Option Investor
Market Wrap

Triple Ugly

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        WE 4-30         WE 4-23         WE 4-16         WE 4-09 
DOW    10225.57 -247.27 10472.9 + 20.87 10451.9 +  9.94 - 28.56 
Nasdaq  1920.15 -129.62 2049.77 + 54.03 1995.74 - 57.12 -  4.31 
S&P-100  540.88 - 15.92  556.80 +  1.86  554.94 -  1.18 -  1.98 
S&P-500 1107.30 - 33.30 1140.60 +  6.03 1134.57 -  4.76 -  2.48 
W5000  10793.66 -356.76 11150.4 + 72.34 11078.1 - 87.98 - 36.36 
SOX      443.48 - 44.50  487.98 +  7.84  480.14 - 31.64 -  2.08 
RUT      559.80 - 30.91  590.71 +  7.34  583.37 - 14.51 -  5.57 
TRAN    2886.44 -115.27 3001.71 + 62.24 2939.47 + 12.59 - 39.78 

For the third consecutive day the markets sold off on heavy volume and serious technical damage has been done. There was only a minor attempt to rally the big caps but the direction of tech stocks was never in doubt. Small caps were also weak and came within two points of a four month low. Big caps, techs and small caps all closed at the lows of the day after three days of selling. Definitely a triple ugly day.

Dow Chart - Daily

Nasdaq Chart - Daily

Economically the results were decent but nobody seemed to care. The report parade began with Personal Income, which rose +0.4% in March and slightly higher than expected. Considering all the complaining about lack of leverage by employees this headline number was a little surprising. However, the wages component only rose +0.2% and it was the slowest growth of the year. The higher growth came from proprietors' income and from supplements to wages. The kicker was the inflation rate at +0.3%. This translates to a REAL income and spending rate of only +0.1% and the lowest growth rate since last fall. Headlines can be very deceiving and they don't always tell the entire story.

The final Michigan Consumer Sentiment for April at 94.2 was up from the preliminary number of 93.2 but still lower than the March 95.8. Both Present Conditions and Expectations fell for the month. In reality the index has been roughly flat for the last three months since the 103.8 posted in January. Consumers are not changing their views along with the current recovery. That suggests there is little real confidence of its progress but consumers are waiting patiently.

The New York NAPM just continues to move forward as economic conditions in the city improve. The index surged over +10 points to 282.2 for April and all major components jumped sharply. The +3.8% gain was very strong and shows the rebound from the 9/11 disaster is well under way. This is not a true reflection of the rest of the U.S. since the economic damage to NYC was enormous but it is encouraging to see the improvement.

A broader representation of the current business environment came from the Chicago PMI rising well above estimates of 60.0 to 63.9 in April. This is a three month high and suggests the March lull finally found some traction. March saw a drop to 57.6 from 63.6 in Feb and analysts worried this was the beginning of a down trend. With the return to the 63+ level there was broad relief from the analyst community. Inventory, production and new orders all jumped nearly +5 points and posted strong gains. The component with the least gains was employment at only +1.7. The prices paid component rose to the highest reading since 1995 at 76.1 and it was also the highest component in the index. Supplier deliveries hit a 16-year high at 69.7 indicating that delays are very common and prices paid should continue to rise. I am sure Greenspan is watching this clear sign of inflation.

The NY-NAPM and the PMI along with other manufacturing surveys published recently are continuing to show growth although somewhat limited in some areas. Strong reports like the PMI are pumping up expectations for the ISM on Monday. It should be strongly positive and well over the 63.0 consensus. Where have we heard this recently? GDP maybe? The pre-release hype builds expectations to levels that may not be met leading to market letdowns. With that said, the ISM has been flat in the 62.5 range since November and with consensus only 63.0 I am with the group in thinking we are in for an upside surprise. We have seen a plateau in this index after last years growth and resistance appears to be 63.0. A major break, say to 65, would be very unlikely but 64 may be in the cards.

The challenge here is the Fed. If we had a real breakout it would drastically increase the chances of a negative Fed event. That puts us back to wanting the porridge to be just right and not too hot or cold. The current best guess for the Fed meeting is for only a change in the Fed statement to a bias that leans toward rate hikes. The only question today is how strong that bias statement will be. It will be examined for hints of how long the Fed will be in a tightening bias and how high the rates might get. Obviously they will not explain it in English but the tea leave readers will be dissecting every word. While there are no hikes expected for May or June the Fed funds futures are now projecting a hike in Aug, Sept and Nov with the funds rate being 1.75% in November. That would be a strong series of hikes in an election year.

The key point beginning to pop up in most reports is rising inflation. The PMI showed prices paid at a nine year high. The NY-NAPM Regional Price Index component jumped +9 points to 71 and well over the multiple consecutive 50s at the end of 2003 and early 2004. Prices for gross domestic purchases in the GDP rose +3.2% compared to only +1.4% in the same period last year. We are reaching the point where the Fed will have to fight inflation regardless of the speed of economic growth. That is the under current analysts will be looking for in the Fed statement.

The growing problem for the markets is not necessarily the Fed but the lack of aggressive guidance as I have mentioned before. With earnings suddenly taking a turn for the worse the markets are not seeing buyers coming in at the dips. For instance in just the last two days we have had outright earnings misses or guidance downgrades from GTW, FDRY, BOBJ, APCC, SPW, IM and WIN just to name a few. There have been numerous tech stocks with less than expected guidance and the Nasdaq has suffered for it.

If you doubt the tech flight has begun you only need to look at SLAB, FFIV, CSCO, NVDA, GNSS, YHOO, ABTL, KLAC, AMAT, etc. Even IBM has dropped to six-month lows. Hardware, software and Internet stocks are moving to multi-month lows. Even the biotech sector, which has seen numerous rockets lately is down -8% for the week. This is pure PE compression from the lack of aggressive guidance and profit taking from the 2003 gains. Expectations at this point are in the tank.

Technically the markets are in trouble. I mentioned Thursday that the bottom of the range was 10250/1975 and the Nasdaq had already broken that level. The Dow had broken but then recovered. Friday the Dow joined the Nasdaq with a new low for the month and a close at 10225. This is well below all the short term averages but still well above the 200dma and well above the 10007 low from March. It is ugly but it is still not a disaster.

The disaster for the week was the Nasdaq, which closed at 1925 and -134 points below the high for the week. Even more critical for the Nasdaq was a break of the 200dma at 1933. The 200dma is historically a rebound point for serious tech corrections and while the Nasdaq did bounce on the first touch it failed again at the close. This is the first time the Nasdaq has closed under the 200dma since March-2003. This is a critical failure if it holds. I say "holds" since it happened late on a Friday in front of weekend event risk. Also, the entire three days of selling could have been the result of some asset allocation program before month end. If buyers show up at the open on Monday and push us back over the 1933 level, only +13 points away, then the tech cat has at least one life left. If the selling continues at the open then we are in serious trouble. The 200dma is considered to be a fairly common institutional sell signal, a stop loss for funds. Because it is an index it is not going to be a wide spread dump signal but more of a warning. Funds will sell individual stocks that break the 200 but not all stocks just because the Nasdaq broke. It functions more as a warning to take profits than a general sell signal. Also, they will not just dump a stock but will begin reducing positions. The only material support level remaining for the Nasdaq is 1900, which held in March. The 200dma was 1890 at the time.

There was some discussion in the Market Monitor on Friday about whether the 200sma (simple) or 200ema (exponential) was the correct average for determining true support. While the most common analysis involves the 200sma at 1933 there is ample reason to suggest the 200ema may be more relative to the Nasdaq itself. The following chart shows both the averages and the differences over the last year. The 200ema is currently 1913 and a negative open on Monday could make the entire conversation mute.

Nasdaq Chart - Daily with 200 sma/ema

The major problem for the Nasdaq is still the SOX and that index broke to another new six month low on Friday. There was an attempt to rally back over 450 at the open but it quickly failed and moved back down to close near the lows. The SOX is well below all the averages but is approaching decent support at 420. That could be the resting point that provides support for the Nasdaq next week. Many of the chip stocks are extremely oversold and are due for a bargain hunting bounce soon.

SOX Chart - Daily

Russell-2000 Chart - Daily

Also providing risk for the Nasdaq is the Russell, which set a new low for the month and came within two points of setting a new yearly low. The small cap stocks have been taking the brunt of the pressure from declining guidance. They do not have the resources or the breadth of business lines that would allow one product line to pickup the slack in sales for another. Many small cap companies are single focus and a slowing of growth in their target market means a slowing of growth for the entire company. The current weakness in small caps is a concern for mutual funds. Many funds concentrate on small caps for high growth prospects and a drop in the Russell means those funds are either selling stock or seeing their investments sink rapidly. The Russell should find support at the 200dma just over 540.

Nasdaq-100 Index Chart - Daily

If the Nasdaq has any single hope of rebounding at the open on Monday the NDX is it. The sell off on Friday closed at exactly 1400 with the 200ema at 1395. This is strong support and we are significantly oversold on the NDX. The QQQ, which is based on the NDX, fell nearly -2.50 from the weeks high to close at $34.80. This -7% drop for the week has been nearly vertical and has shown no letup. It is time for a bounce if for no other reason but to relieve the oversold conditions. The 200ema should be support at 34.69. Putting together the stop at NDX/QQQ support right at the close and the COMPX 200 ema at 1913 I would be really surprised to see a significant drop at the open on Monday. If we did have a strong Monday morning drop it would suggest much more serious problems.

I have mentioned earnings several times and as of Friday about 80% of companies have reported. The other 20% will drag out over the next four weeks. Regardless of the earnings and guidance for those stragglers there is nothing on the earnings horizon to provide an upside catalyst. For all practical purposes earnings are over.

The catalyst for next week is clearly the Fed and the economic reports. We have the ISM on Monday, Factory Orders and FOMC meeting on Tuesday, Productivity on Thursday and the Jobs report on Friday. What the Fed does on Tuesday could make the rest of the week's reports insignificant. The two key reports are ISM and Jobs. The Jobs data is routinely given to the Fed in advance of the release. Whether it is ready on Tuesday for their discussion is unknown. The Jobs are really the only wild card for a rate hike. The ISM is not likely to be strong enough to offset the GDP depression and will not be a material factor unless it is a blowout. The Jobs report is the key. The Fed has been know to use jobs as a rate hike trigger in the past. Another blowout could push the Fed to react. Should the Fed offer a tame bias statement then I would suspect the jobs report will also be tame. Should the Fed issue a harsh statement then I would expect the jobs to be strong.

I have heard very little commentary about the expectations for Friday and the consensus is for only a gain of +185,000. Considering last month produced +308,000 new jobs this is a material drop. If you remember the consensus for last month was only +100,000. Obviously we have a lot of contradictions. Higher estimate but much lower than previous gains. This suggests there is some fear that the month was a blip in the process and not a real sustainable gain. I have heard several analysts suggest anything over +100K this month would be a relief and that worries me. It means they can see the potential for a drop back under 100K and that the jobs growth has not really started. I have heard nobody suggest that the number will be higher than the 185K consensus. No outrageous whisper numbers, no bragging, nothing. This may be good. It means there is some fear of failure and a decent number could actually produce a surprise. We just do not want it to be too strong or the Fed could react quickly. In the past they have been known to act on the following Monday to raise rates. That potential should keep the lid on any post Jobs blowout rally.

Trading next week could be crazy. Whenever there is a major move in the markets that is potentially a trend change the trading activity increases. Those expecting a bounce rush in (at least we hope they rush in) and those expecting a continuation of the drop look for bounces to sell. It can produce some very volatile conditions. The calming force should actually be the Fed meeting and that would be a change. With no rate hike anticipated traders could be anticipating a post Fed relief rally. If this is the case then Monday at the open would be the likely place for it to start. The NDX support at 1400 is my guess for a trigger. If we do get a bounce on Monday it probably will not be very strong due to lingering doubt about rates. I would view it more as positioning for a post Fed move. Volume should be lighter as long as we move higher. Picking direction after the Fed meeting is best left to those psychics with a crystal ball.

Holidays overseas will close the London market on Monday and the Japan markets for three days starting with Monday. Since the Nikkei had fallen for three straight days this could also take some pressure off the U.S. markets. Personally I will be going long in the Monitor on any strength at the open. I will be using NDX 1400 as my guide. Long over 1400, short under 1395. The Dow tried to rally all day Friday and the Nasdaq kept dragging it down. The -6% drop in the Nasdaq for the week was three times larger than the -2% drop in the Dow. That makes the Nasdaq/NDX the key for me on Monday. One word of caution, if you do get long don't get married to your positions. Any rally has plenty going against it for the long term. Until we determine the new range and direction your stops could be your best friend. While I can see the potential for a rebound from 1400 on Monday there is always the chance that 1400 was the last elevator stop before the express ride begins. If we do move lower do not fight it. Should that support fail it could be a long drop.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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