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Market Wrap

Tug of War

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07-31-2002               High    Low     Volume Advance/Decl
DJIA     8736.59 +56.56  8736.73 8537.10 2349 mln  1614/1505
NASDAQ   1328.26 -15.93 1335.79  1307.01 1613 mln  1371/1919
S&P 100   458.87 + 5.97  458.87  446.36   totals   2985/3424
S&P 500   911.62 + 8.84  911.64  889.88
RUS 2000  392.42 - 8.49  400.91  392.38
DJ TRANS 2370.05 -19.46  2390.29 2340.84
VIX        35.21 + 0.06    37.49   34.96
VIXN       57.86 + 1.40    60.15   56.92 
Put/Call Ratio 0.87

Tug of War

What resilience! Several economic indicators were released this morning, and what appeared to be bad news simply can't seem to break the bulls. GDP showed economic growth in the second quarter at only 1.1%, less than half of the expected 2.4%. This was a decrease from first quarter growth of 5%, which was revised downward this morning from a previously reported level of 6.1%. This downward revision from the first quarter happens to be equal to total second quarter growth.

This morning's data release also altered perception of last year, showing that the economy did, in fact, slip into recession in 2001. The economy shrank in the first, second and third quarters last year, and emerged back into positive territory in the fourth. The key to these revisions was the second quarter, which had previously been reported as positive. The revision into negative territory put the economy into a solid recession with the required two straight quarters of economic contraction. In this case there were three in a row, and demonstrated a deeper problem than previously thought.

The GDP report was followed by the Chicago PMI (Purchasing Mangers Index), which came in at 51.5% in July. A reading above 50% indicates expansion of activity in the manufacturing sector. This number was expected to come in at 56.8%, so it is considered a disappointment. Keep in mind that it is also only 1.6% away from contraction.

The Dow started off poorly, down 143 points, but buyers shrugged off the economic data to rally the Dow 118 points from that level, before giving in after a Beige Book report that may have set a new record for use of the word "mixed" in an economic summary. The report suggested that the economy expanded modestly in recent weeks, with uneven performance across sectors. Residential real estate and construction were strong, as were purchases for the home, but commercial real estate struggled. Banks reported strong demand for home mortgages, but continued weak demand for business loans. Agricultural conditions were mostly poor. Labor markets were described as slack, but stable. Prices for most goods and services were steady. Auto and retail sales were mixed. Here is a link to the full text of this report. http://www.federalreserve.gov/FOMC/BeigeBook/2002/20020731/Default.htm

This lackluster report completed the trifecta of uninspiring data, driving the Dow back down over 100 points, however unable to force its way through support at 8500. The average has come close to testing this level on several occasions the last few days, but has held firm.

Chart of the Dow Jones

The S&P 500 has seen similar support at the 890 level. This level in the S&P provided resistance on Tuesday morning, but ever since breaking through, has served as support for the index.

Chart of the S&P 500

These levels will be important the next two days, as more key economic data is released. Thursday we will get a look at auto and truck sales, initial jobless claims for last week and construction spending. On Friday, we will see non-farm payrolls, unemployment rate for the month of July, and personal income and factory orders for the month of June. After a rally of more than 1200 points from last Wednesday's low, the bears will be looking for continued economic weakness. Although the reports today couldn't break through these support levels, bad news over the next two days could combine with today's news to break the bulls' backs.

One theory on today's surge is that end of the month buyers stepped in and brought the Dow back into positive territory. The end-of-month fund statements certainly look better with higher stock prices.

Why the market continues to elevate, in spite of disappointing economic reports, seems a mystery. However, valuation may be the name of this game. Goldman Sachs released data showing that they have raised their global equity weighting to 65%, right at the top of their range. The firm noted that global equities were cheap relative to bonds. Goldman reduced their bond holdings from 23% to 20%, which was at the very bottom of their range, and reduced cash holdings from 5% to 7%. "Switching out of bonds into equities at these valuation levels has proved a profitable tactic in the past," said Goldman's Neil Williams.

As the market has continued to hold its gains, there has been a noticeable reversal upward of bullish percent figures, which measure the number of stocks in an index that are currently giving buy signals. The Nasdaq 100 bullish percent has reversed from a low of 8% at the beginning of the month to currently show 30% of its stocks giving buy signals. The S&P 500 bullish percent has doubled from a low of 12% to 24% and the Dow bullish percent has more than quintupled from 4% of these stocks giving buy signals to 22%. An interesting note on these percents is that toward the beginning of the month, they were diverging, with the Nasdaq 100 on the way up, while the others continued downward. At this point all three are not only on their way up, but remain in oversold territory. The Dow and S&P are both in bull alert status, while the Nasdaq 100 has been bull confirmed.

General Electric certified its financial results ahead of the August 14th reporting period set by the SEC. The company also announced that it would begin expensing employee stock options. This procedure will cost GE $30 million, or less than a penny a share, from its 2002 net income. The cost will increase to about 3 cents a share over the next 3 to 4 years, as the cost is phased in. Investors rewarded GE for the announcement with a gain of $0.60, maintaining its rally of over $9 in the last week. The stock closed today at $32.20. It remains to be seen how many companies expense these options, and whether investors will react positively to a more transparent accounting procedure, or whether the earnings per share cost leads to lower valuations.

We have been predicting for some time that companies would be releasing bad news ahead of the August 14 deadline for certifying financial results, and that this information could weigh heavily on the market. While this is still a possibility, we may also see some investor confidence return as more companies begin to certify, therefore reducing anxiety among investors about which company will be next to announce accounting problems. The SEC has made this information available on its website. http://www.sec.gov/rules/extra/ceocfo.htm

One sector that did not get an end of day lift was the semiconductors. After yesterday's close, NVDA warned that its earnings and revenue for the just completed quarter would fall well below expectations. They attributed this to weak demand for personal computers, which could spell bad news for many other companies in the sector. The stock was pummeled today, and lost 32% of its value, trading down $5.15 to $11.07. The Semiconductor Index (SOX.X) dropped almost 5% after mounting a comeback the last two days from 52-week lows set just last week. The sector has been turned back from the index level of 350 twice, after it served as support on the way down. There is also a downward sloping trend line developing which looks bearish for the sector, when combined with the bad news that seems to come out of the sector every few days. Last week, Taiwan Semiconductor (TSM) announced they were slashing their budget for the rest of the year. Last night, KLA-Tencor (KLAC) reported earnings that fell 64%, citing languishing demand for semiconductor equipment. A Goldman Sachs upgrade of the semiconductor equipment makers last Friday provided a temporary boost, but the near-term prospects do not look good for this sector.

Chart of the SOX

This sentiment was reiterated by the Nasdaq Composite, which lost 15.93 on the day to close at 1328.26.

AOL/Time Warner confirmed today that the Justice Department has opened a probe into its accounting practices. While the Washington Post first questioned AOL's accounting earlier this month, focusing on transactions that boosted advertising revenue through "unconventional transactions," there has been talk that the probe may now widen. A Merrill Lynch research note by analyst Jessica Cohen stated "we are not 100% sure the investigation is contained purely at the AOL division." As daily appearances before the Senate have become a regular occurrence, investors seem to be moving past these investigations and continuing to buy. While the individual issues are getting beaten up, the overall market has been holding up on decent volume, which passed the 2 billion share level once again today. A month ago, news of any investigation sent the market rolling downhill. Now it doesn't seem to register much more than a blip on the broad market.

Verizon said its losses widened in the second quarter and reduced its earnings and revenue outlook for the year. Last week the company asked for help from the Federal Communications Commission in keeping its WorldCom related liabilities in check. Verizon hasn't yet finished calculating what it is owed by WorldCom.

IBM announced its intention to purchase the consulting arm of Price Waterhouse for $3.5 billion after yesterday's close. Analysts have viewed this purchase as a strike at rivals Accenture, which is known as a top level IT consulting firm, and Hewlett-Packard, who will no longer have the option of reconsidering its previous decision not to purchase PwC. Another firm that may suffer from this alliance is Electronic Data Systems (EDS), which said it was "frankly surprised it took IBM this long to realize the benefit of - and to begin taking steps to leverage - the combination of consulting, implementation and outsourcing." It appears this move could be of great benefit to Big Blue, although the stock gave up $1.39 to finish the day at $70.40.

In an environment with very little to get excited about, it is quite surprising that the Dow and S&P have held up so well. Keep an eye on tomorrow and Friday's data for signs of continued weakness throughout the economy. If we get more bad news, and we fall through the aforementioned levels of support, it could lead to a re-test of July's lows. If we manage to get through this data with continued support, we still need to get through congestion between 8700-8900 in the Dow. If that happens, look for a move over 9000, as has happened the last two times the Dow tested the 7500 level in January 1998 and August 1998. Respect your stops, there is pressure building in both directions, and eventually tug of wars end up with someone in the mud. Stay clean.

Steve Price

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