Option Investor
Market Wrap

Economy Is Growing, Does Anybody Care?

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        WE 5-31          WE 5-24          WE 5-17          WE 5-10 
DOW     9925.25 -179.01 10104.26 -248.82 10353.08 +413.16  - 66.68   
Nasdaq  1615.73 - 45.76  1661.49 - 79.90  1741.39 +140.54  - 12.15   
S&P-100  529.20 - 10.72   539.92 - 13.38   553.30 + 30.06  -  7.28   
S&P-500 1067.14 - 16.68  1083.82 - 22.77  1106.59 + 51.60  - 18.44   
W5000  10106.49 -144.15 10250.64 -223.54 10474.18 +456.71  -184.57   
RUT      487.47 -  6.17   493.64 - 15.30   508.94 + 16.21  - 19.59   
TRAN    2749.26 +  5.59  2743.67 - 54.69  2798.36 +155.26  -100.46   
VIX       22.90 +  1.64    21.16 +   .88    20.28 -  4.75  +  1.80   
VXN       45.95 +  3.09    42.86 -   .08    42.94 -  7.79  +  4.47   
TRIN       1.11             1.59             0.78             2.56
Put/Call    .73              .82              .72              .83    

The open on Friday was full of bullish cheerful traders calmly picking over the few bargains available but like Kmart shoppers on a budget there were no volume buyers. A nibble on semis, a biotech or two, even an oil stock here and there. There was a flood of economic reports coming out at 10:AM but nobody seemed to care. They will be positive because everybody knows the recovery is underway. Sure enough they were positive and with that ammunition the buyers became a little more excited as stocks ran up to resistance but once the easy pickings were gone so were the appetites

The Chicago PMI report soared to 60.8 in May and far surpassed expectations. The index gained +6 points from the April reading of 54.7. Any reading over 50 represents an expansion of manufacturing activity. New orders jumped to 65.8 from 59.0 and production jumped to 65.7 from 55.8. The production jump was the largest one month increase since December 1995. You can't get much more bullish than this.

Factory Orders rose +1.2% last month and nearly doubled the estimates. Shipments increased by +2.4% and inventories declined. Sounds like an economic wonderland! Want more good news? The Productivity Report showed a +8.4% spike in productivity and unit labor costs fell by -5.2%. The largest quarterly drop since 1983. Productivity up, costs down, Dow 15,000 here we come, right? Not in this fairy tale.

The holdup is not in the tech sector if you believe the Semiconductor Billings Report. Billings were up +3% in April for the third monthly increase in a row. Wireless communications chips led the gain. Considering the pounding the wireless sector has taken recently this should have been good news. Neither MOT, NOK nor QCOM could manage a gain of more the $.50 cents on the news.

Probably the most watched release of them all was the University of Michigan Sentiment Survey. The index rose to 96.9 in may from 93 in April. This is the highest level since late 2000. The current conditions index was 103.5 and four points higher than in April. The expectations index rose to 92.7. The survey was impacted by the continued drop in home mortgage rates and the continued low inflation. This was also great economic news in that a happy consumer is a shopping consumer.

So why did these great economic reports fail to spark a monster short covering rally that would make the Cisco event look like a lazy day in summer? Multiple reasons. First, it is summer and most investors are worried about other things than following the stock market on a tick by tick basis. They have followed the long standing Ray Hirsch advice to "go away in May." This can be proven by the volume on the Nasdaq which started out the week with a meager 1.2 billion shares and finished up on Friday with only 1.46 billion. Granted Fridays are slow in the summer but it was still the highest volume day of the week. Great economic news but nobody was listening.

Secondly the current active(?) investor has taken a "show me the money" stance. They have been told that profits were coming for several quarters now and they never appeared and in most cases got worse. They are now waiting for "real earnings" from real companies. The earnings shell game that was brought vividly to the surface by Enron and now dozens of companies since has built up a defensive wall between the market and the investors accounts. They do not want to part with the cash until they see who is left standing when the smoke clears.

Thirdly, the bearish sentiment has been so prevalent for so long that it has rubbed off on everyone. It is like having a smoker come to live in a non-smoking house for several months. Even though they don't smoke "in the house" the smoke is in their car, their clothes, their breath, etc. Even in the most cautious home this smoker smell eventually contaminates everything. You don't realize it until one day you open the front door and it hits you. By then it is too late. (I am not picking on smokers but I am relating a recent personal experience.) The bearish sentiment has so infiltrated the market that almost everyone is admitting that we will see lower lows and a retest of some past bottom. They have accepted that all the bear claims are true and many are even beginning to look for the second economic dip. Add to that the daily analyst surprise and you have a recipe for investor apathy.

Did I mention that two nuclear powers are getting ever closer to war? The U.S. government warned that all non-essential personnel should leave India immediately. They were already ordered out of Pakistan two months ago. Both countries now have a million soldiers each facing each other over the disputed line of control. There were warnings of a possible 10-12 million deaths within the next two weeks if the countries escalated their war into a nuclear conflict. The problem is the uneven ratio of power with India the strongest power by far. Possible scenarios include a first strike by Pakistan to level the odds and a retaliatory strike by India to punish them for the attack. While this seems like science fiction or a Tom Clancy mystery novel it is real life and this is weighing heavily on the markets. (Clancy did write a novel about a possible nuclear conflict between these two countries called "Line of Control.") This is not just a distant war possibility but a real potential impact to major companies. Oracle and HPQ have several thousand employees in their manufacturing plants in India and these are only two of the hundreds of U.S. companies with exposure to the potential war.

Those bulls that felt led to buck the trend and buy stocks on Friday were met with several critical downgrades. Lehman Bros drastically cut estimates on Micron to a loss of -.43 cents from a gain of a penny. A major haircut! Morgan Stanley also downgraded Micron on Friday. The problem is the continued slippage in corporate spending. The lack of buyers for computer equipment is causing a severe price war and one of the first items to be cut is excess memory. Prices for components are becoming so cheap that it is hard for the major manufacturers to make a profit because the smaller independents are cutting their throats just to stay open. I bought a Pentium-4 2.2GHZ processor and Gigabyte motherboard today for less than $350. I bought 1.5GB of DDR PC2700 333mhz memory for $297. I will throw this into my existing case and have to buckle my seatbelt when I sit down to trade. The problem? I upgraded to a state of the art system for next to nothing. I could have bought it as an entire computer for a couple hundred more. There is no profit in computers in this market.

There is so much "extra" horsepower available today that there is not enough computing needs to max it out. Even with my four monitors and running Qcharts with nearly 100 charts and almost 1000 active quote sheet symbols, half a dozen browsers, email, Preferred Trade, Interquote, a couple of Word documents and an Excel spreadsheet there will be easily 75% of the power to spare. I can't imagine ever using all the capacity. (Famous last words) This system for normal people would replace 2-3 older computers with one. Many of our readers use multiple computers for trading platforms. One for quotes/charts, one for a browser and/or broker interface and maybe even one for email and "work" during the day. Instead of upgrading all these systems they can upgrade one and toss the others out. This goes the same for businesses. Tasks that took several computers two years ago may only take one now. We have half the servers we had two years ago and twice the amount of data and active pages. For more on this impact to the tech sector I recommend this: http://biz.yahoo.com/smart/020531/20020524aheaofthecurv_16.html

A reader emailed me this link this afternoon and while I don't normally agree with Fleckenstein he is on the same track. http://money.msn.com/content/p24025.asp He is not the only one that thinks the computer upgrade cycle everyone has been waiting for may not be as robust as expected. Lehman Brothers analyst Dan Niles suggested lightening up on chip stocks because the summer was not going to be kind to them. He feels the upgrade patterns mentioned above will continue to pressure earnings and with the average chip stock at a PE of 45 and chip equipment makers over 70, there could be some price compression in the future. (In English, "stock prices are coming down") The semiconductor sector saw a brief bounce on short covering when the economic and semiconductor billing news was released but it was only temporary and it finished at the days lows. Intel barely broke even after trading up intraday after several analysts said they expected Intel to guide to the lower end of their range next Thursday when they have their mid-quarter update. Time and time again we have heard about how this quarter has been very slow and it will be extremely back end loaded. With their update on June 6th they will not know for sure how it is going to end and may be forced to be ultra conservative and guide lower hoping to surprise to the upside later.

Other techs were targeted on Friday as well. IBM, which is continuing to cut workers, 2,000 this week, was the target of cautious comments from several sources. The stock lost -1.80 even though it announced an order for a $224 million computer from the government, announced its leadership role in disk storage and announced its worldwide leadership role in super- computer revenue. Some days it just doesn't pay to go to work!

Merrill Lynch, concerned about the slow IT growth, cut sales and earnings estimates on the software sector, primarily ORCL, SEBL and SY. Microsoft lost -1.73. Merrill said that many companies will struggle to gain limited sales improvements for the rest of the year. Check out the MSFT chart intraday and look at the drop at the close. Somebody wanted out really bad before the weekend. I looked at time and sales and did not see any giant blocks of stock trade but there were a lot of multi-thousand share trades at the low of the day.

The 2Q is shaping up like this so far. According to First Call there have been 285 negative and 247 positive pre-announcements. On the surface that appears bearish but analysts are actually glad it is not worse. Next week the 2Q-warning season will begin to heat up. The economic calendar is also huge with the ISM Survey (formerly known as NAPM) and Construction Spending on Monday. Tuesday we get the BTM and Redbook. Wednesday the non-manufacturing ISM and Friday the Non-farm Payrolls and Wholesale Inventories. The Intel analyst update on Thursday after the close will have tech investors shaking all week. Will they or won't they guide lower?

The markets on Friday appeared to be pricing in many of the negative factors described above. The post economic report rally was likely inspired by some limited short covering since there was no volume and no follow through. I am sure some diehard bulls were buying in hopes of a breakout on the first leg of a new bull market. They were sorely disappointed when the +130 point Dow gain dwindled to only +13 points at the close. What was unthinkable last Friday, a retest of the 9800 lows, when the Dow closed at 10100, came to pass. While it should have been seen as the "bottom" and a successful retest of the May-7th lows, it was met with a yawn and not even a respectable bout of short covering. After Friday's roll over the chances of another retest of even lower numbers are very strong.

The Nasdaq stopped dead on resistance intraday at 1650 and then dropped -34 points to close with a loss of -16 for the day. Nearest support is 1600-1607 but that could be only a pause if the tech downgrades and warnings continue. The next support is a distant 1560 with eventual support well below that in the low 1400 range. While that may only be a doomsday scenario the odds for another drop to something below 1600 are pretty good.

The S&P, probably the best barometer for the general market, failed at 1080 on Friday and closed under support at 1070. The Thursday low of 1054 was only 4 points above real support at 1050. This should be our line in the sand. We can give the bears the next 17 points but the 1050 level is critical. That will determine the next phase of this market decline. If we can stop the bleeding there and trade sideways for a couple weeks then the July earnings expectations may kick in to provide a little positive momentum. That of course assumes enough positive pre-announcements to wake up the bulls from their summer nap.

A well-known market prognosticator who has been laying low recently, made a public statement on Friday. "Until we witness a definitive upside breakout, we will view the sustainability of any rally (or rallies) from current levels as suspect," said Ralph Acampora, Prudential Securities' top technical analyst. In English he said, "if the markets don't go up they will probably go down." After being a lightning rod during the 1999-2000 bubble he has been very quiet and has avoided any market moving calls or predictions.

In reality he is right. If, after the extremely positive economic reports this week, the markets cannot put together a solid gain on Monday/Tuesday then in reality we are toast. With no volume our path may already be carved in stone. Volume is a weapon for the bulls. Markets can go down on low volume simply due to lack of interest but it takes volume to make it go up. Volume is the measure of supply and demand. When there is no demand ANY supply will push prices down. Even a positive advance/decline ratio on both exchanges could not hold the markets up with light volume on Friday. When the good economic news from Friday fades behind nuclear war newsbytes on Monday, bulls may not see an urgent need to own stocks.

Trading in these markets is tough at best. For the Nasdaq the only long positions I would consider would be a bounce off 1565 or a breakout over 1675. Trading the chop in the middle could be expensive. The Dow is even harder. It has resistance at every century mark beginning with 10000. Waiting for a breakout of any hundred mark gives you very little room before the next one is a problem. After the lackluster rebound performance from the 9800 dip on Thursday I would be hard pressed to buy a dip to that level again. I would only play the Dow (DJX) long on a rebound with strong volume or short it on any drop below 9800. I know this may sound very negative or defeatist but this is a tough market and pretending it isn't will cost you money. You need to be very quick about entry points and even quicker about exits.

If you would like some guidance during the trading day about entry points and trade setups then click on the Market Monitor. Leigh, Jeff, Jonathan and myself will provide continuous updates and trade signals through the day. We will help you cut through the intraday noise and understand what is happening in the markets. We can't make the markets better but we can help you understand what is really happening. Enter Very Passively, Exit Very Aggressively!

Jim Brown

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