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Follow the Leader

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08-28-2002                High    Low     Volume Advance/Decl
DJIA     8694.09 -130.32 8823.99  8646.19 1371 mln  773/1965
NASDAQ   1314.38 - 33.40 1340.01  1312.25 1338 mln  955/2231
S&P 100   462.53 -  8.62  471.15  459.99   totals   1728/4196
S&P 500   917.87 - 16.95  934.82  913.21
RUS 2000  389.38 -  8.07  397.45  389.38
DJ TRANS 2313.38 - 69.98 2382.64  2299.00
VIX        36.23 +  3.50   36.96  33.88
VIXN       54.70 +  4.69   56.26  51.53
Put/Call Ratio 0.88

Follow the Leader
by Steven Price

It appears the trend of the Nasdaq leading the rest of the broader markets around by the nose is still in tact. Yesterday's breakdown in the Nasdaq and NDX was the first close below their 50-dmas since last Monday, August 19, when all four major indices, including the Dow and S&P 500 broke above that level for the first time since spring. Sure enough, today the Dow and S&P 500 played follow the leader.

Charts of 50-dma break in Nasdaq, NDX, and Dow

Taking this theory a step further, what is it that leads the Nasdaq? Intel helped answer this question yesterday when its lukewarm comments about next quarter and continuing lack of IT spending sent the semiconductors crashing, and brought the Dow along with them. In an economy driven by computers and technology, this sector has been a barometer for the rest of the markets. After all of the major indices broke their 50-dmas last week, things looked rosy, except for one factor. The Semiconductor Index (SOX.X) was unable to hold above this level. Instead it found resistance at this point, and as a Nasdaq market leader, raised doubts about whether the rest of the market could move forward without it. We got our answer yesterday and today.

Prudential cut its 2002 earnings estimates on Intel, and increased AMD's loss estimates for 2002 and 2003. It cited developments in the Taiwanese PC supply chain, suggesting that Intel will not see more than 10% sequential growth in the fourth quarter. Also back to school spending is not at expected levels.

A look at last week's rally in the SOX, shows the group making it just over the 50-dma, but unable to hold, foreshadowing weakness in the tech sector. As the other indices continued upward, finding support at the 50-dma on pullbacks, the SOX continued to struggle with this level. Until the IT spending environment improves, or we discover another moving economic force, the broader markets will have an anchor hanging around their necks.

Chart of the SOX

In addition to the bad news for the chip makers, Hewlett Packard made comments regarding continuation of the IT spending slowdown, indicating that customers were putting off making large purchases until the economy improves. Revenue also came in more than $500 million below HP's initial guidance. Revenues were down 9% overall.

Nortel warned on Tuesday that third-quarter revenue would be below previous guidance. They are cutting 7,000 jobs and closing facilities. Chief executive Frank Dunn said, "We continue to see reductions in near-term spending plans by service providers especially in the United States." The company is now expecting a drop of 10% in quarterly revenue, as opposed to initial forecasts of flat growth.

Goldman Sachs said this morning that given the current IT spending weakness, it did not expect Sun Microsystems to unlikely to meet earnings estimates for this quarter. Goldman also believes revenue will be closer to the low end of its targeted 10-15% range.

As for the Dow, which ended the day down 130.32, at 8694.09, things do not look good. After falling through support at 8750, it made several attempts to get back above that level, only to be turned away, indicating this level is now acting as resistance.

Chart of the Dow Resistance

What may also be significant is a look at the Point and Figure chart of the Dow. Today's trade of 8750 established a triple bottom breakdown sell signal, followed by 2 additional "O"s at 8700 and 8650, which confirm the breakdown and get us past the possibility of a bear trap. The bear trap is when a single "O" on a triple bottom breakdown is followed by an immediate reversal up. This breakdown formation is very bearish and lends credence to the breakdown of support at 8750.

Point and Figure Chart of the Dow

Another recent concern exerting considerable weight on the economy is the price of oil. There is no better way to keep costs high than to raise the price of fuel for all industries.

The so-called Iraqi premium built into crude oil futures has stayed high as Vice President Dick Cheney indicated the U.S. was considering an invasion sooner rather than later. Iraq is the fourth largest Middle East oil producer. This comes at a time when global inventories are now falling, as OPEC supply curbs come into play. OPEC ministers meet on September 19, a week after the September 11 anniversary and will discuss possible changes in output to keep prices within its targeted range of $22-$28 per barrel. This is not a slam-dunk, however. After cutting output three times in 2001 and again on Jan. 1, OPEC is holding production quotas at the lowest level since 1991 to achieve this price objective. President Hugo Chavez of Venezuela said his country would not support an increase in quotas, and Kuwait has come out against any change, as well. Qatar's OPEC governor has also said OPEC shouldn't increase output because the world is "awash with oil."

OPEC's president, Rilwanu Lukman, however, said the organization has spare output capacity to deal with rising prices. Asked about prices rising over the current target levels, Lukman said, "We are not worried about that. We have enough oil to put into the market if needs be." There is currently several dollars of war premium built into the per barrel price and OPEC's reference export price of $26.67 a barrel reflects a 44% increase so far this year. Since OPEC nations rely on oil profits to fund their governments, restricting supply and raising prices also raises their profits. However, if prices go too high, other countries are encouraged to develop other sources of energy, or increase drilling at home.

In addition, as we enter the busiest travel vacation time of the year, just before labor day and the start of school, higher gas prices will keep more families at home, as the cost of fuel is figured into trips. For those who won't let higher gas prices keep them at home, they will wind up spending less on hotels or restaurants as their larger portions of the vacation budget are eaten up at the pump. This impact on discretionary income is already being felt in consumer spending. The recent downgrades by Merrill Lynch on 16 retail stocks came on the heels of a sharp decline in sales. Analyst Daniel Barry said, "Retailers are saying that traffic is holding up but discretionary spending is slowing... The sales outlook is not good." It is no coincidence that Wal-Mart has issued sales warnings the last two weeks, while Federated, which owns Macy's and Bloomingdale's, has issued sales warnings the last three weeks. These warnings have coincided with the increase in oil prices, as consumers are beginning to feel pinched at the pump. A look at the retail Index (RLX.X) shows the rally from the beginning of August rounding off as oil futures broke above $28 a barrel and stayed there. While oil prices are certainly not the only factor influencing spending, it only adds to concerns about a new wave of layoffs and the economy in general. These factors are all taken into account and reflected in Consumer Confidence, which took a hit on Tuesday.

Chart of Retail & Oil

WorldCom executives Scott Sullivan and Buford Yates were indicted by a grand jury on charges of securities fraud and making false filings with the SEC. They are accused of hiding more than $7 billion in expenses at the phone carrier, a move that created false profits and kept investors in the dark about the true deteriorating finances of WorldCom. Conspicuous by his absence was former controller David Myers, who was arrested very publicly the same morning as Scott Sullivan. This has led to speculation that Myers may be cooperating with prosecutors, who are trying to determine whether CEO Bernard Ebbers was also involved in the scheme. In more WorldCom news, Citigroup owned Salomon Smith Barney apparently allocated thousands of shares of hot IPOs in the 1990s to WorldCom execs. During 1996 and 1997, before Citigroup bought Salomon as part of its merger with Travelers, the average allocation was 101,500 shares for each officer, with a first day payday of $597,570 each. After November 1997, the average allocation was 6,409 shares, for an average first day gain of $60,238 each. Ebbers was allocated more than 800,000 shares from several IPOS, including Juniper networks, UPS, and Qwest Communications.

The markets will be listening closely tomorrow as Alan Greenspan makes remarks at the Kansas City Fed-sponsored economic symposium in Jackson Hole, Wyoming. After four Fed presidents have indicated over the last month that they think interest rates are currently low enough to promote economic recovery, investors will be looking to Greenspan for confirmation. Similar remarks from the Big Cheese will significantly discount any chance of a rate cut at the September 24 FOMC meeting. Short-term interest rate futures right now reflect about a 25% chance of a rate cut, and after tomorrow's speech, it could drop to half that level. This is already a huge reduction from the almost 100% chance the futures were showing at the beginning of the month.

Look closely for 8750 to offer continued resistance on any rebound attempt tomorrow after release of initial GDP, which is expected to come in at 1.1%. We will also see initial jobless claims for the week of August 24, which are expected to be 385,000. Either of these numbers could help with a bounce, but if nothing extraordinary comes out of them, the next level of support in the Dow looks to be just below 8500. The tide certainly appears to have turned, as the Dow has followed the Nasdaq into the red. With September 11 looming, and the traditional fall swoon possibly ahead, be very careful with long positions, lean short, and keep a few extra puts in your pocket.

Steve Price

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