Option Investor
Market Wrap

What A Difference A Week Makes

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        WE 5-28         WE 5-21         WE 5-14         WE 5-07 
DOW    10188.45 +221.71 9966.74 - 46.13 10012.9 -104.47 -108.23 
Nasdaq  1986.74 + 74.65 1912.09 +  7.84 1904.25 - 13.71 -  2.19 
S&P-100  545.13 + 10.80  534.33 -  1.14  535.47 -  1.88 -  3.53 
S&P-500 1120.64 + 27.08 1093.56 -  2.10 1095.66 -  3.03 -  8.61 
W5000  10926.36 +301.26 10625.1 -  9.61 10634.7 - 51.33 -107.62 
SOX      488.86 + 30.68  458.18 +  7.19  450.99 -  6.02 + 13.52 
RUT      568.28 + 22.47  545.81 +  2.05  543.76 -  4.80 - 11.24 
TRAN    2948.01 + 82.26 2861.75 + 12.86 2848.89 +  2.71 - 40.26 

I predicted last Sunday that there was a bounce building in our immediate future. I outlined the reasons I thought the selling was over and why I thought we would rally. I suggested it would slow in the SPX 1020, Dow 10200 range and that is where we stopped. Unfortunately after several weeks of declines and a rebound as predicted the future is far less clear.

Dow Chart - Weekly

Nasdaq Chart - Weekly

The economics for the week were a definite surprise. With a number of reports coming in weaker than expected the markets shrugged them off and continued higher. The bad news bulls appear to be back in charge. The weaker than expected reports continued on Friday with the Consumer Sentiment dropping to 90.2 and the lowest level since Oct 2003. Expectations were for a gain to 95.0 but analysts were quick to downplay the release. The common refrain was that sentiment was "news event" driven and did not reflect the true nature of the recovery. I will agree with them on that except that they always pound the table with delight when it is higher than expected. The increasing pessimism is coming from the Iraq prisoner scandal, rising gas prices and up until this week the falling markets. The Michigan survey is taken from 500 respondents. The preliminary number is from the first 250 respondents and the final number from the total of all 500. The swing from the preliminary release in May to the final number was about -8 points and a very large swing over the last two weeks. This correlates with the ABC News/Money Magazine poll that also dropped sharply.

Conversely the Personal Income and Spending numbers released on Friday showed income was twice the level of spending and up +4.8% year over year. Income rose +0.6% and spending only +0.3%. This was the highest increase in spending since the end of 2000. Inflation as shown by the PCE Deflator rose only +0.1% for the month pushing the core PCE to only +1.4% year over year. This is one of Greenspan's favorite indicators and is showing almost no inflation. This could allow the Fed to remain patient for an extended period of time.

The NY-NAPM rose for the ninth straight month in May but the rate of increase slowed slightly. In May the index hit 287.1 a gain of +4.9 points and a new record high. However current conditions fell to 59.7 from 70.9 and manufacturing conditions fell to 52.7 from 80.3. The quantity of purchases fell to 56 from 75. The worst drop was the six-month outlook, which fell from 85.7 to 62.5. Probably the biggest highlight that the outlook is slipping was the Production Materials Buying Policy which fell from 150 days to only 40 days of inventory. This could be seen in two ways. Either production has ramped up so strongly that managers cannot keep a longer supply on hand OR the future prospects have fallen off so sharply that managers are afraid to keep more raw materials on hand. When you consider the drop in the other components I think the latter is likely the case. It appears the New York recovery may be topping.

The strongest survey for the week was the PMI, which rose to 68.0 and a level not seen since Jan-1988. This report helped to push the weakness in many of this weeks releases to the background with a +6 point jump over expectations. The New Orders component rose to 74.4 and the highest level since 1983. To keep pace with the increasing demand the employment component rose +4 points. Where the NY report showed a slowing rate of manufacturing growth the Chicago PMI shows an exploding rate of growth. This suggests the national ISM next week could also be stronger than expected. This would help continue the bullish optimism in the markets. The only downside was the soaring prices paid component to 80 and the highest level since 1995.

On Thursday the weaker than expected GDP at 4.4% was a small disappointment but still strong. The 2Q GDP is only expected to be in the +3.5% to +4.0% range but the strong PMI and a strong ISM next week could go a long way towards raising those estimates. That ISM for May will be released at 10:00 on Tuesday. The other material reports are Factory Orders and Productivity on Thursday and Jobs on Friday. The Jobs report is the biggest hurdle with consensus estimates at +233,000, slightly less than the +288K for April.

Unless the Jobs report was over +350K the odds of the Fed reacting before the June-30th meeting are slim. Currently the odds of a quarter point rate hike at the June meeting are 92%, down from 94% last Sunday and 100% several weeks ago. This is still a virtual certainty in Fed terms but a lower than expected ISM or Jobs could decrease the odds even further.

With economics mixed but still improving where it matters and strong earnings the markets pulled a recovery out of the hat last week. The Dow rallied to resistance at 10220 and came to a dead stop on Thursday. Friday's high was just below that level at 10216 but support at 10175 was also very strong. The Nasdaq was by far the stronger index with a +120 point gain from the prior weeks lows. The Nasdaq went out Friday at its highs at 1988 and very close to the 2000 level once again. That 2000 level, actually 2000-2025, is very strong resistance and coupled with that 10200-10300 resistance level on the Dow could easily limit upward movement next week. The SPX came to a halt at 1121 right on schedule and the Russell at 570. All of these levels are strong resistance. However, closing at very strong resistance on a Friday with three day weekend event risk ahead was bullish. The major qualification was the holiday volume at only 2.5 billion shares across all markets. The NYSE only traded 1.2B and the Nasdaq 1.09B. These levels are -38% below Tuesday's level at 4.01B for the strong gain. The rally volume was also only moderate and lacking in conviction.

The Nasdaq has now closed up +6 consecutive days and is nearing that stronger resistance mentioned above. With the summer doldrums ahead that trend is not likely to continue much longer. The summer doldrums are commonly known as June-August. Over the last five years the S&P has lost an average of -2.5% over those months. To put that in perspective it would only be -28 points from Friday's close. Hardly a tidal wave of selling and suggests that doldrums is a proper name.

Offsetting the potential for three months of aimless wandering is the election year trend. Since 1900 there has been a summer rally in 73% of election years with an average gain of +7% according to Ned Davis Research. Now we have a choice between aimless wandering and a +7% avg gain. Who is right? Actually historical norms are only accurate over extremely long periods. Short-term views can be skewed significantly by current events and market trends. The doldrums trend I mentioned above simply reflects the bear market for three of the last five years. No surprise that the average was down. The longer election year trend since 1900 covers only 25 election year cycles and multiple major wars and economic disasters. With 73% of those years (18) showing a gain compared to 27% (7) showing a loss that is not really a trend you can count on. It is better than a coin toss but only slightly. Add in the June-30th Fed meeting, Iraq turnover and Olympics and the recent terror warning and the election year trend is probably nullified.

With the Nasdaq and the Russell each up +4% for the week and the SOX up +7% you could easily make a case that the market is overbought. Buyer conviction is far from strong with the put/call ratio 1.05 and the TRIN 1.13 at Friday's close. Low volume, lack of conviction but closing at the highs on a holiday Friday. What a conflicting picture! I had gone into Friday afternoon thinking we were going to see a closing sell off on profit taking but other than some light chop there was no real attempt to take them down. There were several attempts to take them higher but those also failed but not very decisively. It appears there is no conviction on either side.

When there is no conviction we need to look at the real support and resistance and the longer term trend to decide the probable outcome. Each of the major indexes are nearing their downtrend resistance dating back to early 2004. This will be a key test for next week. The Nasdaq has been down trending since January and that trend line is currently 2020. With round number resistance at 2000 to slow any new gains the 2020 level could be tough. Support is well below at 1940 & 1920. The path of least resistance for the Nasdaq is not up or down but sideways. It is right in the middle of a large range and we could wander in this 1940-2020 range for all of June while waiting for the month end events to unfold.

Nasdaq Chart - Daily

The Dow has monster resistance at 10300-10350 and heavy congestion between 10300-10550. The upward path for the Dow is going to be much more difficult than the Nasdaq. The +2% gain (+222) for the Dow was only half the Nasdaq gain and stopped right at 10220 resistance for the last two days. Most of the Dow recovery was based on only a very few stocks. UTX, AIG, INTC, HD, KO, AXP and MMM carried the index with many of the other issues flat to down. The Dow has very low relative strength when compared to the other indexes. With strong resistance from 10220- 10350 and support well below at 9900 the Dow also has a big range available for movement over the next four weeks. The path of least resistance is down for the Dow to something around the 10100 level.

Dow Chart - Daily

The two indexes that helped the rally the most were the SOX and the Russell. Both tacked on some serious gains but both are nearing some serious resistance. The SOX reached downtrend resistance on Friday at 490 and with the +7% gain for the week is definitely overbought. We could easily see some profit taking in chip stocks.

SOX Chart - Daily

Russell Chart - Daily

The Russell is also very extended from the May base around 535 and the +35 point gain was extreme. 570 is strong resistance and could act to blunt any further gains next week. The small caps set a lower high on Friday and were very choppy all afternoon. This suggests indecision and a lack of fund buying. When funds buy or sell the Russell the direction and speed leaves no doubt. There was definite doubt on Thr/Fri.

Based on the market information above I think the rebound is about over and profit taking should follow. With the weekend event risk over and a positive ISM on Tuesday we could easily see a move higher but with all the multiple resistance levels across all the indexes the odds of a major move higher are not high. I believe instead we could see a range bound market with risk to the downside until Friday's Jobs report. Everyone is expecting a blowout report and I have already heard one 500K prediction. The expectations are very high and potential for disappointment high as well. That is where we run into trouble. If the number did come in at 500K the Fed would almost certainly act immediately. In this case a blowout could be dangerous. Then there is also the persistent rumor that there will be a rally after the first cut because it means the Fed has begun to act and the economy is strong. If the number is well below the estimates the Fed may remain on hold and that could also rally stocks. This is a very tough week to call except for the obvious. My best analysis says that any move higher early in the week will fail and we will remain range bound until the Jobs report.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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