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What Didn't Happen

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09-16-2002                High    Low     Volume Advance/Decl
DJIA     8380.18 + 67.49 8389.26  8257.69  1183 mln   493/683
NASDAQ   1275.88 - 15.35 1292.73  1267.69  1089 mln   175/905
S&P 100   446.65 +  2.41  447.09  439.75   totals     668/1588
S&P 500   891.10 +  1.29  891.84  878.91
RUS 2000  386.13 -  3.86  389.99  385.91
DJ TRANS 2231.96 - 14.91 2246.58  2216.47
VIX        40.54 +  1.23   43.08  39.59
VIXN       57.73 +  1.88   59.60  56.59
Put/Call Ratio 1.09

What Didn't Happen
by Steven Price

A holiday session with low volume generally provides few clues as to where the market is headed. However, we had a couple of significant moves, or in some cases, non-moves.

The day started out with a mixed bag of news. On the positive side, Business Inventories and sales for July were both up. Inventories rose 0.4 percent at merchant wholesalers, 0.9 percent at retailers and were down 0.1 percent at factories. The inventory to sales ratio, however, dropped to 1.35 from 1.43 a year ago. This is bullish, as a lower number indicates that businesses are able to move the inventory they have accumulated. With higher inventories and a lower ratio, business appears to be better than last year, when we were in a recession. Sales were up 2.2 percent, while inventories were down 3.7 percent from a year ago.

On the negative side, we saw a host of lowered expectations for the semiconductor stocks. Bank of America cut its 2002 and 2003 estimates for Taiwan Semiconductor (TSM) and United Microelectronics (UMC), citing weakness in the consumer segment. Prudential lowered earnings estimates for the fourth quarter and 2003 for the following semiconductor stocks:

Anadigics (ANAD)
Broadcom (BRCM)
Emcore (EMKR)
LSI Logic (LSI)
Microchip Technology (MCHP)
Pericom Semiconductor (PSEM)
STMicroelectronics (STM)
Microtune (TUNE)
Texas Instruments (TXN)
Atmel (ATML)
Exar (EXAR)
Nvidia (NVDA)
PMC-Sierra (PMCS)
Vitesse (VTSS)

This development is very bearish for the sector, as the Semiconductor Index has now reached a new 52-week low for the 3rd time in six weeks. The support level of 275, from the September 6 low, appeared as though it would hold for a while, as the index ventured back over 300 as recently as last Wednesday. Today's downgrades, however, showed renewed weakness and could lead to a new wave of selling. After the bell, however, Microchip Technology (MCHP), one of this morning's downgrades, announced that higher gross margins would help the company beat second quarter earnings targets. This may give the sector a lift tomorrow, however there has been damage done which news from a single company will be hard pressed to reverse. As the tech sector has been leading the market for several years, the breakdown in the SOX could be the first domino toward re-testing July's lows. I realize this may seem like a leap of faith, but the scenario is developing in the following manner.

The Dow, S&P 500, NDX and Nasdaq Composite have all formed a classic head and shoulders reversal pattern beginning with the rally from July 24 to August 22. Since then, the Dow and S&P 500 collapsed, but found support at the 50% retracement of that rally. The Nasdaq Composite and NDX gave back a larger percentage of the gains during the rally from July 24 to August 22, but both found support above the July lows. This recent support is the basis for the right shoulder of the formation in all three indices. The charts of the Dow and Nasdaq Composite are below, and look very similar to their counterparts.

Chart of the Dow

Chart of the Nasdaq Composite (COMPX)

The last time the markets crossed significant resistance to the upside on the same day, was August 19, when all of the broad market indices crossed over their 50-dmas for the first time since spring. The Semiconductor Index (SOX.X) failed at its 50- dma, however. This signaled a drop in the semis, which led the Nasdaq lower. It can be argued that the Nasdaq, heavily weighted with technology stocks, led the Dow lower as well, as technology has done throughout the late 1990s and early 2000s.

With the Semiconductor Index (SOX.X) now breaking support once again, the whole scenario may be re-starting. If we experience another sell-off in the techs, led by the SOX, it will most certainly lead the Nasdaq through its neckline. A neckline break will be a very bearish sign, and the weight of the techs falling would most likely drag the Dow down, as well.

Chart of the Semiconductor Index (SOX.X)

So where's the good news? Well, both the Dow and Nasdaq Composite have both managed to avoid a neckline break. Both averages have diverged in their direction for the last two days. The Nasdaq rallied, while the Dow fell on Friday. Today was the opposite. However, both appear to be consolidating just above their respective necklines and finished the day right around where they finished on Thursday. The Dow finished the day on Thursday at 8379.41 and closed today within a point at 8380.18. The Nasdaq finished Thursday at 1279.68 and closed today within four points at 1275.88. The Nasdaq closed slightly further away to the downside, but has just a pinch more breathing room before a breakdown than the Dow does.

Chart of the Dow and Nasdaq H&S Patterns

On a day when the both the NYSE and Nasdaq traded just barely over a billion shares, there was hardly enough trading to push these averages through significant levels. However, there was enough trading to take out the previous lows in the SOX, so the technical developments, or in the case of the Dow and Nasdaq, non-developments, can still be viewed with significance. These holds above the neckline are bullish signs, and although they are not so bullish as to attract my dollars to the upside, I have put the hammer back in the toolbox for the time being.

One of the reasons cited for the economy not slipping into a double-dip recession is the strength of the housing market. Last week we received data showing that foreclosure rates have reached record highs. This level of 1.23% pales when compared to this morning's numbers released by the Federal Housing Administration. The FHA said that 4.7% of FHA borrowers are at least 90 days late on their loan payments. This is almost twice the rate of 1995. It appears that low mortgage rates have resulted in a housing boom that may be sitting on a time bomb. While the FHA takes on borrowers that may have more risk, a trend is still a trend. With lay-offs increasing, consumer debt growing, and foreclosures at an all-time high, this delinquency rate looks like another foot on the wrong side of the seesaw.

A look at the Dow Jones U.S. Home Construction Index (DJUSHB) shows that after reaching all time highs earlier this year, the homebuilders experienced a sell-off and are once again experiencing resistance to the upside as the try to recover. With numbers like foreclosures and delinquent mortgages increasing, the group has a lot to overcome. What had acted as support as the index rallied to all time highs earlier this year, is now acting as resistance. Traders may want to keep an eye on increases in the above rates as indicators of short opportunities in the sector.

Chart of the Dow Jones U.S. Home Construction Index (DJUSHB)

After Iraq today said they would allow the unconditional return of weapons inspectors, Thursday's OPEC meeting will take on added significance. With the price of oil already high, and the October Crude Oil Futures trading over $29 a barrel, the decision on whether to raise production quotas could have a pronounced effect on the stock market. If we do go to war with Iraq, oil prices are likely to skyrocket. This is a sure way to raise costs for many industries. If OPEC shows that they are willing to help out by increasing production to keep prices in check, this will help alleviate some of the anxiety over the likely increase. Even if OPEC does increase production, a war in the Middle East can interrupt shipment out of the region. While the largest oil producer, Saudi Arabia, has said it supports increased production, other members, such as Venezuela, Iran and Kuwait have come out against the measure. The OPEC members actually exceeded their current quotas by 1.7 million barrels per day in the month of August, according to the International Energy Agency. Therefore, any increase would have to exceed this extra output before lowering costs. Iraq produces about 2.7 million barrels per day, however it could affect prices by an even greater amount if it acted against neighboring Arab countries as a war escalated in the region. With the return of inspectors, OPEC may not feel as compelled to increase quotas, as the threat of war may be lower. While crude oil may drop slightly in the short-term, the specter of war still hangs over the region. There is no guarantee the U.S. will accept the return of inspectors as a solution to the problem and if President Bush does back off from threats of military action for the time being, we do not know what these inspectors will find, although it is likely that Iraq will clean up any evidence of a nuclear threat.

Dow Jones and Company warned that third quarter earnings would come in below forecasts, due to a drop-off in advertising sales during the month of September at the Wall Street Journal.

In an interesting development that turned into good news for Boeing, the machinists union was unable to muster enough votes for a strike in response to the airline's final contract offer. Although 62% of the 25,000 union workers voted against the contract, they fell just shy of the 2/3 needed for a strike. According to the union's bylaws, they are required to adopt the contract if the strike vote fails. Therefore, they will now spend the next three years working under a contract that was rejected by a significant majority of its members. Both parties are still waiting for an arbitrator's ruling on whether Boeing subcontracting of work to outside companies, at the same time it issued layoffs, was a violation of the union's 1999 contract. Next up for Being is the contract of its second largest union, the Society of Professional Engineering Employees in Aerospace, representing technical workers and engineers, which expires in December.

Northrop Grumman (NOC) and General Dynamics (GD) each enjoyed banner days after the Pentagon announced late Friday that it had awarded the companies a $5 billion contract to build 10 Aegis destroyers. NOC finished up $2.00 to $129.39 and GD tacked on $3.58 to close at $87.32.

The markets will likely react positively tomorrow to the news of Iraq's cooperation, although the President may say something between the time of publication and tomorrow morning that interferes with this theory. I would expect a rally on the news, however in order to prevent a long term breakdown of the crucial levels described above, we will need to see a return of business spending to the tech sector. MCHP's comments will help, but the news from one company in the face of the additional downgrade of thirteen companies in the sector is only a drop in the bucket. Look for a gap up in the morning and then a pause for Oracle's earning's after the bell. Oracle is expected to meet expectations, but that is not always a catalyst to upward movement, as accompanying comments can send an industry reeling. Apparently, someone is expecting a fallout, as the Put/Call ratio has reached 1.09, reflecting the trading of more puts than calls. This reflects today's trading, however, which closed before the Iraq news broke. Tomorrow should see some incredible volatility with the Iraqi news and Oracle announcement, so watch your stops and hang onto a few extra puts on a big rally, in case of negative statements after the bell.

Steve Price

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