Option Investor
Market Wrap

Surprise, No Surprise

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      09-21-2004           High     Low     Volume   Adv/Dcl
DJIA    10244.93 + 40.00 10270.52 10200.25 1.62 bln 2238/ 979
NASDAQ   1921.18 + 13.10  1925.85  1909.43 1.56 bln 2023/1108
S&P 100   544.74 +  2.81   546.08   541.93   Totals 4261/2087
S&P 500  1129.30 +  7.10  1131.54  1122.20 
SOX       403.75 +  3.90   406.66   399.90
RUS 2000  576.92 +  6.18   577.15   570.74
DJ TRANS 3271.22 + 28.90  3271.62  3243.11
VIX        13.66 -  0.77    15.97    13.39
VXO (VIX-O)12.86 -  0.92    14.15    12.66
VXN        20.30 -  0.26    20.70    19.88 
Total Volume 3,472M
Total UpVol  2,519M
Total DnVol    892M
Total Adv  4821
Total Dcl  2403
52wk Highs  270
52wk Lows    71
TRIN       0.72
NAZTRIN    0.86
PUT/CALL   0.76

The FOMC meeting has passed into the history books and there was very little change from the last meeting. The Fed hiked rates and kept the "measured pace" language. Traders hoping for a break in the pace were disappointed that the expected surprise was not delivered.

Dow Chart

Nasdaq Chart

NDX Chart

Russell Chart

SOX Chart

The markets started out positive with traders cheering the jump in Residential Construction and ignoring the now routine drop in Chain Store Sales. The Chain Store Sales number fell -1.1% for the week and continued the weak back to school season. The drop was the sharpest decline since June and analysts suggested improper seasonal adjustments were the problem.

The falling mortgage interest rates continued to push New Home Construction back to the two million level in August. This continued the growth from July where the headline number jumped +171,000 to 1.988M. The single family starts are growing slower than multifamily units but both are growing and that is good news for the economy. Building permits did drop -114,000 in August but with fall weather ahead this is a normal seasonal occurrence. Builders are taking a page from the auto dealer play book and they are offering cash back, upgrades, furniture, cheap interest and even vacations to induce buyers to make the commitment now and not hold inventory over the winter.

Despite the Fed raising rates to 1.75% today the real rates fell with bonds jumping on the Fed announcement. The ten-year rate fell to 4.04% and a new five-month low. This is a reaction to the weak economics and the slow and measured pace comments. Bond traders still expect the Fed to take a pass at the November meeting.

As I stated above the Fed meeting was a non-event with the quarter point hike as expected. The statement was mixed on economic comments. The Fed said output growth appears to have regained some traction after moderating earlier in the year. They felt labor conditions had improved only modestly and inflation expectations have eased. They said the risk of inflation and deflation were still roughly equal. The committee kept its "pace that will likely be measured" language and raised the rate to remove the current over accommodative posture. Yawn, no surprise and no change with the exception of the possibly slightly stronger language about the economy. You would have to look hard to see it. Traders initially thought it was a concession to the future and a potentially softer side of the Fed but once the full statement saw the light of day the excitement faded.

The markets spiked on the news as they always do then faded as is the norm. Once the smoke cleared a buy program tried to break the overhead resistance but all they got for their effort was a failed rally. The Dow fell back below 10250 which has become short term resistance. The Nasdaq fell back to 1920 and the upper end of its range for the last two weeks, also strong resistance. The SPX broke 1130 for about 20 min before slipping back below that strong resistance level at the close. The only index to really close above its recent resistance was the Russell at 576.80 and that was tenuous at best. After the close the various futures contracts bled a few more points despite some decent earnings and no real warnings.

Adobe beat the street and raised guidance. PAYX reported inline with estimates as well as CBK. JBL beat analysts by a penny and traded up about +1.60 in after hours. The markets had traded higher early in the day after Lehman and Goldman both beat estimates by a mile. General Mills was a slight drag on the market after it reported earnings that fell -19% due to higher prices for its ingredients.

It was amazing we moved higher at all with oil reaching a new five week high and trading over $47 for most of the day. The futures closed at $46.90 but fear of more terrorist acts, Yukos and production slowdowns due to the hurricanes is keeping it higher. Tomorrow at 10:30 we get the oil and gas inventories for the week and we have seen drops in inventories for the last seven weeks. It appears traders are speculating that trend will continue. The drop in inventory levels has been due to refineries reluctance to buy the high priced oil according to analysts. With the summer driving season over they are playing chicken with supplies and hoping to produce only as much gasoline as necessary to avoid passing the high prices up the chain. Eventually we will reach a level where gasoline inventories will force them to add to crude supplies.

The XOI Oil Index rose +20 for the day and it was the largest one day jump since July 29th 2002. The 695.75 close is a seven-year high. In a complete disconnect from reality the Dow transports also hit a new five year high at 3271. Something is definitely wrong with this picture.

The earnings picture took another turn south today with Abby Joseph Cohen predicting profit growth of only +5% for all of 2005. That is the lowest level I have heard and even lower than the +8.5% Reuters number from last week. Seems we are faced with a race to quote lower for this cycle instead of the constantly increasing quotes for the last couple quarters.

According to Zachs 85% of companies met or exceeded earnings in Q2 and that quarter finished with +34% earnings growth. Zachs current estimate for the 3Q earnings growth is +14% to +15%. This is below the +13% to +17% range given by Reuters just last Friday. Assuming the numbers are close and will not get worse is that still confirmation of a growing economy and justification for a bull market? In most cases the answer is yes. We are just spoiled by the huge gains over the last year.

I mentioned earlier that the bonds soared on the Fed announcement. Does that strike you as strange? It should because there are only two real reasons for bonds to be soaring. Either inflation is dead for the foreseeable future or the economy is slipping back into recession. The Fed comment today suggests the inflation monster is not dead but at least contained for the near term. The other side of that coin is the economic strength. I just profiled the earnings deceleration for you above. We have been getting daily tech warnings and the chip sector could be on the verge of yet another round of order push outs. Could it be that BOTH possibilities are possible. Could inflation be dropping along with the economy because we are heading into a depression? Scary thought but how else do you justify the four month drop in real interest rates and the rise in bond prices? Doesn't the Fed want rates to go higher and bonds to weaken? With "real" rates falling the Fed may be forced to raise rates even faster to slow the descent. The various possibilities here for the economic forecast are numerous enough to make your head spin.

Those analysts that get paid the big bucks are not quite as positive about the markets chances as they were just a couple weeks ago. They are now claiming the market rallied on the post convention Bush bounce, the drop in oil prices from the 8/20 August highs and the recovery in the Jobs numbers. The Arnold speech was given as the turning point in the market. That was August 31st and well after the price of oil began to drop and long after the 8/16 beginning of the current rally. It was however the rebirth of the current rally which had failed for two days before that 8/31 Arnold speech. August 31st was also the turning point in oil prices at their $41.40 low. The march higher was choppy as the various Yukos/IRAQ scenarios played out but for the last week there has been no hesitation. The prices are nearing the August highs and the equity markets are not paying attention.

I believe this cannot continue indefinitely. The current warning ratio is nearly 3:1 compared to those who have affirmed guidance. We are hearing on all fronts that profits are decelerating and analysts are racing to post the lowest estimate. Money is pouring into bonds while overall economics are less than inspiring. My point to all of this is what will push traders to chase prices higher? Abby said it best today. She said the early stages of a bull market are full of vim and vigor. Once that initial stage has passed and the consolidation begins the next stage of the market is marked by durability. The sex appeal has gone and the lure of doubling your money has passed. Now traders have to decide is the potential for another +10% to +20% is worth the risk. Is it worth buying more at three-month highs and at strong resistance?

That brings us to tomorrow and the rest of the week. The SPX, Nasdaq and Russell are all right at very strong resistance and are either poised to break out or break down. I know you have heard this before but if you are a bear this is exactly where you want to enter your next short. If you are a bull this is the resistance that must break for any material move to succeed. What if this resistance does break? What then? The SPX has even stronger resistance at 1140 and 1150. The odds of those breaking before the election are very slim. The S&P is the strongest of the major indexes with the Dow and Nasdaq still in a down trend even if they break their current resistance levels. I don't want to belabor the facts but the markets are not as bullish as some would have you think.

I do believe we will move higher before the end of the year and we should move higher into the election. How much higher is the question, when and why? With the earnings warning season due to increase in intensity as each day passes the bears are getting excited. The bulls are saying so what? We know that already, buy more, there is always a post election rally. I fear that is exactly the sentiment that we should worry about.

Is it just the expectation of the post election bounce that is really powering all the bad news rallies we are seeing? The Stock Traders Almanac does a great job in telling us how the markets have moved both before and after every election cycle for the last fifty years. The trend is well known and every four years traders try to capitalize on it. I have seen several other trends of late fail to appear once the masses begin to depend on them. I am beginning to think this post election cycle may leave something to be desired. I will be happy to ride any wave higher but I am going to be looking for the sharks behind me.

This week should be the key for me. Economic reports are few and there should be nothing for the market to focus on other than stocks. If we can move higher this week it would mean strong resistance had failed and bulls found the conviction and volume necessary to overcome not only the resistance but the declining sentiment.

Next week the calendar heats up and the road becomes more bumpy. The closer we get to October the more uncomfortable traders will become because the October dip is the longest running trend around. That dip is produced by a weak earnings cycle and mutual fund rebalancing before the typical year end rally. Do the bulls have the conviction to push us higher in front of that trend? We should have that answer really soon.

Enter Passively, Exit Aggressively.

Jim Brown
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