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Market Wrap

Santa's Claus Rally Dead?

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Santa failed to make his Wall Street appearance this morning and traders panicked as news of his demise hit the wires. It appears Santa's sleigh was shot down by the Canadian border patrol when he was mistaken for a terrorist during what Canadian officials are calling an "unscheduled border crossing." His sleigh full of goodies destined for Wall Street investors was confiscated by officials and will be held pending an investigation into the matter. Several reindeer managed to escape but three were caught in the hail of bullets. Their names are being withheld pending identification. However, none of the three had a red nose. Young children are advised to skip the news photo below due to the graphic violence depicted.

Santa and the unidentified reindeer fatalities

The markets opened with a bang on a sharp drop in energy prices but a brief inversion of the yield curve tempered those gains. It has been five years since the curve last inverted followed by a recession. The last four recessions were preceded by an inverted curve. Since 1954 a severely flattened or inverted yield curve preceded every recession and several severe economic slowdowns. This recession worry was given as a reason for the sharp sell off of the morning gains. In reality it was not selling by retail investors that caused the drop. There was a strong sell program triggered when the Dow rebounded to the December highs at the open and then failed to hold. The sell programs knocked the A/D line from +1258 to -2850 in a very short period of time for a net change of -4100 issues. The S&P rallied to 1271.83 and within four points of a new four-year high before imploding to suffer a significant loss back to near the bottom of the December range. It was not a pretty picture for the bulls and the severity of the selling could easily have ruined sentiment for the rest of the year.

Dow Chart - Daily

Nasdaq Chart - Daily

The falling oil prices caused funds to dump energy stocks they had been trying to hold until January. Many funds probably wanted to hold those energy winners until after the calendar expired in order to present the best possible shine to their year-end portfolios. The sharp drop in oil and gas prices sent funds running to the exits despite a minor rebound in oil prices towards days end. Previous big winners suffered huge losses as stop losses were hit as funds dumped positions. A sample of the big losers would be AHC -5.31, IMO -3.59, ATW -3.51, EOG -3.33, SLB -3.05, BTU -3.01, KMG -3.00 and STR -2.90. Many of those stocks were up +50% to +100% for the year and huge profits were at risk. Gas stocks were hit the hardest as warmer than expected weather was predicted for the next seven days. Natural gas prices fell from Friday's close at $12.28 to rest on $11 at the bell. This is a substantial drop from the $14.42 high last Wednesday (-23%) and the $15.78 high (-30%) just over ten days ago. This is a massive loss for natural gas prices and this time of year they are the driving force in the energy sector. Oil prices trade on a btu basis to natural gas during the winter and it is remarkable that oil closed down only -27 cents at $57.85 after trading as low as $57.30 intraday.

Crude Chart - Daily

Natural Gas Chart - daily

If you looked at a list of the top 100 losers today better than 80 of them were energy stocks but the other big drops came from other prior winners. Google (GOOG), Whole Foods (WFMI), Nutri Systems (NTRI), Hansen Natural (HANS), Garmin (GRMN), ITT Industries (ITT), PW Eagle (PWEI), Marchex (MCHX), Hurco (HURC), Franklin Resources (BEN), Terex (TEX), Freeport McMoran (FCX), Education Services (ESI) and Deere (DE) to name a few. The main reason these companies are on the list is profit taking into year-end. Some funds with big gains obviously got nervous and started taking profits early.

After the close the S&P announced changes to the S&P-500. CBX Corp (CBSwi) and the new Viacom Inc (VIA.Bwi) will replace Visteon (VC) and the old Viacom (VIA.B) at the close of trading on Friday. The "wi" means "when issued" on the new stocks above. S&P also announced that Whole Foods Market (WFMI) will replace MBNA Corp (KRB) which is being acquired by Bank America.

Although the fund selling was strong and the internals terrible it was on very light volume. If you recall I mentioned on Sunday that we expected very low volume this week due to the back-to-back three-day weekends. Volume today barely broke three billion shares across all markets and much of that volume was due to stops being hit rather than a sudden burst of activity from investors getting cold feet. The real selling pressure came from two sell programs, one at 11:20 and the other at 1:20. This was not an all day event or a massive change in investor sentiment. It was two large sell programs on a very light volume day and there were no traders around to buy the dip. The result was a -105 point Dow loss and the worst day after Christmas ever according to market historians.

Where we go from here is a different matter. After having the stuffing knocked out of the holiday turkey we may have suffered a sentiment blow that could be terminal. The odds of an offsetting day of buy programs this late in the year are very slim. The tape painters will probably be content with holding the averages in the current range rather than trying to repair the damage. Dow 10725 is an area likely to be defended as long as selling volume does not increase substantially. I believe retail traders may be scared enough to stay on the sidelines until they see what January will bring. Given todays sell programs I think we just got a preview of what is to come.

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The airwaves were full of news about pockets of weak holiday sales although several stores including Wal-Mart and Federated were still on track to meet estimates. Retail analysts were cool to the idea that buyers were strong enough to push profits higher. Retailers appeared to have discounted earlier and deeper in hopes of selling to buyers strapped by higher energy/gasoline bills. This is likely to be a prevailing story as we move into January and more retail info becomes available.

There were some news standouts today headed by a warning from Overstock.com. OSTK issued a press release warning that they were no longer expecting to make a profit in Q4 due to higher expenses and slower than expected growth. The CEO, Jack Byrne, said Overstock decided to build the brand instead of focus on profits. During the period Overstock would have negative cash flows and rising inventory levels. Byrne said the excessive ad spending was necessary to get above the noise. The noise he was referring to was his fight with the mythical "Sith lord" he claims is responsible for the decline in his stock price. Bryne appeared in an interview on Bloomberg on Friday and today he lashed out at Bloomberg for editing out comments they deemed unnecessary. It is going to be progressively difficult to get good press if every interviewer ends up getting ripped by the Overstock CEO. Byrne said Overstock would announce its Q4 results "sometime in late January or early February." That vagueness in earnings dates is less than comforting to investors accustomed to having companies announce a firm date months in advance. OSTK closed at a new 52-week low at $31 with an -8% loss. We bought puts on Overstock in the LEAPS Trader at $38.50 in early December. For comparison Amazon said it had its best holiday season ever with a record number of items shipped.

OSTK Chart - Daily

WFMI Chart - Daily

Whole Foods Markets (WFMI) closed at $150.81 today and split 2:1 after the close. Whole Foods would be a good candidate for some of those year-end investment dollars at its new price of $75 sometime after Wednesday. Since there is likely to be some January profit taking on WFMI I would hesitate to enter until a new uptrend begins. Waiting for any January dip would be a good idea but let the trend tell you when it is time to enter.

Guidant dropped -2.29 to $64.69 after saying it received a warning letter from the FDA about its manufacturing center in Minnesota. On Friday Guidant said earnings would fall below expectations. This is bad news for Boston Scientific and its $25 billion bid for the company. BSX made the bid after Johnson and Johnson lowered its prior offer to $21.5B after a rash of negative news hit Guidant. Will BSX lower its bid as well? Traders appeared ready to take profits now rather than wait to see if another round of bidding or bid cuts would come first.

The potential inverted yield curve had been cussed and discussed for months and its arrival today was blamed for the drop. However, this indicator of future economic weakness is far from perfect. While all prior recessions on record were preceded by a flat or inverted yield curve there have been inversions without a recession. There is a Wall Street adage applied to many indicators as the situation warrants. In this case the adage would be applied like this. "An inverted yield has correctly predicted 10 of the last five recessions." This would mean the indicator appeared much more often than recessions actually occurred. For us it is not as much a worry about a potential recession as it is about how funds will react to the news. If today's selling was the nervous Nellie's bailing on the news then we could see some more tomorrow as the curve is debated ad nauseum on stock TV and in print. The key for us is to trade what the markets give us rather than try to guess in advance.

I warned on Sunday that the markets had serious resistance at Dow 10900-10950, SPX 1275-1280 and Nasdaq 2270-2280. The Dow spiked right into the middle of that Dow 10900-10950 range with today's 10932 high. The SPX could not make the grade to 1275 but came close right at 1272. The morning gap down on the entire energy sector kicked the props from under the SPX preventing it from hitting that 1275 resistance level. The Nasdaq also failed to reach its resistance highs and topped out at 2260 due mostly to the implosion on the Russell-2000. The Russell dropped nearly -10 points or -1.43% compared to only -0.9% on the Dow, S&P and Wilshire-5000. This Russell drag on the market is what concerns me the most. The Russell is a favorite proxy for mutual fund buying and selling. Funds like to buy the smaller companies when markets are expecting a multi month rise in hopes they will become larger. In times where the markets are expected to be choppy or down those same funds exit the small caps and rotate into the highly liquid blue chips. A larger drop in the Russell than the rest of the indexes suggests to me that funds are not planning on rising markets in early 2006. The January effect helped the Russell to a long bounce from the 615 low in October to the +690 levels we saw as resistance for the entire first two weeks in December. That boost to small caps from January expectations is now behind us and funds are starting to worry if the yield curve is right or wrong this time around. If there is a recession ahead the place you do not want to be as a fund is small caps. They are too illiquid and they tend to react sharply to bad economic news. Meanwhile multinational blue chips are safe havens for large amounts of cash.

The rest of the week is likely to remain volatile with buying volume declining as the week comes to a close. However, selling volume could rise if more funds start getting nervous. As a trader I plan on shorting weakness on any bounces in anticipation of a January dip. The Dow Transports dropped -50 points today after setting a new all time high on Friday. This was -50 points when oil was down sharply and a reason for them to be celebrating. If you read my weekend commentary you know I am expecting a sharp drop in the Transports once the calendar expires. A drop in Transports typically drags on the Dow and the manufacturing stocks. From where I sit tonight I see more negative potential on the horizon than I see positives and visibility is decreasing. In cases like this it is best to be overly cautious and go with the trend for short trades. Just remember to enter passively and exit aggressively and definitely don't get married to your positions.

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