Option Investor
Index Wrap

CATCH UP

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Playing catch up is what select big cap stocks have been doing relative to recent Nasdaq gains, especially in the Dow stocks that have delivered improved Q2 earnings. The weekly stats tell the story, with the Dow up 0.8% for the week, the S&P (500) off a half percent and the Nasdaq down by 1.5%.

THE BOTTOM LINE -
The trend looks overall to be sideways for some more weeks, as the market "consolidates" its substantial gains off the bottom. This puts the market in a trading range until and unless renewed upside momentum (and a second leg higher) is signaled by a decisive upside penetration of 1013-1015 in SPX (S&P 500), 505 in the OEX (S&P 100) and 1760 in the COMPX (Nasdaq Composite). I anticipate the market will work still higher over time, in line with a longer-term bullish outlook for an improving economy.

The economy is however only recovering slowly and further overall Index gains may also come slowly, ahead of the all-important Q3 numbers. As the earnings rebounds are selective, some good option plays will be found in individual stocks, such as was seen with CAT (Caterpillar) this past week. Conversely, the levels that would "signal" breakdowns of the current trends are discussed in conjunction with the Index charts below.

FRIDAY'S TRADING -
The market snapped a 3-day losing streak on Friday, lead by the Dow Average in a rally fueled by CAT and MCD. At the close, the Dow nearly got back to 9200, after rebounding off the low end of its hourly uptrend channel. The Industrial Average was up 137 points (1.5%) to 9188. The Nasdaq Composite was up slightly on the day (+10.5 points or .6%) but was lower on the week as noted.

Caterpillar (CAT) and McDonald's (MCD) were responsible for a significant part of the Dow run up. Bargain hunting investors bid up MCD by 4.4% on an upgrade in an analyst's opinion at Bear Stearns. CAT rallied another 3% on Friday after an impressive 8% advance on Thursday. The company blew through consensus (earnings) estimates when it reported Q2 earnings of $1.15 per share versus estimates of only $0.66. Caterpillar said that a weaker dollar against the euro and Australian dollar, helped boost results with revenues rising 12.1% year-over-year to $5.93 billion, versus a consensus of $5.10 billion. The company's machinery and engine volumes were strong. Hey, this is relatively low tech but big muscle business.

McDonalds (MCD) ended at $21.18 or up 3.4%. Bear Stearns upgraded the hamburger giant to "outperform", based on the analyst's belief that there earnings will be better than the Street consensus, based on some improved trends and the current management plan - more Big Mac's please.

Microsoft rallied to above 27 (27.08), a gain of .39 (1.5%) after the Seattle software giant announced late Thursday that its fiscal Q4 income rose 26% on an 11% increase in sales. The welcome surprise was that they "guided" which is unusual for the company as they more often see their own outlook more in line with the Wall Street consensus. Hey, Bill Gates has some dreams of his own!

Another Dow component, Hewlett-Packard gained 3.4% - Lucent technologies was up 5% and Nortel rose 3.9%. As usual, tech stock gains, as reflected in the Nasdaq Composite and Nasdaq 100 (NDX), have run "ahead" of the economy relative to actual current earnings. However, the profit improvement seem to be coming as business spending picks up, albeit slowly. Companies, universities and consumers are starting to replace aging equipment, take on digital hardware and expand their networking capabilities. I'm living proof as I upgraded my PC not long ago to take advantage of the big jump in speed and capacity at LESS money for the box.

Despite the market's weakness during the start of earnings season, earnings reports have mostly come out better than expected - of 151 companies in the S&P 500 reporting so far, 2/3rds have beat or exceeded expectations, with about 6% missing the forecasted numbers. The problem of course, if you want to call it that, is that the market has run well AHEAD of expectations. Old market saying: buy the rumor (expectations) and sell the fact (when earnings match expectations).

The University of Michigan's preliminary July consumer sentiment index rose to 90.3 from June's 89.7. The number was marginally lower compared with economists' estimates for a 90.5 reading.

Most market sectors headed higher Friday, led by the oil service, utility and networking groups. Only airline and paper issues dripped in red ink.

With some of recent recovery in some of the airline stocks - AMR comes to mind - the Dow Transportation average appears to be breaking out above its long standing monthly downtrend line per the chart below, thereby joining its big brother, the Industrial average, shown for comparison -

As per the usual practice the date shown (7/31/03) is when the bar "ends" at month end. We won't know the full story on the close until then of course.

A further note on the above charts - 10,000 on the Industrials and 3000 on the Transports look like big overhanging resistance levels. It's one thing to break out above trendlines and another to churn through increasing amounts (supply) of stock expected to be for sale at key price areas. Stay tuned for the fall and beyond!

OTHER MARKETS -
Government bonds extended recent losses that took benchmark yields to 10-week highs. (Inverse relationship: prices up, yields down - prices down, yields up.) The 10-year Treasury note was down a half point, to yield 3.985%, which puts us back to nearly 4% on the benchmark Treasury.

Mortgage rates last week also spiked higher and if this continues expect a minor shock to ripple outward to home owners still looking to refinance. Hard to believe that anyone is left that is doing that, but it has been on ongoing trend. And, of course, there is the ongoing rush into the new home market and a slowdown here would undermine a key component of the economic growth that has been seen in the last 18 months.

Among next week's economic releases of significance for bonds and stocks: June leading economic indicators, weekly initial unemployment claims, June new and existing home sales and June durable goods orders.

The U.S. dollar gave back some early gains against its major trading partners and headed lower, as the dollar fell slightly, to 118.41 yen. The euro climbed 0.4 percent to $1.1265.

INDEX OUTLOOKS -

S&P 500 (SPX) - Daily chart:
Some change occurred last week in the technical picture presented by the chart and its indicators. While the sideways move continues, we now have need to account for a potential double top. While I don't currently think that the formation marks a "final" top, the reality is that double tops are not something to explain away either - rather, they are potent reminders that that there may be at least a good-sized pullback before another advance and a challenge is made to the prior highs.

While, for example, the apparent double top in March did not lead to much of a dip, there are some differences that can be seen. Mainly, I look for the amount of time that passes from one top to another. If the tops are separated by at least 2-3 weeks, I tend to take more notice of the pattern.

Also, when a new high is not "confirmed" by other indicators such as the RSI (RSI is substantially lower the second time) or there is a bullish extreme in my sentiment indicator, this tends to reinforce the possibility of a significant peak.

Last week my trading "sentiment" indicator, taken from the call to put daily volume in all equities options (CBOE), got to an extreme on the call side - foretelling a correction. Well, if we (option traders) were usually RIGHT, the indicator would work the other way round.

The "typical" correction pattern that consolidates the kind of sizable advance or run up we've seen, is for a larger pullback, such as to below recent lows below 980. There could be a pullback to 950-960 zone at some point that would conform to the pattern. The 21-day moving average is usually key to this - inability to hold above it suggests a downswing ahead. This week may tell the story on that.

To be a strong buyer of Index calls, such as out to Aug-Sept., I would like to see an oversold reading, or close to one, on the 14-day RSI, which is currently neutral at around 50 (see above).

Dow Industrials Hourly (DJX.X) chart:
What is chugging along is the Dow - there is sometimes what is known as the "solitary walk of the Dow", where enough of the 30 stocks are in rallies to keep an uptrend intact. The well- defined uptrend still being maintained on the Dow hourly chart is not being "confirmed" recently by similar action in the S&P 500 (SPX).

Based on its uptrend channel, 90 appears to be level to watch in the Dow Index (DJX) as a key support - if pierced, it would suggest a next downside target to the 88.75-89 area.

Another thing to watch for is whether the Dow is able to take out the prior recent high in the 9250 area or instead makes a lower relative high. Such a pattern would suggest that upside momentum was slowing down.

The 21-hour stochastic is nearing an overbought reading, suggesting a buy of DJX puts on a further extension of Friday's rally that carried into Monday. Buying puts on rallies into declining rally peaks gives an exit point (stop) that is close at hand, or just above the prior top; i.e., a move above the prior high suggests risk of a further advance for a holder of puts.

S&P 100 Index (OEX) - Hourly chart:
The sideways trading range as I see it is outlined in the OEX hourly chart below along with estimated technical resistance and support areas.

OEX stayed mostly above its prior lows in the 495 area, which was a signal for the potential to then rally after the retest of this bottom. However, I have put the next level of support at down in the 485 area at the earlier late-June bottom.

I think the broad trading range we're looking at in the OEX is bounded by 485 to around 510, although I also see resistance coming in at the previously broken ("kiss of death") hourly up trendline intersecting currently around 507.

My suggested strategy is to buy puts somewhere in the 507-512 price zone. Exactly where can be pinned down by how much further the current upside momentum can carry. Conversely, I continue to suggest buying calls in zone noted on the chart - this is a broader range and again is best determined by when the price trend stalls and then starts to reverse. In a trading range, it can be difficult to get the right entry without tuning in during trading and commentary during the session, such as to the OIN Market Monitor.

SEMICONDUCTOR INDEX -
Before getting into the broader Nasdaq index, the trouble in sustainability of the tech advance was signaled by the Philly semiconductor index or SOX. While the strong bellwether component Intel (INTC) was bucking this trend and pierced its prior high, the SOX was signaling at least a temporary top by its bearish price/RSI divergence -

Nasdaq Composite Index (COMPX) - Weekly:

Predictably enough the recent rally stalled at the top end of the weekly uptrend channel, especially given the overbought weekly oscillators like the RSI (setting = 13). The Nasdaq has not been this "overbought" on a 13-week (fourth of a year) basis since late-1999/early-2000. While an overbought extreme should not be used "mechanically" - buy puts and that's it - but does indicate that the probability of a correction is on the rise. That said, the rally could stay alive into the Sept/Oct time frame when there is a tendency for a seasonable top.

If the weekly channel works here, there would typically be a drift lower toward the middle to lower end of the channel, before a next rally sets up. As much as is going to realized from the bull flag pattern that developed in prior weeks probably has been seen. Typical bull flag: sharp up move (the "flagpole"), followed by a few bars consolidating the first run up, then a move higher above the "box" outlining the flag that is equal to approximately the first upswing.

The pattern seen on the daily chart at right is the up trendline, maybe about to be broken, if the downside momentum suggested by the falling stochastic is realized. If so, downside potential is back to the 1600 area. Stay tuned!

Nasdaq 100 Tracking Stock (QQQ) - Hourly:
QQQ dropped back to the lower end of its hourly uptrend channel with the move down to the 31 area - prior resistance has, so far, "become" a new support. This typically comes about because traders who sold those prior peaks and then didn't get back on the dip, will buy again as the Q's come back down to this area. They will also exit in a hurry if this level is penetrated!

I favor shorting rallies, especially on a move back up to the prior peak in the 32.50 area, or a bit higher such as on up toward the top of channel - this seems doubtful right now as many of the underlying Nasdaq 100 stocks that have led the rally are correcting.

If 31 is broken then I would also consider being short on the break, or adding to short positions from higher levels, with an objective to the 29 area. Good Trading Success!

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