Option Investor
Market Wrap

I Think I Can

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The DOW is trying so hard not to slide back down the 11K hill, chugging for all its worth but the wheels are starting to slip. The problem as I see it is that it will gain a head of steam, get those wheels to grip and go charging over the hill only to fall off the other side. Kind of like getting onto a horse too fast and falling off the other side. As of yesterday's close, the Dow, S&P and Nasdaq were already up 2.7%, 3.4% and 5.1%, respectively, for the year -- surpassing all of last year's gains, leading many to believe that stocks may have moved too far too fast.

I (Keene Little) will be filling in for Jim today (and next week) so if you have any disagreements with my analysis please send your hate mail to Jim. He lives for those emails. Thanks. I see today's consolidation as bullish. We should get a resolution higher out of it and then it's a question as to how high it will go. I have my targets but obviously I'm just one of many voices out there. I'll show you in the charts what I think is playing out and what my upside targets are. I continue to believe we're very close to a major high. In fact I think it's more than a little interesting that things are coming together for a high to get put in place this week, and if it were to happen on Friday, that's exactly the 6-year anniversary of the high in the DOW on January 14, 2000. But it's obviously a bit premature to be guessing that scenario.

The day started out in the hole with the futures down almost 50 DOW points before the open. All markets gapped down and then spent the rest of the day backing and filling and closing the gaps. Some new highs were made such as in the Russell 2000 small caps. The fact that funds are pumping money into the small caps and techs is generally a bullish indication. As long as that continues we should be looking higher.

But I can't help but think even the fund managers are getting suckered into a bull trap. The current rally is running out of steam and showing negative divergences and lack of breadth as new highs are being made. I show a chart below of the Nasdaq and compare it to the advancing/declining issues and it's not what bulls want to see. I use EW analysis to help determine where we are in the pattern and one of the things I look for is a 5th wave (up in this case) that is negatively divergent against the previous high (the top of the 3rd wave) which helps identify the move as the final 5th wave. I'm seeing those indications and it tells me we're closer to a top than one would gather when watching money flow into small caps and techs. I see another rally leg directly ahead but after that it will probably be the bears' turn.

There was only one economic report this morning which was wholesale inventories so the market was left to figure things out on its own. Considering the flat close I'd say it didn't figure anything out. Wholesale inventories were up 0.4% as expected while sales were down -0.7%, the first drop since February. The inventory-sales ratio rose to 1.15. It becomes worrisome when this ratio rises because it says we're either producing too much or selling too little and inventory is building. The carrying costs for inventory becomes a drag on earnings and it's a heads up that things may be slowing down (or producing too much).


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Three companies making the news this morning were General Motors GM (22.06 -0.41), Alcoa AA (29.60 -0.97) and Home Depot HD (41.80 0.98). GM announced they would be cutting the prices on most of their vehicles in an effort to spur buying. They wanted to do this instead of offering rebates and discounts in hopes of making it easier for customers to understand. Incentives will still be offered but much smaller. The average price reduction on 57 of their 76 vehicles will be $1,300, with cuts as high as $3,000 on some vehicles. Saab and Hummer are not included in the price cuts. GM rallied up to $22.78 today, just above its 50-dma at $22.60 and then fell back. The daily chart shows overbought so after a nice run up since Jan 3rd, this stock looks like a shorting candidate.

AA announced earnings which disappointed the market. They reported 4th quarter net earnings of 26 cents per share, down from 30 cents a year earlier, which is a 16% year/year decline. They blamed high raw materials costs, energy costs and production outages due to Katrina and a plant in Australia that was closed for a while. AA was the leading decliner of the DOW 30 today. UBS downgraded AA to neutral from buy but they raised their target price to $34.50 from $33, citing rising metals prices.

Home Depot (HD 41.76 0.94) proposed to pay $3.2BB, or $46.50 a share and the assumption of $285 million in debt for Hughes Supply (HUG 45.63 7.08), a distributor of construction, repair and maintenance products. The deal would more than doubles the size of HD with projected 2006 combined sales approaching $12B and is expected to lift HD's earnings in the first year. HD was the leader of the DOW components today.

A look at the DOW components today showed split performance and the DOW finished flat. So it would seem we have nothing new to report today. But a look at today's price action reveals an important pattern that's playing out--a small sideways triangle pattern which indicates we should expect a move higher tomorrow and that it will be the last move before a deeper retracement sets in. First let's look at the daily chart.

DOW chart, Daily

After consolidating near 11K for over a month the DOW is finally making a stab at breaking through this barrier. The straight up leg from Jan 3rd looks like too much too fast but it's probably not finished. Interestingly, as of yesterday's close, the DOW, S&P 500 and Nasdaq were already up 2.7%, 3.4% and 5.1%, respectively, for the year, which is more than all of last year's gains. And this was done in less than a week. As discussed below, this is in the face of deteriorating market breadth so it's looking like we're close to putting in a longer term high. I show an upside Fib target of 11131 so watch for potential resistance at that level.

SPX chart, Daily

Like the DOW, the SPX looks like it's ready to continue higher, perhaps after a small pullback in the morning. If this can press higher, I show an upper Fib target just under 1304. Whether or not it will make it up there is an unknown but watch for potential resistance if it gets tagged.

SPX chart, 30-min

A close up view shows what I think is playing out. Today's consolidation looks like a small sideways triangle and fits best as a small 4th wave consolidation within the move up from Jan 3rd. This pattern says we should expect another rally leg and more importantly says we should expect only One more rally leg. Therefore, once the next rally leg (assuming we get it) finishes, I'll be looking for a longer term short position.

Nasdaq chart, Daily

These all look the same--a big spike up from Jan 3rd and one has to wonder if they all haven't moved too far too fast. But like the DOW and SPX, the COMP looks like it has another leg up in its immediate future. The upside Fib target of 2336 is not far away. In the larger pattern, two equal legs up from its April low is at 2355 and may be the ultimate target. Watch for resistance in this area since this leg up could be finishing the rally and I'll be looking for the start of a big decline from there. One of the reasons for expecting a top soon is the lack of breadth seen in this rally leg, typical for the last leg up. This next chart shows the Nasdaq advancing issues minus the declining issues. Preferably we would like to see this increasing as the market rallies. The fact that the number is falling off as price makes new highs means fewer and fewer stocks are participating.

Nasdaq Advance-Decline Issues, Daily, courtesy stockcharts.com

The declining tops in this chart since the November high is a bearish divergence against the new price highs that the COMP is making. The rally up from October is losing steam. So even though price is shooting straight up over the past week, a look under the hood says we have some leaking hoses and our engine is about to flash a warning light. If you're long the market, get into protection mode and start pulling stops up a little closer. We should get another rally leg out of this but we're getting very close to what I see as major resistance and the negative internal breadth confirms that the top is close.

Yesterday we had the consumer credit numbers released and what I found interesting was the fact that consumer credit has dropped 2 months in a row which was the 1st time in 13 years (since 1993) that it had done that. I've mentioned several times recently that the US consumer is going to slow down and stop the spending binge that we've been on for a number of years. As the money tree gives up the last of its "dollar leaves" (from inflated stock portfolios and then inflated home equities), consumers will be forced to live within their means. The latest numbers were for November so we'll have to see how much of a change we see in December but I think the pattern will continue.

The fact that non-revolving credit fell nearly $1B, much more than revolving credit (like credit cards), means there were fewer loans taken out for homes, home additions, autos and the like. This is very likely a result of less money available from home equities. We've seen a reduction in refinancing activity. And if less money is available to spend on big ticket items the US consumer will likely start to feel poorer. A consumer that feels poorer is one who is not as happy. Unhappy consumers will start to have negative feelings about the future and we'll see consumer sentiment start to take a hit. As consumer sentiment takes a hit we'll see the stock market follow. It's really a simple matter of happy versus unhappy consumers that makes for a bullish or bearish stock market. It's not rate hikes or earnings or other news (though they'll certainly cause ripples in the market).

Speaking of rate hikes, and the speculation that they'll be ending soon, it was brought to my attention over the weekend (thanks John) that the ending of rate hikes is not necessarily a good time to buy stocks. I have always assumed, like most everyone, that the ending of rate hikes is always a good time to buy stocks. It's one of the reasons we hear lately why it's a good time to buy the market since the Fed will soon be done with their rate hikes. A brief discussion by Steve Hochberg, Chief Market Technician at Elliott Wave International, using a chart of the Wilshire 5000 index, pointed out the relationship between Fed rate changes and the stock market.

The Wilshire 5000 is about the broadest index of stocks that we have and it's a good index for measuring market sentiment. One of the reasons we heard for the rally last Thursday afternoon and into Friday was because the Fed minutes gave traders the impression that the Fed could be close to finishing its rate hikes. Always anticipating the next 6 months or so, market participants eagerly jumped on this news and started buying. Or so they would have us believe.

EW analysis is a measurement of wave structures which is a measurement of social mood. The stock market happens to be one of the best measures of social mood that we have. We can also see changes over time in our music, writings, number of protests, consumer sentiment, war and peace, etc. But as for actually charting social mood, nothing beats the stock market and this is true going all the way back before our country even existed. So when we hear that the Fed controls the market through their use of fiscal policies, that's actually not true. They're followers just like the rest of us. They react (usually late and then usually too much for too long) to the market and are simply a piece of the puzzle. They do not cause nor end recessions but instead react to the market changes that precede and follow recessions.

I think we've seen enough evidence in this last cycle to show that rate changes haven't really changed the economy's direction as many believed would happen. Even Greenspan commented in October 2001 before the House and Senate Joint Economic committee that he thought "the idea that the Fed could prevent recessions is a puzzling notion, chalking up such events to exactly what causes them: human psychology". As he has raised short term rates, he has referred to the bond market not following him a "conundrum". A chart shows best the disconnect between the market and the Fed rate changes.

This is the chart of the Wilshire 5000 that Steve Hochberg used:

DJ Wilshire 5000, Daily chart

I hope the chart is clear enough after reducing it. Basically we want to focus on the time period starting near the left side where it shows the final rate increase on 5/16/00 to the first rate cut on 1/3/01. The Fed ended their series of rate hikes in May 2000 after starting the raising cycle in June 1999. As shown in the chart, from the time of the final rate hike to the time of the first rate cut, the market actually lost 9%. If in March or April 2000 market participants had started buying in anticipation of this end in rate hikes, their losses would have been even more severe, something closer to -25%. If market participants are now anticipating an end to current rate hikes and buying the market and we lose 25% before the next rate cut, that would take the DOW down to 8250. I could be missing something here but it seems to me I'd rather be a seller at a time like this. Even after beginning the rate cuts from 6.5% to 1.0% the market continued down, losing about 25% during that period of time. So the rate cutting did not create a bullish stock environment but instead the Fed was just following the market down.

Once the market anticipates that the Fed will need to start raising rates after a rate reduction cycle, one would think, based on the current logic used by analysts, that we should be sellers in anticipation that the Fed tightening will start to choke off growth. Again, the facts don't support this. It was after the market bottomed in October 2002 and March 2003 and then rallied 46% did the Fed feel the need to start raising rates again. The final low was in March 2003 and the final rate cut was in June 2003, well after the rebound was well underway. It was well after the market had rallied strongly that the Fed started its rate tightening cycle, again, following the market. Do you suppose those in the know want us to believe their story so that they have people to whom they can off load their inventory near the highs? Nah, that wouldn't be fair. And then at the bottom they want us to believe it's going to continue lower so that we bail and they happily buy from us? I know, I'm being too cynical.

Financial news people feel the need to explain market moves and basically they don't know what they're talking about, and I'm being kind. I will admit I hadn't checked up on the facts of Fed rate changes and market movements around these changes but the facts speak for themselves. We owe it to ourselves to check the facts and not take what we read, including this newsletter, as fact. At least we at OIN have no agenda other than to try our best to educate. But we can and are wrong at times (although I do forget the last time I was wrong, but then again I forget what I said yesterday) and it's your money. Read a lot, study more and do your best to prove out what you're hearing. Only then can you feel confident in your own opinions about the market.

Helping the tech stocks today was a report from Apple Computer (AAPL 80.86 4.81) saying that Q1 revenues are now expected to reach $5.7B (consensus $5.04B). AAPL's share price continues to make all-time highs. Chip stocks were helped by an analyst upgrade for Advanced Micro Devices (AMD 34.95 1.70) which hit a new 52-week high. These bullish reports helped the SOX continue on its tear to new highs for its current leg up.

SOX index, Daily chart

Different symbol, same chart. The SOX may peak a little earlier than the major indices so keep an eye on it. If it starts to falter before the rest, you'll have a heads up that we could be close to topping.

BKX banking index, Weekly chart

I backed out and looked at the weekly chart of the banks because I couldn't understand why they were stuck where they were. As shown on the chart, there is a parallel channel that's been in place since January 2004 and price is right up against the top of the channel. It will either bust a move to the upside or this is resistance that will hold and the banks will start to head back down to the bottom of the channel. I'm leaning bearishly here.

D.R. Horton (DHI 40.33 0.38) said Q1 net sales orders rose 19% to a record $3.2B which helped the home builders. As shown in their chart below, the homebuilders got a nice pop today and quickly approached potential resistance.

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

I'm back to drawing in a parallel up-channel for price action since the October low, and price is quickly approaching the top of the channel while at the same time nearing potential Fib resistance in the 1050-1060 area. The housing stocks should fall hard once this bounce is finished and I continue to look for the weakling to short. We should be close now.

Oil chart, February contract, Daily

Oil bounced up to its 50% retracement at $64.125 and has been struggling to hold onto this level. It's either consolidating and getting ready to make a run up to its 62% retracement at $65.77 or it's getting ready for a deeper pullback. The daily oscillators, and bearish divergences on the shorter term charts, suggest it's getting ready to roll back over. If it rolls back over, I'll be looking for a drop back down near $60. It's very possible, according to the impulsive move down from August to November, that this bounce is a correction against that decline and that we'll get another strong decline to follow, breaking the longer term uptrend line.

Oil Index chart, Daily

With oil's rise, the oil stocks have also done well. I don't think this index will make it back up to the top of its parallel up-channel (near 580). In fact this one looks very close to finishing its rally and I would be careful with long positions and even think short here.

Transportation Index chart, TRAN, Daily

While the Transports look like they've topped, they won't go down either. I don't foresee it but it's possible this will push a little higher. But I think the high is in and then we'll see if a new high in the DOW is matched by a new high in the Trannies. If no new high in TRAN, be looking to get short the major averages.

U.S. Dollar chart, Daily

The dollar may drop a little further before it bottoms but I doubt it would break below its 200-dma. It may not even make it down to that average. If it does and you like playing the currencies, I'd look to go long the dollar.

Gold chart, February contract, Daily

Well, that bounce surprised me. I did not expect new highs in gold on this bounce and got stopped out of my short for even thinking it. This new high is either the final 5th wave or it's part of a larger correction (a new high can be made and still be part of a larger correction in an EW pattern). In either case it calls for a significant decline so if we get it it's going to look like a very volatile period and traders on both sides will feel whipped. If long gold I'd still protect profits.

Results of today's economic reports and tomorrow's reports include the following:

Tomorrow we get only one economic report again--crude oil inventories at 10:30. Watch the price of oil then and the oil stocks. The fact that I see a high close by in the oil stocks I'm going to guess that crude inventories will be better than expected and the price of oil will take a hit. All together now, awwwww.... Other than that the market will have to survive on its own again and that makes me wonder what could spark a rally in equities. I haven't seen a reliable enough connection between the price of oil and equities to guess that a drop in oil will spark an equity rally but if that's what happens, oil will get all the credit. It's a bunch of phooey but analysts have to have a reason. How about "people wanted to buy"?

Sector action was mixed today matching the tone of the market which was also mixed. Half the DOW components were in the green, half in the red. Half the sectors were in the green, half in the red. Leading to the upside were the oil service and other energy indices, computer hardware and networking. Leading to the downside today were the airlines, drugs and pharmaceuticals, healthcare and Transports. Alcoa's profit warning and then a Q4 profit warning from Phelps Dodge (PD 146.98 -7.57) didn't help the material sector today.

Bottom line for tomorrow is to watch for a buying opportunity. Be careful of the early morning since I think it could be a little choppy and I'm expecting a small pullback first. That should pull in a few more bears so that the lighting of the fuse (a buy program) will ignite the short covering and get our next rally started. If the DOW were to pull back much more than about 20-30 points from today's close, I would stand back and not try a long until it looks like we're going to break above today's range. This is all short term stuff and if you're more comfortable looking for a longer term trade I would stand aside and wait for a new high (I'm thinking around DOW 11100-11200) to get short. That might only be a day or two away. I expect the decline to kick into gear and be a multi-week affair. By the way, this Friday, January 13th is exactly 6 years from the January 14, 2000 high in the DOW and only a few hundred points shy of a new high. This high is being accompanied by lots of bearish divergences on the monthly chart as well. It would be real symmetry in the market though if we were to peak 6 years later.

Good luck tomorrow and I'll see you on the Futures Monitor side of the house.

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