My Outlook for the Second Half of 2011

The Year So Far

Market Action and Investor Sentiment

My Outlook for the Second Half of 2011

Oh, how things have changed in the last two months. In the first four months of 2011, the market was purring along with three clear cycles. From January 3 through February 18, we saw the S&P 500 gain 6.8%. The second stage was a downswing from February 18 until March 16 in which the S&P gave up the gains from the first cycle. The third cycle lasted from March 16 through April 29 and that cycle saw the S&P gain 8.5%.

Now we are in the fourth cycle, which has erased the gains from the third cycle. We don’t know for sure whether or not the fourth cycle has ended yet. The net effect on the S&P 500 through the first half of the year is a gain of 3.9%. The recent pullback has been a good thing in that it has brought the index out of overbought territory and washed out the extreme levels of optimism we were seeing at the end of April.

Now that we have talked about where we have been in the first half of the year, let’s look at where I think we are going in the second half of the year.

First, let me qualify these comments with one statement: I’m assuming that Washington gets its act together and the debt ceiling is raised before the U.S. goes into default. If both sides continue to play games and the debt ceiling doesn’t get raised in time, all bets are off.

With that caveat in mind, I see the market in the second half of the year going into an upward move. The chart of the S&P looks eerily similar to 2010’s chart, as the market went through a correction in May and June, consolidated in July and August and then climbed higher through the last four months of the year. The S&P was overbought at the end of April 2010 and the sentiment was at extremely optimistic levels.

Fast forward a year and we see the same scenario. At the end of April 2011, the S&P was overbought and sentiment levels were at extremely optimistic levels. Now that we have gone through the pullback of the past few months, the S&P is in oversold territory with the 10-week Relative Strength Index hitting a level similar to what we saw last June and the slow stochastic readings hitting their lowest levels since the March 2009 low. Both of these indicators are overbought/oversold indicators.

Looking at the chart below, we also see that the S&P has been in an upward-sloped trend channel over the last two years. The lower rail is formed by the lows of July 2009 and June and August 2010. We also see the upper rail formed by the highs of April 2010 and February 2011. This particular trend channel has a midpoint line formed by minor pullbacks in October 2009, January 2010 and November 2010.

SPX Chart 

The S&P found support right on its midpoint line in June. While the index could run all the way down to the lower rail, I don’t think this will happen given the oversold conditions and the major shift in investor sentiment.

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The Investors Intelligence report measures the optimism and pessimism of investment newsletter publishers. The report is released each week and gives a bullish percentage and a bearish percentage. The bullish percentage has declined from a high of 57.3 back in April to a reading of 37% on June 15. The bearish percentage has jumped from a low of 15.7 in April to 28% on June 22. The ratio of bulls to bears is currently 1.34. Over the last few years the bottoms of corrections have ended when the ratio was near or below one. After dropping from a ratio of 3.65 in April, a ratio below 1.5 is encouraging from a contrarian perspective.

Meanwhile, the CBOE Equity Put/Call Ratio saw its 21-day moving average hit 76.71 on June 17. This is the highest this indicator has been since July 2009. This indicator measures the number of bearish puts traded compared to the number of bullish calls traded; it only looks at individual issues, not indexes. The ratio is measured every day, but the 21-day moving average is a better indicator, because it isn’t as affected by one-day anomalies.

These two sentiment indicators prove that the tone of the market has shifted sharply in the last two months–from a contrarian standpoint it is a buying opportunity when investors are nervous. The shift from overly optimistic to overly pessimistic along with the oversold levels on the major averages presents a buying opportunity.

We could see another consolidation as we saw last summer, but I think it’s likely that the low for the year has already been hit. Last year, the S&P jumped more than 23% in the second half of the year. We might not see a gain that big this year, but I wouldn’t be surprised to see the S&P gain 12%-15% in the second half of this year.

Sincerely,

Rick Pendergraft
Editor of Cabot Options Trader

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