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Market Summary

The Bank of Japan drove Friday's price surge by surprising investors with an announcement that it would increase its bond and asset purchases. "The Japanese central bank has taken the Quantitative Easing (QE) baton from the Fed, and equity traders couldn't be happier," said David Madden, market analyst at IG. Investors were also motivated by speculation that the European Central Bank will follow Japan lead by announcing stepped up stimulus measures at their next policy meeting this upcoming Thursday. This appears to be a classic 'short squeeze' as money managers had been mostly sitting on cash the past few weeks and were underinvested. As stocks moved higher last week investors needing to get back into the game bid prices up. Institutional investors who had to deal with end-of-month window dressing needed to get fully invested as the month ended which further exacerbated the short squeeze.

Both the Dow and the S&P 500 closed at all-time highs as the month ended. All told, U.S. stocks ended October solidly higher, up 2.3 percent. Strong U.S. corporate earnings were the primary driver of the rebound as well as signs that central banks in Japan and Europe were going to do all they could to stop their economies from dragging everyone else down with them. U.S. companies have been reporting strong quarterly results the last two weeks. Corporate profits are up 7.3 percent from a year ago, according to FactSet, compared with the 4.5 percent investors had expected at the beginning of the month.

Recent analysis played out exactly as advertised "...It is reasonable to expect the next few weeks will probably be similar to early April and July when price pullbacks were a prelude to a pickup in quarterly earnings announcements where investors bid stock prices back up... If this trend continues and the Federal Reserve doesn't offer a surprise at their FMOC meeting this week stocks can be expected to continue climbing back toward recent highs..." In the updated performance chart below most of the major equity indexes are showing their highest percentage return for the year. The Russell 2000 is the only laggard as the index has just gotten back to breakeven year-to-date. The small cap index needs to go positive for the year for stocks to maintain bullish momentum.

Last week we noted "...Over the next week we should find out if the price bounce has 'legs' and continues back toward all-time highs or whether momentum slows and indexes trade range-bound..." We have a firm answer with the S&P 500 index getting another all-time high mark. The index is not excessively overbought which suggest there is still room for the price to go even higher.

As we noted last week "...Though the small cap Russell 2000 index is leading the stock market higher during the current bullish move...the index has not yet moved above its 200-day SMA...We need to see the Russell 2000 follow the larger cap indexes above the 200-day SMA to deliver further confirmation the current bullish move will not reverse and head back lower..." The updated chart below highlights the Russell 2000 breaking through its 200-day SMA last week to substantially diminish the probability of a bearish trend reversal over the next few weeks.

We pointed out last week "...treasury prices falling as investors pull money out to bid on stocks as confirmed by the S&P 500 surging last week. Obviously if the current move continues the S&P 500 line will cross above T-Bonds..." In the updated chart below reflects the S&P 500 index reaching an all-time high at the expense of the Treasury bond sell-off.

Market Outlook

According to the Stock Trader's Almanac November maintains its status among the top performing months as fourth-quarter cash inflows from institutions drive November to lead the best consecutive three-month span November-January. November begins the 'Best Six Months' for the DJIA and S&P 500, and the 'Best Eight Months' for NASDAQ. Small caps come into favor during November, but don't really take off until the last two weeks of the year. November is the number-three DJIA and S&P 500 month since 1950. Since 1971, November ranks third for NASDAQ. November is second best for Russell 1000 and Russell 2000 third best since 1979. In midterm years, November's market prowess is relatively unchanged. DJIA has advanced in 12 of the last 16 midterm years since 1950 with an average gain of 2.5%. S&P 500 has also been up in 12 of the past 16 midterm years, gaining on average 2.7%. Small-caps perform well with Russell 2000 climbing in 6 of the past 8 midterm years, averaging 3.9%. The only real blemish in the November midterm-year record is 1974 (DJIA -7.0%, bear market ended in December).

Quantitative Easing (QE) is the gift that keeps on giving. Even after the purchases end, its effects will persist. How could that be? The Fed will still own all those bonds it bought, and according to the agency itself, it's the level of its holdings that affects the bond market, not the rate of addition to those holdings. Having reduced the supply of bonds available on the market, the Fed has raised their price. Yields (i.e. market interest rates) go down when prices go up. The Fed will continue reinvesting the proceeds of securities that mature each month, meaning its more than $4 trillion balance sheet will remain intact for the time being. Last week's Market Outlook stated "...They will most likely continue to "reinvest" interest and principle payments from their massive portfolio of bonds so it will not be a cold turkey end and the Fed Funds rate will also likely remain where it is for some time... more likely the market will continue to advance...the ECB, which is just firing up its printing presses again... Low rates here and abroad should help finance even more stock buybacks and dividend increases leading to higher prices..."

As we move into the fourth-quarter, 'risk-off' categories that benefit from low inflation and are considered 'safe bets' remain market leaders. A strong plus is the small cap Russell 2000 index starting the quarter on a solid note. For the second half of the year, the small cap index has been a reliable predictor of market direction. It is reasonable to expect the large cap indexes to follow the Russell 2000 higher.

The updated Momentum Factor ETF (MTUM) chart down below confirms follow through on the most recent bullish trend. This should be considered a very strong trend because of multiple bullish accumulation days over the past few weeks, plus the strength indicator is not yet grossly overbought. Money managers have gotten back into the market and pushed stocks to lofty levels, as the market becomes more overbought expect the trend to convert to range-bound trading.

As has been the case for most of the past few years, you can see in the CBOE Volatility Index (VIX) graph below how the VIX shrinks to its low point every time the S&P 500 index makes another high. Expect the Volatility Index to remain subdued for a while as third-quarter earnings numbers have been relatively positive and the overall domestic economy continues to improve.

Last week we commented "...The bullish percentage is heading towards extreme levels where contrarians believe a price correction is eminent..." Surprisingly, the updated American Association of Individual Investor Survey (AAII) survey bullish percentage stabilized last week even as equity indexes attained all-time highs. We also said "...individual investors appear to have latched on to long positions and riding out price pullbacks. For this strategy to pay off the market needs to return back towards all-time highs..." Retail investors appear to have won this bet now that the major equity indexes are back at their highs. We also said "...It is a reasonable expectation for stocks to finish the year on strong note, but there will probably be some hiccups along the way..." The 'short squeeze' is probably over as money managers are fully invested in the market again, therefore the best near term bet is a range-bound trading environment as the market consolidates recent gains.

Second-quarter National Association of Active Investment Managers (NAAIM) exposure index averaged 81.64%, the third-quarter average dropped to 71.09%. Last week the NAAIM exposure index was 41.38%, and the current week's exposure is 74.78%. The percentage a few weeks ago was the lowest in history of the index and money managers had to chase prices higher as the market recovered last week. Money managers being underinvested is one of the primary reasons the Dow Jones Industrial Average and S&P 500 ended the week at all-time highs as investors got caught in a classic 'short squeeze' situation.

Trading Strategy

Surprisingly, the rebound in stock prices at the end of October has been driven by the defensive sectors. As seen in the updated graph below, the utility sector has been the best performer, notching up gains of approximately 7% for the month of October. Historically, investors have purchased utilities shares for their robust dividends as protection against stock price drops. Generally, you would expect the demand for utility shares to decline when sentiment is strong, but this has not been the case. Utilities held up better than every other sector during the recent correction and we said they would be a leader when stocks recovered. The question for investors is: Can utilities continue to lead the broader markets higher in the last two months of 2014? Healthcare and Industrials are the other sectors to consider as the market heads higher. Going long the S&P 500 index near the end of October and holding until just before Christmas has been successful 24 of the last 32 years, or 75.0% of the time.



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