Option Investor
Market Wrap

Major Resistance Ahead

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      06-08-2004           High     Low     Volume   Adv/Dcl
DJIA    10432.52 + 41.40 10432.81 10353.05 1.46 bln 1473/1721
NASDAQ   2023.53 +  2.90  2023.54  2008.30 1.47 bln 1342/1719
S&P 100   556.74 +  1.05   556.88   553.43   Totals 2815/3440
S&P 500  1142.12 +  1.70  1142.16  1135.45 
W5000   11109.09 +  9.10 11120.32 11061.27
SOX       489.41 +  1.20   489.41   481.61
RUS 2000  577.91 -  0.99   578.90   575.70
DJ TRANS 3072.40 + 32.30  3072.45  3030.72
VIX        15.01 -  0.38    15.88    15.00
VXO (VIX-O)13.75 -  0.95    15.17    13.75
VXN        22.26 -  0.39    23.10    22.10 
Total Volume 3,116M
Total UpVol  1,648M
Total DnVol  1,388M
Total Adv  3137
Total Dcl  3787
52wk Highs  202
52wk Lows    49
TRIN       0.92
NAZTRIN    0.66
PUT/CALL   0.86

You could not tell it from the indexes during the morning session with red across the board but the market is still in rally mode. They did not stray far from the bullish trend started on Monday despite the negative start. The Russell was the only index to finish in the red although gains on all but the Dow were slight. The good news was a consolidation in place after the monster move on Monday and a bullish close at the highs. It would appear the stage was set for another big move but in which direction?

Dow Chart - Daily

Nasdaq Chart - Daily

SOX Chart - Daily

The economic reports were mixed today with the Chain Store Sales showing only a slight gain for the week after posting a loss last week. Consumers are not rushing to the stores now that the income tax refund checks are slowing.

Slightly bigger news came from the Richmond Fed Manufacturing Survey which rose to 22 in May from 13 in April. While the headline number posted a large jump there was trouble in the components. New orders fell to 12 from 17 and back orders dropped into negative territory at -1 and down from +9 in April. The six-month outlook also fell to 16 from 22. The only really bright component was employment which jumped from +1 to +9 and the strongest reading in over two years. The new orders component was the lowest reading since Oct. The picture is clear that manufacturing may have peaked in early May and is beginning to decline into the summer doldrums. It is ironic that employment peaked to a two year high just as orders and backlog dropped off.

Wednesday we will see Mortgage Applications, Labor Turnover and Wholesale Trade. The NY Fed President will speak at 11:15 and the Kansas Fed President at 4:15. Several previously scheduled events have been rescheduled due to the Reagan services on Friday. The PPI has been moved to Thursday from Friday. Trade Balances have been moved to Monday from Friday along with Consumer Confidence. Greenspan's confirmation testimony has been moved to June 15th from Thursday. The Russell rebalance announcement will still be on Friday and will prevent a lot of positioning that normally occurs on announcement Friday. Look for Monday to have some added Russell volatility added to option expiration week.

With minimum economic news today and very little stock news the markets were left with some huge gains from Monday that needed to be digested. Early in the morning Greenspan sent traders an after dinner mint that was tough to chew. In a speech on economic developments he as much as said the Fed was going to raise faster than expected. There was all the required qualifications and the doublespeak but the message was clear. The economy is growing and while we think inflation is under control we are prepared to act aggressively at any sign of increased inflation. He then went on to target things like oil prices that could cause increased inflation. He kept the measured pace phrase but the general context of the speech was bullish towards the economy and concern inflation might suddenly appear.

He pointed out that business have suddenly picked up a significant degree of pricing power and moved away from heavy discounting. In the first four months of this year consumer prices rose +4.4% compared with only +1.9% for all of last year. Core prices, excluding food and energy, have risen +3% compared to +1.3% for all of 2003. The Fed rate hike picture is clear and it is soon. The Fed funds futures are still predicting +75 basis points by the Aug meeting. No change in that prediction but the chance of June being +25 and Aug +50 are now almost 100%.

Traders have already priced this into the market and the Greenspan comments today only riled the markets for a short period but they did cause uneasiness. Whenever the Fed starts talking about getting aggressive the memory of the 1994 parallel quickly returns. This memory capped the morning rebound and kept us from moving higher at the close.

The offset to the Greenspan comments was a serious drop in oil prices just after 1:45. The price of crude dropped from $38.20 to $37.20 in the last 30 min of trading ending with a -1.50 drop for the day. This is a five-week low and a move under the 50dma, a level that has held prices since last September. Traders are afraid of a build in U.S. supplies and an end to price speculation. OPEC comments were flowing again today and Saudi Arabia said they would pump as much oil as anybody was willing to take. Oil and Gas supplies will be announced at 10:30 tomorrow morning.

The sudden drop in crude prices sent the Dow and S&P soaring at 2:PM but they could not hold their gains once the oil market closed. Sellers appeared at resistance and the indexes began a late afternoon plunge. The Dow fell from 10432 to 10385 in only a matter of minutes but once the 10400 level was broken with a sell program the buyers rushed into fill the gap. The Dow quickly recovered its -45 point drop and finished back near 10430. This was the first close over 10400 in over a month. The Dow has risen +500 points since the May 25th low without any material profit taking. The Dow is approaching serious resistance at 10450-10550.

The Nasdaq recovered from its bout of morning depression and recovered to close over 2020 for the first time since April 27th. The Nasdaq is up +60 points since the pre Intel swoon last week. The Nasdaq is also approaching very serious resistance at 2050-2070.

We talk about the Dow and Nasdaq as "the" market quite often but the real market is more properly reflected in the broader S&P and Russell-2000. The S&P closed at 1141.50 and right at the beginning of very serious resistance from 1140-1150. Where the Nasdaq has a few points to run before strong resistance the S&P is there already. This suggests that further gains this week could be really tough to manage.

Along with the picture of resistance on the various indexes above there is another form of resistance brewing. I have not spoken of this in quite a while but like a bad penny it keeps turning up again. The VXO closed at an all time low (for this symbol) of 13.75. In the year since the VIX was converted to a complicated formula to calculate volatility from a wider range of SPX options the VXO (old VIX) has continued to keep time with the various market swings. The close today is a warning siren that there is entirely too much bullishness given the current environment. The VXO/VIX is calculated on the SPX. As such you would expect a strong correlation between SPX movement and VXO movement.

Chart of VXO-SPX - Daily

Chart of VXO-RUT - Daily

I had never compared a Russell chart to the VXO before but the reaction was equally amazing. On both the SPX and RUT charts whenever the VXO hit the low 14s the upward market momentum completely stopped. There has not been one single day since mid January where the markets made a new high after the VXO hit 14 without first seeing a sell off. Some of the sell offs were dramatic. In late April the VXO hit 14 on two consecutive days and a -60 point SPX drop followed. I am not asking you to take my word, simply compare the charts above. The VXO is flashing a strong warning that the rally may be nearing its end.

We all know that the VXO can go below 14. That just happens to be its recent trigger point. I am not trying to build a case that we always have some kind of response every time the VXO hits a particular level. I am only pointing out that Since January the markets have behaved in a particular way whenever the VXO hit 14. That is six times in six months. If this was a horse race and number 14 was running I would bet on it to win over Smarty Pants every time.

So what is this telling us? The markets are on a roll. Even bad news has no impact and good news just adds fuel to the flames. Shorts are getting squeezed at ever turn and old resistance levels are falling daily. Still this rally has been built on very light volume. We have not traded 4B shares since May-19th and the volume continues to drop each day. Today was only 3.1B shares. The Nasdaq has rallied in June on 22% less than its average daily volume for May. We have not hit 2B shares on the Nasdaq since May-3rd. Volume today was only 1.4B. To put it bluntly there is no conviction to this rally. That is not always bad but it is certainly something to watch for. It will take conviction to move much higher.

The SPX is right at the beginning of very strong resistance and there is no real event to push it higher. All the good news is priced in and all the bad news has been discounted. In short we may be running out of news just when we need a really strong catalyst to break the current resistance levels. Using the SPX chart below you can see the very strong resistance range we are facing.

SPX Chart - Daily

For the rest of the week I would be very cautious about being long. We have some huge event risk with the G8 meeting in progress in Georgia and the influx of VIPs for the Reagan services on Friday. Expiration is next week and we could see some real volatility over the next two days as those positions are rolled forward before the weekend event risk. We are only three weeks from the June-30 Fed meeting and Iraq turnover. Plenty of opportunity for an event to spoil the party. We had news of pending Al Qaeda attacks on the U.S. on Monday and the market did not even blink. They will blink when it happens for real.

I told you on Sunday to be ready for a rally and prepare to buy any dips. Unfortunately we saw the rally but no dips. The rally exploded out of the gate on Monday and added to last weeks gains. Now I am suggesting being cautious about being long. We can move higher but it probably will not be a straight run and will likely be very choppy and range bound. I feel the most likely direction will be flat to down with very minimal additional gains. Watch the SPX. With resistance growing with every point gained toward 1150 it will be the best barometer for market direction.

Enter Passively, Exit Aggressively.

Jim Brown
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