Option Investor
Market Wrap

Don't Look Now!

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       WE 03-19        WE 03-12        WE 03-05        WE 02-27 
DOW    10186.60 - 53.48 10240.1 -355.47 10595.5 + 11.63 - 35.11 
Nasdaq  1940.47 - 44.26 1984.73 - 62.90 2047.63 + 17.81 -  8.11 
S&P-100  543.68 -  6.24  549.92 - 18.53  568.45 +  3.91 -  0.33 
S&P-500 1109.74 - 10.83 1120.57 - 36.29 1156.86 + 11.91 +  0.84 
W5000  10852.98 -115.20 10968.2 -346.24 11314.4 +141.50 + 29.34 
SOX      463.35 - 21.75  485.10 - 19.15  504.25 +  1.99 -  7.99 
RUT      570.74 - 12.10  582.84 - 16.70  599.54 + 13.98 +  5.67 
TRAN    2786.83 - 76.26 2863.09 - 29.98 2893.07 -  9.12 + 10.01 
VIX       19.15 +  0.85   18.30 +  3.82   14.48 -  0.09 -  1.47 
VXO       19.16 +  0.44   18.72 +  3.92   14.80 +  0.04 -  1.49 
VXN       25.99 +  0.69   25.30 +  3.22   22.08 -  0.79 -  1.25 
TRIN       1.93            0.44            1.40            1.26 
Put/Call   1.03            1.05            0.79            0.73 

While the talking heads were focused on the battle in Pakistan and the market analysts were talking about option expiration and S&P rebalancing the SOX quietly headed south. As if escaping under the cover of al Qaeda news the semi stocks ignored several upgrades and a strong book-to-bill report to break support at 475 and break the back of the market as well.

There were no material economic reports on Friday but I doubt it would have mattered. The market makers managed to pin the S&P at resistance before the open and once the index options were settled the ugly began. We traded flat on very low volume until 2:30 with everyone wondering which forces would control our fate. There was no material news out of Pakistan and the news we did get seemed to point to a longer resolution than everyone first thought. It could be days before the military can overcome the resistance and sort through the rubble. They were ordering up a couple more regiments to aid in the battle.

While we waited there was a battle underway in the markets with the bulls and bears trading control several times during the day. The battle fought to a draw about 1:PM and the waiting for end of day option volatility began. At a little after 2:30 Art Cashin reminded viewers on CNBC that the S&P was being rebalanced at the close and within five minutes the bottom fell out of the S&P.

The rebalancing was due to the +$3.8B in new stock being issued by GE. This increase in market cap meant index fund managers had to buy more GE and sell small amounts of the 499 other stocks in the S&P. Between Art's reminder at 2:30 and the close the S&P lost -10 points. The high/low range before that had been five points for the entire day and centered around 1120. We closed at 1110. Ironically GE fell like a rock in the last hour despite the doubling of shares traded for the day in the last hour. GE went from 19M to just over 40M in the last hour. One analyst suggested the hedge funds had accumulated shares to sell into the expected bounce while other funds were hoping for the bounce to unload shares of what has been an under performer. With funds seeing a net -$1.5B outflow of cash for the week ended on Wednesday they may have been targeting the expected rebalancing bounce to raise cash. Unfortunately the joke was on everyone it appears as far more sellers appeared than buyers. The net result was net selling on the S&P without any compensating bounce in GE.

Obviously option expiration may have had some impact in the end of day market direction but that did not prevent some serious confusion at the close. With the potential for a resolution in Pakistan over the weekend you would not have expected anyone to hold shorts over the weekend. Since we did go down and go down sharply it would suggest there was some serious sell side action where traders were simply getting out of the market. This is disturbing to the overall sentiment picture.

I kept watching the Russell all day and it was the strongest of all the indexes and held at the high end of its range. At least it held until 3:PM. About 15 min after the S&P began to implode the Russell followed suit. Whether it was the copycat syndrome where strong selling in one index begets selling in others OR small cap bears combined with options expiration triggered stops. Small cap mutual funds saw outflows of -$1B in the week ended Wednesday.

What we should have been watching more closely was the SOX. The index gapped down on a strong book-to-bill number. That should have been a clue. The 1.14 number was lower than the prior number of 1.19 but only because shipments grew much faster than orders. Orders grew +6.5% for the month and shipments +11%. No weakness there and orders have been accelerating since June-2003. In fact orders are at a three year high. It did not seem to matter to the semi sellers. The drop was blamed on weak comments from Taiwan Semi, the worlds largest contract foundry. The chairman of TSM said he expects spending on new plants and equipment to fall by as much as 50% next year. He expects new plants being built in China to lead to over-capacity. He also said he expected global semi growth to slow to 10% in 2005 from 26% in 2004. TSM just doubled its capex budget to $2 billion last October and the announcement they were cutting it back to $1B was a shock to analysts. It also did not help to have an assassination attempt on the president and vice president of Taiwan on Friday.

Obviously the news was a shock to traders as well. The SOX tried to rise around lunch time as dip buyers bought support at 473 once again but the rebound attempt was weak. A climax spike to 479 at 11:40 was the peak and the downhill slide began immediately and accelerated into the close. The SOX ended up losing -17, -3.6% for the day. The worst of the damage was the failure at support. For the last eight days the SOX has held at the 473-475 level despite some serious selling in techs. This was the line in the sand launch point for any potential April earnings run. There will be no earnings run if the SOX does not participate and after Friday's action I now have serious doubts.

If we back up and look at the market from a broader perspective we can watch the current weakness as it unfolds. Using the Dow as a starting point we had a very nice run that began last year. The spurt into January pushed the index to 10705 on Jan-26th and we spent the next six weeks trying to break that high. Once it became apparent the rally was tired everyone started expecting a profit taking correction. We have seen that over the last two weeks. The bad news is the lack of the expected rebound. The difference between a profit taking correction of -5% to -10% and the beginning of a trend change is the lack of a rebound. We are at the point where that rebound must occur or we are going to retest the corrections lows and I am not optimistic that retest will hold.

Where we would normally be seeing some bargain hunting in various stocks after a week at the market lows there is little buying interest. Intel for instance closed at $26.50 and a seven month low. MSFT closed at $24.63 and a ten-month low. The damage is not limited to techs. PFE, the second largest company by market cap, closed at 33.95 and a four month low. Others at or near multi month lows include Dow components HPQ, MRK, UTX, GM and JNJ. About the only stocks holding the high ground are the materials stocks and the home builders.

The dip that looked like a normal correction at first is starting to look like just a consolidation pause before another dip. Obviously we will not know that until we actually break support at 10000/1900 but the outlook based on the indexes is far from positive.

But what about the economy? Isn't it growing? Yes, from all accounts it is actually picking up speed. Commodity prices are continuing to spike with a price curve that looks like the Nasdaq during the Internet bubble. All the manufacturers are scrambling for raw materials with things like copper and steel seeing shortages in many areas. This is due to the global expansion not just the U.S. economy. Earnings are continuing to climb with First Call quoting 15.9% as of Friday for Q1 earnings. It was estimated at 13.4% at the end of January. Warnings have been almost nonexistent. Productivity is still climbing, interest rates are very low and the goldilocks economy appears to be returning.

Unfortunately where you and I think this should be a good reason for stocks to be moving up instead of down there is ample evidence that economic prosperity does not necessarily translate into a strong stock market. Normally, yes but as I have explained many times in the past, the market is always looking 6-9 months into the future. Over the last couple weeks I have discussed the potential for weakness after the April earnings cycle due to the election and the potential for negative expectations. I have mentioned numerous times that earnings comparisons after the April cycle will become much more difficult given the slow economic growth. None of this is news to anyone.

What I think helped change the picture was the Madrid bombing. Those that were planning on selling in May and going away have accelerated their timetable with the al Qaeda threat returning. Also, changing the outlook was the sudden emergence of John Kerry as a possible winner. Suddenly the administrative and economic picture became more cloudy. Tax cuts are no longer guaranteed and a more restrictive period may be ahead. Oil prices are continuing to rise and closed over $38 on Friday. The $40 level has been the top for 20 years. The last two times it touched that level were before the 1991 Desert Storm and again just before the Iraq war last spring. Already economists are starting to warn that oil prices are going to impact profits as well as consumer spending. A break over $40 could have a very serious impact. Enough of this negativity. You and I may not want to consider it but we do need to look at the worst case in the markets.

The best case would be a retest of the lows and a drop all the way to 10000/1900 just to get it over with then a rebound into April earnings. I do not see any potential for moving back to the highs but we could see a significant rebound from our present levels. This bullish case is built on and depends on no material earnings warnings over the next couple weeks, no new terrorist attacks and positive cash flow into funds. It makes no difference what you and I think about economic and market direction if funds continue to suffer negative cash flow. That is the true voting booth for the stock prices.

The bearish case assumes there is more wrong with the market picture than what we see on the surface. The parade of analysts on stock TV are pounding the table to buy the dip and investors are taking money out of the market. Do you see something wrong with this picture? I know from experience that trying to out think the market is an exercise in futility. Once you get a couple turns correctly and start believing you know what is going to happen the market does the opposite. That means we always have to have an alternate plan and that plan is to trade the trend. That trend may have changed on Friday with the collapse of the SOX. I still want to hold on to my hope for one more rebound into April but I am not going to bet money on it until it happens.

I want you to do something for me. Don't think about Donald Trump's hair.

I told you not to do it but I bet an image of the world famous comb over just jumped into your consciousness. I did that to prove a point. Now look at the charts below without any bias. I have removed the names and prices to help. The black line is the 100 dma. What do you see? Which charts would you buy? Remember, no bias.

Chart 1

Chart 2

Chart 3

Chart 4

Chart 5

Chart 6

Chart 7

If all those charts represented the health of the market would you give it a passing grade? Would your bias be positive or negative? Obviously by shortening the time frame I have taken away all the long term bias that most charts would give the casual investor. I admit I am very easily swayed by past events and past trends. We all are. We tend to unconsciously subscribe to the theory that a "body in motion tends to remain in motion" and looking at the markets over the past year they have definitely been in upward motion. Part of our bias comes from expecting things to continue doing what they have been doing.

If you had to make an investment decision on Monday on those charts above would it be to buy, sell or remain on the sidelines?

The first chart is easy because it is a three-month chart of the Nasdaq. Would you buy that chart? I would probably pass. Most people if asked on the street would probably say the Nasdaq has been in a bullish uptrend. Has it? You might be surprised to know that the Nasdaq has only had one up week out of the last nine and only three up weeks this year. Uptrend? Yes, from March to January, not from January through March.

The Nasdaq closed down -22 points at 1940 and seems a sure bet to test 1900 next week. Fortunately for the Nasdaq the 200dma is rapidly approaching that same level and techs are normally bought at that level. The NDX closed below 1400 on Friday and the QQQ traded three times its normal volume in the last hour. I look for both to test their 200dma as well.

Nasdaq Chart - Daily

NDX Chart - Daily

The second chart is the SOX. The SOX peaked at 560 and the high of the year on January-12th. There has been literally dozens of semi upgrades since then and all to no avail. I shortened the timeframe on the chart to illustrate a point. If you expand the time frame you can always find a critical point to support your trend in motion stays in motion theory. But if you look at the shorter term trend the outlook is much different. Using the longer term chart below and the support break on Friday I would say our risk is to a much lower level. KLAC is the largest weighted stock in the SOX at 10% and it broke major support and fell -2.50 on Friday. It is trading at a five month low and well above its next support level. We could easily see another -$5 drop in KLAC. AMAT also broke support and looks very weak. The SOX closed exactly on the 200dma.

SOX Chart - Daily

KLAC Chart - Daily

AMAT Chart

Chart three was the Dow and by itself may not suggest a strong negative bias but a definite change in trend. The trend that changed was the consolidation trend. The Dow peak was on Feb-11th with successive lower highs into the middle of March. There was a climax high on Feb-19th where a higher high was reached but it quickly retraced to a lower low the next day. Everyone continued to pin their hopes on a recovery to higher highs on the fact that we were not making lower lows. We were simply trading in a consolidation range with 10400 on the bottom and as long as that range held we bought the dips and sold the tops with the expectation that a higher move was coming once all the excess was worked off. The justification for that thought process was the uptrending support line from December. Once that support broke the alarms went off and support at 10400 became the critical level to watch. Now that all pretenses of support including the 100dma have been broken there is no real support below us until we hit the 9600-9800 level. 10000 is round number psychological support but there is no recent technical basis.

Chart four was Intel. If Intel is the proxy for the semi sector and techs in general then what does the chart below suggest will happen. The congestion support at $27-29 barely slowed its decent and the next likely target is $24. Intel has broken all reasonable support and is accelerating to the downside. Do not expect the Nasdaq to recover until Intel finds a bottom.

Intel Chart - Daily

Chart five was GE and as the proxy for manufacturing, the economy and the market it is not painting a positive picture. It is fighting to stay above $30 but after closing below the 200dma and the unexpected drop on the S&P rebalancing it does not look promising. The next real support for GE is $28 and I would be surprised if we saw any institution buying before that level. Once a stock breaks the 200dma it loses a lot of institutional support. That is normally a sell signal for funds. This could have added to the volume at the close on Friday.

GE Chart - Daily

Chart six was the S&P-500 and this is the only real chart that suggests we may still have a chance at a rebound. The uptrend support and the 100dma are just over 1100 and that round number support is critical for this market. The S&P is a much broader indicator of market health than the Dow and tech stocks make up 27% of the index.

I have explained in recent articles that the market top coincided exactly with the 50% retracement of the S&P from the market top in 2000 to the market low in 2002. If the uptrend support does break the next logical support level is the 38% retracement at 1067 followed by much stronger support at 1000. Extrapolating an S&P drop to 1000 projects a much lower Dow and Nasdaq and I am not trying to make any case for that today. I am only exploring the worst case support levels.

S&P-500 Chart - Daily

Chart seven was the Russell. I have been a fan of the Russell for some time and it has influenced my bullish bias considerably. Unfortunately the Russell is struggling. The uptrend support has been broken and it is barely above the 100dma. At this point I think we are looking at a clear double top and that average is about to break. The Russell has rebounded +85% in the last year and came very close to matching its all time closing high from 2000. It is the only index to come even close to recovering all of its losses. The risk now is that funds with huge gains from this rebound will see the break of the 100dma as confirmation that the rally is over and begin closing positions at a faster rate. You can see the battle being waged between the average and the uptrend support where we have seen seven days of long candles. If support eventually fails then we could be faced with a standard retracement of the gains. A -38% retracement would be almost exactly 500. Obviously a -70 point drop in the Russell would be a major hit and would be very ugly.

Russell Chart - Daily

I did not go through this exercise just to say that the market is going lower. I only wanted to demonstrate that the trend had changed and despite positive economics and earnings we could easily go lower. We need to consider both directions when we are researching a potential position.

The optimist view of the charts above would be looking for a rebound from 10000/1900 with the S&P holding 1100. The drop at the close left the S&P at 1109, the Dow at 10186 and the Nasdaq at 1940. Obviously the numbers do not match. The S&P normally drops one point for every ten Dow points. That is a rough average but close. The Nasdaq equivalent is about three points. The S&P is the most widely used index for measuring the market and is seen as the benchmark. Using the SPX at 1109 this suggests a drop to 1100 would put the Dow around 10100 and the Nasdaq at 1910. That would be a new low for the Nasdaq by -17 points but would put the Dow right on 10100 and its support lows from this week. The term support for Dow 10000-10100 is used loosely. There is no real technical support at those levels, only emotional. A -25% retracement of the March bottom to Feb top would be 9919 and 9867 from the Oct 2002 bottom to top.

If I had to watch only one thing next week I would watch these levels. SPX 1100, Dow 10100 and Nasdaq 1900. If there is any chance for an earnings rebound into April those levels must hold because a support break there would cause too much technical damage. (As if we have not seen enough already)

Nobody knows what really caused the market drop at Friday's close. Expiration, rebalancing, profit taking or fear of weekend news events. Nobody knows what will happen at the open on Monday. Did they find Osama or his lieutenant? Did we trip some magic buy level at the close? I personally would like to believe the market will rebound at last ditch support but we have had a lot of those levels broken day after day recently. Keene and Keith, both Elliott Wave followers in the Futures Monitor, are expecting one more wave up to SPX 1138, Dow 10400. I would like to believe that but the semiconductor implosion on Friday bothers me. I have been telling you to watch for a break of 475 as the confirmation for a trend change and Friday's 463 close sure does qualify. However, if you are grabbing at straws today that is also exactly the 200dma for the SOX. Tech stocks have a strange way of rebounding at those levels but I would not be placing bets on this one. All eyes will be on the SOX on Monday and a break of the 200dma could seal our fate.

I am sure I have totally confused everyone with my various scenarios but the bottom line is we are at a crossroad. If we break those support levels (1100/10100/1400) there will be no bulls left in the corral. Actually there were no bids on Friday so maybe they already left. Despite all the option expiration and S&P rebalancing volume we only managed to trade 3.6B shares across all markets. Very paltry. Down volume was 3.5:1 over up volume. There are no economic reports on Monday or Tuesday so nothing to stir up the markets. Choose your direction carefully next week and follow the trend. Sounds like a corny cliché but betting against could be expensive.

Enter Very Passively, Exit Very Aggressively!

Jim Brown

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