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Mother Merrill, Please Pass the Chips

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        08-01-2001        High      Low     Volume Advance/Decline
DJIA    10510.01 - 12.80 10599.96 10484.20 1.30 bln   1817/1271	
NASDAQ   2068.38 + 41.25  2078.36  2045.13 1.76 bln   2185/1528
S&P 100   623.61 +  1.45   627.45   621.82   totals   4002/2799
S&P 500  1215.93 +  4.70  1223.04  1211.23           
RUS 2000  489.24 +  4.46   489.98   484.78
DJ TRANS 2933.78 + 27.60  2933.78  2894.16
VIX        22.99 -  0.88    23.91    22.84
Put/Call Ratio      0.50

Mother Merrill, Please Pass the Chips

Jumpy bears and anxious bulls combined to carry the Nasdaq Composite (COMPX) above meaningful resistance Wednesday. Can the COMPX make it three in a row? We'll see Thursday, but there are a few signs pointing to profit taking over the short-term. As always, the time element of any forthcoming move is the risk to contend with. After all, the future is uncertain. And that fact alone makes trading wonderfully challenging.

For its part, the COMPX advanced and subsequently SETTLED above the 2060 resistance level, which has been a focal point of this market participant. My initial stance would be one of the bullish nature following the COMPX's close above 2060. If the upside momentum persists, the COMPX could trade up to 2100 in the short-term. Thereafter, MAJOR resistance exists at 2150.

At the risk of coming off incredulous, however, dare I suggest we're at a 50/50 juncture. Care for a straddle?

The Ursus arctos in me noticed as of Wednesday that the COMPX stochastic is not only in overbought territory, but also beginning to rollover. Combine that fact with the resistance levels in key sectors, and it seems plausible to expect profit taking.

Concerning the COMPX stochastic, it's worth mentioning that the indicator recently broke its pattern of lower highs, which had been in place since mid-June. I find that to be constructive over the intermediate-term. Furthermore, keep in mind that stochastics is an oscillator. Oscillators work in bracketed (range bound) markets. The market is range bound. Use stochastics.

The largest part of my 50% bearish stance stems from the price action of the Software Index (GSO.X). The software sector is the largest within the Nasdaq, accounting for roughly 25% of the index. The GSO ran smack dab into resistance at 200 Wednesday. That much was not by coincidence as evidenced by the retracement bracket on the chart below. What's more, the single largest component of the Nasdaq and the GSO continues to trade heavily. I'm of course referring to Mr. Softee (NASDAQ:MSFT). The stock accounts for roughly 11% of the Nasdaq, and just can't seem to get out of its own way. The COMPX needs MSFT and the GSO to participate IF it's going to advance from current levels over the short-term.

While the GSO is the largest sector within the Nasdaq, the Semiconductor Sector (SOX.X) continues to assume the leading role. For the day Wednesday, the SOX tacked on over 5%, while the GSO added a comparatively poor 2.3%. The exuberance in chip issues stemmed from the Merrill Lynch (NYSE:MER) upgrade. Analysts at the firm upgraded 11 chip and chip equipment makers Wednesday based upon the "Bottom Is In Place" premise. Whether Merrill is correct or not remains to be seen. And their upgrade following several others among Wall Street's sell side does not garner as much credence. Further, there's the question of whether Wednesday's sharp advance in the SOX was a product of short covering or "real" buying by institutions. If it's a case of the former, then the SOX is set up for a pullback over the short-term as shorts reinitiate positions.

Also, the SOX rolled over at meaningful technical resistance at 650. The probable scenario over the short-term is for the SOX to fall back down to the 600 range, plus or minus 15 points, to consolidate its recent run-up. After all, the index is up by over 15% in just the last five days of trading. That's an awful big move and needs to be consolidated. However, should the SOX breakout above 650, we'd most likely see a capitulation on the part of the bears, which could carry the SOX up to 700 and the COMPX along with it. Like I just wrote, the SOX will probably pullback from current levels, but by no means is a breakout from current levels improbable.

What was interesting is that Merrill's upgrade did NOT include any communications chip makers, and the firm made that much clear. However, shares of PMC - Sierra (NASDAQ:PMCS), Applied Micro Circuits (NASDAQ:AMCC), and the like sharply advanced. That, in turn, boosted shares of the customers of the aforementioned; namely, the networkers. Juniper (NASDAQ:JNPR), CIENA (NASDAQ:CIEN) and Cisco (NASDAQ:CSCO) all had solid days. In the case of Cisco, the stock broke out above its bearish resistance line on the point & figure chart, which has been in place since last November! (CSCO's a current OI call play!)

The chip upgrade spilled over into the Networking Index (NWX.X), which like the GSO and SOX, is very close to breaking out above meaningful resistance. The NWX is riding its ascending trend line higher, in the process of forming a classic ascending wedge. A breakout in the NWX would most certainly benefit CSCO and the continuation of the latter's momentum. The PIVOTAL level to watch in the NWX is 348. Otherwise, another pullback down to its support line may offer solid risk/reward entries into the leaders of the sector (Read:CSCO).

With the looming overhead supply in three of the Nasdaq's largest sectors, we arrive to the question of what catalyst can break the GSO, SOX and NWX out and above their respective resistance? It could come in the form of another upgrade, positive comments from a tech firm, or anticipation that Cisco is going to have a good quarter when it reports next week.

Also, there's a growing belief that the Fed is going to cut interest rates a lot further than previously anticipated. The Fed Funds rate currently sits at 3.75%, and some have predicted that the FOMC is going to take rates below 3%! If Wednesday's National Association of Purchasing Manager's (NAPM) Index is any indication, the Fed may be far from finished cutting rates. July's NAPM index fell to 43.6, below both estimates and June's reading. While still below the waterline at 50, July's number indicated a further worsening of the manufacturing segment of the economy during the month. Greenspan monitors the NAPM closely, so could another inter-meeting rate cut be in the future? The Fed meets on August 21.

Even if the Fed doesn't surprise the market, guidance, or the market's expectation, for further rate cuts could advance the GSO, SOX, and NWX above their respective resistance levels. The consensus had expected the Fed to ease off the accelerator following its August meeting in conjunction with another 25 basis point cut. But with the drop in the NAPM index during July, that consensus may begin to shift towards further easings. And if that happens, the market will rally.

The media has been pretty mum about the Fed's August 21 meeting up until this point, but it should begin to garner increasing amounts of attention over the coming week. In fact, one possible scenario that could unfold over the next week is for the SOX, GSO, and NWX to pullback from current levels in a profit taking fashion before breaking out ahead of the Fed meeting. If that happens, buying the dip might not be too bad of an idea.

Eric Utley
Option Investor

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