Option Investor
Market Wrap

Escaped With A Minor Loss

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        WE 5-14         WE 5-07         WE 4-30         WE 4-23 
DOW    10012.87 -104.47 10117.3 -108.23 10225.6 -247.27 + 20.87 
Nasdaq  1904.25 - 13.71 1917.96 -  2.19 1920.15 -129.62 + 54.03 
S&P-100  535.47 -  1.88  537.35 -  3.53  540.88 - 15.92 +  1.86 
S&P-500 1095.66 -  3.03 1098.69 -  8.61 1107.30 - 33.30 +  6.03 
W5000  10634.71 - 51.33 10686.0 -107.62 10793.7 -356.76 + 72.34 
SOX      450.99 -  6.02  457.01 + 13.52  443.48 - 44.50 +  7.84 
RUT      543.76 -  4.80  548.56 - 11.24  559.80 - 30.91 +  7.34 
TRAN    2848.89 +  2.71 2846.18 - 40.26 2886.44 -115.27 + 62.24 

After a very rocky week traders escaped with only a minor loss across all the indexes. The Dow was the most negative at -104 for the week and mostly on the back of losses in CAT, IBM, MRK, C and JPM. The Nasdaq only finished with a -14 point drop despite some high profile losses in individual stocks. As the time ran out on the clock at Friday's close the bulls mounted a solid goal line stand to prevent the Dow and Nasdaq both from dropping under the critical 10000/1900 levels.

Dow Chart - Daily

Nasdaq Chart - Daily

After dropping to new lows for the year on Wednesday the Dow has managed to trade sideways for two days at the 10000 level. Considering the negativity from multiple events this was a minor miracle. Unlike Thursday the economics on Friday were great. The Consumer Price Index led the list with a minimal +0.2% jump in the headline number and slightly below the +0.3% consensus. The core rate only rose +0.3% and is now only +1.8% for the year. No soaring inflation in sight for consumers according to this report. Both numbers were actually less than they were in March. If you dig into the internals it does show that core inflation although moderate is growing an annualized rate of +3.3% over the last three months. We are far from home free. Most analysts do not expect this rate to continue but to lessen over the summer. This slight bump in the core rate is what lessened the Fed's fears of "unwelcome fall in inflation" or what the rest of us would call deflation. To be free of the "D" monster the Fed would be perfectly happy with a hint of moderately higher inflation ahead.

The Fed has been trying to fan the inflationary fire under conditions similar to midnight in the cold north woods. With only one match left they are very relieved to see a warming flame begin to develop from the smoldering economic embers. The alternative was a cold winter night and frost on their sleeping bags and bears closing in on all sides.

There was one small point of contention. The CPI actually showed that energy prices slowed to only a +0.1% gain in April. Anybody at least room temperature and breathing should doubt this statistic based on the price of oil and soaring gasoline prices. Expect an unwelcome upward revision in May.

Also bullish was a +0.7% jump in Business Inventories and well over consensus of only +0.5%. This was a March number and February was revised up to +0.8%. The governments last estimates for inventory buildup were very low and this hot number should spike the GDP on the next revision. Business Sales also shot up +2.9% prompting the inventory to sales ratio to fall to a record low at 1.30. The +2.9% jump was the largest single month gain in the 12 year history of the report. Manufacturing shipments rose +3.8%. Considering this is a March number and the 1.3 inventory to sales ratio means there was only 1.3 months of inventory on hand I think we are going to see a real blowout in April. We all know April was a stronger month than March and those inventories have got to be much lower today. This ties into the next paragraph on Industrial Production and the rise in capacity utilization. The race is on.

Industrial Production jumped a huge +0.8% and well over the consensus at +0.3%. Capacity Utilization also rose +0.3% and is at the highest level in over a year at 76.9%. Several analysts believe this is artificially low and is a result of the Fed's failure to remove "dead" capacity from their figures. The ISM capacity utilization numbers are nearer 85% and this is more in line with current production growth. However you look at it the number was strong and climbing.

The negative news for the day was the Consumer Sentiment at 94.2 and unchanged from last month. Consensus was slightly higher but the higher cost of gasoline appears to be an offset to the new jobs. Also, the falling stock market over the last two weeks and prisoner scandal in Iraq have combined to depress expectations. The expectations component posted its second consecutive monthly drop and is now at 85.8 suggesting consumers are becoming more depressed as the summer doldrums near. Consumers have held in the 94.5 range for the last six months except for an unexplained spike in January to nearly 104. There is no explanation for that event and we have seen nothing similar since. It remains to be seen if the pace of job creation can overcome $50 oil and $3 gasoline.

$50 oil? Yes, that is the growing forecast. Demand continues to grow faster than supply. Oil traded at a 20-year high on Friday at $41.60 and closed at $41.40. This is the highest level we have seen since the Iran hostage crisis in 1979 that sent oil to an inflation adjusted price of $78. OPEC is meeting on May-22/24th to discuss boosting quotas and Saudi Arabia called on OPEC to raise output by 1.5M barrels per day. Don't hold your breath. I still believe the OPEC countries around Iraq are mad at us for the war and are extracting their pound of flesh in retaliation. Remember I also mentioned last week that oil tankers are booked solid for months to come and there is no additional shipping capacity available. The manager of the Russian pipeline system said output from Russia was at max capacity. This eliminated hope that Russia could fill the shortfall. A survey also announced on Friday said that oil consumption in some sections of China would increase 600% over the next year. Currently $44 is almost a given and $50 is the current whisper number target. With unleaded now over $2.40 in many places $50 oil could spike that price to $3.00 or more very quickly. How would that impact consumer sentiment?

After the close on Friday Oracle reduced its bid for PSFT to $21 from $26 to reflect "current market conditions". Since the tech decline began ORCL has dropped from $15 to $11.50 and PSFT dropped to $17 from $24. If ORCL could not buy it for $26 I doubt they will be successful at $21. I am sure they were beginning to have a lot of stockholders reconsider their offer of $26 with the stock nearing 52-week lows but that is ancient history now.

Dell traded down to $34.50 and barely saw any rebound after posting earnings that disappointed quite a few traders. This was just a drop in the bucket compared to the crash in ADIC which fell to $7.50 from its $10 close on weaker than expected earnings. BEAS got hit for a -22% loss from $10.80 to $8.34 after saying sales declined. This was the backdrop on Friday that saw the Nasdaq hold over 1900 despite a -22 point drop. There is no joy in tech land and the current three-week decline is showing no signs of letting up.

The Dow has failed to rally from the massive sell off over the last three weeks and could not get out of its trading range all week. The negativity is very strong but there is a chance that by holding the line we could be getting ready to attempt a rebound. I know this would be a stretch for most to comprehend given the heavy selling but don't count it out.

Wednesday was very negative and volume was high. Almost 2B shares of the volume came in the last hour when the S&P bounced off the 200dma in what is being called the Barton Biggs Bounce. That bounce found no follow through but sellers have not been able to put in a repeat performance. Volume for Thr/Fri was very low with barely 3.5B shares traded and the A/D ratios were almost even. Overall internals were much closer than the indexes would lead you to believe. Only the Nasdaq internals were significantly worse with declining volume 3:1 over advancing. The high profile earnings problems contributed to this imbalance. More on the rebound potential later.

Other internal problems included very large cash outflows from mutual funds. I mentioned Thursday night the numbers were somehow missing from the news reports. They appeared on Friday and now we know why. Equity funds saw $2.4 billion in outflows for the week ended on Wednesday. Junk bond funds saw outflows of $2.15 billion indicating traders were becoming much more concerned about the future and were jumping to safety now that yields are nearing 5.0%. Emerging market equity funds saw the largest fund outflows on record for any single week. Tech funds saw cash outflows for the 15th consecutive week. Considering the Wednesday drop probably triggered many investors to head for the barn on Thursday those outflows will not be tallied until next week.

There were several comments in the analyst community on Friday about hedge fund losses over the last month. Names were withheld to protect the guilty but evidently there are some hedgies in serious trouble. Seems the monster moves and whipsaw nature of the last couple months have caused some best laid plans to go astray. The momentum players have had their heads handed to them and nobody knows which way to jump. Welcome to reality.

Speaking of reality it is coming home to roost for Greenspan. His appointment as Chairman of the Fed is up on June 20th. Bush has said he would reappoint him BUT has not done it yet. With the next Fed meeting on June-30th the scuttlebutt making the rounds has the Bush administration applying pressure to Greenspan to delay the rate hikes until after the election. The economy continues to ramp up, jobs are created, income generated and everybody votes Republican. If this is the case then somebody is smoking grass clippings. I could see Bush leaning on Greenie about rates but not with a heavy hand. If Bush is really withholding the appointment to apply pressure it is more likely to get him to shut up about the deficit and the looming Baby Boomer Social Security crash. Greenspan has been taking shots at the administration for the last couple of months as if he and Bush have their own cold war brewing. Either way the countdown is on and after 14 years at the helm their may only be 35 days left in Greenspan's tenure.

Ten-year Yields

Banking Index - Daily

When trying to generate a potential scenario for a market rebound it must include financials and they are not leading the pack. Bonds sold off at the open on Friday with ten-year yields hitting 4.90% but then rallied on the tame CPI news. Financials failed to gain any ground and until the Fed begins its rate hike process there will be a cloud over the sector.

SOX Chart - Daily

Another cloud continues to be the Semiconductor sector and the midweek rebound to 470 has been completely erased. The SOX is threatening to break the May support at 440 and test support from last September at 420. The Nasdaq cannot rebound without the SOX.

Russell-2000 Chart - Daily

Behind the SOX the Russell was the next weakest supporter of the Nasdaq on Friday. The index dropped back to close right on its 200ema and very close to a significant drop. Small caps continue to be weak and the record withdrawals from emerging markets last week were a signal to me that the Russell is likely seeing the same fund weakness. If you follow the pattern on the chart above from the last touch of 600 you will see large drops followed by several days of consolidation and then a repeat of the process. This is a "b" pattern selling cycle. The Russell could be about ready to take the next dump to 520 to begin the next "b".

I started this conversation thread with the potential for a coming rebound. Unfortunately the evidence is very thin and not something on which I would bet the farm. Here is my case. This is option expiration week. Open interest is very high, much higher than normal and most of the indexes are underwater. The MaxPain numbers for the DJX/DIA are 103, NDX 1425, SPX 1125 and QQQ 36. This suggests there could be some upward pressure on Monday as traders attempt to square positions and market makers try to maneuver the indexes higher to expire more options worthless.

There are no material economic reports early in the week and nothing significant in the earnings arena until Tuesday. The Nikkei stopped its slide on Friday with a minimal gain but a gain never the less. The Dow closed at 10000 support. The Nasdaq at 1900 support and the NDX at 1400 support. It was a fight but they all held their ground at the close in front of weekend event risk. The SPX has not sold off since testing its 200dma on Wednesday and has been holding 1095, right where it closed. All of this is circumstantial evidence as the say but it is the only evidence we have. They tried to sell them both Thursday and Friday and were unsuccessful. As a betting man I am betting we "could" see an options related rebound on Monday morning assuming there are no "events" over the weekend.

If we do see a rebound I expect it to only be a trading rally and we continue to see weakness once positions are squared. The Dow has resistance at 10200 and strong resistance at 10300. I would be very surprised to see those touched. The Nasdaq is the weak link and has strong resistance at 1930, 1950 and 1960. Corresponding resistance for the SPX is 1110 and 1120. Any expiration rally should slow considerably at those levels. I continue to advise selling any rally until the pattern changes.

I still believe we have some serious risk in front of us with rates, Iraq, elections, Olympics, oil prices, China and declining earnings growth. Now we have the Greenspan time bomb ticking down in our future. Whatever you think about Greenspan the markets will definitely be volatile around any change in the Fed chairmanship. Views of any new appointee will be immediately scrutinized and reacted to accordingly. At least the countdown will reduce the impact of a sudden change from a health issue. The Fed replacements will be cussed and discussed in the media until Greenspan's fate is finally known. Our fate next week should be known very quickly. We will either rebound out of the gate on Monday or sink beneath current levels to our next support plateau. Choose your direction carefully.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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