In our update last week (Market Update: The New Trading Range And How To React) we discussed the trading range on the S&P 500 from approximately 1,350 to 1,425, which corresponds to 135 to 142.5 on the SPDR S&P 500 ETF (SPY), as depicted in the chart below. Interestingly, the bottom end of this year's range was the high end of the range during the first part of last year.
Last week we expected that the market would test the bottom of the current range, which is where it spent most of the last few trading sessions. The market will now either maintain the range or breakdown from it. We are preparing for either scenario to play out and will adjust our portfolios accordingly.
Before we discuss our investing plan, we want to provide an update on some key data points that we are following closely.
Reaction to the News
There has been a lot of bad news for the market to absorb in the last week. The bad news started with the weaker than expected jobs number on Friday, May 4, which sent the market lower. The decline last Friday probably also included sellers that wanted to reduce risk in advance of the European elections over the weekend.
Many commentators believe that the results from the European elections will generate more uncertainty, which is a negative for the market. Still, the market was up on Monday, but there was no upside follow-through and the declines continued for the rest of the week.
During the week we received news that Spanish government is going to push for a restructuring of its banks and Cisco (CSCO) delivered a weak outlook. Then came the news of JP Morgan's (JPM) $2 billion trading loss. JP Morgan's stock was down significantly on the news and the market ended the week at its lows.
Two weeks ago we discussed the fact that the market has been stagnant through the Q1 2012 earnings seasons, in contrast to the previous earning season, which served as a driver for the rally (Market Update: Q1 Earnings Are Not The Catalyst Investors Are Looking For). The market action last week strengthens our concern about the reaction to earnings.
While this string of bad news seems to have contributed to the market's declines, we recognize that these declines were within the current trading range. Big news like a political shift in Europe or JP Morgan's $2 billion trading loss could have been an excuse for the market to breakdown from the trading range. This has not happened yet, which could be an argument for the bullish side of the market.
It will be interesting to see how the Facebook (FB) IPO is received. The IPO market has been active recently, despite the fact that some high profile IPOs have struggled, including Zynga (ZNGA) and Groupon (GRPN). The market reaction to the Facebook IPO over the weeks and months ahead could be an indicator about investor appetite for risk.
Update on Key Indicators
The Apple's (AAPL) rally, which had been a driver for the market earlier this year, has ended and the stock has been choppy. It will be hard for the market to enter another major rally without leadership from Apple, which is the largest company in the S&P 500.
The declines last week in the banks, led by JP Morgan, are beginning to worry us. Bank stocks were up significant during the rally that began in Q4 2011 and continued through Q1 2012. The market probably would not have been able to rally without a rebound in banking stocks, considering the issues in the last half of 2011 for the banking sector, including the demise of MF Global (MFGLQ.PK) and worries about the exposure of some US banks to European debt, most notably Jefferies (JEF).
Therefore, we are closely watching the performance of JP Morgan following its $2 billion trading loss and the sector more broadly through the Financial Select Sector SPDR ETF (XLF). JP Morgan had been trading in the mid-$40 range, which was the same range in reached last year, before the huge drop on Friday to $36.96, just above the 200 moving average. We will watch JP Morgan's stock closely over the next few days.
Europe was a source of bad news last week, which is usually negative for banking stocks. The Spanish government announced plans aimed at helping its banking sector, but the yield on 10 year Spanish government bonds are again above 6%, indicating concern about the situation in Spain. The yields on 10 year Italian bonds are still elevated and closed the week at approximately 5.5%. The Spanish yields are at year-to-date highs, but the Italian yields have come down from the beginning of the year.
Oil continued its decline last week. Although natural gas prices rebounded, they remain at very low levels. The combination of the decline in oil and the continued weakness in natural gas provides headwinds for the energy sector.
We continue to remain cautious about the market. Last week we reduced our exposure by selling some long positions and increasing our shorts.
With the market at the bottom of its trading range, we want to see its next step before committing to ours. We noted several reasons to be bearish above. Maybe, the best case for the bulls is the fact that all this bad news has not pushed the market below the current range.
If the S&P 500 can stay in the range, then it may be able to rally up to the top end at 1,425, or 142.5 on the SPY. However, if it cannot hold the 1,350 level we may see further declines in the weeks ahead. The next few days could be important in establishing the next trend.