Option Investor
Market Wrap

Stronger Than Expected

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        WE 5-07         WE 4-30         WE 4-23         WE 4-16 
DOW    10117.34 -108.23 10225.6 -247.27 10472.9 + 20.87 +  9.94 
Nasdaq  1917.96 -  2.19 1920.15 -129.62 2049.77 + 54.03 - 57.12 
S&P-100  537.35 -  3.53  540.88 - 15.92  556.80 +  1.86 -  1.18 
S&P-500 1098.69 -  8.61 1107.30 - 33.30 1140.60 +  6.03 -  4.76 
W5000  10686.04 -107.62 10793.7 -356.76 11150.4 + 72.34 - 87.98 
SOX      457.01 + 13.52  443.48 - 44.50  487.98 +  7.84 - 31.64 
RUT      548.56 - 11.24  559.80 - 30.91  590.71 +  7.34 - 14.51 
TRAN    2846.18 - 40.26 2886.44 -115.27 3001.71 + 62.24 + 12.59 

April was a strong month for jobs according to the employment report released on Friday. The much stronger than expected numbers led to some serious volatility as traders alternately bought and sold the markets on supposed Fed fears. There is no doubt now that rates are going up soon. The only question is when?

Dow Chart - Daily 100/200

Nasdaq Chart - Daily 100/200

SPX Chart - Daly

The big news on Friday was the Jobs Report. The U.S. economy created +288,000 jobs in April which was well over the +185K expected. Not only did jobs grow in April but there were upward revisions in both February and March. February was revised from 46K to 83K and March was revised up from 308K to 337K. This was a total of +66K in upward revisions and when added to the April gains of 288K we get a monster jump of +354,000 over the prior numbers. This was the 8th consecutive month of job gains that total 1.113 million jobs.

A gain of +300,000 or more was the point many analysts thought would trigger a Fed rate hike either at the June meeting or before. +288K is very close and when you add the revisions it looks to most analysts like a rate hike soon is in the cards. JPM went on record as saying the Fed would hike +25 in June and +25 in August. Merrill duplicated those remarks with only slightly less conviction about the June hike.

The Fed funds futures are now calling for a 92% chance of a +25 point hike at the June meeting and successive hikes of +25 points at each of the Aug, Sept and Nov meetings. The Fed target is showing as 2.0% by the end of November. There is already a 76% chance of another +25 point hike in December.

There is also a chance that the Fed could hike before the June meeting. In 1994 the first rate hike after a three year layoff was on a Friday after a blowout Jobs report. With the weekend event risk I believe the Fed would wait for Monday if they had plans on doing it now. If it does not happen on Monday then June-30th should be the date.

Since the Fed did not hike rates at the recent meeting the majority of analysts feel the Fed is behind the curve and will have to accelerate their pace to catch up just like in 1994. I went back and looked at the 1994 rate hikes and it was a very strong, very fast series that investors are afraid they will repeat. This is a table of the 1994 hikes.

- Date - Day - Hike
02/04/94 Fri +0.25 surprise hike
03/22/94 Tue +0.25 FOMC meeting
04/18/94 Mon +0.25 surprise hike
05/17/94 Tue +0.50 FOMC meeting
08/16/94 Tue +0.50 FOMC meeting
11/15/94 Tue +0.75 FOMC meeting
02/01/95 Wed +0.50 FOMC meeting
Total +3.00% in 12 months to 6.00%

You can see why traders are concerned. Even if this came to pass this does not mean the market is not going higher. We are starting from a much lower level at 1.0% instead of 3.0% and the state of the economy has changed significantly in the last ten years. 1994 was pre Internet and global consumption was significantly less high tech. Here is a chart Jeff put together showing the S&P growth after the 1994 rate hikes. Note that 1994 was flat during the hikes but growth really took off when the hikes stopped even though interest rates were significantly higher.

Jeff's SPX Chart - Monthly 1993-2004

There are considerations for the gigantic ramp job and leading the list was the rush to change out computer hardware and software systems prior to Y2K. Add in the Internet revolution and the stock market bubble and you have the extreme highs in 2000. Most of that activity did not start until 1997 leaving the gains in 1995/1996 on their own and on top of a strong Fed funds rate. Economic growth does and will trump rate hikes but that growth has to have a chance to get a strong foothold before the Fed accidentally stunts its growth.

I believe the Fed has learned its lesson after the various rate hike debacles under the Greenspan leadership and will continue at a measured pace this time around. Greenspan would love to leave as a legacy a booming economy and a booming market. Both would do wonders to resolve the coming deficit crisis when the baby boomers begin to retire in 2008-2012. Massive corporate profits and large gains in the market create strong cash flow from taxes and strong consumption by retail consumers. I am expounding here because I believe that the market has already priced in the potential rate hikes and there is nothing ahead from the Fed to hold the market back. This is an excuse for selling that is being applied by analysts to compensate for their bullish views not coming true. Get over it!

I built my case on Thursday that the market malaise is not rate related. I agree it is a factor but it is not the only factor. Since Wednesday I think the market is factoring in the potential for a Kerry victory as the Bush administration goes down in flames. Revelations from multiple sources show the Iraq prisoner scandal has been known since last year. Numerous relief organizations had filed complaints and charges over the last six months. We are hearing now that there are video tapes of even worse atrocities being committed and may even include prisoner deaths. I will be the first to admit I don't have the facts and all I get is the news from the various major sources. We all know how sensational news makes better copy. I think investors are seeing the same thing and running for cover. Gail Dudak, a noted analyst from one of the big firms, said a couple weeks ago that appearance of a Kerry victory could knock -1000 points off the Dow and do it in a hurry. We know from experience that markets prosper under both democrats and republicans so it is not a party problem. The major problem is the vow to reverse the tax cuts and remove some of the business friendly initiatives that are helping this rebound. Kerry is more eco friendly than Bush and has a strong reluctance to approve defense spending to name a couple. Again, it is not a party thing but an administration change that the markets are dreading. The more the Iraq scandal takes over the headlines the more likely Kerry will win.

Another factor continues to be the jump in oil prices. Oil finally traded at $40 on Friday and closed at $39.90 with no indications that there is any relief in sight. This price gain was in spite of a serious ramp in the dollar to highs for the month. Gold also got whacked from a morning high at $391 to close at $379.30.

While I talked down the rate hike impact above I am talking about the impact from a Fed hike. The market has already priced in way more in the way of rate increases than the Fed could do in good conscience over the next twelve months. Yields on the ten-year treasury soared on Friday to 4.769% and a TWO YEAR HIGH. Considering we were at the 3.65% level in March this is a +30% jump in little more than a month. This is going to have an impact on the markets because real borrowing costs have already gone up. Any Fed hike will be anticlimactic.

Ten-year Yield Chart - Weekly

Big problems in the Dow on Friday included GM after saying that inventory levels had risen about +30% over their desired levels. Auto sales are slowing at a time consumers should be buying with their tax refunds. GM fell to a six month low. HD also fell to a six month low on fear higher mortgage rates would slow home repair projects. AA and DD both crashed on falling metals prices. Citigroup and JPM fell to four month lows on fears higher rates would shrink their margins. It was not a good day for the Dow.

The Dow lost -124 points and closed only three points off its low of 10114. Support at 10250, 10200 and 10150 failed with barely a hint of slowing. Because we rallied off the prior Friday's lows the Dow only ended down -108 for the week but it was a critical 100 points. Current support is 10100 with disaster support at 10000 which is also the 200dma. The month long downtrend closed at its lowest point and internals were very negative.

For all markets the A/D line was 5:1 in favor of decliners and volume was 4:1 in favor of declining volume. Volume was only slightly higher than Wed/Thr but did manage to break 4.0B. The new 52-week highs hit a new 12-month low at only 61 and new 52-week lows also set a new 12-month high at 897. We have gone from double-digit new lows just three weeks ago to nearly 1000 on Friday. There is no joy in Mudville tonight.

The Nasdaq was slightly less negative and tried to single handedly keep the markets from falling off the cliff. It was a valiant effort but it did close at the low of the day at 1919 and support from last week. There is no other way to look at it today. The Nasdaq has broken the 200dma at 1939 by a bunch and is on the verge of testing real disaster support at 1900. A break under 1900 would be to a new six month low and very negative for tech bulls. Remember our discussion last Sunday about the difference between the 200 sma/ema? The 200sma is 1939 as I mentioned above and it has broken again. The 200ema is 1915 and just below where the Nasdaq came to rest at the close. A rebound here would be a successful second test. A failure here could be ugly.

Helping push us lower is a complete lack of support from overseas markets. Art Cashin said on Friday the emerging markets are turning into submerging markets and he is right. The Nikkei has been down for five straight days and losing nearly -700 points. The rising dollar, rising oil and threats of slowing in China are knocking the profits out of the overseas markets. This global sentiment is not helping our direction.

Other challenges remain the slowing consumer for whatever reason and the peaking in earnings for the year. Add all these things together and the market has a lot of weight on its shoulders heading into the summer doldrums. Fund flows were negative last week for the second time since March and fund managers cannot be thrilled about that. Tax day is on the way and money is flowing out to make those payments. This additional drag is worsened by the flood of new IPOs with the heaviest schedule since 2000. $39B in new issues has been sucked out of the existing market over the last 90 days.

Trading next week could be frantic. With the markets right at or just above critical support this would typically be the right place for a relief rally. The selling over the last several days was very strong internally and we should see some relief of that pressure on Monday. Last Friday I suggested going long at the open on Monday because the NDX was resting just above 1400 support. Well the plan worked and we did rally at the open and the NDX rose to 1436 before failing. This Friday the NDX has fallen to just over 1400 once again. I am not nearly as optimistic this time around.

While I would like to think that closing the at NDX 1400, Nasdaq 1920, Dow 10100 and SPX 1100, all critical support levels, would produce a Monday rebound I can't make that recommendation today. I will be making the call in real time on the Futures Monitor Sunday night but there is too much risk to make it today. The major risk is that we are beginning that -1000 point election dive Gail Dudak predicted. We also have the risk the Fed will hike rates at the open on Monday. It is a slim chance but it does exist. Actually I wish they would as it would clear the table for the next three months and take that implied threat out of the forecast. I think the markets would rally if they did.

Russell Chart - Daily

Once past Monday morning we should see the real direction appear. Unfortunately based on the Russell as the leading market indicator the direction is still down. We may get a trading rebound when the Russell hits the 200dma at 544 but I am not counting on it. The Russell has broken to a new four month low and that is not a good sign for mutual fund health. The semiconductor sector actually closed up on Friday and was instrumental in holding the Nasdaq up for most of the day. Despite the rebound in the SOX it is still in a down trend as well. There is a lot of potential here with all the major indexes at support but there is just enough cracking of that support to weight that potential to the downside. Even if we do get a trading rally on Monday it may be very brief. There are simply no material events on the horizon to act as catalysts for a sustained move higher. For the next 90-120 days we are in a period of economic, political and geopolitical uncertainty that may not lend itself to broad gains in the market. We are no longer in a range bound market where selling tops and buying dips will work. The game plan for the future has changed to simply sell the rallies. I suggested last week to remain in short mode under 10275/1940 and that advice still stands.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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