Will Risk Rally Falter? (Lee)

Will Risk Rally Falter?
Keep Close Eye on Equities as they Hit Key Resistance Levels

Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management

October 20, 2011
Recent Developments:

  • Changes in sentiment continue to dictate the huge swings in the market. Coming into 2011, investor sentiment was already demonstrating extreme reaction to headline risk. Since the downgrade of U.S. Treasuries by credit rating agency Standard & Poors (S&P) in early August however, the pace of the market has become even more furious. Investors need to focus on volatility mitigation in their portfolio construction process as a result.
  • On a technical level based on its previous resistance area the Dow Jones Industrial Average (Dow 30) is currently testing the 11,645 resistance area (Chart A). Investors should keep a close eye on whether the Dow 30 can push beyond this level and hold. As many market participants likely have limit buy and sell orders around that area, how the Dow 30 reacts near resistance can dictate which direction it will break. Should it break to the upside, the price objective could be as high as 12,720 or a gain of 11.6%.Should the Dow break to the downside, support is likely to be found around 10,730 or a drop of 8.7%.
  • Aside from last week's "risk-on" trade, a significant driver to the Dow 30's recent move to the upside has been assisted by the fall in the U.S. dollar (Chart B). U.S. based multinational companies tend to be inversely correlated to the greenback given some of their costs are in U.S. dollars but have revenue exposure in foreign currencies. Should the U.S. dollar continue breaking to the downside, this would be supportive for the Dow 30. If last week's "risk-on" rally re-emerge, the U.S. Dollar Index can fall from 76.6 to its former range of 73.5 to 76.
  • Whether the recent risk-asset rally will continue or not will be dependent on what comes out of the European Union (EU) Summit on October 23. Although we don't expect a permanent fix to the sovereign debt issues, the market could view "the plan" as a temporary fix. Should this be the case, the market would instead shift their focus from the macro to the micro, being the U.S. earnings season, which we believe could come in better than expected. If the EU Summit disappoints, however, the Dow would likely fall at least to our downside target, as much of the recent run-up has been in anticipation for this "plan." Currently the rumour is that European governments are considering deploying US$1.3 trillion to help tame the sovereign debt crisis. A consideration investors may want to consider is trading out of higher beta names and into blue chips.

Potential Investment Opportunity:

  • We continue to view the Dow 30 as our most favoured broad market index. The Dow 30 gained 10.7% on the year before recently dropping to roughly flat on the year. It is however still the top performing major market index year to date.
  • Through the BMO Dow Jones Industrial Average Index Hedged to CAD Index ETF (ZDJ), investors can access the stocks in the Dow 30 without having to worry about USD/CAD currency risk. Our upside and downside targets on the Dow 30 would translate to roughly $21.85 and $17.90 respectively. Should ZDJ fall below $18.60 we would expect the trade to fail and the ETF to fall to its downside target. By placing a stop loss at $19.00, investors can potentially create an asymmetric trade where their returns would better their risk at roughly 1.3 to 1.
  • Volatility in equities has been dissipating, which is pleasant news, especially if it continues to drift lower. The VXD Index (Chart C), which is the equivalent to the VIX on the Dow 30, has recently broken below its support area of about 27.5. It's important that VXD does not break upwards as it may move as high as 40. As politics continue to be the wildcard to the market's fate, stop loss orders can help mitigate some risk in an investor's portfolio. We note however, that our long-term indicators still favour bonds for the time being and the recent move in equities have yet to prove to be anything more than a countertrend rally, but the next weeks should be telling.

Upcoming Events:

ETF Lunch and Learn Presentation
Weighting Matters: Developments in Weighting Strategies
Co-sponsored by Toronto Stock Exchange and BMO Exchange Traded Funds

Hear what Mark Raes, Vice President and Portfolio Manager, BMO ETFs, has to say about the developments in weighting strategies – from traditional market-cap weighting to equal weighting and factor-based weighting.
Wednesday, November 2, 2011
12:00 pm to 1:00 pm

TMX Broadcast Centre
The Exchange Tower
Ground Floor
130 King Street West
Toronto ON M5X 1J2

Space is Limited

CE Credit: Pending approval from IIROC. If the credit is approved, you will receive accreditation documentation from TSX within 45 days of the event date.

Chart A: The Dow Testing Key Resistance Area

The Dow Testing Key Resistance Area

Source: BMO Asset Management Inc., Stockcharts.com

Chart B: Greenback Provides Clues to Appetite for Risk

Greenback Provides Clues to Appetite for Risk

Source: BMO Asset Management Inc., Stockcharts.com

Chart C: Keep Close Eye on Volatility Levels (VXD Index)

Keep Close Eye on Volatility Levels (VXD Index)

Source: BMO Asset Management Inc., Stockcharts.com

*All prices as of market close October 17, 2011 unless otherwise indicated.

Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual's circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, a portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

Previous Article

The Happiness Dilemma (Feldman)

Next Article

Which Gold Miners Have the Most Upside? (Holmes)

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.