Option Investor
Market Wrap

Bonds Up, Stocks Down, Traders Confused

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WE 05-13


WE 05-06


WE 04-29








+  34.80



+    9.45


+  45.70


-  10.54

S&P 100


-    8.04


+    5.46


+    1.34

S&P 500


-  17.30


+  14.50


+    4.73







+  26.22



+  11.41


+  11.17


-    3.70



-  14.50


+  17.14


-  10.15







-  13.61















Bonds Up, Stocks Down, Traders Confused

That has been the story of the week with bonds soaring and pushing yields on the ten-year note to 4.11% intraday and a new three-month low. The Dow retreated from resistance at 10400 last Tuesday and quickly fell back to the bottom of its recent range at just under 10100. Oil slid to a three month low and the dollar rose to a six month high. Triple digit days are becoming the norm as volatility makes a comeback. It was a heck of a week.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

On the economic side Consumer Sentiment fell again to 85.3 from the prior reading at 87.7. Consensus estimates were for a slight rise to 88.0. This marks the fifth consecutive monthly decline since the 97.1 high in December. May's reading was the lowest since March-2003. A weak labor market, rising interest rates and high-energy prices continue to weigh on the consumer. New jobless claims have risen for three consecutive weeks and are nearing 350,000 once again. The recent drop in equities has also soured the mood among those with retirement accounts. The drop in oil prices should provide some relief at the pump but it may only be brief. Have you ever noticed that gas prices never return to their prior levels after a prolonged spike? Once consumers become used to paying more the retailers take advantage of it.

Business Inventories advanced at the slowest pace in three months with a gain of only +0.4%. This was below the consensus for a gain of +0.6%. The inventory to sales ratio slipped back to 1.31 and only one tick above the cycle low at 1.30. A low inventory to sales ratio means sellers are not confident enough in the trend to stock a backlog of products. They are carrying only the minimum necessary for short-term needs. This is good for companies like FedEx and UPS since it generates a constant flow of small shipments. In theory a demand spike could cause an order spike and manufacturers would have to race to catch up. Unfortunately we have not seen any demand spikes in quite a while and that is why inventories have been allowed to drop.

Dell announced earnings on Thursday night and almost single handedly supported the Nasdaq and kept it in positive territory. Dell rose +2.73 on their earnings to $39.22. Dell had been fighting resistance at $37 and it could have been a monster short squeeze for those thinking they would post marginal results. Regardless of the reason the +2.73 jump provided a sizeable boost to the Nasdaq. Since they only reported inline and guided inline I fail to see what prompted the rush into the stock. Dell had a good quarter because HPQ, GTW, SUNW and LXK are floundering not because Dell is so outstanding. I know that is heresy among Dell fans but you have to agree the competition Dell faces is weak at best.

Also providing tech support was earnings from Nvidia and another +2.50 jump above recent resistance. NVDA posted earnings of +36 cents compared to estimates of only 29 cents. Morgan Stanley was quick to issue a note to investors saying Nvidia was undervalued and had little downside risk. The NVDA and Dell earnings gave chip buyers some encouragement and the SOX finally broke back over the 400 level with a close at 408.

Positive tech earnings did little to erase the Wal-Mart warning earlier in the week. The Retail Sales report on Thursday had a headline gain of +1.4% and significantly over the +0.4% in the prior month. This was heralded as the end to the soft patch in consumer sales. However, there were two factors not mentioned. The prior month had been abnormally low as a result of seasonal adjustments. It appears that skewed the numbers and it was corrected in April. Secondly, much of the gains in retail sales was due to rising gas prices. Sales at gas stations rose +1.9%, motor vehicle and parts dealers +2.5% and clothing rose +2.8%. This was the official government numbers. However when Wal-Mart missed estimates and warned that Q2 earnings would probably miss as well that is the real proof. Wal-Mart accounts for roughly 10% of the U.S. retail sales and caters to 150 million shoppers. If Wal-Mart says consumer buying is slowing I am going to believe them rather than the "adjusted" government numbers. The Wal-Mart warning helped convince investors that the soft patch was not over and equities weakened as a result.

Other than the couple of tech earnings mentioned above there was little news to move the market. Commodity stocks continued to lead the drop with steel, copper and gold moving to new lows. Since bull markets are said to have copper roofs a strong failure in copper could be a sign the economic expansion is slowing. Since copper is a component in almost every electronic product made today a sudden rise in inventory levels and signs of shrinking demand speaks volumes about economic health. I have heard there is 150 pounds of copper in every new home. We have seen copper rise to near $1.50 in late February and hold there for three months with no credible attempt to move higher. The drop to $1.38 on Friday was a three-month low.

Gold fell to close just over $420 and well off its $439 highs just three weeks ago. This is also a three-month low. Oil broke under $48 intraday and came within 25 cents of its 200-day average at 47.50. $46-47 should be very strong support and further declines would be surprising.

The drops in commodities can be attributed in part to the rising dollar. The dollar began spiking on Tuesday and accelerated to a new six month high. A stronger dollar means it takes fewer dollars to buy the same amount of a commodity. A barrel of oil or ounce of gold has not changed in value only the currency used to buy it. The dollar has risen +6% since the April lows and it clearly diverges from the price of commodities, which are trading at new lows for the same period.

Dollar Index Chart - 120 min

Crude Oil Chart - Daily

The real question is why is this market scenario changing? I believe it is still related to those hedge fund rumors that won't go away. The selling this week was clearly program related and volume was heavy only while the programs were active. There were numerous attempts to buy the dip and each ended in disaster. The rumors continue to fly as to who is in trouble and what trades need to be unwound. Bonds have been bought heavily with the yields on the ten-year dropping to a three-month low at 4.12%. Somebody is either covering some massive shorts or rotating out of corporate paper into something safer prompted by multiple debt downgrades over the last two weeks. Since we don't know what trades these funds are trying to unwind we have to watch the market for clues to the extent of the damage. Previously strong stocks and most importantly those with huge long-term gains have been sold off in volume as each sell program appears. Most analysts feel this is a desperate attempt to raise cash to support other positions or withdrawals. Several hedge fund managers were interviewed on Friday and all believe there is some truth to the rumors and are seeing abnormal activity behind the scenes. Goldman Sachs is rumored to be in trouble with huge trading losses and very high derivative risk. GS has fallen sharply the last two days from $104 to $97.

On Friday the selling was especially strong once the S&P failed at 1165. A strong sell program hit and triggered sell stops as prices cascaded down. Just before 3:PM the S&P hit 1146, Dow 10075 and Nasdaq 1975. Shorts were piling on and market sentiment was very negative. Suddenly at 3:04 Carl Icahn announced he was taking large positions in several high profile stocks. With everybody short from Thursday's failure at resistance and highly profitable the sudden emergence of Icahn's announcement with only an hour left in the week produced a knee jerk short covering rebound. The stocks he mentioned were Dow component HPQ, RAD, SEBL, LTS, IMCL and TELK. There was no substance to the move only reaction. Traders trying to decide if they wanted to hold short over the weekend suddenly had their decision made for them. It was just enough news to shock the market back into reality. Like a groggy fighter stumbling to the corner just after the bell the market was losing its grip and suffering from an increasing dizzy spell. When the manager sees his fighter is one punch away from a knockout in the next round he stuffs some smelling salts under his nose to clear his head and bring him back to life. The Icahn news was smelling salts for the market. Unfortunately if the fighter was already being pummeled into dizziness the odds of a further decline are good despite the brief return to consciousness. This is the same with the market. The Icahn bounce stalled at 10150 only 20 min after it began and the Dow weakened into the close. To put it simply the Icahn bounce was nothing but eye candy to frustrated investors and should have no impact on Monday's market.

If you are following my recommendations you should have been short since 10350 on Monday. The drop to 10075 on Friday was a complete retracement of all the gains made in May. We fell back to just above the April lows and are in danger of moving lower. The NYSE advancing volume over the last two days has been horrible. Thursday it was 4:1 declining over advancing and 3:1 on Friday. There is no buying interest on the NYSE because that is where most cyclical and commodity stocks trade. If the dollar continues to rise you can expect those stocks to continue down. Initial support is 10K followed by 9800 and my eventual target.

The Nasdaq was the reverse of the NYSE with advancing volume nearly 3:1 over declining on Friday, nearly even on Thursday and 2:1 on Thursday. For some reason there is a stealth rally underway on techs even as we head into historically the weakest period of the year for tech stocks. Chip stocks bounced off 390 after the Cisco earnings and hit 400 before Dell. I believe shorts loaded up again at 400 thinking Dell would disappoint. While I thought Dell's report was average for them there were enough traders short that a monster short squeeze developed. The chip stocks reacted as well and shorts were squeezed to nearly 412 before the spike cooled. I believe there is no substance to this bounce. It looks to me like two back to back short squeezes on the SOX and that supported the Nasdaq. The Nasdaq still has resistance at the 200-day average at 1995 and horizontal resistance at 2000-2010. Any further gains will be hard to achieve and with earnings over there are no catalysts in sight. Current support at 1965 is rising. While the Dow is suggesting a further breakdown the Nasdaq is giving bullish signals. This divergence could further hamper any additional Nasdaq gains but a sudden change of fortune for the Dow could accelerate them.

That presents a conundrum for traders to use Greenspan's term. Half the market appears headed for the cellar and half trying to move higher. If we look to the other indexes for help the Russell 2000 would be the first stop. Small caps don't normally do well in the summer and the RUT has failed at 600 resistance twice in the last month. The drop on Friday to 580 was a retest of the April 18th low but there was a lower low at 570 on April-29th. You could make a case for an inverted head and shoulders but given the lack of excitement Friday at -5 and the positive SOX/COMPX suggests that 580 support could fail.

Russell 2000 Chart - 60 min

SOX Chart - Daily

The SPX fell to 1146 intraday and briefly lost its grip on the 1150 level. It did lose the support of the 200-day average at 1158 and Friday was the first close below that average since April-28th. There is some short-term uptrend support at 1150 that adds to the congestion in the 1140-1150 range. The S&P does not look as negative as the Dow or RUT but far weaker than the Nasdaq. If I had to call a direction on the S&P I would say the charts favor a bounce somewhere in that 1140-1150 range. To have staying power it would have to move over 1175 and hold it and I don't see that happening. A break under 1140 is lights out for the bulls.

A bullish event that went unnoticed was cash inflows into funds of $4.4B for the week. This is a huge jump in cash flow compared to the last six weeks. Even more unusual was that the vast majority ($3.5B) actually went into U.S. funds not overseas funds as we have seen for months. Trimtabs said on Friday that only +$8 billion has flowed into U.S. equity funds year to date compared to +$75B at this time in 2004. Meanwhile $29B has gone into overseas funds compared to $33B in 2004. According to TrimTabs investors are avoiding equities in general and favoring real estate, gold and energy funds. Corporate buybacks at $90B are twice last year's levels. Earnings growth has been better than estimates for nine consecutive quarters. Tech earnings for Q1 came in at +18% and much better than expected. The only thing missing is incoming cash flow into the market. Last weeks +$3.5B was nearly half the total inflows for the entire year. It is entirely possible that sentiment is changing and the slight uptick in techs is the leading edge of that move.

There are several things that trouble me with that concept. Summer is typically not kind to techs or small caps and both would be needed to create a real rally. Nothing says they can't rally into summer but it is not the sentiment we have seen to date. Add in the hedge fund problems as a wild card to really confuse the picture. Maybe one more fund induced drop will be the catalyst for a bottom. If we can finally get a washout in the Dow from fund selling it could create the capitulation event we need to end the last two months of losses. Regardless of the immediate market direction the odds of a range bound market over the summer months remain strong. What we don't yet know is what that range will be. For next week I have moved closer to neutral on market direction. I believe any S&P dip to 1140-1150 will be bought and the Dow will find some buyers around 10000. The wild card is still the hedge funds. Maybe Friday's sharp sell off was the closing blast BUT again maybe not. Huge intertwined positions don't get unwound over a couple days. The sharks smell blood and nobody wants to be holding the bag when the final reveal appears. Bids in quantity have dried up and we are only seeing token offers. There is fear in the market that another Long Term Capital type blowup could appear any day and that is not something that will disappear overnight. It could take time for the rumors to subside and buyers feel comfortable getting back into the market. Remember the lack of conviction I have been discussing over the last several weeks. It is still there as is the question "Why buy?"

If the economy really is improving then the Fed is far from done. If it is not improving and the Fed continues to hike then a recession is imminent. Earnings guidance has been less than exciting and earnings for Q1 are basically over. Market rallies at the end of a hike cycle typically start one hike before the end of the cycle. Based on current expectations that would be around October and coincidentally the month where normal end of year rallies begin. Factor in the head start gene and that suggests a late summer rebound from the early birds trying to beat the rush. It also suggests that the smart money is going to wait out the Q2 earnings to be sure of guidance before moving back into equities. If you are not confused now you are doing better than me. I would key on S&P 1140 for guidance. A break below 1140 signals a new leg down. Until then we are likely to be range bound between 1150-1180 as the summer doldrums begin to grind up those traders trying to pick a direction. According to Ameritrade the doldrums have already started. Trading volume at Ameritrade dropped -30% in April prompting an earnings warning from them on Friday. The CEO said retail investors were waiting for economic conditions to improve before investing. Average daily trades fell from 200,000 to 140,000 and summer is not even here yet. I remain neutral on next week and suggest you key on 1140 for a trading bounce or a new short opportunity if it fails. Cash is always a position. Definitely enter passively and take profits quickly.


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