, and it will likely be the hedge funds that bid the equity market higher before the general public. As I said a few weeks ago, there is major firepower for a longer-term market rally, but it is difficult to determine when exactly this firepower will be unleashed.

From a shorter-term perspective, there is a tremendous amount of put open interest just below current levels on major exchange-traded funds that we follow. If the market stabilizes during the next few days, short covering related to expiring put open interest in the next few weeks could support a rally from SPX 1,040, the lower boundary of the current trading range. But if support breaks, sellers of the index puts will short futures to offset losses from the sold puts, leaving the market vulnerable to a quick, sharp decline. If you are an options player, we have found straddles as the ideal low-risk, high- reward play given the possibilities discussed above.

Indicator Of The Week: Presidential Approval Ratings
By Rocky White, Senior Quantitative Analyst

Foreword: There were some headlines early last week that President Obama's approval rating (as reported by Gallup) for the week prior fell to 43%. That was the lowest level of his presidency. That got us wondering, does the presidential approval rating drive the stock market in any way? Or maybe it's the other way around; does the stock market drive the approval ratings? In the analysis below, I look at the return on the Dow Jones Industrial Average compared to the approval rating of the current president and of past presidents. I have approval rating data from Gallup going back to 1938.

The Last Two Administrations: It is interesting that the approval ratings of the last two presidents (Obama and Bush) could not have been more negatively correlated with the stock market.

Below is President Obama's approval rating along with the Dow since he took office. The market has been very strong for a lot of his presidency and has been sideways for the last several months. But his approval rating has been steadily declining almost since day one. A lot of different things that have nothing to do with the stock market can influence a president's approval rating. It depends on the events of the time. However, in our current situation, I'm speculating that the way people view the economy is heavily influencing the way they feel about our president. If this is the case, then the lower approval rating may end up being a good contrarian indicator. In other words, the president's approval rating is dropping because people are afraid in this economy. But that level of fear is a healthy driver of the stock market.

I mentioned earlier that with President Bush, like Obama, there was a disconnect between the stock market and his approval rating. Here's an example, I think, of an approval rating that had no bearing on the stock market. President Bush's rating skyrocketed after the attacks on September 11, 2001 and declined for the rest of his presidency. However, his ratings were driven by thoughts on the war, and less on people's view of the domestic economy. It's not a surprise, then, that the action in the stock market did correlate with the way people thought about the president.

Presidential Approval and Dow Performance: Below is a table averaging the return of the Dow over different time frames depending on the president's approval rating. Again, the data goes back to 1938 and it was collected by Gallup. The data I have is not in constant intervals but averages out to be about one reading per month.

As I pointed out earlier, the president's approval ratings are often based on factors that have no implications for the stock market. So consider that when looking at the data. That being said, it doesn't look like the approval numbers are contrarian indicators. The market has done worst across the time frames when the presidential approval numbers are in the 20s. The market does better than average three months and six months later when the approval numbers get to the 80s. Again, take it for what it's worth, but the best six-month and 12-month returns happen when the approval ratings are in the 40s, which is where they are currently for President Obama.

Implications: During typical times, I wouldn't look to the presidential approval numbers as a stock market indicator. The ratings are actually pretty uncorrelated to the stock market. However, there are certain times when you might be able to glean some information on public sentiment. And you know us: we'll look at anything that has to do with sentiment. With the economy high on people's minds, this might be one of those times. The president's approval rating is signifying some fear about the economy, which often parallels a fear in the stock market. We contrarians like to see this fear, which represents a wall of worry that allows the market to climb higher.

This Week's Key Events: Three Days of Jobs Data
By Joseph Hargett, Senior Equities Analyst

When will the consumer come back? When we're not worried about losing our jobs. That's why all eyes will be on the jobless data being released Friday. We'll get some hints on that score with other jobs reports due on Wednesday and Thursday. 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 Commerce Department will release personal income and spending reports for July on Monday. Origin Agritech Ltd. (SEED) and Winn-Dixie Stores Inc. (WINN) will release their quarterly earnings reports.

Tuesday

--The Case-Shiller home price index, the Chicago Purchasing Managers' Index and the Conference Board's Consumer Confidence Index for August will be released. Dollar-General Corp. (DG) and DSW Inc. (DSW) are scheduled to report earnings.

Wednesday

--The ADP report on private sector job growth in August will kick off three days of employment data. The Institute for Supply Management (ISM) will release its manufacturing index for August, while the Commerce Department will report on construction spending in July and auto sales for August. The usual weekly report on U.S. petroleum supplies is also due on Wednesday. Charming Shoppes Inc. (CHRS), H.J. Heinz. Co. (HNZ), Joy Global Inc. (JOYG), Collective Brands Inc. (PSS), and Hovnanian Enterprises Inc. (HOV) will post their quarterly results.

Thursday

--We'll get the weekly report on new jobless claims, along with July reports on factory orders and pending home sales. Del Monte Foods Co. (DLM) and H&R Block Inc. (HRB) will report earnings.

Friday

--The hammer drops on Friday with the Labor Department's numbers on nonfarm payrolls and the unemployment rate in August. The ISM will also release its services index for August. Campbell Soup Co. (CPB) will round out the week's earnings.

And now a few sectors of note...

Dissecting The Sectors

Sector
Real Estate
Bullish

Outlook: The iShares Dow Jones U.S. Real Estate Index Fund (IYR) rebounded solidly off key long-term support at its 160-day moving average last week. This long-term trendline has risen to help bolster the IYR's 80-day moving average, and round-number support in the 50 region. With thee levels of potentially stout support below, the IYR appears poised to resume its run higher. 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 39% of the 1,113 analysts covering the sector have doled out "buys." Any upgrades could provide lift for the sector.

Sector
Energy
Bearish

Outlook: While the Energy Select Sector Fund (XLE) rebounded on Friday, it wasn't enough to erase last week's harrowing descent toward multi-week lows. The fund was smacked lower by its 10-day moving average last week, extending a rout that began when XLR was rejected by its 200-day moving average in the week prior. Making matters worse, a rising U.S. dollar and advancing U.S. inventories have pushed crude oil prices toward 11-week lows in the $70 per barrel region. Meanwhile, 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
Bonds
Bullish

Outlook: Talk of a bond bubble continues to blanket Wall Street, even as economic data remains questionable. Along those lines, we are seeing articles pop up online on how to not invest in bonds, such as a recent MarketWatch piece titled "What to buy instead of bond funds." Despite this negativity, the iShares Barclays 20+ Year Treasury Bond Fund (TLT), which seeks results that correspond to the price and yield performance of the long-term sector of the United States Treasury market as defined by the Barclays Capital 20+ Year U.S. Treasury index, has soared more than 20% off its April bottom near the 87 level, with the fund now trading firmly above support in the 105 region. TLT's current price action is reminiscent of its late 2008 activity, meaning that we could see another end-of-the-year surge in the bond market. With investors growing more wary of the equities market, bonds could continue to find buyers in the current Wall Street environment. Furthermore, 10-year rates, which move inversely with the TLT, bounced off 2.50% last week, underscoring the benefits of entering a long position on bonds. That said, traders should hedge their bullish positions on the TLT, as bonds, and the market as a whole, have been quite volatile over the short term.

 

August 30 , 2010
Schaeffer's investment Research
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