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Market Wrap

Higher Ground, But For How Long?

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11-04-2002                  High    Low     Volume Advance/Decl
DJIA     8571.60 +  53.96  8730.64 8521.60   1972 mln  1336/621
NASDAQ   1396.54 +  35.84  1320.25 1279.46   2358 mln  1917/405
S&P 100   462.26 +   4.10   470.58  458.16    totals   3253/1026
S&P 500   908.35 +   7.39   924.58  900.96
RUS 2000  386.97 +   6.29   391.34  383.45
DJ TRANS 2333.84 +  18.16  2372.41 2318.47
VIX        34.47 +   0.49    34.85   32.45
VIXN       49.22 -   0.64    49.64   46.96
Put/Call Ratio 0.73

Higher Ground, But For How Long?
By Steven Price

I can hear the bulls screaming "I told you so!" It's tough to argue with them after the Dow has pasted on 1400 points in 3 1/2 weeks. However, why do we keep reading about more spending cuts, low demand and declining revenues? Because businesses have yet to increase spending budgets, and demand is still soft. While the market is going up, it is awfully hard to jump on for anything more than the short term. We did, in fact, cross some significant resistance today, but ran smack into more. The Dow jumped over 200 points intraday, following Microsoft up $4.25 at one point. However, the rally collapsed toward the close, with the blue chips finishing up 53.96 on the day.

On a macro scale, the recent Dow rally began October 10, pulled back, found support at the 50-dma, and then took off to higher ground. When I see a stock with this type of chart, I think "long play." So why am I not singing the praises of long term calls? It doesn't take a genius to understand that when companies reduce spending, workers lose jobs and suppliers don't see much income. When suppliers see reduced income, they let employees go. When consumers lose jobs, they don't go shopping as often. When they don't shop, stores don't sell, and don't need as many employees. Consumer spending makes up 2/3 of GDP... By now you get the point.

I certainly don't want to rain on the parade. Those traders who have played long for the last few weeks have a nice profit and should be aware of the big picture heading into the next couple of days. The elections on Tuesday bring with them the possibility of republicans taking control of the Senate. This is seen as bullish for the market, as republicans are generally more sympathetic to big business. Following the elections is Wednesday's FOMC meeting, where the Fed is expected by many investors to lower the Fed Funds rate by 25 basis points, to 1.5%. The December Fed Fund futures are pegged at 1.395%, not only predicting one cut of 25 points, but possibly an additional cut before year's end. Certainly both of these developments could be positive for the market; however, it seems there is still plenty of work to do before the overall business environment sees significant improvement.

Let's start with a look at what we've accomplished so far. The Dow bottomed on October 9 at 7197, before catching fire and blasting its way to current levels. Once it got through 8000, it was straight up to resistance at 8300 and then consolidation between 8200 and 8550. A look back at the old head and shoulders formation between July and September gives us a good picture of recent resistance levels and has been fairly reliable. If the index can break through 8750, where it stalled out today (high of 8730), then 9000 appears to be the next step. Certainly it does us no good to be bearish the whole way up, so jumping on for the moves between levels and then reducing as we get close to resistance or support seems to be the best strategy. Right now the rally stalled below resistance and landed above support at 8550, so that is the current range. This corresponds to support of 900 in the SPX, which formerly served as resistance. However, with the events of the next two days, it is likely we will test those bounds. The wild card in all of this is pegging just how much effect we are seeing from the aforementioned events on Tuesday and Wednesday.

Chart of the Dow

Why all the hoopla over the rate cut? There are several reasons. First, lower rates make business investment cheaper. If a business can borrow at a lower rate, it makes it cheaper to finance a new factory, accumulate inventory, or upgrade current facilities. One of the biggest problems we've seen is the reduction of spending in the business world and all other things being equal, a rate cut should help. The other factor that could be playing into the bullishness in individual stocks is that it may help debt ratings. Moody's cut the credit ratings of 69 companies last month, which was the third highest total since 1986. The ratio was also 6.9:1 for downgrades to upgrades. If that rate continues through the quarter, it will be the worst on record. Lower rates can help corporate creditworthiness, similar to the way lower mortgage rates have allowed more people to purchase homes. According to Moody's chief economist, "If the Federal Reserve cuts rates, that improves the outlook for corporate credit ratings. It should increase the supply of liquidity, and suppliers of credit might be willing to assume more risk." A better credit rating makes it cheaper to finance current debt as well, adding to a company's bottom line.

The techs got mixed news today. Dell said it expects strong growth in servers and "the phenomenal growth" in services to continue, as the company continues to standardize technology. It also said it is taking a look at routers and security gear. On the flip side of this news, Salomon Smith Barney downgraded the chip equipment sector, saying the elevated prices the group has reached recently will put it in line with the market movement from here on out. In addition, the Semiconductor Industry Association had some mixed data to report, as well. The organization said that third quarter global semiconductor sales grew 21% from last year's levels. That is certainly good news, and has fueled the recent rally in the Semiconductor Index (SOX). However, growth is expected to stall for the quarter, as sales grew a paltry 3% in September. In addition, some of the biggest names in the industry have predicted a slowdown. These include Texas Instruments, which expects a 10% revenue drop in the fourth quarter, and Intel, whose flat to 6% growth forecast is far below normal. The Association releases its 2003 outlook on Wednesday, which is expected to be reduced from the current projection of more than 20%. Applied Materials (AMAT) also announced it was laying off 11% of its workforce, in an attempt to adjust to a two year slump in chip demand. This afternoon, Steve Jobs, CEO of Apple Computer (AAPL), said he has been hearing about a tech recovery 6 months out for the last two years, and they still have yet to see a turnaround in the PC market. Prudential also said that a tour of Chinese EMS facilities showed that demand remains lackluster, and still suffers from near term pricing pressure. A look at the SOX shows how the current upward trend is continuing, but faded with the rest of the market this afternoon. There is blue sky up until about 360 in the index when we look at the chart, but after a gain of 52% in less than a month, along with slowing growth, it seems that longs should beware of a stall.

Chart of the SOX

This morning also brought several downgrades of the retail sector. As we head toward the holidays, the recent economic data doesn't look promising. Personal spending is down; personal income increased less than expected; payrolls are down and Consumer Confidence is atrocious. If one sector is likely to feel the effects of these things more than others, it would seem to be the retailers. We started to get monthly sales warnings back in the summer, with stores repeatedly missing forecasts. These misses were blamed on a number of factors, mostly the weather (weather is always a factor in apparel sales). However, eventually companies began dropping sales targets, including Wal- Mart, which has cut them in half. One of the downgrades, May Department Stores (MAY), warned that third quarter earnings would come in below expectations. It said earnings would be $0.08-

$0.10, approximately half of the mean estimate of $0.17. Most importantly, MAY reported third quarter sales fell 4% from last year, and there was also a 4% drop in October sales. Same store sales also dropped 7% in October. This is clearly an ominous sign heading into the holiday shopping season, since last year we were suffering the September 11 hangover. The fact that shoppers are purchasing even less this year speaks volumes about spending habits and the results of the economy. Recent retail darling Kohl's (KSS) was also downgraded, based on decelerating earnings growth and valuation. Goldman Sachs said it was cautious on the hard line retail sector, which includes Home Depot and Lowe's, citing "daunting" near-term comparisons and few organic growth opportunities. Many retailers will release monthly data on Thursday, so we should get a better look at the sector then. A drop in temperatures at the end of October has increased sales in some areas, but the trend heading into the biggest sales season of the year will not be dependent on the weather.

So, why all the bearishness here? Because if we don't get a republican Senate and a 50 basis point rate cut, then we will only be left to ponder the economic data and business environment. We will most likely see a market on hold until election results begin to creep in tomorrow. With the fed meeting the next day, it will be interesting to see just how committed investors are until Wednesday afternoon. It seems that whatever bullish sentiment there was to start the week quickly faded as the sellers sold today's rally. I would initially think the rally failure was bearish, but there is no argument that we broke into higher ground, above Dow 8550. Bears should be careful with anything more than a 1/2 position here and look for not only a breakdown under 8550, but resistance there, as well. Bulls should look to take some profits if another rally stalls at 8750. While I'm still bearish overall, the next two days are recently uncharted water, so trade what you see, not what you think you should be seeing.

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