Option Investor
Market Wrap

Ho, Ho, Ho!

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Santa Claus appears to be playing a trick on traders by teasing us with dreams of new highs but delivering bouts of profit taking as we near those highs. After a week of volatility produced by fund sales and tax selling the indexes returned to close very near to where they started the week. Given the sharp periods of selling early in the week a return to the last weeks levels is a positive event. Many commentators referred to the weakness last week as the absence of a Santa Claus rally. This is incorrect. The Santa Claus rally refers to the last five days of the year and the first two days of the next. The week before Christmas typically has a bullish bias but has been plagued with tax selling in recent years as funds clean up lose ends before they leave for the year. Last week saw some broad based selling events but no real damage was done to the indexes. The return to the high end of the range by Friday may have erased the index losses but investor sentiment was still badly bruised.

Dow Chart - Daily

Dow Chart - 60 min

Nasdaq Chart - Weekly

The markets started off in the dumps Friday morning after a sharp drop in New Home Sales. Sales in November fell to 1.245 million units on an annualized basis. This was a drop of -159,000 from the October rate of 1.404 million units. It was the biggest drop since 1994. While this looks negative on the surface we need to remember that October was a record high and the current pace is still very strong and just slightly under the 1.29M average rate for the six months prior to October. The inventory of new homes rose to 503,000 units and a 4.9-month supply. This was the highest level since 1996. However with sales much stronger than prior levels this rising inventory is not necessarily as bad as it looks on the surface. November and December are not strong months for home sales with the pace accelerating once the holiday lights come down in January. Talk of a bursting bubble continues and the internals of this report suggest the West Coast is in full decline. Sales of new homes in the west declined by -22% with the Midwest dropping -18%, the South -5% and Northeast rising +13%. Remember this is a survey of contracts signed not houses closed and is less reliable than the regular Home Sales survey. The markets reacted negatively to these numbers and erased their early gains. It took several hours before the indexes fought their way back to positive territory.

This housing news came on the heels of a prediction by Fannie Mae that the housing market has peaked and will continue to decline in 2006. Fannie said housing starts in 2006 could drop from -5% to -10%. They predicted existing home sales would decline by -4% and new home sales by -5%. 30 year fixed rate mortgages are expected to rise to 6.6%. The New Home Sales for November as reported above fell -11% from October to November and that seemed to provide validity to Fannie's claims.

Offsetting the drop in New Home Sales was a stronger than expected Consumer Sentiment at 91.5 for December. This was +10 points over the November level at 81.6 and significantly over the cycle low at 74.2 set in October. Expectations provided the biggest jump adding +10.6 points to 80.2 with the present conditions component rising +8.9 to 109.1. The headline number rose +2.8 points from the initial December reading suggesting the holiday sentiment accelerated as December progressed. As heating bills for those December cold fronts and holiday credit card bills begin hitting mailboxes in January this positive sentiment could fade.


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Durable Goods Orders surged in November for the second consecutive month. November posted a +4.4% jump compared to +3.0% jump in October. Both months were pushed higher by aircraft orders. Looking under the hood the orders ex-aircraft actually fell -2.0%. Inventories also rose sharply in all categories. Spending has been steady but the rise in inventories could be a warning that this buying trend is slowing. While the sharp jump in aircraft orders is good for the economy it is far less a driver than home sales. It may be good news for Boeing but not especially a positive economic indicator for the U.S. economy. Some estimates suggest that the home building sector has produced up to 50% of the GDP growth in 2005.

After Friday's economic reports the talking heads were consumed with the potential for an inverting yield curve as an indicator of a coming recession. The yield on the 10-year sank to 4.38% only one point away from merging with the yield on the two year note. An inverted yield curve is said to be one of the best indicators of an approaching recession 6-9 months in the future. Unfortunately for the doomsayers none of the other indicators are cooperating. Other indicators needed for confirmation are falling commodity prices and a declining stock market. While oil is off its highs it has not turned into a nosedive yet. Copper, an excellent indicator of economic activity hit a new high on Friday at $2.04. While the equity markets have been volatile of late the S&P is only six points from a four-year high. Transports, another indicator of economic activity hit a new all time high at 4282 on Friday. The CRB Index (CR00Y) is only ten points off its all time high set last week at 336. Without confirmation an inverted yield curve is an indicator without a home. Once confirmation from the other indexes begins to form you can bet there will be a rush to the exits but that is a problem we are not likely to see until January or later.

Oil prices slipped to close just over $58 despite comments from OPEC that they would have to trim production after January if prices continued to fall. How quickly they became comfortable with the new price range after saying they wanted a $30 range just over a year ago. Boone Pickens was on TV this week saying he could see prices fall to $53 in early 2006 as winter demand declines but will reach $100 before the decade is over. More detrimental to the price of oil this week was a sharp drop in gas prices after a smaller than expected drop in gas storage levels of -162 bcf. Many had expected the drop to be over -200bcf given the very cold weather the prior week. Natural Gas closed Friday at $12.28 after trading up to $14.42 before the inventory report on Thursday. With no cold front on the horizon and warmer weather forecasted for the holiday week traders were quick to take profits. That urge to sell was hastened when Pickens said gas prices could fall to $9 as winter demand declined.

Crude Oil Chart - Daily

Natural Gas Chart - Daily

This drop in oil and gas prices helped to push the transports to another new high. Stellar performers have been the airlines, AMR, CAL and JBLU. Railroads have been making the grade with NSC, UNP, BNI, CSX and CNI the leaders there. FDX spiked to a new all time high on Thursday after better than expected earnings but UPS failed to break resistance after the FDX earnings news. I am mentioning all these outperformers because January has not been kind to the transports for the last five years. In 2005 the first three weeks of January saw a drop of nearly -400 points in the transportation average. In 2004 the decline did not begin until the 3rd week of January but continued for nearly -400 points. The decline in 2003 begin with the opening of trading for 2003 and continued for nearly -500 points to bottom on the week of March 9th. 2002 losses were somewhat moderate compared to 2003-2005 with only a decline of around -250 points but it did start with the opening of trading for 2002. 2001 was ugly with more than -575 points lost from the end of December high at 3157 to the March low at 2578. In 2000 the index fell from 3017 to 2260 for a whopping -757 point drop. I listed this history for those looking for a post holiday trade. The transports can be traded using the $DXT.x options or the transportation iShare (IYT). Past performance is no guarantee of future results but given a five year trend and transports at an all time high it seems to me to be an opportunity ahead. You could also use options on some of the stocks that make up the index and I would pick on those who have the weakest recent performance and the largest index components. The top ten components are FDX 11.5%, UPS 10.4%, UNP 8.1%, EXPD 7.0%, R 6.4%, CHRW 6.3%, YELL 6.2%, CNF 5.9%, JBHT 5.3% and BNI 5.1%.

Transport Chart - Weekly

The Chairman for Norfolk Southern was on CNBC on Friday on the eve of their 175th birthday. David Goode said business was as good as he had seen it in his forty years in the business. Railroads have better than a 4:1 advantage over trucks in energy consumption and the performance of the rails is showing it. He said there is currently a shortage of rail cars and trucks due to the demand and a lack of CapEx spending by truckers over the last five years. NSC has been expanding since the acquisition of Conrail and appears to be in a good position to profit from the current cycle. NSC is a big coal shipper and the price of natural gas has increased demand for coal to the point where there are not enough cars to carry it. I would probably not pick NSC as a short candidate for January. They are tied with BNI at 5.1% as a component in the transportation index.

Unless Santa's face shows up on a milk carton over the weekend we should see another attempt at the highs next week. The game plan for last week was to buy any Monday dip and hold on the rest of the week. Well, as they say the best laid plans of mice and men sometimes go astray. The Monday dip continued into Tuesday and accelerated into the close. That may have scared many traders out of the plan and back to the sidelines. The indexes did return by Friday's close to near their recent resistance levels but there was far less bullish excitement than we had hoped.

This lack of excitement could have been the result of several weeks of selling the rallies by funds. This has given investors numerous cases of indigestion and a reluctance to hold stocks as we close in on resistance. While I was expecting a bullish year end once we consolidated the November gains I am quickly losing that bullish sentiment. As I indicated last week January has seen some substantial losses in recent years and the Transportation Index losses I highlighted above suggest it is about time for that transportation rally to correct. Falling transports typically drag the Dow down with them. In straight English I am beginning to fear there is a serious dip in our immediate future. Because funds have a strong interest in keeping the indexes supported at these levels I do expect some tape painting into year end but they have been less than successful over the last week. Hopefully they will apply a little more effort once the weekend has passed.

Because the holidays are being recognized on Monday the back-to-back three day weekends will produce even lower trading volume next week. That is actually a plus for the tape painters. The lower the volume the easier for funds to move the prices higher. Unfortunately it is also easier for sell programs to push them lower and sharply lower if the fund is really dumping positions. For those still bullish the odds of strong sell programs are less in the coming week than they were in the week just over. Funds want to sell into volume so that prices remain firmer and not fluctuate wildly. They will get an overall better price with higher volume. Volume levels last week started out at 4.3B on Monday and declined to 3.6B on Thursday and 2.5B on Friday. We will be lucky next week to break 3B shares on any day. This is not the kind of volume funds want to sell into. We can't ever guarantee any outcome but hopefully the Santa rally will arrive as expected and produce the +1.5% average S&P gain. That is a little less than +20 points and with the 4.5 yr resistance high at 1275 it would give us a new breakout attempt. Notice I said attempt.

Chart of VXO - Weekly

Chart of VIX - Weekly

Despite the bullish sentiment normally prevalent this time of year the VIX/VXO are both flashing warning signs. The VIX closed at 10.27 on Friday when the indexes were barely able to rebound back into the green before the close. The VXO or the old VIX closed at 9.87 and only .75 above its low for the year. While the volatility last week was extreme the volatility indexes failed to confirm with a move higher. Far too many traders are expecting the post Santa bounce and nobody is protecting against a fall. When the VIX/VXO is low it is time to go because nobody is buying puts. Traders are too confident that the market will move higher and just like curiosity killed the cat, overconfidence kills traders. The VXO 9.87 reading ahead of the expected Santa rally suggests any market rise next week could produce a new low for the year below 9.12. I have set my chart alarm at 9.12 and I will be exiting any longs on that signal and loading up on puts on the first signs of weakness. That weakness could come very quickly given the resistance on the current charts.

The SPX has solid resistance between 1275-1280. The Nasdaq has correspondingly hard resistance from 2270-2280. Combine that with the Dow resistance from 10900-10950 and traders will have a hard time making any rally stick. It is entirely possible to see a breakout into year-end, it has happened before, but you can bet there are still some sell orders waiting at those highs. The bullish sentiment has faded and worries about January are appearing on all sides. January begins a new earnings cycle and with Q4 performance seen as mediocre the January numbers could be weak. For 2006 S&P earnings are expected to fall into the single digits and that is not going to be market friendly. I am not going to launch into a 2006 outlook this week and will save it for next Sunday. But, I still believe that long term investor sentiment is fading fast as the year closes. If Santa suffers a reindeer transit strike and fails to show next week we all know what will happen. Remember the adage, "If Santa fails to call, the bears may come to Broad and Wall." Typically weakness between Christmas and New Years is a leading indicator of selling to come in January. Keep your fingers crossed that Santa produces a breakout next week but keep those stops tight just in case he fails. Until next week Merry Christmas and Happy Chanukah to all and to all a good night!

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