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Market Wrap

Below the Trendlines

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     08-06-2003         High     Low     Volume Advance/Decline
DJIA     9061.74 + 25.42  9134.57  8997.11 1.75 bln   1212/1995
NASDAQ   1652.68 - 20.82  1675.46  1648.42 1.84 bln   1610/1607
S&P 100   488.13 +  1.47   492.70   484.68   Totals   2822/3602
S&P 500   967.08 +  1.62   975.74   960.84
RUS 2000  453.91 -  3.54   458.24   452.79
DJ TRANS 2533.81 - 10.05  2556.31  2526.38
VIX        23.30 -  0.81    25.88    23.11
VXN        34.42 +  0.19    35.98    33.84
Total Volume 3,875M
Total UpVol  2,372M
Total DnVol  1,442M
52wk Highs     157
52wk Lows       92
TRIN          0.80
PUT/CALL      0.88

Below the Trendlines
By Jonathan Levinson
Click here to email Jonathan

In a tale of two markets, the Dow added 25 points today and the Nasdaq lost nearly 21. Both results were surprising, as it appeared possible this morning that we might see a full-fledged meltdown following John Chambers' less-than-stellar attempt to talk up CSCO's most recent results, and the selling frenzy in the futures following the cash close yesterday.

20 day 30 minute INDU

The Dow's 30 minute candlechart is open to interpretation, to say the least. However, the strong bounce off the morning low violated the downtrend off Thursday's high, and the close left us right on that trendline for a retest with the oscillators lagging the closing drop.

20 day 30 minute COMPX

The equivalent chart of the COMPX avails itself of no such bullish interpretation, although the descending channel from Thursday could be construed as a bull flag. The CSCO-show effectively prevented the breakout we saw today in the INDU, and note the strong stochastic divergence on the closing sell candle. The up-phase in progress from this morning's opening low aborted early on both indices, a bearish development on the COMPX and the INDU.

6 month daily chart of the INDU

Zooming out to the 6 month chart of the Dow, we see that today's 25 point gain did nothing to correct the damage done by yesterday's trendline break. The oscillators are in downphases, and it will take a strong push from the bulls to regain the trendline and reverse the sell signals on the stochastics and macd.

6 month daily chart of the COMPX

We have the same setup on the 6 month Nasdaq chart, except that today took the index lower still, and paints a pretty unequivocal picture. While the optimistic bull flag drawn on the 30 minute chart above is not technically incorrect, I find it difficult to think bullish thoughts about the index when looking at the daily chart. A bounce and even possible trendline retest is possible from here, but the onus has clearly shifted from the bears to the bulls.

The Mortgage Bankers Association (MBA) announced this morning that seasonally-adjusted demand for mortgage refinancings, the MBA refinancing index, declined 2.4% for the week ended July 31 following the previous week's 32.9% drop. Demand for loans with which to buy homes, the Purchase index, rose 6.9% following the previous week's 3.5% loss. The Application index rose 1.1% following the prior week's 24.9% decline, posting its second lowest reading for the year. The average interest rate for a 30- year fixed rate mortgage rose to 6.37% from 5.87%, a 50 basis point increase in one week. Given the continued rise in yields and the fact that most home equity borrowers probably aren't watching the stochastics, Macd and ADX on the Ten and Thirty year yield charts, I'm thinking that the uptick is simply stragglers and latecomers to the market who had been procrastinating. I do not expect to see home borrowing and refinancing activity continue to advance side-by-side a climb in yields.

On that basis, so long as bonds continue along their downtrend, I expect to see mortgage activity and overall borrowing contract. Whether this is the cause or the effect of an overall contraction in liquidity, or rather in the availability of money to the financial system, is a chicken-or-egg question worthy of bounteous discussion. But the result is the same, which is good enough for us traders. With a contraction in liquidity comes what the Fed has been calling "dis-inflation," and for an idea of the effects of dis-inflation on the markets, take your charts of Jan-June and turn them upside down. You'll see the US Dollar Index rising, mortgage and refi activity falling, yields rising/bonds dropping, stocks dropping, gold falling. I believe that the efforts to avoid or at least ease the effects of the former will cause the latter, gold, to outperform, but I do not believe that commodities will be exempt from price declines in an overall deflationary. If dollars come to be worth more, then assets valued in those dollars will sell for fewer of them.

It's worth recalling a quote from Vice president JP Morgan Chase, Peter Smith: "Gold is nobody else's paper." This applies to commodities and "hard assets" in general. The fear of deflation derives from its potential to cause a descending spiral in a high-debt economic environment such as we have currently. If liquidity contracts and bond prices drop, yields will increase, requiring higher payments from debtors. At the same time, as money is increasing in value/becoming harder to come by, business investment softens, and unemployment persists. This causes debtors to default on their debt, which ultimately pressures creditors holding that paper, and so on. This is the trend that the Fed has been fighting. In such an environment, hard assets are not vulnerable to default. While their return on investment might be poor, their return OF investment is far more certain than in the case of paper assets.

Updated chart of Total Consumer Credit Outstanding

Total Loans and Leases at Commercial Banks

Bank Prime Loan Rate 1949-2003

The above discussion is intended to put some context behind the current market action we've been seeing and the recent releases from the Fed. One would think that equities would be far weaker than they have in fact been, and I'm not suggesting that we grit our teeth and go short, awaiting a certain crash. We've been seeing the beginning of an uptick in economic activity in some of the reports of the past few weeks, and as even Doug Noland has speculated, the aggressive inflation of the money supply by the Fed and aggressive consumer spending even on foreign goods, must have at least some stimulative effect on the economy. For example, discount air carrier JBLU reported today that its July load factor rose 2.8% over July 2002's level to 90.6%, with a 79% increase in traffic and a 74% increase in capacity. We've also seen declines in the initial jobless claims data in recent weeks.

Furthermore, more directly related to the markets themselves, the aggressive inflation of the money supply, lowering of rates and expansion of debt serve to inflate the price of all financial assets. This effect was, in my view, the cause of the rally in stocks and bonds this spring. While the value of stocks and bonds may not be increasing or even diminishing, their price rises as increasing amounts of money seek different investments. For this reason, and given the huge stakes, traders, particular options and futures traders, must remain nimble. The equity and commodity markets are very small relative to the treasury and currency markets, and each ripple in those larger markets is a potentially huge wave in equities and commodities.

The Energy Department reported that U.S. crude oil inventories rose by 2.9 million barrels to 280.2 million in the week ended August 1. Yet again, analysts got it wrong, predicting a drop for the week. The American Petroleum Institute (API) reported a 1.6 million barrel gain for the same period. Gasoline inventories dropped by 2.7 million barrels to 201.8 million barrels according to the Energy Department, with the API reporting a 4.5 million barrel drop. Distillate supplies gained 1.7 million barrels to 119.1 million barrels, with the API reporting a lower 400,000 barrel increase to 116.1 million barrels.

The second day of this quarter's record 60B treasury auction saw 18B in five year treasury notes sold at a 3.30% yield, compared with last quarter's 2.68% yield. The notes were well-received at that rate, generating a bid-to-cover ratio of was 2.48 vs. the average over the previous four quarters of 1.86. The demand was unexpected after the softness in seen yesterday, with three year notes generating a mere 1.32 bid-to-cover. The strength in treasuries throughout the day, with no apparent assistance from the Fed via its open market operations, bodes well for tomorrow's 18B ten year note auction.

We have the following economic data due tomorrow:

               Report                   Briefing  Market    Prior
                                        Expects   Expects
Aug 07 8:30 AM Initial Claims 08/02 -      400K     395K     388K
Aug 07 8:30 AM Productivity-Prel Q2 -      3.5%     4.0%     1.9%
Aug 07 10:00 AM Wholesale Inventories Jun -0.2%     0.0%    -0.3%
Aug 07 3:00 PM Consumer Credit Jun -      $5.5B    $6.0B    $7.3B
Today's session left us with more questions than it answered. Was the decline in the Nasdaq merely CSCO-related, or does it represent the confirmation of the trendline break yesterday? I believe that the failure of the Dow to put together more than a 25 point gain following its trendline break yesterday points to something beyond CSCO. More puzzling, however, was the strong bid in treasuries and the positive reception of the 5 year treasury auction. The Fed did not add reserves via its open market operations this morning, and if treasuries were being bought by "value" players looking for bargains at current yields, then we have perhaps witnessed the bottom in treasuries. I'm at a loss to explain it, as the 18B of new 5 year paper should have drained liquidity from stocks and bonds, compounding yesterday's losses. We'll watch the ten year auction tomorrow for clues, but for the moment, it remains puzzling. As Jeff Bailey noted in a comment from a reader, the Fed is meeting tomorrow, and while the Fed Funds futures are predicting zero possibility of a rate cut, perhaps some of the bid in bonds today was frontrunning the possibility. I do not know.

The economic data tomorrow before the cash open should go a long way toward determining market direction. Initial claims are expected to come in relatively low, and an upside surprise could move economic concerns back to the forefront of the market's attention. See you at the bell!


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