Option Investor
Market Wrap

Just Like Butter

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The market has been churning for the past week and the higher volatility of the past few weeks has slowed down and movement in the market has become incredibly tight and slow. Trying to get a trade to stick over the past week has been an exercise in frustration no matter which side you've been trying to trade. Tight volatility leads to expanding volatility so it's just a matter of time before this breaks, and when it does we could face another bout of strong volatility.

The morning started off weak after a disappointing sales forecast from Cisco (CSCO) last night and reports that General Motors (GM) quadrupled its Q2 loss figure and will have to restate 2001 earnings. GM's accounting has been under scrutiny by the SEC and said it must restate financial results for not just 2001 but also possibly subsequent years as well. GM said it overstated income for 2001 by as much as $300-400M, equivalent to about 50% of the profit it reported at the time, by "erroneously" booking credits from suppliers. The company said its accounting for credits from suppliers is "one of the matters" being investigated by the SEC. Its shares fell yesterday to their lowest level since November 1992 (which was during the company's last financial and management crisis), closing down $1.23, or nearly 5%, at $24.63. Also yesterday, Fitch Ratings cut its already junk-level rating on GM's debt by another two notches. Today GM gapped down, closing down another $1.12 (-4.5%) at $23.50. GM is down nearly 14% from Monday.

Also making the news today was Fannie Mae which in the course of an ongoing review reported that it has uncovered new accounting problems, identifying more than $10B in issues related to derivatives, insurance accounting and other matters. In its practice of hedge accounting they've identified problems that will lead to an estimated net cumulative aftertax loss of about $8.4B as of Dec. 31, 2004. FNM said it also identified errors related to misapplied cash-flow hedge accounting for its mortgage commitments and it will cost $2.4B to fix it. But wait, there's more. The company also said it booked a $257M aftertax charge for the effects of Hurricane Rita and Hurricane Katrina. Their exposure to losses as a result of the hurricanes, as reported by the company, "arises primarily from its guaranty of principal and interest payments due to holders of Fannie Mae MBS [mortgage-backed securities] secured by property in the affected areas, its portfolio holdings of mortgages and other mortgage-related securities secured by property in the affected areas, and real estate that it owns in the affected areas." But wait, that's not all. It also identified problems with its accounting for investments in low-income-housing tax credits and synthetic-fuel businesses. Understandably, FNM gapped down this morning but shortly after 10:00 AM the stock price never looked back, rallying from its low of $45.21 (closed yesterday at $46.38) to close nearly flat at $46.34. Excuse me while I make the accusation that someone (PPT?) stepped in to protect this stock (as part of the protection for the whole market). The derivative exposure in this company alone could cause an implosion of the entire banking industry and it WILL be protected.

The trade deficit report for September showed a widening by 11.4% to a new record $66.1B, from $59.0B in August, well above the $61.3B economists had forecasted. Imports costs surged partially as a result of imported energy costs related to post-hurricane oil shut-downs. The interesting thing about crude oil imports is that we paid more but actually imported less (lowest level since February 2003). Prices for imports ex-petroleum products were up +0.8%. The widening of the trade deficit initially caused a negative reaction in the U.S. dollar but the dollar continued to rally today to new highs in its current move.

Exports declined by the largest amount since 9/11 and Boeing (BA) got the blame for not delivering as many aircraft due to their union strike. And no surprise, the trade gap with China widened to a record $20.1B. Export prices ex-agriculture were up +0.6%.

Jobless claims data was released and showed initial claims rose 2K to 326K (consensus 320K) for the week ending November 5th. Weekly continuing claims were up 23K to 2.82M. They're continuing to track claims related to the hurricanes and the cumulative total so far is 535K.

The University of Michigan Consumer Sentiment index showed a slight increase from October's 74.2 to 79.9, which was above expectations of 76.0. However, since the data doesn't correlate well with consumer spending trends and has little economic implication, the market shrugged its shoulders at the report.

We got natural gas inventories this morning and the following report was released by EIA, "Working gas in storage was 3,229 Bcf as of Friday, November 4, 2005, according to EIA estimates. This represents a net increase of 61 Bcf from the previous week. Stocks were 93 Bcf less than last year at this time and 123 Bcf above the 5-year average of 3,106 Bcf. In the East Region, stocks were 56 Bcf above the 5-year average following net injections of 36 Bcf. Stocks in the Producing Region were 15 Bcf above the 5-year average of 857 Bcf after a net injection of 22 Bcf. Stocks in the West Region were 52 Bcf above the 5-year average after a net addition of 3 Bcf. At 3,229 Bcf, total working gas is within the 5-year historical range." Prices of the various energy components dropped today--natural gas was down on the report and then rallied a little into the afternoon, closing at $11.36, down from yesterday's $11.67. Oil was down $1.15 today, closing at $57.80 which was below its 200-dma. Lack of demand? Economic slowdown coming? Investors would like to know.

After the wild ride in the indices since the October low, we got into a very tight trading range for the past week. It looks like today was an attempt to break out of that range to up side. Let's see where we could be headed.

DOW chart, Daily

The DOW has managed to break all obvious resistance levels and by that measure looks quite bullish. The previous highs around 10700 would be the next resistance level to tackle and with the daily looking overbought I would guess that we're due a pullback sooner rather than later. A pullback needs to stay above its 200-dma at 10501 in order to maintain its bullish pattern, otherwise I would expect the pullback to be steeper than that. A pullback that finds support at its broken downtrend line from March-July 2005, currently at 10600, would be bullish.

DOW chart, 120-min

The 120-min chart shows the bearishness of the climb. Whether or not it's in a bearish ascending wedge is arguable but the bearish divergence showing up at new price highs is not. Negative divergences can last far longer (as part of an irrational market) than you can trying to short a rallying market so don't go by these indicators alone. But it's a heads up that not all is well in rally-land.

SPX chart, Daily

Like the DOW, the SPX has managed to break above several layers of resistance and faces on of its last ones (before breaking to new annual highs) at its downtrend line from July, currently at 1238. With the daily chart looking overbought, any rally up to that resistance would probably make for a good short for at least a deeper pullback.

Nasdaq chart, Daily

Like the others, the COMP has made it past most resistance levels and faces its next one at its previous high in July ((just under 2220) and the trend line along the highs since January 2004--a little higher at 2228.

Intel (INTC) gave the market a little boost today after reporting it's going to increase its dividend 25% to 10 cents a share, beginning with the dividend that will be declared in Q1 of 2006, and they're authorizing a $25B buyback as part of their ongoing stock repurchase program. The SOX was up 1.3% with the help of this news today.

SOX index, Daily chart

Not only did the SOX break out of its down-channel, it didn't even stop to say hello to its 50-dma. That's pretty bullish looking and doesn't have any real resistance until the downtrend line from March 2002 through January 2004, which is identifying the top of a sideways triangle pattern playing out since its larger post-2000 drop. This sideways triangle pattern, by the way, is a consolidation pattern (more easily seen on a weekly chart) and I'm counting the current leg up as the last one (wave-e in an a-b-c-d-e triangle wave count) before the dominant trend resumes--down. If we've got higher to go in the current rally, I would expect a pullback first which is what I'm depicting on the above chart.

Based on recent price action I'm thinking again that we're going to see a push to new annual highs. But there's something that's not quite right with the current rally so I'm being very cautious about thinking higher. As can be seen in the banking chart below, there is some serious buying coming into certain stocks and sectors. But looking under the hood makes me think it's not all as rosy as it appears on the surface. For example, when I look at the number of new 52-week highs and lows during this rally I don't see full participation. When I look at a chart of new highs since the October low I see an increase in the number of new highs as the rally progressed so that looks good. But then the number of new highs started dropping off since a high on November 3rd. This week's new price highs, including today's, have been met with a lower number of new 52-week highs. Worse, the number of new 52-week lows has been increasing all week, from a low of 71 on October 31st to 137 today (which was higher than the 134 new highs today). A rally of nearly 100 points in the DOW and the number of new lows exceeded the number of new highs. That's just not right and something smells on the street of Wall.


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While the DOW has remained fairly steady (the trading range over the past few months has been fairly tight), a look at the DOW components shows many have suffered large losses. Then they recover while another stock gets taken out behind the wood shed. There's been a greater than usual intermarket divergence between the indices. It seems to be water sloshing from one end of the tub to the other as money moves around. Where's the new money? With mutual fund cash down to 3.8% of total assets, the lowest level since 2000, where's the fuel to drive ALL stocks higher, not just the indices? Worse, if some selling kicks in and investors start to get worried and want to cash out, mutual fund managers will be forced to start selling since their cash reserves are so low. That could exacerbate any selling and worry investors even more, thus causing a vicious cycle.

As another example of intermarket divergence, one look at the new highs being made in the TRAN while the DOW languishes below all lower highs made since March 2005, creates some concern according to Dow Theory. There are many who are saying it's different this time (like Greenspan saying an inverted yield curve will be different this time) tells me to be even more cautious. If there's one thing 2000 taught me it was to distrust those who tell me it's different this time. Burn me once, shame on you. Burn me twice, shame on me. In the current rally, especially since the end of October, and as pointed out in the above charts, we're seeing a loss of momentum as the indices rally and internal measurements such as new highs versus new lows is a part of what we're seeing there. Obviously price rules but it's a warning that the current rally leg so far doesn't have the required participation to continue to drive it much higher. Can they drive SPX up to a Fib target of 1265? Absolutely, it's not that far away. But unless and until I see greater participation, it will only convince me further that the bull market is topping. And speaking of pushing something higher, check out the banks:

BKX banking index, Daily chart

There were either a lot of shorts in the banks or the banks became a particularly hot commodity; probably both. This buying frenzy sinxe the October low can't continue--way too much too fast. The trouble with this kind of rally we've seen is that they tend not to end well so be careful if you're long the banks. In the meantime, if we get any kind of appreciable pullback, look for support at the previously broken downtrend line near $100.

BKX banking index, 120-min chart

Looking a little closer at this zoom climb (and you know what happens after zoom climbs, right?), the banks have reached up to the top of very steep parallel up-channel. A pullback that finds support at its uptrend line would be bullish whereas a break below its uptrend line, currently near $101.50, would indicate a larger pullback, at a minimum, is in progress. Use this to guide your trading in the banks.

Also helping stocks in general, and banks in particular, today was the rally in the Treasury market. A stronger than expected demand (55.6% indirect bidder (foreign) participation, which was more than twice this year's average of 25%) from foreign central banks for this afternoon's $13B 10-yr note bond auction, which drew a yield of 4.578%, created some excitement in that foreigners still wanted to buy US. Having them buy up our debt created some relief and the thought (expectation) that they'll continue to buy equities as well. In response to the auction, the benchmark 10-yr note was up 18.5 ticks, knocking the yield down to 4.56%, improving overall sentiment in a rising interest-rate environment which continues to be a restraint as investors worry about corporate profits. This helped the home builders as well but unfortunately it only looks like a bounce within a downtrend.

U.S. Home Construction Index chart, DJUSHB, Daily

MC Hammer's song "U Can't Touch This" comes to mind when I look at this chart. The combination of the 50-dma and 200-dma slapped this index silly and it was followed by a strong red candle. Today's bounce looks like a short term oversold bounce and until the 200-dma is recaptured, I'd be shorting all rallies in this index.

Oil chart, December contract, Daily

Oil can't even seem to bounce up to the top of its down-channel. Worse, it couldn't find support at its 200-dma today, at $58.10. At this point, watch for support at the bottom of its channel, which has been providing bounce support all the way down. That's currently down near $56.70.

Oil Index chart, Daily

Another "U Can't Touch This". This index touched the electric fence at its 50-dma and made for a great spot to cover any longs and get short. The next test is obviously another test of its 200-dma but I'm thinking it will break this time (after a smaller bounce off it). The uptrend line just below its 200-dma will also likely provide a bounce but at this point, unless it can recapture its 50-dma, I'd continue to short rallies in this index.

Transportation Index chart, TRAN, Daily

I knew I should have listened to what the Trannies were telling me. The strong rally in this index was a clear heads up that the broader market would follow. The trouble is that there's been a disconnect between the Trannies and the DOW, which of course from a Dow Theory standpoint is bearish. But by itself it's not a sell signal; instead it's a heads up signal and the fact the DOW hasn't (yet) been able to best any of this year's lower highs since March 2005 tells me something's not right with this rally. By the internal wave count and Fib projection inside this leg up of the rally, I'm thinking it's close to being done, if not done as of today's high. If you're long any Transports, tighten up those stops.

U.S. Dollar chart, Daily

The U.S. dollar consolidated underneath resistance and got the pop above. Now watch to see if prior resistance just below $91 acts as support to any pullback. The larger pattern in the dollar hasn't changed--it should make its way higher over the next several month to about $96.

Gold chart, August contract, Daily

I thought for a couple of days that gold was a goner. It broke below the $461 level which looked like a H&S break down but has since bounced back up. By not breaking below the August $453.40 high, it has maintained a potential bullish EW pattern that is looking for one more new high in a 5th wave up, as labeled on this chart. I show a Fib projection of $485.30 so if that level is reached, watch for potential resistance and pull your stops up since that could mark THE high in gold for quite some time.

There are no major economic reports tomorrow.

Sector action was obviously mostly green today, led by the airline index (they liked the drop in oil) which was up over 4% today. Following them were the healthcare providers, retail, financials, securities and brokers, SOX and Trannies. There were only a few in the red today and leading to the downside was the oil service sector, down nearly 4%. Other losers today were other energy indexes, gold and silver and the utility index.

After the bell we got Dell's earning's report which disappointed investors. After rallying from the day's low of $28.62 to close at $29.20, it dropped in after hours to $28.86, so back down to near its daily low, which also was a new 52-week low and 2-year low (lowest since April 2003). Dell reported in-line and guided in-line--they reported Q3 (Oct) earnings of $0.39 per share and sees EPS of $0.40-0.42 for Q4 (Jan) with revenues of $14.6-15.0B (vs. $14.91B consensus). DELL reported in-line gross margin of 18.6%. The company said net income fell to $606M, or $0.25 a share, from $846M, or $0.33 a share in the same period a year ago. Recent quarterly results were hurt by $422M in charges ($0.14 per share) to repair a faulty computer component and costs related to restructuring. Operating income was in line at $754M, or $0.39 a share. Sales were a record $13.9B, up 11% from the $12.5B last year. However, the $13.9 billion was below company's prior guidance of $14.1 to $14.5B and analysts' forecast of $14.3B. Hence the after hours sell off. From July's high of $42, this stock has taken a drubbing.

Tomorrow could be a little tricky. Today's rally looks ready for at least a pullback. As mentioned above, there seems to be an effort to prop this market up, especially as we head into opex week. Whether it's the PPT, large funds, or a combination of both, there's concern about the derivative risk that many large hedge funds are exposed to. A down market would expose many of these funds (and Fannie Mae and Freddie Mac) to an unpleasant surprise that could cause massive "ripples" through the system. There will be an effort that's not, shall we say, "free market", to hold the indices up for at least another week. Expect to see buy programs come out of nowhere, especially if the market is looking vulnerable to a steep decline. The lack of full participation in the rally makes it suspect. But for now, don't fight the tape and the tape says potential rally ahead to new annual highs, at least for the S&P, and the the NDX is already there. Speaking of the NDX, I have a potentially very strong Fibonacci resistance zone for NDX in the 1660 area. Today it closed just shy of 1651. If NDX fails at this level I'll be watching it closely for clues in its pullback--if it starts to pull back impulsively, it could be our clue that a market high is in. If it starts to pull back while other indices press higher, the intermarket divergence will be another clue (the water sloshing from one end of the tub to the other). But there's a trend line across the highs from January 2004 higher up above 1700 so it's possible we'll see this index continue higher if the DOW and SPX have higher to go as well.

Back in the summer time frame when I though the market would press higher than it did, I thought SPX would press up to a tight Fibonacci zone around 1265 (or up to a Gann level of 1275). The rally from the October low now makes that level possible again if the market has an agenda to rally into the end of the year. I'd actually like to see that happen since it would fulfill a longer term EW pattern and Fibonacci objective. The market has about 6 weeks to achieve another 35-45 SPX points (350-450 DOW points) which shouldn't be difficult if that's what's in store. The next major Fibonacci turn date is December 27th and I had been thinking it might mark an important low from which we'd get a rally into January. Now I'm beginning to wonder if it will mark THE high for this bull market run. Time will tell. For tomorrow, watch for a pullback that finds some support in the 38-62% retracement of the latest rally leg to indicate there's more upside to come. If the market drops back below this morning's low, that would be more intermediate term bearish. Good luck tomorrow and I'll see on the Monitor.

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