Option Investor
Market Wrap

Why Worry?

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      01-04-2005           High     Low     Volume   Adv/Dcl
DJIA    10630.78 - 98.70 10769.56 10605.15 2.13 bln  763/2420
NASDAQ   2107.86 - 44.30  2159.64  2100.56 2.73 bln  744/2414
S&P 100   566.77 -  5.56   574.49   565.51   Totals 1507/4834
S&P 500  1188.05 - 14.03  1205.84  1185.39 
SOX       410.36 - 13.90   426.10   406.08
RUS 2000  628.54 - 11.90   643.05   627.89
DJ TRANS 3678.33 - 82.00  3768.51  3674.94
VIX        13.98 -  0.10    14.45    13.93
VXO (VIX-O)14.13 -  0.07    14.96    13.89
VXN        20.06 +  0.56    20.81    19.57  
Total Volume 5,210M
Total UpVol    809M
Total DnVol  4,306M
Total Adv  1820
Total Dcl  5547
52wk Highs  142
52wk Lows    27
TRIN       1.68
NAZTRIN    1.34
PUT/CALL   0.77

We expected a drop this week and I have reported those expectations in this commentary more than once. After two days of decline the market pundits are suggesting the market conditions have changed and the bears are coming out of the woods to feast on fresh hamburger. Who is right and has investing as we knew it changed over the last week?

Dow Chart

Nasdaq Chart

SPX Chart

Russell Chart

In my opinion nothing has changed. The economy is still struggling along and the multitude of worries mentioned on stock TV this week are just a rehash of the worries the bulls trampled over the last quarter. I will try to touch on the majority of those worries but first the economics of the day.

Chain Store sales fell back to mediocre at only a +0.2% rate for the week ended Jan-1st. This is a very strong shopping week and buyers failed to appear in droves but the year over year number rose to +4.6%. Only a minor increase week to week but strong gains over the prior year. Retailers can now take their Rip Van Winkle nap until next fall with only Valentines and Easter to provide any waking excitement.

Factory Orders jumped only slightly more than expected at +1.2% for November. All components rose slightly with the majority of the gains probably related to last minute pre-holiday shipping and a rebuild cycle beginning for depleted year end inventories. No big excitement here.

Auto sales rebounded strongly in December with red tag specials and higher than ever cash back programs. The annualized rate jumped to 18.4 million from 16.4 million in November. This turned out to be the fourth strongest year on record. Light trucks jumped +10.1% but Japanese makers Toyota, Honda and Nissan topped the leader board with even higher double digit gains as they increased their share of the market to greater than 40%. Hybrid vehicles are selling faster than they can make them as consumers try to avoid the high gas prices ahead.

Economics were just like they have been for the last three months with mixed messages across all components. The biggest economic bombshell today did not come from an economic report but from the Fed minutes from the December FOMC meeting. The Fed stated that the economy was expected to continue its leisurely pace of recovery and the recovery was seen to be firmly entrenched. They cited labor markets as improving and this should continue to support consumer spending.

The problems appeared in the interest rate outlook with comments that the recent depreciation of the dollar, elevated energy costs and the possibility of slowing growth as factors that could increase the risk of inflation. They still see the risks to be balanced between inflation and deflation but they are now leaning toward inflation ahead. They said the increase in inflation signals over the last few months might be a warning sign that expectations for low inflation were not as well founded as they had been last summer. Fear is creeping into the Fed outlook and they feel part of that creeping inflation is still being fueled by excessive liquidity. In Fedspeak excessive liquidity means interest rates are too low.

"Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums."

The bottom line for the report was a significant fear that the Fed was losing control and could begin to ramp up the rate hike cycle with more aggressive hikes. The Fed believes that energy prices will remain low, a point I would argue is in error, global growth will continue and trade deficits will diminish due to the drop in the dollar. In general they are nearly united in their view that the Goldilocks economy is returning with the exception of a greater risk for inflation.

Where the Fed minutes should have painted a positive outlook for investors given the Fed's rose colored glasses it also shattered that outlook with worries that rates were going higher soon. There had been a near unanimous view that the Fed would pause at the February meeting and take a longer view of the economic picture before making any new changes. After today's report the current 2.25% rate has now been speculated to rise to as much as 4.25% by year's end. This would mean at least one hike greater than 25 points or no passes at any of the eight meetings scheduled for 2005.

This sudden change from a no more hike sentiment to a full and possibly aggressive hike scenario knocked the wind out of the market this afternoon. The yield on the ten-year treasury spiked to 4.3% and the equity markets imploded. The Dow dropped -100 points on the 2:PM news to 10605 and barely rebounded to close at 10632. The Nasdaq dropped another -21 points on top of an already steep decline to -59 off the highs at 2100. The Nasdaq only managed a very weak +9 point bounce into the close. It was the worst day for the Nasdaq in five months.

Also helping the decline was a downgrade on AMZN to sell at Smith Barney. Despite very strong sales this year the analyst thinks other online firms are eating away at AMZN market share and will continue to do so. Brick and mortar retailers are reporting a much faster ramp in acceptance of their online sites and the online retail space is becoming more crowded. AMZN dropped -2.38 on the news and took all the other Internet stocks with it. GOOG fell -8.21 from its all time high reached just yesterday.

Another crowd favorite also took a major hit of -1.83 or -14.8% after acknowledging accounting improprieties. The company, Krispy Kreme Doughnuts, admitted it had padded sales, double shipped, disguised problems at certain stores and misreported earnings. The stock dropped to $10 but my question is why not $1? This company appears to have committed multiple counts of fraud and could be delisted very soon. Looks like the public still has a sweet tooth for KKD. Maybe they should go back and look up Boston Chicken, BOST. All the shareholders got greased when BOST finally imploded after years of being the darling of Wall Street.

Depending on which sentiment indicator you want to use the 2005 year is not off to a good start. Today was the last day of the typical Santa Rally period following Christmas. Needless to say the Dow or any of the indexes for that matter did not see a visit from Santa. The Dow lost -200 points during the period after the Dec-23rd close. The Nasdaq lost -53 points, Russell -22, -28 from its high and the SOX -17 (-4%). If you were counting on Santa for your sentiment then the Santa adage is running through your mind tonight. When Santa fails to call bears will come to Broad and Wall. It would appear on the surface the door is open and the red carpet rolled out for their arrival.

The other market barometers include the first five days scenario. Theoretically the first five days of January are supposed to predict the direction of the market for the year. Not looking good for that one. Then there is the January barometer, as January goes so goes the year. None of these predictors of market direction have very good records but they are all consistently prove more often right than wrong. Bah humbug!

We knew the market was going to sell off once the calendar rolled over. We talked about it in this space several times. When the indexes rally as they did in the fourth quarter the money managers are just holding their breath hoping to get to the new year before everybody pulls the rip cord on their profit parachute. Remember this table from last Thursday?

Index Low 12/30 Gain
Dow 9708 10800 +11.2% from October low
Nasd 1899 2178 +14.6% from October low
$SPX 1090 1213 +11.2% from October low
Nasd 1750 2178 +24.4% from August low
TRAN 2959 3807 +28.6% from August low
$RUT 516 653 +26% from August low
UTIL 260 336 +29.2% from May low

Since August the Russell was up +26%, the Nasdaq +24%. There were huge amounts of profit to be taken and the managers are doing that this week.

Whenever the market takes a sudden and unexpected (by the uninformed) drop the talking heads on TV scramble to find the reason. Today we were told it was weakness in China, unemployment in Germany, spiking oil prices, sudden inflation fears and last but not least new Fed fears.

Obviously it was not oil since it fell over -$2 on Monday and the market still tanked. Today it rebounded to erase those losses but is still trading in exactly the same range it has been trading for the last five weeks. Today the oil worry is only smoke. It will eventually bite us but not today.

The Fed outlook was blamed but there was really nothing in the outlook that was different than any prior outlook. The optimistic analysts had convinced themselves into believing their own dreams that the Fed was done. The Fed has never even hinted that it might pause. Every comment has always been "accommodation will continue to be removed at a measured pace." No change there.

Some analysts blamed the drop on a lack of fund flows. The $31B of expected money had failed to appear. This is also smoke. The money does not appear the first two days of the year. The majority appears over the second and third weeks of January. TrimTabs said today they were still expecting $2.5B to $3B PER DAY over the next two weeks. No change there.

Are you starting to get the picture? Nothing has changed and the current drop is just profit taking. Even Ralph Acampora came out again today and affirmed his Dow 13K forecast. Nobody expects a blowout market but they do expect the markets to move higher over the next two quarters.

Where to from here? The Nasdaq has been literally slammed as funds took profit in techs. The index dropped back to 2100 today and decent support. It could stop there or it could drop all the way back to 2050 but it will stop. When the rebound starts it is likely to be sharp and on very strong volume. Be prepared.

The volume today was very strong and weighted heavily to the downside. On the NYSE the down volume was 9:1 over up volume with over 2B shares traded. Despite the beating on the Nasdaq the down volume was only 4:1 over up volume. The NYSE volume was drastically stronger because the majority of energy stocks are on the NYSE. Of the 350 energy stocks I cover in my Oil Crisis Report there are only 36 listed on the Nasdaq. When you think about which sector had the biggest gains the last six months it all makes sense. The funds are taking profits in energy and tech. Crude was up nearly +$2 today but energy stocks were down. This is clearly a buying opportunity in the making.

For the rest of the week I would look for a bounce but possible not before even deeper support levels are tested. SPX 1175-1180, Nasdaq 2050 and Dow 10450 would be my worst case support levels. I believe we will bounce before then but these corrections nearly always get overdone as traders react to the negative news in the press. The Nasdaq normally corrects about -5% in January and even if you count from Monday's high of 2191 to today's close at 2109 it is only -3.7%. There could be some weakness remaining but once the selling stops don't try to short the bounce. Managers will not be under any pressure to buy until the real money flows hit next week but they are generating a lot of cash from these two days of selling. If somebody steps on the trip wire we could change directions very quickly. Watch the up volume. If we get a reversal in the volume from 9:1 negative to 4:1 or 5:1 positive then we have seen the bottom.

Pick your entry targets now. If you have no target you will probably miss the bulls eye.

Jim Brown

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