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Market Wrap

Reality check !

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        WE 5-14           WE 5-7          WE 4-30          WE 4-23
DOW    10913.32 -118.27 11031.59 +242.55 10789.04 + 99.37  +193.78  
Nasdaq  2527.86 + 24.24  2503.62 - 39.23  2542.85 - 47.84  +106.65  
S&P-100  673.57 -  8.17   681.74 +  6.09   675.65 - 11.76  + 18.76  
S&P-500 1337.80 -  7.30  1345.00 +  9.82  1335.18 - 21.67  + 37.85  
RUT      443.13 +  7.02   436.11 +  3.30   432.81 +  1.08  + 10.15  
TRAN    3666.34 - 76.49  3742.83 +95.54   3647.29 + 57.61  + 60.98  
VIX       29.66            26.72            26.07            23.96
Put/Call    .71              .61              .53              .59

Reality check !

I reported last week that eventually an economic report would come out soon that when viewed under a microscope would show traces of inflation. That report would be like yelling fire in a crowded theater. On Fridays CPI report you did not need a microscope. The numbers were shouted by every talking head in analyst land. The market reaction was swift. S&P futures were down -26 at the open and CNBC was warning "look out below, this is going to be bad." Visions of -300, -400 even -500 points were cropping up like old nightmares. I was long in OCT 1997 when the futures were locked down at the open and options did not open on some stocks for an hour after the market. Was I ready to jump out the nearest window on Friday? Heck no! I was long, but I was long DJX puts! More later. The long dreaded sell off on inflation news last Friday was almost a non-event. Yes stocks went down but in most cases they barely went down half as much as they had gained the previous three days.

I was impressed. The +1300 points the Dow gained in the last 5 weeks was up for consolidation and we could easily have dropped twice what we lost Friday. While this may not be the end of the sell off story I really think it showed the strength of the broader market. When the economic numbers are with you the analysts just say "good numbers" and we go on. Friday the numbers themselves were called into question all day. "Outdated indicator", "invalid sector ratios", and "just a fluke" were some of the more common excuses. In reality there are some problems. Computers for instance account for less than .1% of the CPI. Tobacco accounts for 1.3% of the number. Tobacco weighting in the CPI is actually 18 times bigger than computers. With tobacco users shrinking daily and computers growing, there is a huge problem here. This is just one example but with tobacco costs growing by leaps and bounds to pay for their court losses and computer prices dropping daily you can see why this number is skewed.

The actual numbers came in at a +.7% rise. This was the largest rise in over nine years. The estimates were for only +.4%. After deducting food and energy the core rate was +.4%. What really prompted analysts to start digging was the difference in the PPI on Thursday, which showed zero inflation, and the CPI with a huge inflation rate. The numbers normally move in tandem and caught many off guard. The bond market went hysterical. Yields were in the mid 5.9% range all day, finally settling at 5.92%. A 6% bond yield is almost a given now. The fear that the Fed will do something on Tuesday has grown sharply.

Anatomy of a Rate Increase

In actuality the sequence of events normally precluding a rate increase have just started. First the Fed (Greenspan) starts trying to talk the markets down by carefully worded suggestions of caution. (sound familiar?) Next the Fed may change their official bias toward rates. The current bias is "neutral". Many now expect the Fed to change the bias on Tuesday to a "tightening" stance. Once the bias changes then more jawboning of the markets will take place. Expect Greenspan or Rivlin to make mention that the Fed is growing more concerned with the growth of the economy and warn that the Fed may have to increase rates. All this takes place over many weeks and gives the markets time to factor in the rate change before it occurs. Most analysts are now predicting August as the date for the next change. A word of warning, this is the normal sequence of events but nothing precludes the Fed from announcing a rate change at any time just like they announced one of the rate cuts last year.

While I was impressed by the lack of drop in the market I am still concerned about market direction. The advance/decline line, which has been on a steady upward move since early April, took a dramatic turn downward last week as evidenced by the this chart.

The two blips last week were of course the Rubin resignation and the CPI report. Granted these were both news related but we need to confirm upward movement again before getting comfortable about the market again. The numbers on Friday were drastically negative. The NYSE advances were beaten by decliners almost 4:1, 668 to 2399. Nasdaq advancers were stronger at 1560 to 2479 decliners.

The Dow traded in a narrow range after the initial drop on Friday and did finish off it's lows. 10,900 could be viewed as support but the weak rebound off the lows at the end of the day needs a lot of confirmation Monday before we can claim it. The previous 10,800 suport from last week would be the next level to test on the downside and Monday could be the day.

Since most analysts still feel the economy is getting stronger, then the only real reason for a market drop is the interest rate scare. Most also feel that a +.25% rise is already priced into the market as a result of all the Fed talk recently. No one expects the Fed to do anything on Tuesday except possibly moving to a "tightening bias" and most feel that this too is already factored into the market after Friday.

So where is the beef? Investors are still faced with post earnings depression now that most large companies have announced. They will still be cautious about making bets before the results of the FOMC meeting on Tuesday. After the Fed meeting the market will be left to establish direction based on fact not supposition. The facts are still a booming economy, rising earnings and almost no visible signs of inflation if you discount tobacco and gas prices in the CPI. If the Fed maintains a "neutral" bias that would be very positive. Even if they move that up a notch it would not be the end of the world. Where I was leaning to a temporary market decline on profit taking and consolidation last week I am now sitting on the fence. I think the lack of a huge drop Friday shows strength and any lack of downward movement on Monday would confirm this. Monday could be listless in front of the Fed meeting and would not be a trading day in my book. Cautious investors would probably be better off waiting until Wednesday to start new positions. This allows the market to settle, read the Fed, then establish a new direction. The VIX is at the highest point in the last two months and the put/call ratios have spiked up to a .71. These are a direct result of the "news reversal" on Friday and we need to see if they cool this week.

As a side note I have a theory that someone knew in advance what the CPI numbers would be. Look at this chart of the Nasdaq.

At exactly 1:30 Thursday the Nasdaq was at its high of the day with very positive ticks and advance/decliners. Immediately and for no reason the Nasdaq rally died and dropped -50 points. Why do I think somebody knew? The stocks to be hurt the worst in an interest rate sell off are techs. Techs are first up in a rising market and first down in a falling market. Second, as an astute subscriber pointed out, somebody purchased 25,300 MAY/JUN DJX-110 puts at the close. The entire trade went at the ask price indicating it was a buy and not a sell. The cost of the trade a cool $7.5 mln dollars. If you knew in advance what the number was going to be and you shorted tech/Internet stocks in large numbers and bought Dow puts you could make out like a bandit. Do you think anybody really new? I would bet on it!

Maintain your focus, don't buy on impulse, have a great week!

Jim Brown

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