Option Investor
Market Wrap

Surprising Strength For Overbought Markets!

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       WE 11-16         WE 11-11         WE 11-02         WE 10-26
DOW     9866.99 +258.99  9608.00 +284.46  9323.54 -221.63  +341.06
Nasdaq  1898.58 + 70.10  1828.48 + 82.75  1745.73 - 23.23  + 97.65
S&P-100  588.07 + 10.08   577.99 + 18.00   559.99 -  7.99  + 14.18
S&P-500 1138.65 + 18.34  1120.31 + 33.11  1087.20 - 17.41  + 31.13
W5000  10486.67 +189.46 10297.21 +280.40 10016.81 -168.72  +290.64
RUT      451.31 + 13.21   438.10 +  5.03   433.07 -  5.58  + 12.95
TRAN    2497.37 +176.68  2320.69 + 74.03  2246.66 -   .92  + 73.30
VIX       27.17 -  1.59    28.76 -  3.64    32.40 +  1.87  -  5.31
VXN       55.04 -  3.55    58.59 -  2.60    61.19 +  4.28  - 12.37
TRIN       0.99             0.90             0.92             0.87
TICK       +750             +784             +701             +828
Put/Call    .50              .74              .70              .53

The expected Friday sell off on profit taking came right on schedule but was met at the close by ready buyers. After sprinting to resistance at 9900 at the open, the Dow fell back to 9792 and a -80 point loss before end of day buying almost brought it back to positive territory. The Nasdaq was a carbon copy except the morning high was the second day in a row that the index posted a lower high which could indicate weaker internals and the beginning of a declining trend.

The markets traded on economic enthusiasm at the open after the CPI came in weaker than expected and continuing show that inflation is nonexistent. The main factor continues to be cheaper energy prices being passed through to consumer prices. Industrial Production fell again in October for the thirteenth straight month and to the lowest level since the great depression. Capacity Utilization fell to 74.8%, which is the lowest level since 1983. Low capacity eliminates supply bottlenecks and has virtually eliminated inflationary pressure from the economy. Growth continues to remain negative and could be a warning that the 4Q GDP will show a deeper recession

Probably the best news for a sleepy Friday was a comment from Continental Airlines that holiday travel was stronger than expected. This along with cheaper oil powered the airline stocks to highs for the week. This was even more remarkable due to the American Airlines crash on Monday and the news that American was going to cancel a couple dozen airplane orders in light of the decreased passenger traffic.

About the only period of serious weakness on Friday was when the Atlanta airport was closed due to a security breech. Bids were cancelled as the markets hit their lows but they quickly returned when the all clear signal was given.

The Taliban and Al Queda suffered several new blows including the loss of Osama's right hand man. Mullah Omar reportedly offered to turn over Kandahar if he could get safe passage out of the area. Things are not going well for the Taliban as it appears they have collapsed as a government and a fighting force. Coalition special forces are acting with impunity within the country and most feel it is only a matter of days before all the likely suspects are killed or captured. The continuing good news from Afghanistan continued to support a market that is clearly overbought.

Friday was options expiration day and while cruising through my watch list it was evident in the stock prices. There were many stocks that had good runs recently that were "pinging" at a major strike price. This means the stock will run up to exactly the strike price or a few cents under the strike and fail to break it. The market makers and hedge funds hold the price down so that the covered calls written at that strike price expire worthless. They do this by outright shorting or by sacrificing a portion of their holdings to protect the rest. If a fund had five million shares of XYZ stock purchased at $7-$10 and wrote $20 calls after it passed say $17 they would be at risk for losing their stock if the stock closed over $20. Many funds use options to increase returns and it is not unusual for them to get caught close to a strike price in expiration week. By selling stock as the price threatens to go over the strike price it pressures the stock and many times holds the prices under the strike. By sacrificing a few thousand they save the majority of their position.

Market makers also hedge the positions they take during the month by buying/selling options and many times they would rather those options expire worthless instead of expire in the money. These market makers work on 10-20 times the margin that regular traders enjoy and they use this leverage to prevent breakouts if it would hurt them financially. Without the options expiring on Friday I doubt we would have had any volume at all. It was very anemic with only 1.3 billion on the NYSE and 1.7 on the Nasdaq.

While the market momentum appeared to be slowing near the end of the week the underlying strength is still there. I was worried that a pull back could occur on Friday and carry over into Monday. Instead the finish on Friday was bullish and even though we did not close in positive territory there was decent strength coming back from the dip. The Dell earnings hit only Dell and not the markets. Despite the AMAT caution many chips continued upward. When I was going through my watch list on Wed/Thr there were many stocks rolling over at resistance which gave me a reason for caution. When going over the same watch list on Friday night many of those same stocks were back up at resistance and threatening to breakout. Many smaller stocks were accelerating while blue chips were showing minor weakness from profit taking. Bonds continued to sell off as asset allocations shift back to stocks.

If you have been reading my comments for the last three weeks you would know that I have been bullish and telling you to go long even when everyone else was calling for another major sell off. There has been a gain of over 800 points on the Dow and over 200 points on the Nasdaq in that time. Thursday I said don't buy the dip on Friday because I was afraid it could be the beginning of a multi-day profit taking sell off. As I sat and watched the market move towards the close on Friday, with almost everyone now bullish, I was pondering the coming week. The VIX and the VXN closed at new three months lows and the advancers beat decliners on a down day. Bullishness is rampant going into a normally bullish week but the put/call ratio is very bearish.

What we have is a very confused market. The long term investor is looking at ten rate cuts and expecting a roaring economy next year. The bond markets are now looking at the December Fed meeting and factoring OUT another rate cut. The home mortgage rates spiked this week in reaction to the ten year bond yields. Inventory levels are rising again and tech giants are dodging comments about a 2Q recovery. What do you think will happen if the Fed does not cut again and changes their bias to neutral on Dec-11th? Even though the markets know the change will eventually come nobody wants to think it will be in December. That is only three weeks away.

So now investors are about to be confused as well. Investors are finally turning bullish just as the market is showing signs of topping. The economic recovery hopes have dimmed significantly in the last two days but investors have not caught on yet. The week before and after Thanksgiving is normally bullish. Does that mean we buy with reckless abandon just because the period is normally bullish? I hope not. I saw a lot of bullishness in my charts this weekend but my subconscious still says be careful. We have bounced off overhead resistance for three days now and it will take more than wishful thinking to get through it. I just don't think the minor selling we saw on Friday was enough to compensate for the three weeks of gains. There is profit taking in our future and it will not be pretty. It could come any day next week and the longer it takes the more severe it will be.

Support levels are still 9750 on the Dow, which is only -110 points away. The Nasdaq could easily drop to 1868 but that is only a good days move from Friday's close at 1898. The S&P is more critical to the continued rally than either the Dow or Nasdaq and it looks weak. Support on the S&P is 1130 which barely held on Friday with a drop back to 1129.92 but the rebound was not as convincing. Real support is 1115 which is a good two day drop away.

As I close this article I am struggling. I went back and reviewed charts again and MANY look like pending breakouts. BUT, most big drops are after the most bullish days. I could easily see a huge relief rally on Monday if nothing negative happens over the weekend. I could also see those pending breakouts roll over instead as the negative economic news starts to weigh on the markets again. Most investors are relieved to hear that airline load factors are up and the retail holiday may be better than expected but that is already factored into the markets. Investors are also bullish because gas is so cheap but that condition can change overnight. The last +1800 points from the September lows has been easy money. The next 600 points on the Dow will have to be fought for on a day by day basis. We no longer have the September panic drop into severely oversold conditions to power us. We are now largely overbought and the fight is in front of us. Valuation downgrades are becoming an everyday occurrence. Cisco for example on Friday.

The bottom line for me this weekend is still the same as Thursday, caution. I don't want everyone to sit on the sidelines should the market rally against reason. (now there is a thought, when has the market ever been reasonable?) I also do not want readers to venture blissfully into next week expecting a turkey rally. Farm turkeys eat really well for several weeks before thanksgiving then their world comes to an end. We have eaten very well in the market for the last three weeks. Let's just be on the lookout for the guy with an ax this week. Keep those stops close. One more thought, I said don't buy the dip on Friday. I am changing that to buy any "rebound" from the support levels I stated above. Let's see if we can tempt fate and buy one more dip before we start worrying about December earnings warnings. Yes, it is almost that time again!

Enter passively, exit aggressively!

Jim Brown
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