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Market Wrap

Paying the Piper

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01-08-2003                  High    Low     Volume Advance/Decl
DJIA     8595.31 -  44.11  8736.07 8580.10   1770 mln  509/1252
NASDAQ   1401.07 -  30.50  1424.12 1399.06   1431 mln  224/1194
S&P 100   460.06 -   7.78   467.84  459.34   totals    733/2446
S&P 500   909.93 -  13.00  922.93  908.32
RUS 2000  389.07 -   4.88   393.95  389.07
DJ TRANS 2370.65  - 26.24  2398.22 2366.45
VIX        28.42 +   0.94    28.78   27.47
VIXN       44.56 +   1.60    45.81   44.44

Paying the Piper
By Steve Price

As we get into earnings season, we are bound to get schizophrenic reactions to surprises on an almost daily basis. The President's tax plan release took us into higher ground to start the week, and Tuesday brought mixed reactions between the techs and the blue chips. The Nasdaq continued to churn higher on EMC's upside surprise, while the Dow pulled back slightly, digesting Democratic resistance to the president's plan and failing at heavy technical resistance after the leg up. Wednesday brought a continued pullback in the Dow and a Nasdaq reversal following a profit warning from Gateway and an Alcoa earnings miss. It would seem that the almost 600-point Dow explosion over the past several days was unsustainable and those concerns appear to be founded.

There were several levels of previous resistance on the way up that failed to hold as support today on the way down. While we still have a series of higher highs and higher lows in place from the rally of the last few days, that pattern is becoming endangered, particularly with today's Dow pullback below 8600. The bears have come out of the woods to reinitiate talk about a possible bearish head and shoulders pattern that may be forming in the Dow/OEX/SPX. This is not the first time we've heard this talk this year. From July to September, we saw similar concerns and they wound up being right on. In fact, the head and shoulders pattern at that time fulfilled its downside measuring objective just below 7200 almost exactly. The Dow bottomed at 7197, before rebounding all the way to the December high of 9043.

The next time we started predicted a bearish head and shoulders pattern was in the midst of that rally to 9043. That took place from the middle of October, to the middle of November, where a possible left shoulder appeared at 8550 on October 21, a possible head appeared at 8800 on November 6 and then the possible right shoulder appeared at 8579 on November 18. The rollover began from that November 18 high, headed toward a neckline break around 8300. Only problem was that we got a big reversal off a low just over 8400 and raced higher. We learned a lesson about getting ahead of ourselves before that neckline was broken. Now that we are looking at the formation again, we are using what we thought was the head at 8800 as our left shoulder, with the head at 9043. The Monday/Tuesday high of 8800 would certainly provide a symmetrical right shoulder, but we need to be careful not to mistake a series of higher lows and higher highs on the recent rally for a bearish pattern. We also need to be aware that the SPX did not experience the same symmetry as the Dow, having blown through its left shoulder at 925 to a high of 931.77. The OEX, on the other hand, came about a point shy of the 472.47 left shoulder, with a high of 471.41.

The move below Monday's support at Dow 8600 would certainly appear as though the higher lows pattern is in danger and traders can use the break under that level as another piece of evidence in favor of the H&S. Similar support levels in the SPX and OEX are 908.59 and 459.20, respectively. Those SPX and OEX levels held up at the close, so we don't yet have confirmation of a pattern break, but we are getting close.

Chart of the Dow

Chart of the SPX

The Nasdaq Found its way all the way down to support at 1400 after the Gateway warning, giving up 2% and 30 points. It failed its 200-dma on Tuesday and today's rollover appears as though that failure more closely represents the last failure at the 200- dma in December, rather than the other milestone it crossed on Tuesday, which is a close over resistance at the August high of 1426. The last time it had closed above that level on the way up, it exploded all the way to 1500. That certainly does not appear to be the case this time around.

Chart of the COMP

The action in the bond market also indicates that we are seeing a reallocation back into bonds after the equity rally. Traders can watch action in the treasuries for signs of a continued sell-off in stocks.

Chart of the Ten Year Note

The retailers attempted to mount a comeback today, in spite of more negative news from the sector. Poor Christmas sales led Laura Ashley to lower earnings expectations. Flowery items weren't the only ones seeing disappointing sales, as Men's Wearhouse (MW) also warned for the fourth quarter and full-year 2002. Those warnings were accompanied by a report from Electronics Boutique (ELBO) that said worldwide same store sales were down 9% in the holiday season. That drop in sales was felt not only by retailers, but by electronic manufacturers, as well. It wasn't a surprise, as it matched earlier predictions, but it was confirmation that those doom and gloom predictions are coming true.

We are just beginning to get earnings warnings in the retail sector, following sales warnings throughout the month of December. The sector sold off hard during those December sales warnings and the latest bounce appears to be in rollover territory. We will begin to get retail earnings results in February and it is hard to imagine many of them coming in above expectations. The one pleasant surprise in the sector came from Coach, which raised its earnings expectations after what it called "robust holiday sales." This is most likely an aberration, as we will find out tomorrow. Thursday is the day many retailers announce December sales results. Tuesday's chain store sales showed a 2-2.5% gain in same store results. However, according to Michael Niemira, senior retail analyst at Bank of Tokyo-Mitsubishi, which puts out one of the chain store reports, "overall sales were modest for December and for the November- December period as heavy discounting held down reported sales gains." I have said in this space repeatedly for the last couple of months that the shortened holiday shopping season (due to a late Thanksgiving) might not lead to fewer purchases, but lead to a larger percentage of those sales being concentrated closer to the holidays and therefore more goods being sold at deeper discounts. Add to that the poor economy and dock workers' strike and the upcoming earnings reports should be anything but positive in the sector. The question remains just how much of this news is already priced into these stocks. However, if we do get the warnings and earnings misses I think we'll see, I expect another leg lower for retail. The RLX.X is right now holding above support at 260, but if that level breaks, I'd look for a move to the October low around 245.

Chart of the Retail Index

The Semiconductor Index, which has been a good leading indicator over the past year, turned south quickly on the Gateway warning. Gateway increased the size of its predicted loss on disappointing holiday PC sales and aggressive sales promotions that cut into margins (sounds a lot like the retail story). It was only a few weeks ago that we were hearing about an upturn in chip orders due to increased holiday PC demand. Apparently things didn't exactly go as planned. If Gateway is suffering, then investors figured that there may be other surprises in the sector, as well. After climbing impressively through resistance at 330, the SOX rolled over and gave up %, testing support ten points lower at 320. The fact that it is testing support at 320, however, is actually evidence of a pullback, rather than a decisive rollover. The previous resistance level it cracked before heading up to 330 was actually 310. If we find support at 320, then we may have a trend of higher lows developing. On a move back under 310, then look out below.

One of the big factors in today's rollover was the downgrade to J.P. Morgan by UBS Warburg. The banks are another leading group that can signal a change in market direction and today's comments from UBS highlighted issues with capital markets and corporate credit quality. The credit issues have continued to make their way into the news occasionally over the past few months and until the economy improves, they are likely here to stay. UBS also said the stock now discounts stock now discounts a healthier economy and improved market conditions for 2003. Morgan Stanley also got in on the action, cutting its 2003 profit forecasts from $2.42 to $2.20 per share, citing higher credit costs and lower revenue.

Apparently not even "cheap" vacation destination point Las Vegas has been able to hold up in the face of a sinking economy. Mandalay Bay Group (MBG) warned that fourth quarter earnings would miss expectations after the bell last night. The company said it would earn only half of analysts expectations ($0.10 v. $0.20) after " Softer-than-expected results on the Las Vegas Strip over the holidays, and a low win percentage on table games." That was a major change from what the company's CFO had said in early December, which was that the holiday appeared as though it would be solid. This was the first casino to warn, but a number of hotel owners have said that the fourth quarter of 2002 was barely an improvement over 2001 and much worse than expected. It didn't take MGM long to join the parade, with its own warning this morning. The casino operator reduced its fourth quarter outlook, as well, citing a weak economy and its impact on high-end domestic customers.

General Motors is making more pension news again. After under- funding problems in the billions, now the company will apparently reduce its expected rate of return for the plan from the 10% it has been using since 1993. This could cut further into the company's bottom line and may signal a similar move by other firms facing similar issues. With 60% of its pension fund invested in stocks, a lower predicted rate of return might not only lead to more funding problems to make up the difference, but also a shift in the fund out of stocks and into other assets. If we begin to see pension funds looking to put their money elsewhere, that would weigh even more heavily on equities and could end up as a self-fulfilling bearish prophecy.

The telecoms also headed lower today, following a UBS downgrade of regional baby bells (Verizon, BellSouth, SBC). The reduction in rating went from a "hold" to a "reduce," saying fundamentals remain weak and do not justify current price levels. It also said that consensus earnings estimates for 2003 were too high and that the FCC's Triennial Review will not return as favorable an outcome as recent media reports suggest. Those stocks lost 4-5%, reversing much of the gains of the last few days.

With the Dow, OEX and SPX rolling over into what could be a head and shoulders formation, traders should watch the support levels highlighted above for a break in the trend of higher highs and higher lows. There may be some bounce after today's sell-off and if it fails significantly below that right shoulder, then we can cautiously begin playing the short side. So far this year we are 50/50 on H&S predictions and should keep that in mind when jumping in.

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