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Market Wrap

Internals Rule

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      06-03-2003           High     Low     Volume Advance/Decline
DJIA     8922.95 + 25.10  8940.38  8861.32 1.80 bln   1758/1465
NASDAQ   1603.56 + 12.80  1603.74  1584.70 2.04 bln   1680/1583
S&P 100   488.11 +  2.75   488.93   484.27   Totals   3438/3048
S&P 500   971.56 +  4.56   973.02   964.47 
W5000    9290.05 + 35.10  9300.74  9226.40
RUS 2000  443.87 +  1.24   443.92   440.63 
DJ TRANS 2512.03 -  0.30  2512.42  2490.35   
VIX        22.45 +  0.22    23.42    22.34   
VXN        33.51 -  0.12    34.79    32.96 
Total Volume 4,109M
Total UpVol  2,365M
Total DnVol  1,682M
52wk Highs  757
52wk Lows    19
TRIN       1.48
PUT/CALL   0.93

Internals Rule
By Jim Brown
Click here to email Jim

Despite a follow through dip at the open and another attempt to sell off in the afternoon the internals continued to rule. With IBM getting whacked for -$4 intraday the Dow still managed to return to positive territory and climbing at the close. New highs beat new lows 40:1. Nothing bearish about that.

Dow Chart - Daily

Nasdaq Chart - Daily

Economically it was a slow day but overall the results were positive. The Chain Store Sales snapshot for the week was flat despite a wet Memorial Day weekend but they are still running at +3% year-over-year. Declining gasoline prices are giving consumers a little more extra cash in their pocket and some of that cash is finding its way into the stores. Still stores are complaining of higher than normal inventory levels due to no buying surge at the end of the war. This would suggest the summer period will see some heavy sales to reduce these levels. Sales means lower prices which means more buying is necessary to maintain the same levels. It is a vicious spiral until demand returns on its own.

The Challenger Layoff report showed that layoffs dropped to 30 month lows at only 68,623 job cuts compared to -146,400 cuts in April. This is in stark contrast to the U.S. Layoff report we saw last week which showed a significant increase in layoffs announced. While this is a positive change in the trend it still means the Jobs Report on Friday could be negative. The -68,623 number may be better than April but it is still negative. The bad news bulls celebrated this bit of good news with a nice late morning bounce.

The automakers dominated the news this afternoon with different views and results for the last month. Overall the May auto sales came in slightly better than expected at 16.1 million units on an annual basis. Sales of Japanese manufacturers increased as they entered the incentive race. Although the overall number was slightly above the consensus the individual makers were not all positive. DCX said they would lose one billion Euros in the 2Q due to higher incentives and tough competition. GM posted a gain of +4% but Ford dropped -0.7%. DCX lost -3%. GM cut its production plans for the second quarter by -20,000 units and predicted the 3Q production would be down by -6%. GM said it would continue the zero-percent financing through July-7th and will offer cash rebates as high as $4000. UBS Warburg is already on record as saying one of the big three companies is likely to file bankruptcy if the trend continues. The news outlets continued to spin the better than lowered expectations results as positive. Sales were bad but not as bad as they expected! I know I am splitting hairs here but sometimes I think they could spin an earthquake as a positive event. Shucks, they do produce urban renewal. Ford also said they would cut 3Q production by -14% or -141,000 vehicles.

FedEx also said things were not as rosy as expected. They announced plans to cut 14,000 salaried employees and take a charge of up to $160 million due to declining overnight package shipments. They have already reduced capital expenditures, cut aircraft orders and limited hiring. They warned that earnings could miss First Call estimates by -19 cents for fiscal 2004. Workers are going to be offered a lump sum $10,000 termination incentive and full pension benefits if they are over 50 years old.

In addition to FDX the market took a serious hit from IBM on the day after they announced an SEC probe into their accounting practices. The stock dropped over -$4 intraday before rebounding slightly to close near $84. (-$3.51) Seems there is a problem in revenue recognition. You know, the place where most accounting games are played. Not enough details are known to form an opinion but IBM has been criticized for years for the funny money games they played internally. If you remember the earnings estimates for last quarter were off because analysts had grown accustomed to aggressive stock buybacks for IBM to make their numbers. With the acquisition of Rational Software they delayed purchasing additional shares due to the dent in the cash flow. For the last three years IBM would reduce the number of shares outstanding each quarter by just enough to let them meet the earnings per share estimates. If you know you are going to be short a penny then buy back a couple million shares and you are home free. Recently I thought IBM was going to get away from the accounting games when they purchased PWC. Price Waterhouse was a cash generating money machine and would only get better when absorbed by IBM. It looks like the past has come back to haunt them.

Revenue recognition determines when you get to account for profits. If you sell a computer today for cash you account for it in this quarter. If you sell it on time payments over five years then you may accrue 1/60th of the profit each month. If you lease it then all of your profit may be in the month it came off lease. If you assumed a 10% residual (customer paid out 90% of the cost during the lease term) and the computer is worth 25% at the end then you claim a 15% profit in the month it is sold. That profit expectation is sometimes booked as deferred revenue at the start of the lease. Companies like IBM build up billions in different types of deferred revenue due to the thousands of different ways they sell their products. In the case of a consulting agreement do you claim the revenue up front for a 24 month agreement, prorate it on a monthly basis, recognize it when billed or when paid? What if the bill remains unpaid for 90 days, 180 days? To please the earnings sharks you want to recognize it as quickly as possible.

This is part of the claim in the current investigation. It appears IBM was claiming revenue on sales that were unpaid for more than 120 days which is normally amounts to a collection account. It is so tempting when you are as big as IBM to quietly take a few million out or put a few million into the deferred income bucket to appease the earnings crowd. The problem? A journal entry here, an offsetting entry there, a couple more to adjust the adjustments and then the next quarter needs adjusting to. Pretty soon you have an MCI or Qwest debacle if the income stream to support the entries dries up. Nobody expects anything like that from IBM. IBM is not a MCI or Enron. They are a quality company that probably pushed some numbers management to the outer limits and some accountant called them on it. The SEC will probably slap their hand and fine them for something so they can claim a victory for the little guy. Bottom line, buy IBM on weakness over the summer. The PWC and Rational Software acquisitions, new server lines and bleeding edge technology in an improving economy will win in the end.

If you want to short something then MSO could be a better target. According to news reports the SEC is going to file criminal charges against Martha Stewart possibly as soon a tomorrow. There is a strong rumor that she will resign from the company to avoid further hits to the stock. When this first came out the stock dropped to a low of $5.26 but had recovered to $11.65 last Friday. MSO dropped -$1.68 to $9.50 on Monday. Should she be charged she has said she will defend herself until proven innocent. This means a lot of negative publicity and not good for the stock that bears her name.

Probably the biggest plus for the market came from Greenspan who gave a mixed message while speaking on monetary policy in Berlin. He said when discussing the recovery, "The best we can judge is that the acceleration has not yet begun even though obviously the marked moves of the stock market in recent weeks, and especially the credit markets, are suggesting a fairly marked turnaround." That remark was spun all day as "Greenspan is expecting a "marked turnaround." I do not read that into the full sentence. Maybe my glass is half empty and I am only seeing the negative side. I see the "acceleration has not yet begun" as no recovery yet. I see the marked moves in the market as without basis according to his comment.

On the bullish side he said "inflation is not something of significance for the Federal Reserve to be concerned about." Say what? For years we have feared the inflation monster under the bed and suddenly the Fed has decided it is not a problem. Yes, I am exaggerating. When taken in context he is saying they are much more afraid of the deflation monster now since inflation is virtually nonexistent. He said that deflation, although a low probability, was a much more important problem and one the Fed must take action to guard against. Bingo! The rate cut lottery just sold a few million more tickets. Overall the tone of the speech was very cautiously bullish. His comments that he "did not expect the growth to quicken as much as others expect" kept a cautious tone to the message. He said it was important for policy makers to consider the possibility they were wrong about the future and take out insurance in advance. He even went so far as to praise the recent tax cut as fortuitous and happening at the right time. The markets loved the speech despite the cautious tone and saw it as blank check for stimulus until the recovery begins in earnest.

The Dow sold off -100 plus points at the close on Monday after touching the electric fence at 9000. The Nasdaq retraced -30 points in the same period. Traders were holding their breath overnight afraid that the summer slump had begun. The opening dip this morning to 8877 was bought strongly on the Greenspan news and despite an afternoon dip the Dow and Nasdaq both recovered some of Monday's losses. Most importantly there was no follow through to Monday's drop. It appears to be simple profit taking and even the -$4 in IBM, roughly -32 Dow points, could not hold the Dow back.

As I said over the last couple weeks, follow the internals. They are very strong and the dip buyers are alive and well. Until that changes we need to go with the trend. The new 52-week highs across all markets came in at 757 compared to only 19 new lows. This is down from Monday's 1087 new highs DESPITE the afternoon drop. That is a record for the last 12 months. Before everyone rushes out to get a second mortgage we need to recognize that this could still change at any moment. We still have the Productivity Report and ISM Services on Wednesday, Factory Orders on Thursday and Nonfarm Payrolls on Friday. Much more important than the remaining economic reports for the week is the Intel mid quarter update on Thursday after the bell. Part of the drop on Monday was a rumor that Intel would warn this week. While it was just a rumor all eyes will be on the event and the health of the tech sector will be judged by their comments. Remember the comments from the CEO two weeks ago? "No recovery in sight, we are hoping for a better year in 2004." Draw your own conclusions.

While it is becoming increasingly apparent that no amount of bad news can derail the train there is always the possibility of a sell the good news event. We are moving into the summer doldrums and anything is possible including monotony. The markets do not have to go up and we all know how strong Dow 9000 resistance should be. After this week the economic reports start slowing again and we will be into the warnings cycle for the 2Q. Enjoy the train ride while it lasts but keep looking for hijackers to appear. If they don't appear we will eventually be talking about 10,000 just like 9,000 tonight. If they do appear you will already have your defensive plans in place.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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