Option Investor
Market Wrap

Surprise, Surprise

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       WE 01-30        WE 01-23        WE 01-16        WE 01-09 
DOW    10488.07 - 80.22 10568.3 - 32.22 10600.5 +141.62 + 49.04 
Nasdaq  2066.15 - 57.72 2123.87 - 16.59 2140.46 + 53.54 + 80.24 
S&P-100  560.31 -  5.10  565.41 +  0.69  564.72 +  8.17 +  6.56 
S&P-500 1131.13 - 10.42 1141.55 +  1.72 1139.83 + 17.97 + 13.38 
W5000  11029.20 -127.58 11156.8 + 40.74 11116.0 +187.04 +151.14 
RUT      580.76 - 15.38  596.14 +  5.73  590.41 + 15.21 + 14.35 
TRAN    2885.96 -186.99 3072.94 + 36.66 3036.28 + 47.34 - 19.22  
VIX       16.63 +  1.79   14.84 -  0.16   15.00 -  1.75 -  1.47 
VXO       17.05 +  2.18   14.87 -  0.40   15.27 -  0.67 -  2.00 
VXN       25.06 +  3.79   21.27 +  1.03   20.24 -  2.77 -  1.50  
TRIN       1.00            1.15            0.47            1.63    
Put/Call   0.81            0.77            0.51            0.65    

The wheels came off the whisper number bus Friday when the GDP failed to reach even the weakest estimates of 4Q growth. All the analysts quoting obscene growth numbers were left to sift positive component numbers out of the overall report in an effort to justify their missed estimates. The market behaved very well considering the negative news.

Dow Chart - Daily

Nasdaq Chart - Daily

The New York NAPM jumped to 257.3 from 242.6 and showed that while the recovery may be slow across the country the New York area is roaring out of the 2001 recession. Manufacturing conditions improved with the quantity of purchase component jumping from 40 to 61. This is a huge gain but the majority of the other components were mixed. The headline number is up a whopping +13.2% since November and may be experiencing some rally fatigue soon. The non-manufacturing activity jumped to 78.5 due to a rebound in financial services and is near its highest levels since 2000. Considering manufacturing is not a major part of the New York economy this suggests the rest of the area economy could be growing at an even faster rate.

Switching to the center of the country the Chicago PMI soared to 65.9 and well over the estimates for a decline to 60.0. Except for employment the report was very strong. Production jumped to 76.5 from 68.9, backlogs to 57.3 from 52.2. Employment fell slightly to 48.3 from 49.6 and inventory fell to 37.4 from 42.2. A negative component was the jump in prices paid to 67.8 from 57.3. This is a huge one-month jump and suggests that inflation may be closer than we think. A +10 point jump in prices was a +18% gain in one month. This one component weighed heavily on the positive initial reaction to the headline number. Offsetting the jump in prices was the inventory contraction at the fastest rate in the last two years. Despite the good news the report also stretched to three months the continuing layoffs in the manufacturing sector.

Consumer Sentiment edged up only slightly for the final January revision to 103.8 and a +11 point gain for the month. Analysts suggest that severe weather in December could have impacted the December decline but we have had very cold weather the last four weeks as well. I suspect the December decline was simply due to holiday depression and financial stress. We are clearly out of the dip and moving to higher ground and part of the higher sentiment is probably due to new highs on the Dow. With massive tax refunds on tap for the next three months those warm feelings should continue but the gains could slow without a real pickup in hiring. The Michigan Sentiment number is also much higher than the Conference Board and Money Magazine indexes. This suggests the difference in polling questions could be adding to the positive responses.

The biggest disappointment for Friday was the Q4-GDP which came in at a bland +4.0% compared to huge whisper estimates. The gains were wide spread but emphasize the slow growth thought process rather than the exploding economy. Through out the day on Friday the whisper numbers slowly declined from the +6.5% Thursday level to only +5.0% by the close on Friday. That 1.5% difference simply went up in smoke once reality appeared. The last article I found Friday night was comparing the 4.4% official estimate to the wildly optimistic "5%" whisper. Obviously expectations, or at least those willing to admit their expectations after the fact, imploded in the white light of day.

The 4Q growth of +4.0% was being called "decent" by some and "strong" by others when compared to the +3.1% total for all of 2003. That makes you realize how weak the first two quarters really were at +2.0% and +3.1%. The 4Q slowdown was being called "inline with expectations" by Friday night. It appears in hindsight that the 3Q explosion was due to exactly the reasons we have been claiming in these pages. It was due to the last round of home refinancing with ten year rates hitting 3.25% lows in June. This prompted two months of massive cash generation and a serious upgrade cycle for homeowners. Adding even further to the economic explosion was a tax rebate, tax cut program that gave billions of dollars back to consumers. They immediately spent it all as evidenced by the sales slowdown in the 4Q to only +2.6% growth.

Government spending in the 4Q at +0.8% was less than half the pace of the 3Q. Housing continued to be strong and the weaker dollar continued to add to the bottom line. Inventory rebuilding added +.60 basis points to the 4Q number with IT equipment spending up +10%. Make no mistake, this was not a shabby quarter. It simply did not live up to the overly optimistic expectations and proved that the 3Q spike was just a spike and not a lasting trend. The "lasting recovery" is still in doubt as the slowdown in Durable Goods Orders earlier this week suggested.

The good news in the GDP report is actually the lack of a blowout number. This decent growth is right on track and it means the Fed is on hold for a much longer period. The fears from Wednesday that the Fed could be ready to pull the rate hike trigger as early as May were totally groundless. There is nothing in the GDP that would suggest the economy is running wild or even that the economic recovery is self sustaining. The Fed statement that they were still worried about the potential for deflation confirms they did see this coming. Without a massive jump in jobs soon we are going into the summer doldrums at probably a +3.5% GDP rate. That is actually a normal GDP target for steady growth. It is just far shy from the overly optimistic estimates.

No overheating economy and no rate cut in sight and bonds rose on Friday once that reality struck home. This means interest rates will stay low though the spring home buying season and tax refunds will keep the economy running for the next six months. With no real economic worries the stock market recoiled from the initial GDP announcement but the drop was very short lived.

Sellers knocked the Dow back to Thursday's closing support at 10450 on the GDP news but bargain hunters jumped on the dip. It was a low volume seesaw for the rest of the day but 10450 support held for the second day. The Dow wandered back to 10500 resistance by day's end on short covering but was unable to beak that current resistance barrier with Super Bowl event risk looming large in our future.

Russell 2000 Chart - Daily

The Russell was the strongest index once again and closed the day positive and suggests that bargain hunters were hoping for an oversold gap up on Monday. The Nasdaq traded in positive territory most of the day despite some lowered guidance from Thursday night tech reports. The SOX also closed positive and rebounded back to 514 and the current 50 dma.

SOX Chart - Daily

The market action or actually lack of action on Friday was encouraging. With the already negative tone for the week the GDP could have sent it into a death spiral. When the initial dip was quickly bought the potential sellers had to rethink their actions. The lure of a potentially positive Jobs Report next Friday is a powerful incentive to hang on as long as the market is not self destructing. Friday turned into a consolidation day and traders left early for the weekend.

I suspect it would have ended differently were it not for the Super Bowl event risk. The Dept of Homeland Security did not change the threat level but the actual site security is extremely high. With Osama vowing to go out a martyr and according to some reports has said he would die in an attack in the United States this is a very high profile target. 135 million viewers will be watching in the U.S. and over 1 billion worldwide. Think that would not be a tempting target for a crazed terrorist wanting to go out with a bang? This week was also the start of the Muslim Hajj Pilgrimage where over two million Muslims fulfill a central duty of Islam. For 14 centuries countless millions have made the trek to Makkah to fulfill one of the five pillars of Islam. This is a very high profile event and a period that could produce extra terrorist activity. News reports out at 8:PM Friday night said there was a sudden surge in intelligence communication and the emphasis was on airliners flying into the U.S. from other countries. So far no flights were reported cancelled but you can bet any arriving around Super Bowl time will be very heavily screened. Let's hope that this event ends peacefully as have all the other potential events like New Years Eve in New York.

The one fly in the ointment to suggesting a potential rebound next week is the crash in the transportation sector. The transportation index has fallen -6.5% in just the last week. For Dow theorists a falling transportation index would prevent any meaningful rally in the Dow. The index was only 12 points away from its 100 dma at the lows on Friday. Despite the rebound in the broader indexes the TRAN lost -86 points or nearly -3% for the day. There are various reasons for the wreck and YELL was a big reason on Friday. Yellow Roadway missed estimates and lowered guidance. What really worried traders was lack of shipment growth. YELL shipments rose only +1.1% in the 4Q and Roadway shipments actually dropped -14% during the quarter. What worries traders is the drop in shipments in an economy that is supposedly growing. If it is growing then shipments should be increasing. YELL dropped -$5 on the news. Another company that is involved in shipping, GATX Corp (GMT) dropped -15% or -$4.15 on a -5% drop in revenues during the same period.

The transportation drop is further complicated by the slowdown in airline passenger traffic while airlines are racing to add capacity. Fare wars are increasing and the business traveler has not come back yet. This suggests the broader market and the economy is not yet out of the woods.

Why fear? The S&P closed the month with a gain and that almost guarantees a gain for the year. Since 1950 that January barometer has a very impressive record of 91% accuracy. The S&P closed up about +20 points for the month and theoretically gives us a 91% chance of closing the year in the black. Of course what the statisticians don't tell you is that the barometer failed two of the last three years. There is also another catch that we don't always hear. If the S&P closed the year today at 1131 the record would be intact. Just closing the year anywhere in positive territory keeps the statisticians happy.

While we do not care about keeping the statistics guys happy we do need to keep mom and pop investor happy. The bean counters reported on Friday that 2003 saw an inflow of $152.8 billion into equity funds. This was the fifth largest inflow on record with 2000 being the highest. There is currently $7.4 trillion being held in all funds including money markets. Those investors should be happy with their gains over the last twelve months but that brings up the performance issue once again. Those burned in the worst bear market since the great depression have put their faith back into Alan Greenspan and the stock market while moving full speed into the election cycle. If your fund was up +30% to +50% in 2003 then what are you expecting for 2004? I would bet it is not +10% and the consensus market projections for the rest of the year. For the next 90 days I would suspect those investors are going to be sitting on pins and needles until we get a resumption of the bullish trend and over the current highs.

I think the potential for that to happen is very good. I know there were some setbacks this week with several high profile techs not living up to the standard of the majority of prior announcers. FDRY, GILD, NVLS, LEXR, RNWK, SNDK and PSFT are just a handful of the most recent disappointments. If only a handful per week is all we have to worry about then I do not think it is a problem. We know from past history that the deeper we get into the earnings cycle the weaker the results because the quality of the companies begins to decline. With earnings currently running at +25% growth for the 4Q there is plenty of room for weaker results ahead and still have a great earnings cycle.

The bottom line is still a growing economy, albeit slow growing but still growing. Add in the massive tax refund stimulation that will hit over the next three months and the markets have plenty of room to grow. It is what will happen after April that worries me. The comparisons to 2003 earnings will become progressively tougher and if the economy does continue to grow the Fed will eventually start the next rate hike cycle. The deficit is growing and expected to be over $500 billion in 2004 and over $1 trillion soon. The Fed actually expressed concern over the deficit in the December FOMC minutes. But in the scope of our current view that is still a long way off. The average investor operates on a quarter by quarter basis. With 4Q earnings about over the investing public is pocketing their winnings and trying to decide who will be the big winners for Q1. The forecast based on the current guidance is for another great quarter.

Investors should be examining their portfolios now and cutting back on those companies with lackluster results. That cash should be used to buy on any pullback those who raised their guidance. This portfolio rotation is just beginning for this quarter and those companies that did disappoint have been severely punished. With one more week of decent earnings volume and a flurry of critical economic reports the odds are good we will see some erratic market moves. Larry Ellison is planning ahead for this exact plan. He announced at 9:PM Friday night that he was selling $1.67 billion in ORCL stock starting on March 4th. It is a planned sale program to diversify his holdings according to the press release. While that should depress ORCL stock on Monday I would not feel too sorry for him. He still has nearly 1.3 billion shares left. Interesting timing on the announcement.

Assuming a successful Super Bowl weekend we should see some month end cash flows put to work early next week. Unless there is some real economic disaster we will probably continue to trade in a range until after the Jobs report on Friday. That range is probably between Dow 10300-10650 and is wide enough to drive a truck through. The Nasdaq range is probably between 2000-2150 and considering we have had more than a 100 point move last week we are real close to exactly in the middle. I am basing the lower end of my estimates on the oversold conditions in the SOX. We saw it test 500 on Thursday and rebound but I suspect we could see another dip to the 490 level and the 100 dma. I do expect that level to hold. If the semis quit falling so will the Nasdaq. That does not leave much more downside assuming we don't have any negative surprises in our future.

Buy the dip! Assuming we do not have a black hole in our economic future I would suggest buying the next dip. My target for conservative traders would be Dow 10300 and Nasdaq 2000 but recognizing we may not reach them. Over the next couple weeks look for a sharp dip brought on by some yet unknown event that drops us close to those levels. If we pause at the lows and consolidate on high volume I would enter partial positions. Once we get a close above the prior days highs I would add to those positions on any future dip. I fully expect to see new highs before April-15th but that forecast and a $5 bill will get you a cup of expensive coffee and a newspaper.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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