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Market Wrap

Running On Empty

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10-21-2002                  High    Low     Volume Advance/Decl
DJIA     8538.24 +  215.84 8547.83 8230.50   1701 mln  1401/279
NASDAQ   1309.67 +  21.81  1312.53 1267.76   1564 mln  1150/391
S&P 100   456.24 +   7.22  456.91  443.22    totals    2551/670
S&P 500   899.72 +  15.33  900.69  873.06
RUS 2000  368.63 +   5.26  368.63  360.59
DJ TRANS 2338.53 +  59.44 2339.50  2263.47
VIX        38.91 -   0.91   41.27   38.47
VIXN       52.34 -   2.99   57.60   50.71
Put/Call Ratio 0.73

Running On Empty
By Steven Price

We saw a host of technical barriers fall today, and this bear is back in hibernation for the time being. We saw the Dow, S&P 500, Nasdaq Composite and OEX all break through support levels from the head and shoulders patterns they had formed on the way down from the end of August to beginning of October. They also broke through two Fibonacci retracement levels, of both recent rallies and declines. They now look poised to test the shoulder tops of those previous H&S formations, which should provide the next level of resistance. The Dow finished the day up 215.84, to close at 8538.24. The Nasdaq Composite was up 21.81 to close at 1309.67. So, why am I not more bullish at this point? We cleared out resistance and rallied just far enough to find more. We may still have a couple hundred Dow points to the upside, but we are now heading into the next ceiling. Whether it is made of glass, or concrete, is the big question. I am not going to stand in its way, but I haven't bought too many out of the money calls, either. Another level to note is 900 in the S&P 500. It was the S&P hitting its July low that seem to trigger the recent rally and if it cannot breakthrough 900 (the high today was 900.69), the rally could be ending before we even get to the levels highlighted below.

Chart of the Dow

Chart of the SPX

Chart of the OEX

Chart of the COMPX

Last week, we saw a run up to the above mentioned resistance levels. After reaching those levels, the broad market indices fell back slightly, regained their legs and then uncoiled to the upside this morning. This looks bullish for the short term, at least until we hit those shoulder tops, outlined above. What I am still having a hard time with, is the fact that the economic numbers are anything but outstanding. Even those companies that are reporting earnings in line with expectations, or beating them, are giving cautious statements. Here is a sample of some of the statements we've heard a third of the way into the fourth quarter.

From 3M, which met expectations and placed yearly earnings near the high end of previous expectations: "Looking ahead, there are no clear signs of improving global economic conditions."

From Microsoft CEO Steve Ballmer, which beat expectations last week and surged on higher than expected revenue: "We're not trying to say that we think the sales results of our first quarter will be sustainable, it is kind of a one time anomaly. We're still seeing business as being reasonably tough, at least compared to let's say the good old days, reasonably tough around the globe."

From EMC: CFO Bill Tueber said that there was "no indication that IT spending will recover in the short-term. In fact, I believe the IT spending environment eroded further at the tail end of (the third quarter) and that any optimism companies had about things getting better had dissipated by the end of the quarter."

From Sun Microsystems: CFO Steve McGowan said, "Given the uncertain economy, giving a relevant revenue forecast is difficult. We look to be profitable in the second half of fiscal year 2003." CEO Scott McNealy said "I am out of the forecasting game," and that trying to evaluate revenue outlooks for SUNW was "wasted energy." Sun just reduced its capex for 2003 by 75%.

Regarding automakers: The head of the Center for Automotive Research in Ann Arbor, Michigan said," Over the last 30 or 40 years, this is probably the most difficult time that they've had. It's very challenging. What I think is most interesting is the speed with which things came apart on them ... It's just not something that you expect to see happen that quickly." This statement came in spite of GM beating earnings expectations by $0.21.

We also have to keep the rally in perspective, much like the previous drop. A common sense look at the almost 2000-point drop between August and October, leading up to the recent bounce, just "looked" oversold and due for a reversal, or at least an temporary one. By the same token, the current rally looks awfully extended and seems due for a correction some time soon.

A look at the bullish percentages now shows the market bounce looking awfully extended. The Dow has rebounded from a low of 8%, to a current reading of 50%. The bearish resistance line for the Dow is just above, at 58%. The SPX has rebounded from a low of 20%, to a current reading of 42%. The NDX has bounced from 14% to 46%. While the extreme recent volatility has certainly caused big swings in these numbers, which represent the number of stocks in an index currently giving point and figure buy signals, the risk seems to have shifted from being short at oversold level, to being long after an exhaustive rally.

The Index of Leading Economic Indicators came out this morning, showing the fourth straight monthly decline. Five of the ten indicators fell, including stock prices, average weekly initial claims for unemployment insurance, interest rate spread, manufacturers' new orders for nondefense capital goods, and index of consumer expectations. The Coincident Index was flat, but continues to show a weak economic recovery.

Why am I raining on the parade? The resistance levels were significant and only a market with a decent number of buyers could blow through these levels. It appears that we are seeing a massive asset allocation from bonds into stocks. The bond market is seeing selling over the last week, while the Dow and other indices are rallying. This may be due to pension funds and institutional investors getting back into stocks, as they reached their July lows and the valuations became more attractive. However, a look at the bond market shows the sell-off approaching support levels, so we should keep an eye on these points as an indication of when the allocation may pause, at the very least.

Chart of the 5-year Treasury

Chart of the 10-year Treasury

One sector to watch is the semiconductors. A look at the Semiconductor Sector Index (SOX.X), which is usually a good indication of tech demand, shows an impressive run. The index has broken out of its descending channel and broken its 50-dma. While there is no doubt that there has been a trend line break, one of the more interesting developments has been the group's behavior in regard to its 50-dma. Back in August, this sector couldn't hold its breakthrough of that barrier, even though the Dow, S&P and Nasdaq all experienced continued runs after they broke out. I saw that as a sign that all was not well back then and I may not get that same signal this time. That does not mean that I think everything is fine, just that the charts may not bear me out. Back in August, the SOX did break the 50-dma at that time, but was unable to hold it. It broke through once again today, and I think this sector will be a good indicator as to whether the rally will hold. If it does not, it could be the anchor that weighs down the rally, in addition to the action in the bond market. After the bell, Texas Instruments (TXN) said they expect sales to slide 10% in the current quarter. This was far worse than expectations of a 1% drop and the stock, which closed at $17.12, was trading $14.02 after hours. I would expect the 50-dma to fail on the TXN warning and we'll look to see just how bad the failure is before predicting its effect on the broader markets.

Chart of the SOX

Another issue that keeps showing its head is the pension plan problem. GM has gotten plenty of publicity for its pension plan being underfunded by as much as $20 billion this year alone. However, a report in this weekend's Barron's suggested that almost half of the pension plans for the S&P 500 are underfunded, which seems to be a waiting time bomb, as companies are required to find cash to fund the programs. Morgan Stanley estimated that there was a $300 billion shortfall in 2002, which is money these companies will have to come up with over the next few years and will come from corporate cash flow. Many pension plans were heavily invested in the stock market and relied on continuing business as well. In the current environment, this number could grow, turning into a rolling snowball.

I have avoided the Martha Stewart ongoing soap opera for some time now, as the file-in-the-cake recipe jokes have gotten a little old. However, it appears that the home economics queen is looking at some deeper trouble. The SEC is apparently getting ready to file a civil securities lawsuit against Stewart, which may prevent her from serving as director of a publicly traded company, such as Martha Stewart Living Omnimedia (MSO). On the positive side, if the SEC is concentrating its efforts on a civil suit, it would indicate they aren't seeking a criminal complaint involving jail time.

United Airlines (UAL) announced another 1,250 job cuts today, as it struggles to avoid bankruptcy. Airlines are currently seeing a wave of selling in airline debt securities, as well, making it that much more difficult for them to raise the cash they need. UAL has already warned that they may seek bankruptcy if it cannot get federal loan guarantees and wage concessions. J.P. Morgan increased its loss estimate for Northwest Airlines (NWAC) and narrowed its loss estimate for Continental (CAL). JPM's analyst said that the airline industry lost $1.6 billion in the third quarter and that revenue trends have not shown much improvement.

We have seen a convincing rally in the broader markets. However, be careful of long positions here and keep your stops very close, as I am getting the feeling that we may be running out of steam soon. I say keep your stops close, because there is no reason to limit upside profits while the momentum is still heading that way. Just make sure not to fight a sinking tide if it does turn. Enjoy the euphoria, but keep a few puts in your pocket just in case.

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