Option Investor
Index Wrap

What Me Worry\?

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While the market has been holding up quite well overall (and was again on the week), with more new highs than new lows as it chugs higher, there are technical warnings of a further correction coming. The Nasdaq which is leading the market, is in turn being led by the recovering semiconductor index (SOX), but the SOX has formed a bearish rising wedge on its chart, signaling a possible fall. Moreover, the Composite (COMPX) is at an overbought extreme and has fallen out of its hourly uptrend channel. Volume and price trends for the key bellwether stocks, including QQQ, are also suggesting that the market will retrace some of its gains.

A bearish rising wedge pattern is also seen on the OEX daily chart, although in a less pronounced manner than the SOX. All in all, technically momentum has slowed significantly and the market is vulnerable to accelerated selling on negative news. Fundamentally, a real concern from Friday is the drop in the CPI and the implied inability for companies to raise prices and lift earnings. This and the decline in producer prices may raise further concern about a possible deflationary cycle and draw more comparisons between the U.S. and the stuck Japanese economy.

Relative to deflationary or downward trends in prices - what might not be so good for stocks is heaven to bond holders. Treasury prices mounted a strong rally into the end of Friday trading.

Bonds rose early on news that suggested a deflationary price trend, then fell on a round of profit taking and finally rallied again into the close. 10-year T-bonds rose 20/32 to 101 13/32, to yield 3.46%. The 30-year Treasury gained 23/32, to yield 4.45%. Bond market participants pointed to the release of the April Consumer Price Index or CPI by the Labor Department and which came after Thursday's release of the wholesale price report (PPI), which contracted by the widest margin in over 50 years.

The April CPI fell 0.3% after a 0.3% increase in March. Falling post-Iraq conflict energy prices were behind the overall decline; the core index, which excludes food and energy items, held steady for a second consecutive month.

The flat reading of core CPI in April meant the annualized rate of core inflation for the first four months of the year is now running at 0.6% compared with a rate of 2.0% during the second half of 2002 - quite a drop. The price declines fed into the market's current concern about deflation - despite economists that were suggesting caution in reading too much into the report.

Concerns derive from the Federal Reserve's meeting of just over a week ago, in which policy makers said the chief risk to the economy is that already low inflationary pressures will fall even further.

A significant aspect of the report was the unchanged reading for the core inflation rate. Unlike Thursday's PPI report, softness in the core was broadly based and may bring us closer to a further Fed easing - Morgan Stanley's chief economist noted that this becomes even more likely if the next jobs report is poor. What concerns me is that the Fed has less and less room to ease rates - they can come down to a Fed funds rate of .75% from the current 1.25%, but they aren't going to go to zero like Japan.

Normally influential for the market, the U of M consumer- sentiment data was mostly ignored as the focus was on the inflation numbers. The midmonth report on consumer sentiment showed the preliminary estimate for May sentiment at 93.2, versus 86.0 in April and 77.6 in March. The reading came in well above economists' forecasts. The (positive) "expectations" number increased dramatically to 92.7, from 79.3 in April, which was up from 69.6 in March.

In other economic data released Friday, housing starts fell by 6.8% in April to an annual rate of 1.630 million, with single- family starts down 3.0% to 1.356 million and multifamily starts down a much sharper 22.5% to 244,000. Consensus estimates were for a drop of 3.1%.

The S&P 500 or SPX fell 2 points (0.3%) on Friday to 944. The Dow ended the day off 34 points at 8678.97. The Nasdaq Composite Index closed down 12.85 to 1538.53. The Russell 2000 Index (RUT) of small-cap stocks was off 1.7% on the day.

Despite what looks like mostly a sideways and sluggish trend this past week, only the rate of upside momentum slowed - there were overall gains and it was the 5th straight week of higher highs for the benchmark SPX. The Nasdaq Composite and the S&P 500 each finished 1.2% higher for the week with the Dow up 0.9%.

Volume totaled a decent 1.5 billion shares on the NYSE and 1.75 billion on the Nasdaq Market. New York Stock Exchange market breadth was positive with advancers slightly outnumbering decliners - 16.6 to 15.9. On the Nasdaq, decliners beat out advancers by 18 to 13.

Trim Tabs estimated that equity funds that invest primarily in U.S. stocks got an infusion of $200 million versus inflows of $400 million during the prior week. Bond funds got inflows of $2 billion vs. inflows of $2.2 billion the prior week. You can see where the money is going primarily in the past two weeks.

In sector action Friday, retail and brokerage fell, with the broker-dealer index dragged down by negative analyst comments. GM was a Dow decliner following a downgrade while Dell Computer dropped after releasing it last quarter earnings.

Dell Computer (DELL) fell 3% on Friday, after the company reported Q1 results that only matched Wall Street targets - buy the hope (hype?) sell the fact I suppose.

General Motors (GM) dropped 1.3% after Prudential lowered its rating on the Dow stock to a "sell" from a "hold," citing negative market share. Prudential - an influential research group as the firm does not have investment banking operations - also was cited as a key influence on brokerage stocks after cutting its rating on the industry sector (XBD) to a "market perform" rating from a "market outperform".

Their report cited a belief that stocks in the group will remain in a trading range due to current valuations. Pru cut Merrill Lynch (MER) to a "hold" from a "buy" due to it current (P/E) valuation. Merrill fell 1.3% while Goldman Sachs ran up 0.8% and Morgan Stanley gave up 0.4%.

Gold has been advancing again - go figure, what with no inflationary trend. Best I can figure, as far as basic economic reasoning, is the decline in the dollar causes gold to rise as the metal is priced in dollars. I find this tendency for gold to rebound unsettling for an overly bullish outlook on equities -

Maybe the rebound in gold doesn't bode exactly well for equities in general, but anyone who played these stocks and the sector off from technical support as indicated above, has a nice bullish play going.

Speaking of the dollar, it fell again on Friday. The greenback was down against the yen (to 115.91, from 116.5) and also slipped against the euro, which changed hands at $1.1582, compared with $1.1390 the week before.


The Semiconductor Index (SOX) daily chart leads off the indices -

The rising wedge pattern is outlined above. This usually signals a correction ahead as lower highs and higher lows tend to suggest the exhaustion of buying. I anticipate a correction that might take SOX back to its main (up) trendline, intersecting currently around 318.

S&P 500 Index (SPX) - Weekly, Daily & Hourly charts:

Resistance appears on the charts as likely in the 950 area, then at 960. I don't see how SPX will break out above 960, at its prior weekly closing peaks, without a decline in the overbought extreme suggested by the 8-week and 14-day RSI readings (see the weekly and daily charts below). Overbought oscillator readings are never an "automatic" sell. But they do suggest where a market is vulnerable to shocks.

Given that the trend is up, traders can wait to see if there are definite signs of a breakdown in the trend such as a decline through a prior low - around 937 in the case of the hourly chart. The other strategy is to buy puts with SPX around 950, or up at 960 if there is a further upswing, and exit on a close above this same resistance say by a 5% margin.

On this later trading strategy, it is my preference to buy calls at support or puts at possible major resistance before their premiums get inflated - as they do as soon there is a definite signs of breakdown or breakout. I suppose you could call this the "assumed" top or assumed bottom.

Taking this approach also depends on how many factors line up to suggest the probabilities of a correction or reversal to the trend. And a profitable outcome also depends on adherence to exiting on a decisive penetration of such a well-defined line of resistance or support.

By the way, the end of the current bear market is not really confirmed on even a preliminary basis, until we witness the S&P 500 (SPX) close above 960 on the week and then maintain that level as support on subsequent pullbacks.

S&P 100 Index (OEX) - Daily & Hourly charts:

I mentioned a slight upward sloping or rising wedge type pattern that can be seen on the OEX daily chart. A much more pronounced and "classic" pattern is seen on the SOX chart above. But this pattern and the fact the current levels are pretty extended above the key moving averages, goes suggest a correction back down toward the "mean" so to speak - in this case, back toward the moving average.

Its pretty common to see a re-test of the moving average later on, such as is seen on the chart (more than once) where prices rallied to, but not above, the 200-day average.

Resistance implied by the top of the hourly channel and by prior daily highs comes in around 482-485. Near support is at 473, then more key technical support in the 467 area. A break of 465-467 would suggest a deeper correction such as back to 450.

On a longer-term trend basis, I would also note that last week saw the first bullish upside crossover of the 50-day average above the 200-day.

Market "sentiment", at least as measured by my equities option call to put volume ratio (seen below the daily chart above, left), is neither at a bullish or bearish extreme. It seems that the current rally is more led by the institutional fund managers who need to put money to work as the market rises rather than by a bullish "public" - typically, they have little faith in stocks at the end of a bear market if this is that.

Nasdaq Composite Index (COMPX) - Weekly, Daily & Hourly:

The Composite or COMPX has cleared 1520 on the weekly chart, which is a bullish development. Now the question becomes whether it can maintain this level. Resistance, once broken, should "become" support to be a valid breakout and bear trend turnaround.

As mentioned with the S&P, COMPX is overbought. The bearish signs of possible failing (upside) momentum is that prices are slipping below its uptrend channel. This might signal a pullback to at least initial support around 1480-1490.

It would take a close above 1552-1555, and the ability to maintain this level, to suggest a renewed up leg.

Another bearish omen for the Composite, beside the waning momentum and overbought condition is the bearish Price/RSI divergence that has developed, as is highlighted on the daily chart above. Prices have made new highs but the RSI has registered a lower low. Such divergences are so often a sign of an upcoming trend reversal - at least signaling a deeper correction than has come before.

Given the factors I've discussed above, I suggest bearish trading strategies by buying NDX or QQQ puts on further rallies in the Composite. Basis the Composite, I can foresee a move back down to at least 1485-1490, from recent highs around 1550.

QQQ charts - Daily & Hourly:

As prices have moved higher on balance, On Balance Volume or OBV is suggesting that volume is picking up on down days, not on up days, which does not maintain a strong bullish picture. 29.00 is near resistance, then 29.50. Short the stock in this zone.

Near support is at 28.00 to around 27.60-27.75 currently. A close under 28 would be bearish, suggesting a possible correction back to the 27 area or to as low as 25.50-26. I am not suggesting that a correction to this area would spell an end to a bullish trend - a correction to this degree would still fall within a "normal" correction in an emerging uptrend.

QQQ is registered an overbought extreme on the daily stochastic, although not in terms of the hourly model (measuring 21 hours) so another rally may well develop - to my favor, as I would rather short a further rally than take out a new long position on another minor price dip. I believe that the risk (to profits) is on overstaying on the long side currently.

Good Trading Success!

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