Are U.S. Assets Starting to Decouple from Europe?

It was a glass-half-full kind of week on Wall Street, as traders opted to celebrate the positive rather than dwell on the negative. For example, speculators shrugged off Alcoa’s (AA) first quarterly loss since early 2010, and instead focused on the company’s top-line beat and encouraging trade data out of China. This pattern was repeated several times throughout the rest of the week, with the major market indexes even paring their Friday losses in spite of credit-rating downgrades across the pond. As such, Todd Salamone questions the evolving relationship between U.S. assets and their European peers, and examines the encouraging technical trajectory of small- and mid-cap stocks. Meanwhile, Rocky White runs the numbers to find out what investors can expect this holiday-shortened week. Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Stocks Make Headway, Despite European Headwinds
By Todd Salamone, Senior VP of Research

 

“The S&P 400 MidCap Index (MID – 891.49) remains stuck below the key 900-920 range — an area that marks the 2007 peak, 2011 breakeven and first-half 2011 lows, as well as its 200-day moving average. But all is not so bad in mid-cap land, as the MID closed the week above its 160-day moving average, which had capped rallies in October and December. The close above this trendline paves the way for a move into the 910-920 area in the coming months… “ 

“The Russell 2000 Index (RUT – 749.71) finally made a run at 750, its peak ahead of the 2010 “flash crash.” The RUT ventured above 750 last week, but comes into the week trading slightly below this level. The index did close above its 160-day moving average at 742.09, after this trendline had capped a late-October advance … sideline cash could be the catalyst for a breakout above “neckline” resistance in the 750-770 area, as there are a couple of potentially bullish inverse head-and-shoulders patterns developing that would push the index up to its all-time highs in the 850 area.” 
– Monday Morning Outlook, January 7, 2012

 

With both U.S. equities and Treasury bonds marching higher, despite signs of recession in Europe and debt downgrades, are domestic assets beginning to decouple from troubles in Europe? And/or, are market participants viewing rating-agency actions as belated, with equities significantly paring Friday’s losses, regardless of news that Standard & Poor’sdowngraded France’s triple-A credit rating amid rumors that other euro-zone nations could be next? For what it’s worth, since the first day of trading after S&P downgraded U.S. debt in early August, the S&P 500 Index (SPX) has rallied 7.5%, while Treasury bonds — as measured by the iShares Trust Barclays 20+ Year Treasury Bond Fund (TLT) — have rallied an impressive 14.5%. That said, Friday’s post-close news that S&P downgraded Spain, Italy, Austria, Portugal, Cyprus, and Slovakia, in addition to putting Finland on credit watch for downgrade, could make for an interesting open on Tuesday morning.

Nonetheless, U.S. equities managed to rally again last week, despite weaker-than-expectedretail sales and jobless claims data. The price action of late should be viewed positively by bulls, as equities advanced amid headlines that could have easily pushed stocks lower. In fact, the technical backdrop continues to improve for small- and mid-cap equities, an area of the market we believe must display leadership, which has indeed been the case since late September.

For example, the S&P 400 MidCap Index (MID – 906.59) closed above the 900 mark for the first time since early November, and also closed above its 200-day and 320-day moving averages. These moving averages are situated at 906.35 and 905.42, respectively. The 200-day moving average has had some significance in the past, acting as support in August 2010 and capping rallies in September and December 2011. But work remains to be done, as the 910 area marks a 61.8% Fibonacci retracement of last year’s high and low point, in addition to its October 2011 high, while the 920-925 area lingers above, which is the site of the 2007 peak.

The Russell 2000 Index (RUT – 764.20) made some significant headway this past week too, closing above the 2010 pre-“flash crash” high of 750 for the first time since late October. Additionally, the RUT closed above its 200-day moving average for the first time since late July, or about a week prior to the downgrade of U.S. debt. While the close above 750 is encouraging, the RUT, like the MID, is still facing potential overhead resistance. For example, a 61.8% Fibonacci retracement of the 2011 RUT peak and trough is right at current levels, while the 2011 first-half lows linger just above, at 775. But as we discussed last week, a breakout above this resistance would complete a bullish inverse “head and shoulders” pattern on a daily chart, even though some technicians were betting on the potential for a bearish “head and shoulders” formation to develop on a longer-term chart.

So, who are the buyers? As retail players continue to flee equity funds, it appears institutions and hedge funds are in accumulation mode. These market participants drove stocks higher from the March 2009 bottom, and signs suggest they are in the early stages of accumulation mode again, after moving into an underweight position in the second half of 2011. For example, evidence of accumulation is in the options market, where we continue to see more call buying than put buying on CBOE Market Volatility Index (VIX) futures. Fund managers will buy VIX calls to hedge long equity positions they are accumulating. In addition, fund managers are buying more put options relative to call options on broad-based equity exchange-traded funds that we follow, sending the combined buy-to-open put/call volume ratio higher from an extremely low level — another sign of hedging. Plus, bullish price action is usually preceded by the ratio’s turn higher from an extremely low level. The lower this ratio, the more underweight hedge-fund participants likely are, which means there is plenty of sideline cash to fuel a rally.

In conclusion, technical resistance again lies just overhead, with the SPX knocking on the door of the round-number 1,300 level, so a short-term pullback or hesitation wouldn’t be surprising. But, the sentiment backdrop continues to favor the bulls, as there is plenty of sideline cash and short-covering potential to push equity indexes through resistance.