Monday Morning Outlook: Dow Jones Industrial Average Suffers Worst Week Since February 2009

              

That was not fun. The Dow Jones Industrial Average suffered its worst week in nearly a year, effectively wiping out 2010's gains. Earning reports failed to provide much lift, the Chinese are threatening to tighten lending policies, jobless and housing figures disappointed, and the banking sector is worried about President Obama's financial reforms. Looking ahead to next week, Todd Salamone, Schaeffer's Senior Vice President of Research, says that the current pullback mirrors similar action from the October 2009 earnings season. Next, Senior Quantitative Analyst Rocky White notes that Friday's big decline was the fifth day in a row that the Dow moved at least 100 points. He takes a look at what happens when the Dow moves up or down in a big way two days in a row. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.

Recap of the Previous Week: Proposed Banking Reforms Spook Street
By Joseph Hargett, Senior Equities Analyst

Before the bottom dropped out later in the week, things were actually looking up for the major market indexes. The bulls emerged well-rested from the long holiday weekend on Tuesday, kicking off the week with a gain of 1.09%, as the Dow Jones Industrial Average (DJIA) effectively nullified the heavy losses of the Friday before. Health care issues led the way higher, as the Street awaited the outcome of a tight U.S. Senate race in Massachusetts. Despite a fourth-quarter loss, even financial firm Citigroup (C) found its way into the black, as investors focused on CFO John Gerspach's comments that the firm continues "to see indications that credit may be stabilizing or improving, particularly in Asia and Latin America."

But things quickly turned sour. Stocks were hammered on Wednesday due to revived economic concerns and bad news for a pair of blue chips. Specifically, China's bank regulator reportedly requested that several banks stop issuing loans, suggesting that liquidity is quickly tightening in the global credit market. Meanwhile, housing starts dropped a sharper-than-forecast 4% in December. Meanwhile, IBM (IBM) forecast slower earnings growth in 2010, while Kraft Foods (KFT) took a turn for the worse when shareholder Warren Buffett expressed his displeasure with the company's planned acquisition of Cadbury (CBY). Against this backdrop, the DJIA reversed Tuesday's gains and then some, shedding 1.14% for the session.

The slide deepened on Thursday, as enthusiasm over solid earnings from Goldman Sachs (GS) waned in the face of a surprise rise in initial jobless claims and a drop in the Philadelphia Fed manufacturing index. What's more, President Obama spooked financial sector investors by announcing his intent to clamp down with new legislative reforms. Traders anticipating a return to Glass-Steagall style regulation fled financials in droves, and dragged the Dow to a loss of 2% on the day.

Friday was more of the same. Even though details were short, the Street really doesn't like Obama's proposed financial reforms, and banking heavyweights suffered. Meanwhile, American Express' (AXP) fourth-quarter earnings failed to impress, overshadowing upbeat earnings reports from General Electric (GE) and McDonald's Corp. (MCD). Against this somber backdrop, the major market indexes effectively nullified their year-to-date headway. The Dow was off another 2.1% for the day and 4.1% for the week -- its worst performance in nearly a year. The S&P 500 Index ended the week on a similar deficit of 3.9%, while the Nasdaq Composite skidded 3.6%.

What the Trader Is Expecting in the Coming Week: End-of-Week Sell-offs Have Reversed in Past
By Todd Salamone, Senior Vice President of Research

Are we seeing an unfortunate end-of-week trend for the bulls? Three of the past four weeks have ended with market drops, including Friday's 2.2% S&P 500 Index (SPX) decline. Is there a bright side for the bulls? Sure, these end-of-week misfortunes were quickly reversed the following trading session. In fact, the last time the market experienced a sell-off as big as Friday was Friday, Oct. 30. It gave back 30 points on that day, or 2.8%. The following Monday, it regrouped to post gains and dashed higher for the next two weeks.

In the past couple of weeks, Monday Morning Outlook has discussed the heightened possibility of a market pullback, based on short-term trader optimism mirroring that heading into the October 2009 earnings season. Our concerns included: 1) the retail trader showing relative enthusiasm for the market, as evidenced by the American Association of Individual Investors' weekly survey, 2) option players buying equity calls at a higher-than-normal rate relative to puts, and 3) the SPX and Russell 2000 Index (RUT) bumping up against major long-term resistance levels, specifically the 160-month and 80-month moving averages, respectively.

Poor earnings reactions, tough talk by the Obama administration to curb bank risk-taking, and the revelation on Friday that two more Senate Democrats would be voting against the reappointment of Federal Reserve Chairman Ben Bernanke also jarred the market. Bernanke's fate could be decided upon by a Senate vote as early as this week, adding to Friday's volatility. The populist rhetoric was greeted negatively on Wall Street. From Tuesday's closing high at 1,150, the SPX retracted 5% and ended below support in the 1,100 area. This three-day correction is slightly less than the 5.8% correction that occurred from mid-October through early November, but the duration of the current decline is much shorter.

The SPX comes into the week trading at its December lows and just below its 80-day moving average, which is situated at 1,096. The chart below conveys the significance of this trendline since July 2008. It will take a strong Monday session to push the SPX back above this moving average, which bulls would like to see. Moreover, the CBOE Market Volatility Index (VIX – 27.31) spiked 55% from Tuesday's mark, similar to the magnitude of the spike that occurred from mid-October to early November and marked a short-term bottom. If this is a replay of the October-November price action, we'd expect the SPX to move back to 1,150 during the next few weeks. However, if this ship doesn't right itself in relatively short order, we'd look for a move down to the 1,050 area.

If you aren't familiar with Bernie Schaeffer's SENTIMENT magazine, you will find it a great companion to Monday Morning Outlook. It includes educational pieces for those new to options trading, as well as advanced strategy articles to help experienced traders build their portfolios.

Our winter issue of SENTIMENT is hot off the presses and in it I discuss the status of the market from a longer-term perspective. The article, entitled, "The Rally That No One Believed," is on page 6 of the magazine. What can we expect to see in 2010? What does the sentiment and technical backdrop look like when viewed through a lens designed to look further out into the future?

Regular readers of this column will also notice another familiar voice in SENTIMENT. Rocky White, our Senior Quantitative Analyst, who regularly pens the Indicator of the Week column here, has some interesting thoughts on how to quantify sentiment on individual stocks to give you a trading edge. His article is on page 30.

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: The Potential Impact of Consecutive 100-Point Dow Losses
By Rocky White, Senior Quantitative Analyst

Foreword: We finally saw some volatility in the market last week. Friday's big decline was the fifth day in a row that the Dow moved at least 100 points, besting December's total of four 100-point moves for the whole month. Unfortunately, four of those five 100-point days were down, including the last three. Below is a graph of the Dow with red dots marking times when the average fell by 100 points two days in a row. I also show (green dots) times when the market gained 100 points two days in a row.

A quick look at the chart illustrates the lack of volatility during the past several months when compared to early last year (only three dots since July, but 10 prior to that). The last time the market posted consecutive massive declines, the Dow rebounded quickly, placing the average significantly higher one month later. However, the time before that was in June, and the market had farther to fall. I'll take a look at past data for the Dow to see what followed these big moves in terms of returns and volatility.

Mean Reversion: Below is a table comparing market returns in the month following two big consecutive Dow moves in the same direction. No wonder the market is flat during the past 10 years! Whenever you get consecutive down days, the market gains almost 1% in the next month. Furthermore, when the market posts big gains for two straight days, the following month sees an average loss of about 1.5%. Since 2009, those mean- reverting returns are even more pronounced.

Doing the same analysis for three consecutive 100-point up or down days shows the same pattern, but there are so few signals (12 for consecutive down days and four for consecutive up days since 2000) that the results can be deemed insignificant.

Volatility: The table above shows the market has an upward bias after two straight big down days. Meanwhile, the table below shows that we may also see increased volatility. The table below shows the market's volatility in the month preceding the consecutive up or down days. Also displayed is the average volatility for the month following those big moves (the volatilities are annualized). Notice how, after two big down days, the volatility tends to increase, averaging 32% after a move and 27.7% before the move. However, after two straight big increases, volatility falls from 29.4% to 24.9%. If history is our guide, then we should see an increase in volatility during the next month.

Finally, the data below shows return and volatility data for the Dow on the days that it fell at least 100 points two days in a row. The last five incidents were followed by positive returns in the next month. Six of the seven occurrences since the beginning of 2009 resulted in an increase in volatility, with the only exception arriving in late March.

Implications: During the past 10 years, the market has tended to correct itself following two days of big up or down moves. That's good news, given the Dow's price action last week. Also, following big down days, we have seen that volatility tends to rise during the next month. That's a great combination for bullish option premium buyers.

However, one thing to be nervous about is that the last time the Dow fell three consecutive days by 100 points or more, it didn't stop there. In early October 2008 the average lost at least 100 points for seven consecutive days in a row. In those seven days there were losses of 348 points, 370 points, 508 points, and 679 points.

This Week's Key Events: A Look at Fourth-Quarter Gross Domestic Product
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

• The economic calendar kicks off with the release of December's existing home sales. AK Steel Holding Corp. (AKS), Halliburton Co. (HAL), Apple Inc. (AAPL), Texas Instruments Inc. (TXN), VMware Inc. (VMW), and Zions Bancorporation (ZION) will enter the earnings confessional.

Tuesday

• November's Case-Shiller home price index and January's consumer confidence index are scheduled for release on Tuesday. Corning Inc. (GLW), Delta Air Lines Inc. (DAL), DuPont (DD), EMC Corp. (EMC), Johnson & Johnson (JNJ), Verizon Communications Inc. (VZ), RF Micro Devices Inc. (RFMD), and Yahoo! Inc. (YHOO) are slated to release earnings.

Wednesday

• The Federal Open Market Committee will issue its decision on U.S. monetary policy, while December's new home sales and weekly U.S. petroleum supplies will also hit the Street on Wednesday. Abbott Laboratories (ABT), The Boeing Co. (BA), Caterpillar Inc. (CAT), ConocoPhillips (COP), SAP AG (SAP), The Southern Co. (SO), UAL Corp. (UAUA), BMC Software Inc. (BMC), E-Trade Financial Corp. (ETFC), Hoku Scientific Inc. (HOKU), Netflix Inc. (NFLX), and QUALCOMM Inc. (QCOM) will report earnings.

Thursday

• Traders will see weekly initial jobless claims and December's durable goods orders on Thursday. 3M Company (MMM), Altria Group Inc. (MO), Colgate-Palmolive Co. (CL), Eastman Kodak Co. (EK), The Estee Lauder Companies Inc. (EL), Ford Motor Co. (F), JetBlue Airways Corp. (JBLU), Lockheed Martin Corp. (LMT), Motorola Inc. (MOT), Nokia Corp. (NOK), Potash Corp. of Saskatchewan Inc. (POT), Amazon.com Inc. (AMZN), Juniper Networks Inc. (JNPR), Microsoft Corp. (MSFT), PMC-Sierra Inc. (PMCS), and SanDisk Corp. (SNDK) are scheduled to report earnings.

Friday

• Friday ends the week with advance fourth-quarter gross domestic product (GDP), the January Chicago purchasing managers' index (PMI), and the January University of Michigan consumer sentiment index. Arch Coal Inc. (ACI), Chevron Corp. (CVX), Fortune Brands Inc. (FO), Honeywell International Inc. (HON), and Mattel Inc. (MAT) 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 quite resilient price action amid the current economic condition. Specifically, the iShares Dow Jones U.S. Real Estate Index Fund (IYR) has soared more than 43% during the prior 52 weeks. By comparison, the S&P 500 Index (SPX) has risen just 34% for the same time frame. Last week's weakness was a real shocker, but bullish investors should take heart in the fact that the IYR's decline was halted at its rising 80-day moving average. This trendline provided a solid floor for the exchange-traded fund (ETF) in October and November 2009. What's more, 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 68% 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 8.68%. 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) 94% surge during the past 52 weeks, a result of HHH beating a steady path higher from its November 2008 low of $23.20. What's more, the trust continues to rally higher along support at its 50-day and 80-day moving averages. Despite the sector's technical strength, traders are trying to call a top to HHH's uptrend. The number of shares sold short rose by nearly 16% during the most recent reporting period, and the current accumulation of bearish bets represents 11 times the trust's average daily trading volume. Several outperforming members of the Internet sector have also attracted the attention of short sellers. Priceline.com (PCLN) has racked up a short-to-float ratio of 13.78%, despite rallying to a 52-week gain of 194%. Meanwhile, 20% of Netflix's (NFLX) float has been sold short, with the shares up more than 61% in the past year. Other notable names within the group include Expedia (EXPE) and Amazon.com (AMZN). From a contrarian perspective, the rampant pessimism amid HHH's technical prowess has bullish implications.

Sector

Retail Bullish

Outlook: While retail sales dipped an unexpected seasonally adjusted 0.3% in December, the sector took the news rather well. Specifically, the SPDR S&P Retail (XRT) exchange-traded fund (ETF) has staged an orderly pullback to support at its rising 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 support 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 963 analyst rankings on retail stocks are "buy" 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.