Option Investor
Market Wrap

Higher Highs

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      12-22-2004           High     Low     Volume   Adv/Dcl
DJIA    10815.89 + 56.46 10822.68 10739.19 1.75 bln 1694/1129
NASDAQ   2157.03 +  6.12  2163.48  2145.18 1.80 bln 1676/1376
S&P 100   575.34 +  1.98   576.04   571.85   Totals 3370/2505
S&P 500  1209.57 +  4.12  1211.42  1203.81
SOX       424.05 -  0.35   427.13   422.39
RUS 2000  648.46 +  2.26   649.75   645.68
DJ TRANS 3790.62 -  1.47  3803.75  3786.24
VIX        11.45 -  0.10    11.71    11.37
VXO (VIX-O)11.81 +  0.29    12.18    11.58
VXN        17.15 +  0.21    17.38    16.44
Total Volume 3,556M
Total UpVol  2,191M
Total DnVol  1,306M
Total Adv  3370
Total Dcl  2505
52wk Highs  390 
52wk Lows    19
TRIN       0.82
PUT/CALL   0.91

The Dow and SPX hit new highs for the year as the Nasdaq trailed behind. An unexpected rise in oil inventories saw crude oil drop sharply, a move that was credited by some reporters for the higher high in the Dow and SPX.

Breadth was positive, with advancing volume nearly doubling declining volume on the NYSE and the Nasdaq. Volatility remains very low, with the VXO going out at 11.81 and the QQV dropping another 1.46% to close at 15.48

Daily Dow Chart

The Dow blasted higher in a move that kicked off at 10AM, reaching a 42 month high at 10822.68 before 11AM and held for a minor correction to 10786 before resuming its upward march to close the day at 10815.89. Support below is at 10780, 10740, 10640 and 10575. While the daily oscillators are vulnerable to a bearish divergent downphase, that will only occur if the Dow reverses hard from here. The more likely scenario would see a minor pullback to one of the supports I've drawn as the bull flag breakout in the Dow continues to play out. A move below 10430- 10440 support would invalidate that bullish scenario.

Daily S&P 500 Chart

The SPX reached a new year high at 1211.42 on the 10AM runup, and the pullback bounced from a double intraday bottom at 1207 to stall out at 1210, closing the day at 1209.57. Support from 1205-07 is followed by 1189-92 and 1172. As with the Dow, the daily cycle oscillators suggest caution, but only the bears can drill the price below the 1172 level from here.

Daily Nasdaq Chart

The Nasdaq missed the party, touching a high of 2163.48 on the morning pop, below its Dec. 15th high of 2171.27. The afternoon bounce was weaker as well, failing below 2158 to close at 2157. The bearish divergence is steeper for the Nasdaq as well, but the question remains as to whether it's a bearish divergence or a corrective bullish consolidation. Provided that 2070 doesn't get violated on a closing basis, it should prove to be the latter.

Weekly TNX Chart

The Mortgage Bankers Association reported that the Mortgage Index was flat at 689.3 for the week ended December 17, following the previous week's 1% decline. The Refinancing Index rose 5.7% to 1958.2 following the previous week's 2% decline, while the Purchase Index declined 3.6% to 471.1 following the prior week's 0.4% decline.

The sideways drift of the ten year note yield (TNX) in recent weeks has the weekly cycle upphase faltering. Provided that the 4.0%-4.02% rising wedge support line doesn't fail, the upphase should begin to get traction on a break above 4.26% resistance, above which 4.4% is the next significant confluence. For the day, TNX rose 3.3 bps to close at 4.201%. Interested readers can follow the daily action of the TNX in my nightly Futures Wraps.

Weekly chart of Crude oil

The Energy Department reported today that crude oil inventories rose by 2.1M barrels, catching analysts off guard on their expectation of an 800K barrel decline. Gasoline inventories rose 1.8M barrels against expectations for inventories to remain unchanged. Distillate supplies rose 600K barrels vs. expectations for a 1.13M barrel decline. The American Petroleum Institute confirmed the increases in supply, reporting increases of 2.9M, 4.2M and 315K barrels for crude oil, gasoline and distillate supplies respectively.

Crude oil futures got slammed on the news, dropping from an intraday high of 45.95 to a low of 43.65 before bouncing to a range in the low 44's. On the one-year daily chart, the move kicked off what might prove to be the right shoulder of a head and shoulders top with a horizontal neckline at 40 or a hunchback neckline at 41. Using the 40 neckline, the implied target would be as low as 25. While I would be personally surprised to see levels even approaching 25, that's the implied target of the formation. A move above 50 would invalidate the pattern, but 46 is a confluence that has acted as support and resistance this year, and the failure 5 cents below it fit well with a relatively symmetrical h&s pattern. For the day, crude oil closed lower by 3.17% at 44.30.

The big news of the day landed overnight as FNM announced the resignation of CEO Franklin Raines and CFO J.T. Howard, as well as a number of smaller management changes, following last week's announcement that the SEC would require to amend prior accounting "errors". Those errors allegedly resulted in the overstatement of $9B worth of past profit. FNM owns 25% of current US mortgages and is the countries largest GSE. It's currently defendant to a number of class action suits and under criminal investigation by the Justice Department, investigation by the SEC and an ongoing probe by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). The company also announced the dismissal of FPMG as its auditors.

Raines was replaced by interim CEO Daniel Mudd and Howard was replaced by Robert Levin.

The Washington Post reported that the OFHEO alleges that FNM "systematically manipulated accounting estimates, ignored accounting requirements it had lobbied unsuccessfully against and operated with weak internal controls that helped obscure the other problems." The OFHEO has been aggressive in its call for Raines' removal, blaming him for promoting a corporate culture that prioritized "stable" earnings rather than accurate disclosure. The OFHEO stated last night that FNM is "significantly undercapitalized". To get an idea of the potential enormity of that statement, consider that FNM has outstanding debts to bondholders totally 957B and guarantees the principal

and interest on 1.9T of mortgage-backed securities. These are significant percentages of the total amount of US debt in circulation, a particularly worrisome situation as the media began to utter names like "Enron" and "Worldcom" in the same breath as "Fannie Mae". Others however, note that FNM aptly qualifies for the phrase "too big to fail".

To make up for the 9B shortfall, FNM would likely have to sell part of its portfolio, issue new stock or reduce its dividend. Traders following this story will recall that FNM had previously been ordered by the OFHEO to increase its capital reserves by 5B no later than mid-2005.

What's important for traders to note is that while the situation continues to unfold, it is not a new one. Bears have been discussing FNM and FRE for years, and for years the sky has not fallen. Given the size and breadth of FNM's commitments, the issue is, if anything, as political as it is financial. Regardless of the financial outcome, the departure of Raines, a self-made man, a Rhodes scholar and former director of the Office of Management and Budget, raises all the old issues of corporate governance and ethics that continue to plague our markets.

FNM gapped higher at the open and traded a high of 73.81, bounced from a low of 71.61 and settled into a range around 72 to close +2.32% at 71.98.

On a lighter note, at 8:30, the Commerce Department announced the final Q3 GDP results, which came in at 4% vs. the 3.9% previously reported. The 4% expansion of the economy for Q3 exceeded estimates for an unrevised 3.9% and Q2's 3.3% growth rate. The core personal consumption expenditure index (PCE), which nets out food and energy costs and is the Fed's preferred measure of inflation, rose at a .9% annual rate vs. the .7% expected, the smallest rise since last year's .9% increase, which was a 32 year low. Corporate profits were low as well, however, with domestic profits decreasing by 59.3B in Q3 compared with an increase of 28.3B in Q2. That 59.3B decline was comprised of a 68.7B drop in profits of domestic financial corporations (which dropped 7.9B in Q2) and a 9.4B rise in profits of non-financial corporations (which had increased by 36.2B in Q2). The personal savings rate declined to a low of .5% in Q3, down from 1.3% in Q2 and 1.0% in Q1.

In other news, Marketwatch reported that SNE has won injunctions against 2 Hong Kong companies allegedly engaged in producing counterfeit PlayStation products. However, SNE declined to comment on a report in the Financial Times to the effect that investigations have revealed significant networks such counterfeiters- one story covered a container that left one such sub-contracting factory, entered a prison in Shenzen, China loaded with parts and remained for several days, long enough for the inmates to assemble them. The issue of intellectual property between the West and East remains critical and unresolved. SNE lost .66% to close at 37.80.

MSFT lost an appeal in the European Union to delay an order requiring it to immediately release a stripped-down version of Windows and amend its business practices. The EU's Court of First Instance had upheld the European Commission's sanctions imposed on MSFT in March, and today's failed appeal leaves the original decision intact, along with the finding that MSFT had abused its monopoly. MSFT's General Counsel Brad Smith said that the company would comply with the decision. Consumer groups applauded the decision, and the fact that MSFT will now be required to share its protocols and offer a version of Windows that contains no multimedia apps, deemed to prejudice competitors such as RealNetworks. The fine upheld totals 497M euro. For the day. MSFT closed lower by .37% at 26.97.

For tomorrow, there's a full slate of economic reports as the markets prepare for the long weekend. At 8:30AM, we get November Durable Orders, Personal Income and Personal Spending, as well as initial claims for the week ended 12/18. At 9:45 it's Michigan Sentiment for December and at 10AM, November New Home Sales. Volume should continue to thin out ahead of the weekend, and with the headlines reporting the bullish new highs, we can expect retail traders to adopt that as the theme. After today's dismal intraday downphases following Tuesday's strong rise, the environment should remain decidedly unfriendly for bears even in the shortest timeframes, at least above today's lows.

As I watch the hail outside my window, I'd like to take the opportunity to wish everyone a warm and happy, healthy and prosperous holiday season.


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