Option Investor
Market Wrap

Turn Out The Lights

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       WE 01-21        WE 01-14        WE 01-07        WE 12-31 
DOW    10392.99 -165.01 10558.0 - 45.96 10603.9 -179.34 - 43.82  
Nasdaq  2034.27 - 53.64 2087.91 -  0.70 2088.61 - 86.16 + 14.15 
S&P-100  557.32 -  7.12  564.44 -  1.94  566.38 -  8.64 -  1.04 
S&P-500 1167.87 - 16.65 1184.52 -  1.67 1186.19 - 25.46 +  1.52 
W5000  11507.29 -145.45 11652.7 +  3.85 11648.9 -323.90 + 38.98 
SOX      389.66 - 13.48  403.14 -  4.42  407.56 - 25.72 +  6.85 
RUT      611.08 -  6.40  617.48 +  4.27  613.21 - 37.87 -  1.71 
TRAN    3471.17 - 97.99 3569.16 - 67.62 3636.78 -160.56 +  9.56 
VXO       14.55           12.43           13.85           13.58 
VXN       19.37           18.57           19.15           18.37

Will the last bull out the door please turn out the lights. The party may be over if this week's market action is any guide. The major indexes secured a place in the history books with their 2005 performance. The Dow, SPX and Nasdaq have NEVER been down three consecutive weeks in January. You have to go back to 1977 for both the Dow and SPX to start the year with a three week drop. By itself the Dow was the last index to string three but it was back in 1982. This is not the way to start a happy New Year.

Dow Charts

Nasdaq Chart

Without any major news on the stock front or the world scene the indexes continued their swoon on Friday and all closed at new lows for the year. The only material economic report was Consumer Sentiment which fell slightly to 95.8 from 97.1 but that was hardly a market mover. The fear of higher rates is beginning to weigh on consumers but not enough to push the sentiment significantly lower. The falling market has become a bigger fear factor and the next revision to the sentiment survey is sure to be significantly lower.

The ECRI Weekly Leading Index stopped its multi-week drop and rebounded to 133.3 from 130.7. This is a very strong bounce that was mostly in part from the unexplained drop in jobless claims early this week. This should have been slightly positive but this is not normally an indicator that traders watch.

Bearishness abounded on Friday despite a successful conclusion to the inauguration. The major indexes all closed at their lows for the year and stock TV was full of bearish interviews suggesting that the market weakness is going to continue. Actually this could be a contrarian indicator as the number of bears has dramatically increased over the last couple of weeks.

With the market setting records for ugly performance those bears should be very happy. This is the worst January in over 20 years and the complete lack of cash inflows is really upsetting the strategy of fund managers. Normally there are withdrawals in January as some investors pull out cash once the prior tax year is over in order to use it for other reasons like taxes. The massive inflow of year end retirement contributions offsets this smaller outflow of withdrawals and gives fund managers liquidity to handle the outflows without having to close positions. The complete lack of inflows this year has upset those patterns and fund managers are having to trim positions to cover withdrawals. TrimTabs said again on Friday we are on track to see nearly -$5B of cash outflows in January and this is unprecedented in recent years. January 2004 saw inflows of +$43.8B.

There is no single reason for the lack of cash other than investors waiting for the profit taking from the Q4 rally to ease. We had a huge bounce off the October lows and most funds/investors were fully invested. With expectations for 2005 less than exciting many investors are deciding to put money in other places than the market. Bond funds are seeing huge inflows of cash and funds that invest overseas are receiving new money.

The challenge is not earnings but the guidance. 115 S&P companies have reported earnings and 65% beat estimates, 18% reported inline and only 17% missed analyst estimates. For this reporting cycle the GAAP earnings are running about +9.4% growth over 2004. Proforma earnings are about +18.2% over last year. This performance both in percentage of companies beating the street and percentage of earnings growth are both really good given the strong comparisons from 2004. Unfortunately many companies that beat the street this quarter are warning for Q2 or longer and few are raising guidance.

For instance GE beat the street by a penny and said they were confident they would return to double digit growth in 2005 and the market yawned. It was really good earnings from a corporate giant and they said good things about the economy. Immelt said the breadth and depth of the economic momentum is very positive. However they only predicted +10%-15% earnings growth for 2005. That is not bad but it is not exciting enough to make investors rush into the stock. GE closed down a quarter and well off the highs of the day.

Oil also came back to haunt investors with a return to $48.95 after a one-day dip. Speculators are betting that the Iraq elections next week will see a huge spike in attacks on oil facilities. Sabotage in Iraq has completely halted exports from the northern fields since an attack more than a month ago. Barclay's Capital said Friday the inability to keep pipelines and wells operating in Iraq was a growing indication of serious reservoir damage caused by under investment, misuse and neglect. They said the outlook for Iraqi oil production is getting dimmer. Output is currently -21% under pre invasion levels.

Also, another snowstorm for this weekend is expected to deplete even further the heating oil supplies which are already -13% below last years levels.

OPEC said on Friday that demand is continuing to rise unexpectedly but they would still be able to meet that demand. It may cost us $55 or $60 but if we pay they will pump it. OPEC meets again next Sunday to discuss the next round of production cuts but it is looking less likely it will happen with oil already near $50. They said their current projections for demand show an increase of 1.65 mbpd for 2005. That would push the daily global demand to 83.64 million barrels per day. This jump in demand is more than OPEC had predicted just a month ago. OPEC expects demand from China to only grow +7.2% in 2005 to 6.9mbpd after a +15.5% jump in 2004. I would bet against that low number. With the rapid internal growth and the huge ramp in the delivery of autos it could actually exceed the 15% jump from 2004. High growth countries expand oil usage much quicker than those already stable. The Venezula Oil Minster said he would support a million barrel cut because current oil prices are just given the growing demand. Makes sense to me. Demand is growing unexpectedly fast so lets cut production and charge more. We will be hearing a lot of this in the not to distant future.

With the worst three-week start in recent history to set the stage we have some serious decisions in front of us. There are a growing list of problems and although none of them are serious they seem to take on added importance when the market is performing exactly the opposite of what analysts expect. The bears claim it is the slowing economy and we have seen several instances of that in just the last week. They also point to the rising inflation and the potential for higher rates as a wet blanket on stocks. Add in the deceleration in earnings guidance, higher oil and the coming Iraqi elections and we have a witches brew of trouble.

I thought the market would shake off all these problems with a swish of its bullish tail and continue higher on the January cash flow. That lack of cash flow now has me singing a more cautious tune. My critical market levels of SPX 1175 and Dow 10425 have failed and the next stop could be a long drop lower. As long as the market was consolidating above those critical levels there was still hope. Once broken that hope turns into despair and more traders will begin throwing in the towel until some sanity returns to the market. It is not that there is insanity now but when historical market trends are broken with no specific reason the average trader tends to panic and over react.

The Dow closed under 10400 on Friday and there was not any material driving force. It was simply a lack of buyers and steady selling across the board. Once the 10500 level was severely broken on Thursday and buyers did not appear the sentiment of the market changed drastically. We could call it an option expiration event and that could be right. We already knew this expiration cycle would produce negative market pressure but I don't believe that is the only reason. It may have been a contributing factor but not the cause. Sentiment has turned nasty in just the last two days. The lack of inflows has caused traders to question their beliefs and assumptions. What does $40 billion in retirement cash know that we don't? It is very strange that this many people would suddenly pull the plug on that much money with no warning. This has really spooked many traders.

With the Dow close under 10400 it appears the next minor support level at 10350 will only be a speed bump. I don't know how many times I have said it over the years but Monday will be a key day. If the down trend confirms with post OpEx move lower then funds could begin to dump stocks in volume. Once we pass 10286 and the 50% retracement level for the October rally the next support could be 9800. Yes, 9800. Once a real correction takes hold we tend to aggressively over correct and the drop accelerates even faster. It could get really ugly if sentiment does not change almost immediately.

The Nasdaq appears much weaker than the Dow and the weak book-to-bill number on chips on Thursday has not helped. The Nasdaq closed well under 2050 at 2034 and below all material support levels with the possible exception of the 38% retracement at 2022 and the 100 day average at 2019. That is weak at best on my chart and the most likely target now would be 1900-1920 if we break that 2020 level.

The SPX closed well under my 1175 line in the sand and right on 1167 which some analysts are calling terminal support. Terminal because a break here could be deadly to the future outlook. I see that level as 1160 but that difference of opinion is what makes a market. We are already under my "get flat" level at 1175 and under 1160 I will switch to a strong short bias. Under 1160 we could see pause points at 1140 and 1100 but the next real support is not until 1060. Funny how 1300 and 1325 were all the rage last week on stock TV and this week 1060 is now the silver bullet for killing the bear. That would be the 100% retracement of the October rally and a concept I have trouble grasping at present.

SPX Chart - Daily

SPX Chart - Weekly

I am sure there are others scratching their head today and trying to figure out why we are not moving higher. As long as you are scratching your head and not buying the dips you will be ok. Once the market breaks critical support levels the best thing bulls can do is stand aside. Those who can make the mental switch to the potential plunge can don their chutes and go along for the ride.

The key point to remember is "don't fight the trend." We should be in "short the rally" mode under SPX 1175 instead of buy the dips. Until historical trends return to the market we need to remain focused on short term positions. Monday could be pivotal for sentiment but we just need to keep our eyes on the 1175 level for direction and not listen to all the analysis on stock TV. It is our red light, green light indicator and we all know what happens when we ignore red lights. The result is not pretty. Cheer up! The last time the Dow started the year with three down weeks was 1982. Actually the first three months were down for the Dow but it came back to gain +20% for the year. This is also 2005 and we have not finished negative since 1880 on a year ending in five. A 120-year trend may be just a long anomaly but it does exist. Unfortunately the first year of a second term president also has a rocky history so we are right back where we started watching 1175 for direction.

Jim Brown

"Nothing is more exhausting than searching for easy ways to make a living"


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