Option Investor
Market Wrap

Five Months

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        WE 7-09         WE 7-02         WE 6-25         WE 6-18 
DOW    10213.22 - 69.61   10282 - 89.01   10371 - 44.57 +  6.31 
Nasdaq  1946.33 - 60.33 2006.66 - 18.81 2025.47 + 38.74 - 13.14 
S&P-100  542.63 -  4.54  547.17 -  2.58  549.75 -  5.06 -  0.09 
S&P-500 1112.81 - 12.57 1125.38 -  9.05 1134.43 -  0.57 -  1.47 
W5000  10842.68 -154.87   10997 - 76.05   11073 + 39.48 - 11.83 
SOX      451.14 -  6.17  457.31 - 21.60  478.91 + 25.83 - 23.20 
RUT      563.73 - 18.99  582.72 -  4.98  587.70 + 17.16 +  1.42 
TRAN    3087.97 - 58.20 3146.17 - 18.01 3164.18 + 95.61 + 43.96 

We have been trapped in this trading range for five months but it appears we may be in for a change of confinement. Instead of sitting in our cells staring at walls of charts that never move we may be in for a change of scenery. That change of scenery may include a lot more red if the current market sentiment continues to decline.

Dow Chart

Nasdaq Chart

The markets roared out of the gate on the IBM earnings, Dell guidance and a tame expected CPI. That opening blast failed to hold and before the day was out we were trading at new lows for the month. Welcome to July.

The market positive CPI at only +0.3% sent bonds soaring on thoughts the Fed was on hold for the near future. The CPI headline number was actually a little higher than most analysts expected but only due to higher energy prices. The core rate was only a minimal +0.1% for those who don't use food and energy. Considering energy prices are +17% higher than they were this time last year it is amazing that the current annual headline inflation rate is only +3.3%. Core inflation on an annual basis is only 1.9% and very tame. Raising the CPI for June was another +3.1% jump in gas prices after a +8.1% jump in May. With oil nearing $42 today the odds are good we will another jump in the July report.

In the continuing saga of manufacturing surveys the California numbers were announced today. The headline number at 61.6 was still strong but well below the 66.9 high in the prior report. Unlike the other monthly surveys this is a quarterly update. Still the same trends we have seen in the others continued to appear in the CA report. Production slowed to 65.3 from 71 and New Orders fell to 58.4 from 71.3. Employment also slipped slightly. These numbers are still in expansion territory but indicate declining growth in the second quarter.

The only other economic report Friday was the first take on the July Consumer Sentiment. The headline number barely moved at 96.0 from June's final at 95.6 but it was the highest level seen since January's 103.8. May saw the low for the year at 90.2 and this represents two months of gains if it holds through the next update. The present conditions component fell -2 points to 104.6 and the future expectations component rose +2 points to 90.4. Gas prices were given as the most negative input.

Don't look now but oil prices are still climbing. Oil neared $42 once again and is showing no signs of easing. The global demand continues to increase and OPEC is already pumping at almost full capacity. This is a recurring nightmare for consumers and becoming a very large cloud on the future of earnings for corporations. Recently the stock market has traded opposite the oil market and today was no different. Keep your eye on oil prices next week as we could see a new high.

Oil Chart

The combination of economics and high oil prices sent bonds soaring to two month highs. The yield on the ten year fell to 4.361% which is very good for the home builder sector. They may get one more really good summer selling season after all. The drop in the CPI and the mixed economics all week sent the Fed funds futures even lower and we are very close to dropping one of the three remaining rate hikes that had been projected this year. The August hike is still on the table but one of the later hikes is on the verge of disappearing. The Fed has been exceptionally quiet the last two weeks but that will change soon. Greenspan gives what was formerly known as the Humphrey Hawkins testimony before the House and Senate committees on both Tuesday and Wednesday. I expect that interest rates and the softness in the economy will be high on the list for the Q&A session. The dollar hit a four month low on Friday despite strong assurances from the administration they support a strong dollar policy. Obviously talk is cheap.

Ten-year Yield Chart

The markets opened higher on the strength of IBM earnings but that bloom quickly wilted. IBM rose as high as 86.50 but slowly dropped into the close at 84.40. Good news simply does not last past the first coffee break in the current market.

Dell added to the opening excitement by raising guidance by +2 cents and jumped nearly +$1 at the open. Dell said those better earnings came from a better tax rate and cost savings on components. Revenue guidance stayed the same and that blunted the positive earnings news. Dell gapped up almost $1 but kept only half that amount at the close. First, traders do not really care about the tax rate because it does not apply to growing sales. Second, lower prices on components suggests there is lower demand for components and could means weakness in the overall sector despite the Dell gains. In some cases gift horses really do have bad teeth.

I'll be back! Martha Stewart repeated those words twice ala Terminator style at a press conference after she was sentenced. The domestic diva managed to turn an apology speech into a sales pitch for advertisers and customers while standing on the court steps. The blatant sales pitch just moments after being sentenced to five months in prison, five months under house arrest and two years probation was a little too much for some people. Most wanted her to just say I am sorry and get the sentence over so life at Martha Stewart Living could get back to normal. There was nothing normal about the action in MSO stock. Volume was about 50 times normal and it spiked from yesterday's close at 8.73 to a high of $12.29 and close at 11.81. The lighter than expected sentence and the prospect of putting the whole affair to bed brought the bargain hunters back to shop. Had you bought the July $10 call for its 10 cent close on Thursday it would have been the home run for the month with a close at $1.90 on Friday and high of $2.30.

Despite IBM, DELL and MSO the markets still had trouble holding down breakfast. Good news does not stick any longer than hair spray in a Houston wind and the sellers appeared once again. A study out Friday morning showed foreign investors had been net sellers for the last three months and the selling was continuing. This is confounding analysts given the very respectable earnings we have seen so far this cycle. With 77 S&P companies already reported, a whopping 75% have beaten estimates, 19% reported inline and only 6% have missed estimates. If the current rate and quality of earnings continue we will post the fourth consecutive quarter of +20% gains. This would be only the fifth time ever that the market has seen a string of earnings this good. The earnings parade continues next week with a huge number of reporters. 170 S&P companies report along with hundreds of smaller ones. We will have a much better view of the future once those firms give guidance.

So why are the gains not translating into a market rally? There are two main reasons and a bunch of little ones. The two biggest culprits are future expectations and event risk. Even the most optimistic expectations for 2005 earnings is only +10% for the entire year. Not 10% per quarter but for the entire year. This is a very big letdown from the high numbers we have been posting and the market is having trouble digesting the future outlook with a string of high risk events in our near future.

I have mentioned it before and will not dwell on it but the Democratic convention begins next week on July 26th. This is the first high risk event followed by the Republican convention and the Olympics over the next 60 days. These are prime terrorist targets and at this point it make no difference if any attacks are even contemplated. It is pure risk avoidance coupled with decelerating earnings that is driving investor flight.

Fly they did. For the week semiconductors ended down -9% but they are down -15.6% for the month. I missed the fire alarm on semis on July 1st but evidently I was the only one. The SOX closed at 411 on Friday and well below the 420 support range. The bottom has fallen out of the sector despite some positive earnings reports. Next real support is 375-385. There is a fire sale in progress and there will be some real bargains once the smoke clears. October is normally the buying season for semi stocks and that seems a long way off today. Next week we will get the Semi Book-to-Bill numbers for June and a drop from the 1.11 in May could actually accelerate the selling.

SOX Chart

With the SOX imploding the Russell-2000 never had a chance and when comparing 2003 gains there is far more profit waiting in the RUT than there was in the SOX. The Russell rebounded +85% off the Jan-2003 lows and has consolidated in the 560-590 range since Jan-2004. That consolidation appears about to resolve itself to the downside dragged down by the SOX. We saw a strong fight at 560 support but that level caved in at the close. In May there was a profit taking dip to 535-540 and we seem destined to visit that level again next week.

Russell-2000 Chart

Semis were not the only sector to get knocked for a significant loss. Airlines dropped -10% for the week as the price of oil soared. Retail continued to be weak as earnings warnings in the sector continued. ISI released a survey that showed sales in July were actually weaker than June and suggested the consumer had taken a real vacation from consuming.

There was some serious market damage done Friday but despite the drops we are still clinging to the recent range. I say clinging because the Dow has broken its 200dma at 10197 and support for the last two weeks at 10160. The close at 10140 was the lowest close since May 26th. Since January we have fallen from the highs twice to trade in the 10000 range with the May drop the worst with an intraday spike to 9852 but a close back over 10K. The lowest close was 9906 with multiple closes in the 9950-10000 range. Considering the event risk ahead I can easily see the Dow back at the 10K level next week. Hopefully this will remain the bottom of our range as it has since January.

Dow Chart - Weekly

The Nasdaq is a different story. It closed on Friday at 1883 and right on the edge of a serious break. 1900 has been headline support since October with brief periodic dips to around 1875 which were always quickly bought. With the SOX and RUT imploding the Nasdaq is falling faster than a twin engine plane with both engines out. The 1900 level barely provided a speed bump to Friday's drop and with the SOX and RUT both under critical support it appears the Nasdaq could easily hit that 1875 level that has been a buy trigger for the last eight months.

The only index that held support on Friday was the SPX at 1100. Actually the 200dma at 1103.66 provided support most of the afternoon but we did see it pierced right at the close when several late day sell programs stacked on top of each other. The SPX is the most critical of the indexes to support tests. The SPX is the most widely followed index for funds and the most widely program traded index. The 200dma is a critical support level for this index. It has held as support since April of 2003. This sets up a rebound potential for Monday morning. Since it has such a strong following and has been such strong support there should be some technical buying on Monday. It had better be strong because the S&P moving under the 200dma is also a sell signal for many speculative funds. Not a dump signal but a sign to lighten up. Should we move much below 1100 it could begin to get ugly very fast.

Where are we going from here? How many times have we said the markets are at a crucial point and the next week would be pivotal? Consider it said again. The next week is going to be hectic to say the least. We have the Greenspan testimony on Tuesday (2:30) and Wednesday (10:00). Fortunately there are no major economic reports to provide negative sentiment and the few numbers we will get should be market neutral. We have over 500 companies reporting earnings but if the current trend continues 65% of those will beat the estimates. So far this cycle the number has been 75% but we know it declines as the cycle matures to include the smaller companies. Unfortunately good earnings news has failed to impress the market and the fire exits are still flashing red.

The motivating event next week, besides Greenspan, will the coming Democratic convention on July 26th. The odds of a sustained rally are almost zero in advance of that event risk but we could see a rebound on Monday from our current SPX support level. I view any early bounce as only a short entry for the rest of the week. Hopefully the fear factor surrounding the convention will be much ado about nothing but the markets cannot afford to ignore it. This does bring up the potential for the Fed's Plunge Protection Team to suddenly appear with a couple buy programs in the interest of protecting the markets from overactive speculation. This is exactly the kind of crisis that they were created for under the Reagan administration.

As for me I am going to be watching for an uptick in the futures at the Sunday night open to see if the SPX support at 1100-1103 will hold. If so I am going to be Long in the Futures Monitor with plans on reversing to short when any rebound fades. Conversely a break under SPX 1100 will have me looking for a short opportunity. This is one of those rare instances where the dividing line is so clear. For next week remain short below SPX 1100 and sell any rally over 1100 as it fails.

Enter Very Passively, Exit Very Aggressively!

Jim Brown



 
 



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