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Market Wrap

Holding the Line

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        WE 5-09         WE 5-02         WE 4-25         WE 4-17
DOW     8604.60 + 18.92 8582.68 +276.33 8306.35 - 31.30 +134.24 
Nasdaq  1520.15 + 17.27 1502.88 + 68.34 1434.54 -   .96 + 66.65 
S&P-100  472.25 +   .38  471.87 + 15.77  456.10 +  2.49 + 12.74 
S&P-500  933.41 +  3.33  930.08 + 31.27  898.81 +  5.23 + 25.28 
W5000   8883.34 + 49.28 8834.06 +308.17 8525.89 + 59.04 +239.31 
RUT      413.53 +  5.86  407.67 + 19.17  388.50 +  4.80 + 12.40 
TRAN    2462.18 +  1.38 2460.80 +108.19 2352.61 -  9.58 +131.63 
VIX       22.04 -  1.57   23.61 -  0.29   23.90 -   .69 -  3.68 
VXN       32.09 -  0.27   32.36 -  1.34   33.70 -  2.18 -  3.74 
TRIN       0.83            0.66            1.95            0.50    
Put/Call   0.82            0.71            0.87            0.52   

Holding the Line
By Jim Brown
Click here to email Jim

On a slow news day and on light volume the markets eased back up to close the week where they started and just below the recent highs. The Dow managed to climb within 36 points of its 8641 high from Tuesday. The Nasdaq closed within 12 points of its high for the week. This was pretty bullish for an early summer Friday in May even if the move was on very light volume.

Dow Chart - 240 min

Nasdaq Chart - 240 min

While the news was good on the surface the Friday sprint only managed to get the indexes back to where they started the week. If you added the weekly gains for the top six indexes, DOW, Compx, SPX, OEX, RUT and $TRAN you would only get a total of +47 points. That is an average of only an eight-point gain per index. While the result was bullish it still lacked conviction but nobody was complaining at the close with the Nasdaq at the high for the day.

There were no material economic reports on Friday and the only release was strongly positive. The ECRI Weekly Leading Index rose to 121.8 and it was the second largest jump in a year. The +2.4 point jump was driven by an improving stock market and new mortgage applications. The S&P-500 gains helped power the rise as it gained +3.5% for the week. The six-month growth rate rose to +0.6 from zero and the highest rate since July-2002. This index is not a market mover because it is based on a combination of components, which have been previously released. It is however an indicator that shows a clearer trend and that trend is rising. Much of the gains are powered by the recent stock market rally and any selling can turn it around just as quickly.

Stocks got some help from Treasury Secretary John Snow who came out against the Fed statement expressing worry about deflation. Snow said emphatically there was "no danger of significant deflation" and while the economy was sluggish it was improving. Clearly the economic reports over the next 30-60 days will be critical. The next round of reports which begins next week will be post Iraq reports and continued declines will not set well with investors. They are writing off the last couple weeks of data as prewar but that excuse will no longer fly.

The sentiment on the market is changing fast or should I say changed fast? The Investors Intelligence survey shows that bulls are firmly in control. According to the survey 56% of newsletter writers are now bullish with only 24.4% bearish. According to editor Michael Burke this is extremely bearish for everybody to be so bullish. I know, it sounds strange but it is true. Burke points out that at the market top in March 2000 the rankings were 55.7% bullish and 26.4% bearish. He also pointed out that the PE ratios are higher now than in 1929 and 1987 when valuation concerns helped tank the markets. He points out that when the numbers reach these extremes there are no bears left to convert meaning there is nobody left to buy. Burke claims each time these numbers have been reached a drop occurred citing 1991, 1992, 1998, 2000 as recent examples. Unless an asteroid hits the planet soon we will get a chance to see if this historical trend repeats itself. The key point here is that it may not occur for some time. There is no magic time element where reaching a specific level instantly produces a result. It is more of a cycle than an event.

Speaking of cycles, Hochberg of Elliott Wave has gone on record saying this is just another bear market rally. A good rally by his own admission but he is quick to point out that they have analyzed every financial cycle from the 1600s to the present and the pattern is the same. Cheerful thought. The thing I like about the wave guys is they can be wrong more than they are right and still claim success. They are like weathermen. It may rain or it may not. If this low pressure system, that high pressure, these clouds, that wind moves like this then it may rain. If it rains they say I told you so. If it does not then it is because one of the conditions did not occur. I still like to analyze the wave guys and we have two good ones at OptionInvestor. Steve Gould does wave analysis in his articles and on some of his stock selections. Herb Keith has been giving us the blow by blow on the Futures Monitor for the last couple weeks. Unfortunately they are both echoing the comments from Hochberg. Do you think they are looking at the same play book? A week ago Herb predicted a rise in the S&P to 934 by last Friday. He missed it by four points. I will be interested to see his comments for next week. Steve did an excellent wave article on the Dow last Sunday. Check it out.

Back to the bullishness. Investors piled a total of $12.9 billion into stock funds in April according to AMG data. This was the largest inflow of cash since the $17 billion in April 2002. The resulting rally has pushed us to new highs. However, the first week in May has only seen an inflow of $1.1 billion to equities and taxable bond funds saw inflows of $3.4 billion. Money Market accounts saw inflows of $13.4 billion. Does anybody see the clue here? Of the nearly $18 billion of cash flowing into to investment vehicles only 6% of it actually went into stocks during the week ending May-7th. The money is there and available for instant infusion but the lack of conviction is very apparent.

Part of that lack of conviction came from a Goldman Sachs survey of CIOs from large corporations that was announced on Friday. The CIO survey showed they saw no increase in tech spending in 2003 and only a +2-5% increase in 2004. They said the current overcapacity left over from the tech bubble was preventing any need to upgrade. The companies overbought during the height of the tech bubble and the massive layoffs and cutbacks over the last couple years has idled much of that equipment. With excess capacity in every area they said it would take a substantial recovery some time to require new buying.

Countering the Goldman Sachs survey Intel President Paul Otellini said that they see strong demand in China and they expect a "slight" recovery in the semiconductor industry this year. He said the Centrino chip had met full expectations and Chinese demand remained strong. This is particularly strange since all other reports out of China are for a sales slump of from -5% to -20% due to the SARS panic. Numerous chip/tech companies have already warned about slower sales and lower earnings. Either those companies are using the SARS ate my earnings excuse now that Iraq is over or Otellini has been inhaling chip dust too long. In predicting a chip recovery he said "the past year has been so bad that the semiconductor sector can only improve this year." I don't know if that is positive or not. If sales were off -50% last year and they gained a "slight" +1% this year that would be an improvement but I don't think investors are thinking in those terms.

With the hysteria over deflation fears since the Fed meeting there is an entirely new round of rate cut scenarios. The current consensus is that the Fed will cut rates by 25 points at the June meeting. The odds of this cut in June are about 52%. The Fed Funds futures are predicting a 100% chance of a 25 point cut by September and a 46% chance of another 25 point cut at the September meeting. An HSBC analyst went out on a limb Friday and predicted the Fed will take drastic action at the June meeting and cut a full 50 points. The theory is that the deflation comment in the FOMC statement was code for we are going to act immediately and drastically in June if the next 30 days of prewar economic reports do not show a credible rebound in the economy. The Fed cannot take the chance that deflation will be a possibility and they would much rather have the inflation monster back with rampant demand and rising prices than be stuck in the quicksand of deflation. Deflation is much harder to stop and drains jobs, markets, profits, taxes and sentiment more thoroughly than a plague of leeches. If the coming reports do not show improvement analysts expect the Fed to act quickly and not only with rate cuts. There have been numerous comments about "other" methods at the Feds disposal including massive infusions of money and artificial support of bonds to keep real interest rates lower.

The markets managed a positive close on Friday. They are either poised to explode next week or poised to crash. The Dow is marching ever upward and the short pullback last week did not even come close to uptrend support. Buyers stepped in at 8500 and market breadth improved again. The Dow closed at 8604, a level first reached on Monday. The resistance highs around 8635-8640 held all week and a new bullish wedge is forming at 8630. Should this wedge break to the upside the next real target could be as high as 8850 with a pause at 8700. The Dow is poised to explode on good news but the lack of conviction is still a problem and a problem that could be serious if we get an unexpected event.

The Nasdaq still looks strong but not as strong as the Dow. The +35% gain off the October lows is finally starting to produce some drag. It is still only 12 points off the high for the week and well above real support at 1435-1450. With AMAT and Dell earnings next week there is one last chance for improved guidance that could break to a new high. The close Friday was right at the December high of 1521 and strong resistance even though it has traded as high as 1531 during the week. Again, the Nasdaq is poised for another surge if we can get enough conviction and AMAT/DELL/SCMR/NTAP/BEAS/BRCD/INTU do not disappoint with earnings this week. The sentiment is very bullish and broad based but we are very extended and a change in that sentiment could be sudden.

The economic highway for next week is full of potholes with a potential washout late in the week.

Monday: None Scheduled
Tuesday: Chain Store Sales, International Trade
Wednesday: Import/Export Prices, April Retail Sales
Thursday: NY Empire Index, Jobless Claims, PPI, Business Inventories,
          Industrial Production, Capacity Utilization, Philadelphia
          Fed, Semi Book-to-Bill
Friday: Housing Starts, Building Permits, CPI, Michigan Sentiment
Obviously Thursday and Friday are going to be big days with the potential to either set fire to the rally rocket or watch it implode on the launching pad. The bullish sentiment may provide a buy the rumor move on Monday/Tuesday as bulls hoping for signs of a recovery continue to enter long positions. That could set the stage for a serious sell the news event if the news is less than exciting.

There is a bullish case for stocks despite any negative news this week. (No rocks please) The Fed is poised to pour massive stimulus into the economy to prevent the "D" monster from getting a foothold. Believe it or not the housing bubble is still alive and well and growing. The falling mortgage rates and the arrival of spring are going to fuel yet another round of the housing boom. Auto sales are actually rising due to stronger incentives and consumers buying cars instead of mutual funds. This is the third year of a presidential term which is almost always positive with politicians promising two chickens in every pot. A tax cut package for $500 billion was passed on Friday and though a long way from done it will eventually happen. The government is spending money at record rates to prop up the economy, provide security, grow defense and replace billions in supplies used in Iraq. Oil prices are dropping with a probable glut returning. The SARS panic is easing with the disease contained in most countries.

The dollar is trading at four-year lows, which makes our exports cheaper and imports less attractive. It is still bad for foreign investment in the stock market but the balance of trade will benefit from increasing demand for our products. And lastly, there is a huge amount of money waiting on the sidelines. Estimates range between $2 and $3 trillion in cash, money markets, brokerage accounts and bond funds that can be shifted back to equities on a moments notice. In layman's terms the pregame has begun. There is a pent up demand not for products but for good news. The conditions are becoming increasingly positive but the game has not yet started. The spectators are filing into the stands and milling around the parking lot while the opposing teams warm up on the field. There are storm clouds on the horizon and everyone is patiently waiting to see if they are going to dump torrential rains which will postpone the game until the end of summer make up schedule or blow over revealing sunny skies and the start of the big game.

The bearish case stresses the grossly over valued market based on a historical PE compared with the average S&P PE today of 33. The historical PE value for supposedly fairly valued stocks ranges between 8-20 depending on who you talk to. Between 1990-2000 the average PE for Dow stocks was 19. The highest PE ever for the Dow was 1991 and right after the Gulf war at 31.4. The second highest was September 2001 at 30.7. Bears feel the current lack of earnings (+6% ex energy) and a high rate of warnings for the 2Q (58%) makes stocks over valued. They also feel the negative economic reports like Jobs, ISM, etc are pointing to more earnings pressure ahead. They may be right but the bulls claim the PE ratios are justified based on what the companies will earn when the recovery appears. Costs have been cut so far that profits will soar when demand picks up in the 2H of this year. Bears remind them that the recovery was supposed to come in the 2H of 2001, then the 2H of 2002, now 2H 2003 is slipping and many fear it may not appear until the 2H of 2004. Bears point to the Fed's fear of deflation as confirmation the end is near.

Regardless of your market view there are two charts I want to leave with you today. The first is the McClellan Summation Index. This is the ratio adjusted chart and a reading of +1000 or -1000 points indicates an imminent direction change in the markets. It is basically an indicator of market breadth and displays the amount of bullish or bearishness in the market. Note the index closed at an extremely high level of 1077, which indicates extreme bullishness. This is a contrarian indicator and an extreme reading of bullish activity is actually bearish because that trend is due to change. Since July of 1999 the indicator has touched the -1000 level three times. This is the first time in four years it has touched the +1000 level. Note the bearish divergence already forming in the MACD. Note that when the MACD hit zero in the past the direction change was nearly immediate.

NYSI Chart - Daily

The last chart is a comparison of the DOW/VIX for the last three years. Note that each time the VIX moved below 20 it represented a market top. It closed at 22 on Friday and one or two more positive days should do the trick. Maybe Wednesday afternoon? Again the effect is not immediate and several days can go by before the drop. In some cases it can stay under 20 for several weeks. However, like sunrise in the morning you can always count on the eventual market turn.

My gut feel is that we will see gains early in the week as traders take positions hoping for some positive economic reports on Thr/Fri. Those gains should push us to new highs and well into extreme overbought territory. If those reports are negative there could be a quick change in sentiment and a change in direction. As of Wednesday morning traders may require oxygen and a parachute to enter the markets. Oxygen for the rarefied atmosphere we could attain if the reports are favorable. The parachute may be needed if they disappoint. Buckle your seatbelt because either way it should be a thrilling ride.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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