Option Investor
Market Wrap

Considerable Period

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      12-09-2003           High     Low     Volume Advance/Decline
DJIA     9923.42 - 41.90 10003.12  9916.90 1.79 bln   1257/1954
NASDAQ   1908.32 - 40.50  1956.97  1906.84 1.80 bln    990/2249
S&P 100   524.15 -  3.52   529.14   523.63   Totals   2247/4203
S&P 500  1060.18 -  9.12  1071.94  1059.16 
W5000   10326.70 - 98.50 10449.94 10318.40
RUS 2000  534.54 -  8.50   544.85   534.26 
DJ TRANS 2920.92 -  8.60  2948.66  2919.74   
VIX        17.63 +  1.09    17.80    16.56
VXO (VIX-O)17.08 +  0.77    18.00    16.40
VXN        28.32 +  0.77    28.47    27.35 
Total Volume 3,946M
Total UpVol    955M
Total DnVol  2,949M
52wk Highs  617
52wk Lows    33
TRIN       1.38
NAZTRIN    1.61
PUT/CALL   0.73

That was not how long the Dow lingered over 10,000 on Tuesday. The hang time was far less than two minutes and the result was exactly what I had expected. The Dow slipped back to 9960 and held there until after the Fed announcement. There was a valiant effort to hit D10K once more after the announcement but that effort fell short by .46 of a point. Close enough for me and it was close enough for the sell programs as well.

Wilshire-5000 Chart - Daily

Dow Chart - Daily

Nasdaq Chart - Daily

The morning opened with a mission and that mission was to hit D10K and put that target behind them. Many of the traders on the floor at the NYSE brought their Dow 10000 hats with them to work today. Does that give you a clue that the fix was in? Once that mission was accomplished in the first ten minutes of trading investors were left to focus on economic reports and wait for the Fed. The economics were not pretty.

The Weekly Chain Store Sales dropped -2.5% compared to -0.1% the prior week. This was the biggest drop in sales in three years. The excuse was the snow in the Northeast despite the early reports that stores were packed over the weekend even with the snow. Somebody is wrong. If stores were packed in the Northeast then they must have been vacant elsewhere. There are definitely some conflicting signals in the retail sector and there are some signs of rising prices making discounting difficult.

The second report was the Richmond Fed Manufacturing Survey and it also disappointed with a +11 compared to last months +20. If you will remember it was just yesterday that the Kansas City Fed Survey fell from +28 to +6 with some nasty drops in the internals. The Richmond Fed Survey showed that Shipments fell from 20 to 11 but New Orders rose from 6 to 14. This was more neutral than the Kansas City Fed number but still a drop. Production on the Kansas survey fell to 6 from 28, Shipments to -1 from +21, New orders to 14 from 29. The Kansas survey was not positive in any respect from my view. With the Richmond Fed Survey confirming the Kansas numbers it should not take a rocket scientist to conclude the recovery is slowing.

This weighed on the markets but with the Fed meeting underway the focus was on the 2:15 announcement and not the economics. The Fed announcement had the potential to be the economic trump card and nobody was making any bets until that card was shown.

The Wholesale Trade report which showed a sharp increase in sales also failed to lift the markets. Sales were up +2.0% and inventories were up +0.5%. This was an October number so the revelation was old news and not earth shaking. There was a sharp drop in the inventory to sales ratio to 1.18 and an all time record low. I have conflicting thoughts about that. First, it suggests that there is a huge inventory build somewhere in our future. Second, it makes me wonder where the inventory is going to come from for 4Q sales. You can't sell it if you do not have it and the two Fed surveys show that nobody was making any in November. If demand were suddenly to surge there would be a strong inventory short squeeze and you know who would get squeezed. The consumer would end up paying more if retailers are fighting for the product. Remember Chicken Dance Elmo last year? They were selling for 2-3 times retail on EBAY because the stores had no inventory.

The Dow had plenty of support this morning or the pull back would have been much worse. GM soared +1.50, bringing to almost $5 the last week's gain after they said their pension returns were +14% for the last year. They only need +8% to keep them fully funded and +14% is almost twice that amount. Two years ago their $44 billion pension liability was the topic of conversation constantly and how would they ever recover. Evidently a little Fed liquidity injection and a nine-month bull market was all it took. It also did not hurt having an upgrade from Goldman Sachs to provide some short covering urgency.

UTX, GE and MMM also helped boost the market as each made new highs for the month and new 52-week highs in the case of MMM and UTX. Unfortunately they all closed well off their highs. Dow component HPQ tried hard to help out with an upbeat forecast but HPQ ended up in the red. Fiorina said HPQ expects to grow its earnings +20% per year in 2004 and beyond. I listened to an in-depth interview with her on Kudlow-Cramer tonight and I was impressed. She took the hardball questions and the comparisons with IBM and DELL and really surprised me with the answers. I have to admit I never thought I would buy HPQ due to years of lackluster performance by CPQ tainting my memory but I was impressed. She has taken the enormous heat from the merger and even before that and has not wilted. I am thinking about adding HPQ to our TOP 50 Stocks for 2004 Special Investor Guide as a wildcard play. I have to do some more research but if what she said was true there is plenty of upside potential there.

One thing Fiorina did say negative was there is no bounce in IT spending in the 4Q. She said there was no end of year flush the excess budget buying as in years past. She also said IT spending in 2004 was likely to be flat at maybe twice the GDP. Assuming the GDP is 4.5% that keeps the IT spending under 10% growth and does not suggest a strong IT recovery. This could have helped accelerate the Nasdaq slide and at -40 points it was definitely downhill.

The biggest news of the day was of course the Fed meeting. The answer to the $64 trillion question was, yes. They kept the "considerable period" statement in the forecast and gave the markets a holiday gift. At least that is what they thought they were doing. In order to leave it in they played with the context and the preface to that statement to give them some wiggle room. The initial reaction was positive and the Dow soared back to 9999.56 again but once the impact filtered through it was lights out for the bulls. It is not that there was anything bad in the statement and in reality it was just one factor in the D10K sell off. One analyst suggested maybe they are telling us the economy is not as strong as we thought. I seriously doubt it but that view was making the rounds. Of course they do have inside data we do not have so it could take a couple more months to know for sure.

Here is the text of the statement:

The Committee continues to believe that an accommodative stance of monetary policy, coupled with robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period confirms that output is expanding briskly, and the labor market appears to be improving modestly. Increases in core consumer prices are muted and expected to remain low.

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period.

The key points are "output expanding briskly, labor market improving modestly, prices low". All three of those items are past tense if we are to believe the recent economics but that is not the problem.

The problem was "unwelcome fall in inflation has diminished" and "with inflation quite low and resource use slack". With these words they sank the bond market and suggested that contrary to the explicit English there could be a rate hike in our March future. If deflation fears have diminished then inflation, which is already beginning to appear, could rise quickly. As long as the larger risk was deflation the bond market felt safe with their long term investments. The inflation statement put a qualifier on the "considerable period" sentence. Reading between the lines it says if we see inflation rising and/or an uptick in capacity utilization then all bets are off. This was always implied in past Fed stances but by adding the inflation tag line to the considerable period context they set the stage for a faster exit from accommodation if needed. Bonds crashed on fears that the inflation trigger could be pulled at will and they no longer had the "considerable period" of safety despite those words in the announcement. Ten-year yields jumped from 42.09 at the announcement to 43.52 at the close. This almost completely retraced the drop from Friday which was the biggest one day drop since Jan-2002. Easy come, easy go.

The capacity portion of the announcement does not really produce any worry. The Fed seldom raises rates in these situations until the capacity utilization is over 80%. It is currently only 75% and should take many months to rise to the 80% level. Durable goods utilization is only 70.5%. With this much excess capacity it is tough to make the "risk of deflation has been minimized" argument. But then the Fed said it so it must be true or at least that is the way the bond market reacted.

The stock market reaction after the announcement probably had more to do with the touch of Dow 10,000 than it did with the Fed but there always has to be an excuse. Nobody expected the Fed to raise rates and very few people expected the Fed to leave the phrase alone. The Fed performed as expected and investors simply sold the news. There were seven sell programs and only two buy programs in the 30 minutes after the announcement. Obviously institutions were ready and waiting and hoping for a post announcement spike to provide the volume to exit safely.

The Dow effectively made a double top today at 10,000 intraday and failed both times. While it looks spectacular on the charts it is not material until we see what follow through appears. The real key is the next support level.

Dow Intraday Chart

Dow 30 min Chart

The Dow held 9850 since Dec-1st and that is strong support. The -41 drop today was nothing and only brought it back to the top of last weeks range. It only appears more important because of the touch at 10,000 and the dramatic post meeting drop. The Dow has three critical levels of support at 9850, 9725 and 9600. The odds of 9850 being tested are good. 9725 is possible and 9600 would be only a remote possibility before the Santa rebound. While I expect a serious bout of profit taking in January I also expect us to remain range bound between 9700-10000 until year end. There is too much support below and too much overhead supply between 10000 and 10200 to break out of either side of the range. At least that is the model I am going with today. The way this market has been acting anything is possible.

The more important breakdown today was the Nasdaq. The Nasdaq broke a level of serious support at 1925 (50 DMA) and appears headed to 1880. It was barely able to remain above 1900 at the close. While the 50 DMA was never the strong support for the Nasdaq as it has been for the Dow it was still a market milestone. The 100 DMA at 1850 would be the next crucial test but baring a disaster before the holidays I would be surprised to see it tested.

Nasdaq Chart 60 min

For the balance of the week the markets need to find a sector to lead the way back to neutral. Chips led the Nasdaq down with Intel dropping -10% since last Thursday. The SOX broke its 50 DMA which HAS been support since March. This is a critical test for the techs. The bank index dropped to a new low for the month on warnings from Washington Mutual and National City that mortgage loan demand was down and corporate borrowings were declining. Home builders dropped like a rock on the mortgage news despite record earnings by HOV and raised guidance. There were comments making the rounds that the outlook for the first quarter was softer than originally thought. Even the Biotech index was sliding on problems with the drug pipeline.

The only economic report for Wednesday is the weekly Mortgage Application Survey which could help or hurt the homebuilder sector depending on the results. That leaves the markets free to focus on any new earnings warnings. The Nikkei opened down -200 points on our performance and our futures are down slightly at 8:PM. Thursday and Friday the pace of the economics releases picks up and you can bet there will be some more rehashing of the Fed statement until every word has been dissected hundreds of times. I am still expecting a slight pullback this week and then a rebound into the holidays. Use the support levels I outlined above to plan for that rebound. The wildcard is the profit taking by institutions. Eventually somebody is going to pull the trigger that fires the starters gun and the race will be on. I am just betting that it does not get serious until January. I am hoping that the majority of funds will hold out hoping for one last bounce into the end of year retirement contributions and a chance to push tax consequences into 2004. This is obviously just speculation based on historical trends but so far the script has played out as we expected. For the rest of the week I would be patient about entries and let prices come to you.

Enter Very Passively, Exit Very Aggressively!

Jim Brown

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