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Summer rally, summer rally, summer rally! If you say it enough will it come true?

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        WE 7-7           WE 6-30          WE 6-23          WE 6-16
DOW    10635.98 +188.09 10447.89 + 43.14 10404.75 - 44.55  -164.76
Nasdaq  4023.20 + 57.09  3966.11 +120.77  3845.34 - 15.22  - 14.28
S&P-100  803.00 + 12.75   790.25 +  9.18   781.07 -  7.67  +  9.04
S&P-500 1478.90 + 24.30  1454.60 + 13.12  1441.48 - 22.98  +  7.51
RUT      528.22 + 10.99   517.23 +  6.82   510.41 -  3.33  -  9.32
TRAN    2784.64 +139.27  2645.37 + 14.66  2630.71 - 42.48  -116.98
VIX       21.82 -   .44    22.26 -  3.63    25.89 +  2.34  -  1.64
Put/Call    .48              .48              .61              .53

Summer rally, summer rally, summer rally! If you say it enough will it come true?

And the answer is....you decide. The talking heads could not say it enough on Friday and for good reason. After a huge drop on Thursday both major indexes came roaring back after a tame? jobs report. The bullish sentiment may be so rampant that traders could not see the numbers behind the numbers due to the tint of their rose colored glasses. Ask anyone about market direction next week and the odds are they will say up, enthusiastically! It appears that almost all sectors took part in the rally and when you get banks and techs moving in the same direction it can't be all bad.

Finally we are going to see some real earnings next week. The last major week of warning season was a killer. Every time traders thought they had digested the most recent confession another one self destructed in their path. The list was long and included companies like CPWR, CA, BMCS, HMN, LZB, DNEX, BRIO, MNTR, NESY, FD, HAUP and on and on. The warnings caused a real scare on Wed/Thr as both indexes appeared to be heading south at a high rate of speed. The warnings on Friday were ignored as market moving events in light of the tame? Non-farm Payroll report.

What did move specific sectors on Friday were specific news events including a down grade of YHOO by DB Alex Brown to a "buy" from "strong buy." The analyst said valuations are more important now with advertising rates dropping fast. She said other companies like Lycos and AOL are also in danger of flat revenue growth. With dot.coms dropping like a rock, have you looked at SFE, CMGI or ICGE lately?, the Internet boom is rapidly turning into a bust. Internet stocks are facing a long hot summer that may end up being a dead end trip through death valley. Those that make it past October will be stronger and consolidations are going to be occurring at rapid rate. The analyst said in an interview that as the Internet model matures you would expect a return back to a more realistic PE of 30 instead of the astronomical triple digit numbers of today. Remember PE means price to earnings ratios. YHOO currently has a PE of 563. Using a PE of 30 and 12 month earnings of $.50 would give you a share price of $15.00, not the $116 close today. While I disagree strongly with her forecast of future dot.com values, (heck, I am one!), I do feel there is some irrational exuberance in numbers like the YHOO 563. Where the future values of stocks in a sector where there are 4000 new competitors every day, (really), will finally settle is anybody's guess but both extremes are definitely not on my horizon. I do look at the YHOO PE in amazement. I know profitable dot.coms are rare, heck, I am one of those also, but try offering me even a 100 PE and I will show you a prime example of "sell to soon." This "reality check" by investors is what I think will eventually "mature" the sector. Mature companies like IBM, GE, WMT, INTC, MSFT, in mature sectors have "quarterly profits", measured in billions of dollars each, which is more than the "yearly revenue" of the leading Internet companies. Eventually the Internet sector will conform to the norm but it will be a long and painful process.

In the financial world today Merrill Lynch made the news with the possibility of a 2000 person layoff. Normally this is good for stocks since the $150 million savings would increase earnings but after the recent spike in MER there was a sell off at the open and a slight loss for the day. Other brokers fell in sympathy but quickly rallied as well. Actually financials mounted a rally for the week on the prospects that the Fed is finally done raising rates.

I might as well quit beating around the bush and bring up the employment report on Friday. On the surface the drop in new jobs to only an increase of +11,000 was pure evidence of a slowing economy. Everybody loved it. The market soared. End of story. Sorry, wrong number. In reality the new jobs number was +206,000 for the private sector. Is it my imagination but isn't that the sector that we are concerned about? If you look behind the numbers you will see that the government laid off -197,000 census workers last month. That makes the net number only +11,000 but you can bet your bippy, (remember that term?) that they will not be laying off 197K more in July. The census has inflated or distorted the numbers for the last three months as they added and now subtracted large numbers of workers. So lets look at the real numbers. Net private sector jobs was +206,000. Average hourly wages increased +.4% in June compared to +.1% in May. The unemployment rate dropped to 4.0%, down from 4.1% in May and only .1% away from the 30 year low set in April. Looks pretty negative to me. Also there is a rumor going around that the jobs number would have been higher if there were trained employees to hire. The job market is very strong for qualified help but that is the catch. At 4% unemployment you are scraping the very bottom of the barrel. I know we have a terrible time getting qualified employees. We placed nine ads in both the local papers last week and we only hired one person this week out of the 20+ we are looking to hire. Several more are in the process but the majority of people applying for even the non-technical positions are not employable. At least not in our office. I am sure the rest of the country is having the same problem. The July employment report will be very interesting. Coming before the August Fed meeting a 3.9% unemployment again will start the entire Fed worry cycle anew.

Enough gloom and doom. I like what I am seeing for next week. The Nasdaq sellers tried to take the market down on Thursday along with the Dow and buyers met them head on. We had what I would call an orchestrated market test. With the low volume it does not take many sellers to move the market. If fund managers wanted to test the bottom of the market it would not take much to push the prices around. If you were a fund manager, bullish but skeptical of a possible "summer rally", you could test the bottom, kind of like testing thin ice. Say you had a large position in a dozen tech stocks. To test the market you dump a quantity of sell orders in increasing quantity on the market. If the stocks don't firm at support or you scare other sellers off the fence then there is no bottom and you stay on the sidelines. If a bottom appears, as it did on Thursday, then you can buy back the shares you dumped earlier, possibly at a profit, and then feel more comfortable about adding to previous positions. If you know there is a bottom then wading into murky water is far less risky. This is of course a simplified example of how this happens but you get the point.

Again, I like what I see with the exception of the VIX. The Nasdaq closed over 4000 and only -40 points off its recent high. The Dow closed right at the high of its recent down trend channel. Both indexes appear to be poised to breakout. Even the S&P-500 appears poised to breakout over resistance that has held since April at 1485.

While I am not a cheerleader for summer rallies I would gladly accept one. Recent history has shown July to be bearish. However we all know that nothing always happens the same. Just because October is normally a bad month... well maybe that is not a good example. Let's try that differently. Just because the last two Julys have had an almost identical -15% drop after expiration Friday does not mean that it will happen this year, does it?

In 1999 the Monday after expiration was the 19th. In 1998 it was the 20th. Is this just a coincidence? I think not. However trends change just as quickly as they form. This year we have several things working in our favor. First we have already suffered a severe sell off from the spring highs. After dropping into a bear market, excuse me I don't need any hate mail, a "correction" in March we have struggled with a two steps forward, one step back market to a position of being poised for a breakout. This is good! Two, we are now free of the Fed dread for at least the next several weeks. Well, at least four days, until the PPI next Friday. If the PPI comes in higher than expected the fear of an August rate hike will return immediately. Three, oil prices appear to have peaked after several months of steady increases. The falling oil prices will relieve pressure on many prices and soften the blow from higher interest rates. Four, Dow theory followers are bragging about the rebound in the transports as confirmation of the Dow rally this week. The rebound of course was due to falling oil prices but lets not let that fact get in the way of their bullish view. Five, the term soft landing was used almost as many times as summer rally in the major media. It is again not reality but perception of reality that will govern our markets going forward. If the perception exists that the Fed has engineered a soft landing for the economy and that they are done raising rates then why should we tell them any different?

Friday was a good day. The Dow posted the biggest gain since May 30th. The gains were solidly on the back of IBM +3.44, HWP +6.38, INTC +2.69, MSFT +1.06, UTX +1.06 and a monster move by two non-techs, WMT +4.06 and HD +4.00. Financials helped some with C +1.31, JPM +.94, AXP +1.81. I would expect the financials to add more gains next week but there is no trend to confirm the moves on HD and WMT. Actually with the Retail Sales report next Friday we could see a pull back in the retail sector. The tech stalwarts put in a good performance and with earnings coming we could have a good week for them. On the Nasdaq side DELL actually broke out over $50 and almost made the play list this weekend. It did not because they announce in August and typically they lose ground in the prior month. Adding to the Nasdaq gains was CSCO which looks like it is mounting a rebound and ORCL recovered some of its recent loss. With the top five stocks MSFT, INTC, DELL, CSCO and ORCL all showing positive trends the Nasdaq should hold its own for at least a couple days.

So here is the skinny. If the Nasdaq can breakout and hold over 4100 that would be a confirmation for many that the rally was real. Same with the Dow if it can hold over 10650 traders would nibble but if it closes over 10750 there could be a flood of money off the sidelines. Our challenge will be the PPI, Retail Sales and Industrial Production reports on Friday. Any big gains early in the week will probably see some profit taking in front of Friday's reports. The CPI follows on Tuesday but is not normally a big mover. The big movers next week will be the arrival of real earnings announcements. Dow component Alcoa (AA) starts the parade on Monday followed by International Paper and YHOO on Tuesday. Thursday Dow components GE and JPM announce. With the downgrade of YHOO on Friday any softness in the numbers after the close on Tuesday will likely be an Internet disaster of titanic proportions. If YHOO beats the street with higher revenue than expected then the Internet sector should breathe a sigh of relief and continue with earnings as usual.

I would view any rally next week as a trading rally, not a buy and hold event. Even with the positive points I outlined above I would still be ready to move to the sidelines on or before expiration Friday. Since expiration this July occurs on the farthest possible date, 21st, any "sell the earnings news" event could start before that day. So, trade, profit, enjoy, but keep your eyes on the calendar just in case we get a three-peat of the previous July drops. In case you are wondering, the drop in 1997 started on Thursday, the day before expiration, but only lasted several days and was less than -100 points. (1600 Nasdaq) There was a summer rally in 1997 that added +350 points or +25% to the Nasdaq between June-15th and October-13th. (1400 to 1750) The following week took almost all of it back but that is another story. Summer rallies do occur, just rarely.

Last week I mentioned that the VIX was at a three month low of 22.26 and was flashing extreme caution. The wed/thr market drop spiked it back up to almost 25 and neutral but the ensuing rally has pushed it to a new four month low of 21.92. Remember the VIX is seldom wrong and then only by a few days. Below 22 is a warning but under 20 is extreme danger. We have only been there twice in the last year. Nov 19th we hit 19.50 and the other day.....July 16th, 1999 at 17.70. Need I say more? That was a 52 week low. The previous 52 week low? July 20th 1998 at 16.73. We will see if lighting strikes the same place three times in a row.

Don't forget the 3-day stock/option seminar in New York starts next Thursday and there are still a few seats available. Instructors include Chris Verhaegh, Steve Rohades and Scott Zimmerman. Traders Corner writer, Mary Redmond, will also be there. See the rest of the schedule below.

Check out my Options 101 article this week called "Exit Stratagies, Escaping With Profits."

Trade smart, sell too soon.

Jim Brown
Editor

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