Option Investor
Market Wrap

Time to Consolidate

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We'll be switching writers around a little bit this week for the Market Wrap. I (Keene Little) will be writing for Jonathan tonight, Jonathan will be writing for Jim tomorrow night and then we'll see the normal schedule for the remainder of the week.

Today was a day for the bulls to breathe again. After holding their breath all day Friday, they dared to take a breath today in hopes that Friday's carnage has come to an end. The bad news (for bulls) is that my interpretation of today's price bearish is that it's merely consolidating before another leg down. The good news (for bulls) is that after another leg down we should be set up for a larger corrective bounce that should last a couple of weeks. The bad news (for bulls) is the bounce will likely fail to make a new high. The good news (for bears) is that the bounce into February will likely give you a shorting opportunity the likes of which you haven't seen in quite a while.

It was a quiet day all around today. There was only economic report, leading economic indicators, and earnings reports were nothing earth shattering but still a little disappointing. The Leading Indicator index was up +0.1% to 138.5 in December from an upward revision in November of +0.9%. Expectations were for +0.2%. The index in October was +1.0% so the upward trend, albeit a slowing one, has been in place since April 2003. The growth rate has moderated since last June. For reference, the index was equal to 100 in 1996.

The December Coincident index, which measures current economic activity, was up +0.2%. The Lagging index was +0.1% after rising +0.5% in November. Looking at the 10 components that make up the index, 6 were up--consumer expectations, real money supply, stock prices, average weekly initial jobless claims, interest rate spread and manufacturer's new orders for consumer goods. The 4 negative components were vendor performance, lower new orders for non-defense capital goods, a drop in building permits and a drop in factory hours. Since the stock market is a good reflection of investor mood, any market decline would likely make for a double-whammy to this index. I've discussed at length the efforts of the Fed to increase M-3 money supply and that will not likely diminish much over time. I would not be at all surprised to see this indicator showing negative growth in January, which will be the first time in almost 3 years.

This morning's report from Bank of America (BAC 43.94 -0.23) did not help investor mood as related to banks. They said quarterly net fell to $3.77B, or 93 cents/share, driven by "increased provision expense and lower trading results". I'm always curious about what they mean about "lower trading results". Does that mean someone shorted gold last quarter? Yes, banks too are getting much more speculative in the market. They're not the staid banking institutions of our fathers. Excluding charges, BAC earned 94 cents/share, well short of Wall Street's $1.02/share expectations. BAC dropped hard on the news, to a low of $43.49, but recovered some into the close.

Something we'll be hearing more about as the banks report earnings is how the flattening yield curve hurt them. While this is true, it's not like analysts didn't see this coming. But it offers up an excuse. The flattening yield curve, due to an increase in short-term borrowing rates without an improvement in long-term rates, resulted in net interest yield that fell 36 points to 2.82%. This is why a flat, and especially an inverted, yield curve hurts the banks. But today's bounce in BAC, after its gap down, looks like the broader market--it looks like a dead-cat bounce and it looks like it will press lower once the consolidation finishes. One look at the daily chart of BAC and you'll want to short every bank out there. As will be shown later, the banking chart (BKX) does not look so good.

Another negative for BAC was the number of personal-bankruptcy cases due to the law that changed last year. Many people rushed to file personal bankruptcies before it became more difficult to do so. This has hurt many banks, especially those who offer credit cards to people who are considered higher risk profiles. Interestingly, I've read recently that the bankruptcy rate has not slowed down like they had hoped. It appears the law change may have backfired on them (all together now--awwwww). For BAC, The accelerated bankruptcy filings led to a higher credit-loss provision of $1.4B, double the $706M a year ago. Net charge-offs rose to $1.65B, or 1.16% of average loans and leases, from $845M, or 0.65%, reported in the year-ago 4th quarter.

Many analysts came out of the woodwork to defend BAC today. They tried to point out that Wall Street's estimates on many stocks are "too high amid a decelerating earnings growth environment," and that BAC "remains attractive on account of its growth prospects, dividend yield, and valuation." Reading between the lines, what they were really saying is "please come and buy this stock so that we can offload this pig to you." I think it was just last week that these same analysts were saying Alcoa's and DuPont's guidance was an anomaly and that they were expecting continued growth in earnings. My how quickly they can change their tune. Do not listen to analysts, period (except us at OIN of course).

Ford (F 8.28 +0.42) gave itself and the auto industry a little boost today. Actually, for some stocks, like General Motors (GM 21.80 +1.80), they got a big boost. Ford reported net income rose to $124M, or 8 cents/share, from a year-ago profit of $104M, or 6 cents/share. Selling their Hertz rental care business and the performance of luxury brands (including Land Rovers) helped their bottom line. Ford reported they would be cutting up to 30,000 jobs and shutting down 14 manufacturing plants in North America by 2010 in hopes of saving $6B. They hope to achieve profitability in their N. American market by 2008 and made good headway in that regard by cutting their pre-tax loss in the 4th quarter to $143M, compared to a loss of $470M in the year-ago period.

Ford's bullishness rubbed off on General Motors which saw a 9% rise today. Ford gave up some of its gain as the day wore on but GM continued climbing throughout the day and looked stronger. It looks like a little short covering thrown in there but GM closed above its 50-dma today (21.60), after being soundly rejected at this moving average last time it tested it on Jan 10th (near the market high on the 11th). If GM can hold above $21.60 on a closing basis, it could have a shot up to the $24-25 area; otherwise this will look like just another failed bounce attempt. The daily chart left a bullish divergence at its last low and based on that this one actually looks like it has a chance to bounce a little higher. I would no longer be interested in being short this stock. Not yet anyway.

Another stock making the news today was Research in Motion (RIMM 64.15 -2.37) which had its U.S. patent violation case rejected by the Supreme Court. They kicked it back to the federal district court in Virginia which now raises all kinds of speculation that RIMM may up its offer to settle the issue with NTP, Inc., a Virginia patent-holding firm that owns patents on wireless technology. In November 2002, a jury found that the technology behind the BlackBerry violated NTP's patents. It turns out the U.S. government is concerned about this case because they're concerned about officials not being able to send and receive emails to each other. Horrors, this may shut the government down and we could save billions of dollars in the process.

What we had today was essentially a sideways consolidation day, very typical after a large move like we had Friday.

DOW chart, Daily

When I reviewed these charts last Thursday I said the DOW gave the most bearish feeling. It also dropped the hardest on Friday and as this chart shows, it looks ugly. Today's consolidation could continue through much of tomorrow (I'm thinking a sideways coil could form) and if it does, expect lower prices ahead. That pattern suggests the DOW could drop to its 200-dma at 10443 before finding firmer support. From there I would expect a larger bounce back up into February but the bulls should first experience a little more pain before getting a bigger bounce.

SPX chart, Daily

That throw-over above the trend line across the highs from January 2004 looks like a classic ending to a rally. The 50-dma at 1262 is currently supporting this decline but with its corrective sideways consolidation, this should proceed lower before setting up a bigger bounce into February. The January low near 1245 is a good downside target.

Nasdaq chart, Daily

Like the others, the negative divergence at the last high foretold what was coming. The COMP is currently finding support at its uptrend line from October, which coincides with the trend line across the highs from January 2004, and is trying to hold onto its 50-dma at 2250. Like the SPX, a break lower suggests the January low at 2190 would be the downside target before setting up a larger bounce into February.

SOX index, Daily chart

After looking like they were going to make a stab higher on Thursday, the SOX retraced almost all of Thursday's gain on Friday. Today it's consolidating that drop. The daily oscillators suggest this drop just got started and I'd look to the uptrend line and 50-dma near 500 for support.

BKX banking index, Daily chart

As mentioned above, BAC's report set a negative tone for the banks today. But the damage was already done on Friday and today this index merely consolidated that drop. Last Thursday I had said any further drop will likely see an acceleration downward to the 200-dma. Friday's drop was a little faster than I thought it would go. After the consolidation is finished this should continue lower and I'll be looking for the 200-dma to lend a hand to set up a bounce into February.

Housing stocks got hurt today after JMP cut KB Home (KBH 74.91 -1.75)) and Standard Pacific Corp. (SPF 38.24 -1.39)) to market outperform from strong buy and reduced its target prices on the stocks. Based on the preliminary quarterly sales figures reported by the homebuilders, JMP said it was "prudent to adjust its estimates, assuming the companies will also see some of the softening reflected in their orders in coming quarters." The analysts said the sector "may face some margin pressure in the second half of 2006 as pricing power decelerates and the use of incentives picks up."

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

That was a quick trip back down to the bottom of the parallel up-channel. The combination of the uptrend line, the previously broken downtrend line from July and the 200-dma, all coinciding near 940, is providing some support. There's a good chance this index will find support around this area before setting up a bigger bounce. But if 940 gives way, the next support levels are the December lows at 913 and 892. If this drops much lower before setting up a bounce into February, we could see the setup for the bounce to only get back up to the broken uptrend line. That would be an excellent short play. For now, this is close enough to support that I wouldn't want to initiate any new short plays on housing stocks and protect profits in currently short plays.

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

I wanted to show a longer term view of the housing stocks to discuss what I think is setting up. It looks like a H&S pattern with the neckline just above the October low (it's a rising neckline). It's obviously very early in this pattern but I believe it will play out this way. The downside objective would be about 500 which would take this index back down to the lows of 2004 (or lower).

Oil continues to hold onto its highs, largely due to concerns out of the mideast, but natural gas has no such concerns. The price of NG dropped almost 8% today, closing at $8.74 (March contract), down from $9.44 on Friday. It got down as low as $8.50 before reversing back up a little. That was its lowest price since last June. My best guess is that oil will soon follow with a reversal to the downside.

Oil chart, March contract, Daily

Oil keeps defying my efforts to find a top (like gold). I thought oil would find resistance in the $68-69 area and so far the high is $69.20 (March contract). The daily chart shows evidence of bearish divergence at this new high and rolling back over. Today's drop and corrective bounce looks bearish and I believe a top is in. I know Iran is not settled yet (but believe it will settle down after the U.N. figures out to stuff the mouth of Iran's blowhard leader) but the bad news is probably baked in. Marc Eckelberry on the Futures Monitor has been trying to nail a short entry in oil and I think he may have gotten it today.

Oil chart, March contract, 60-min

Moving in a little closer on oil, the 60-min chart shows a throw-over above the ascending wedge pattern and then a drop back inside. Sell signal #1. Price then rallied back up to the upper line and fell away (kiss goodbye). Sell signal #2. If price will now drop below the uptrend line at $67 that will be sell signal #3. And then if price rallies back up to give that lower trend line a kiss goodbye, that will be sell signal #4. Play along with Marc on the Futures Monitor and watch for those setups.

Oil Index chart, Daily

As oil has held its highs so too have the oil stocks. But like oil, this looks to be topping, and has been for days now. Even if it's a touch early to short this index right here, I would not want to be long. If you're long any oil stocks, I would raise your stop to protect profits. If the air is let out quickly on the inflated oil price, this index will drop like stone.

Transportation Index chart, TRAN, Daily

The Transports continue to display an ugly daily chart. The bearish divergences signal a very weak top is in progress but it's not exactly dropping away. I feel bearish this index but would not be choosing it for a trade. There are better looking fish to fry.

The Federal Reserve and European Central Bank officials were out today suggesting that the difference between U.S. and euro-zone rates could shrink this year. The euro rose +1.2% to $1.2337 as the dollar dropped nearly -1.25%. Iran's nuclear strategy, Russia's debt repayment plans and Canada's elections today also made currency traders nervous about the US dollar. Michael Woolfolk, a senior currency analyst at The Bank of New York, said "the biggest factor weighing on the dollar are new remarks by central bankers that suggest the European Central Bank might become more aggressive on raising rates this year, even as the Fed winds up its cycle of rate increases." Also, as crude oil prices have been rising, this tends to hurt the US dollar since the U.S. is a net importer of oil.

U.S. Dollar chart, Daily

I thought the US dollar would find support at its 200-dma but today it sliced right through it. This is either very bearish for the dollar or it's just an over-throw of this support level and the dollar will come bouncing right back up. It needs to bounce back above it in the next day or two otherwise it loses its value as support. In the meantime an internal Fib projection for the current move down is at $87.12 which is where I'll be watching for the next support level. I haven't given up yet on the idea that the dollar has another rally in its immediate future before it enters its next bear market phase.

I had mentioned last Thursday that I would discuss gold and some suggestions to think about how to use in your own portfolio. With the huge run up in prices in the past 6 months, most everyone has been wondering if they should have bought some gold, whether now's a good time to buy, or wait, how much, how long to hold, etc. So before reviewing the gold chart I thought it might be useful to cover some of these things.

One of the concerns that I have about our stock market is that we have had such a high expectation for so long that we could be set up for a great disappointment. And it's not just in the stock market. We see it today in the housing market--I have many friends and family that are 100% convinced housing prices will continue to rise. They tell me it's because of where they live, because everyone needs a home, it's not like stock, etc., etc. The laws of supply and demand just doesn't enter into their thinking.

Similarly, the world's trust in the US dollar is a recipe for disappointment. I came across a quote (I can't remember who said it) that I thought hit the nail on the head. "The U.S. economy has been so strong for so long, people all over the world have come to accept its currency as though it were real money." The US dollar is fiat, or paper money, meaning it's not based on anything (such as gold) except the good faith and trust in the ability of the US government to make good on its debts. Fiat is subject to manipulation by governments and has always been subject to devaluation when governments can set its price.

Many people believe the only "real" money is gold. The value of gold has stayed remarkably consistent. A man could buy a nice business suit for an ounce of gold in 1900. Today it costs about an ounce of gold for a good business suit. It would have bought the same amount of bread in 1900 as it would today. So it does a better job than paper money in maintaining parity with inflation. By comparison, one US dollar in 1900 is worth about 5 cents today. Therefore one idea is to hold gold as an inflationary edge. One of the reasons given for the recent run up in gold price is because of the fears of inflation.

From an investment standpoint though, gold is not necessarily the right vehicle. After the price of gold was fixed at $35 in 1934 it has increased in value about 16 times since. By comparison, the S&P 500 is up just shy of 130 times the price it was in 1934 (just under 10 at that time). Even bonds beat gold over the same period. And an investment in gold will not prevent you from seeing some wild swings in volatility. And from 1971 gold, up 15 times, has actually outperformed the S&P 500, up 12 times.


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Even with gold up 15 times in the past 35 years, it has been more of a trading vehicle than an investment vehicle for the past 20 years. Other than the quick shot up in the past 6 months, the better trade would have been in oil (up 4 times), natural gas (up 8 times at its peak) and even copper. But gold is the shiny stuff and it catches the public's imagination. Besides, with the US dollar expected to worth 5 cents again by the end of the century, gold at $10,000 sounds a lot better. If our inflation rate remains only 2-3% over the next 15-20 years, the US dollar will lose about 50% of its value, potentially much more if the Medicare crisis gets much worse into the next decade. Gold over the longer term will do well in this environment, although it will be volatile as always.

So owning some gold as an investment is not a bad idea. The common answer to "how much?" is about 5%. But you may want to think of gold from an insurance perspective. We often talk about owning some put options as a hedge against your stock portfolio. Even 401(k) accounts allow the purchase of put options (if your broker doesn't allow this, change brokers). Another option to hedge your portfolio is to buy a reverse index fund (it goes up if the market drops). Rydex and others offer these funds. They even have a reverse bond fund so that if bond prices drop, the fund value increases. This is not a bad idea if you or your parents are heavily invested in bonds.

Owning gold as insurance is essentially telling yourself that you'll be protected against economic Armageddon. We all know there can be, and has been over time, economic "dislocations" and anything that could severely shake the confidence in the US dollar or equities will likely not negatively affect the price of gold. Just the opposite probably. Just be sure you have a way to get your hands on the gold should you need it. No sense having insurance if the place you store it does not allow access to it in the event of an emergency. Gold coins in your bank storage box is one idea, but remember gold coins hold numismatic value which will likely drop in the event of a collapse in prices of most everything else.

Think of this insurance as something you'll never need and that you'll be able to pass along to your kids. We all buy life and health insurance and hope we'll never need either one. Buying gold can be done with the same rationale. If you dollar-cost average your purchases you'll probably do well over time. Insurance gold is not necessarily something you want to market time. If you're interested in gold as a trading vehicle then obviously that's a different story.

God typically peaks in late winter and bottoms in late summer. We (as in buyers all over the world) buy more during the holidays and at year end. Assuming the Russian central bank does not start buying large amounts of gold, historical trading patterns suggests gold will be cheaper at some point next year than it is today. As you know I've been trying to pick a top in gold. I like to play the e-mini futures on gold (YG) and have been stopped out twice for trying to find a top. I'm essentially break-even for my attempts but I'm thinking if I catch it right, it could be an excellent multi-week, if not multi-month trade (I'd have to switch front month contracts of course). If you're looking to buy some gold as a relatively short term trade/investment, you'd probably do better waiting for summer. If you'd like to protect recent profits, think about raising your stops.

Taking a look at the chart, I think (again) gold is topping.
Gold chart, February contract, Daily

The daily chart shows a shooting star doji on last Friday but we haven't seen much follow through to the downside yet. However, based on the sharp drop on Friday and the subsequent corrective-looking bounce, this one (again) looks like it has topped. If you like trading gold, this looks like a short right here.

Gold chart, February contract, 60-min

Looking a little closer at recent price action we can see that after dropping through its uptrend line last Wednesday the 18th, gold rallied back above it and tapped its upper trend line before falling again on Friday back below the lower uptrend line. The last high was met with bearish divergence. While the bounce could travel a little further, I like the setup for a short play. This top should last for quite a while and as discussed above, gold could see a drop into the summer so this would be a position trade versus a day or swing trade.

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

As you can see there are no major economic reports scheduled for tomorrow. The rest of the week is relatively light on economic reports. Existing home sales on Wednesday could move the housing market (lower I expect if tomorrow sees further sideways consolidation) and durable goods orders on Thursday could move the market if there are any surprises. GDP and new home sales on Friday are potential market movers as well. The market is more interested in earnings reports so we'll keep an eye on reaction to those. The general tone of the market has turned more negative so expect to see good news get sold and bad news to get sold. We're in one of those cycles so don't try to make sense of it all, just be aware that's what happens. But assuming we get another leg down we should be set up for a stronger bounce into February and that tone should see a reversal.

Sector action was mixed today, as were the market internals. The relatively flat but green day that we had is reflected in the advancing issues slightly higher than the declining and up volume slightly more than down volume was normal. The red sectors were led by the healthcare index, retail, biotechs and natural gas. The green sectors were led by the oil service, up strong with a 2.3% gain, the airlines, securities broker index, disk drive, cyclicals, gold and silver and then the energy indices.

A quick look at the DOW stocks shows GM was the strength behind the DOW today. It was up +1.80, +9%. As mentioned above, it looks like it might have some strength behind the current bounce which could continue. Alcoa (AA 29.18 +.38), which dropped hard on Jan 10th after earnings disappointment, looks like it's attracting some "value" players. Unfortunately the bounce looks like the dead cat variety and this stock looks lower to me. Dragging the DOW down today was Intel (INTC 21.35 -41) which is still paying the price for disappointing guidance last week and the consequent downgrades it's received. It has now dropped below the 2005 lows seen in January and April. Its next support level could be just below $20.

Reaction to Texas Instruments (TXN 31.68 +0.04) reported after the bell that 4th quarter net income rose 34% from a year ago, thanks to mobile phone chips and reduced manufacturing costs. But total sales came in lighter than expected and earnings were $655M or 40 cents/share, up from $490M or 28 cents/share. This included 3 cents/share to account for expensing of options (something analysts are still not accounting for in their estimates). Analysts had been expecting 42 cents/share so the "miss" may have been due to the options expensing difference. Guidance, as usual, is probably what hurt the stock after hours. TXN reported they are looking for 29-33 cents/share for the next quarter and this compares to analysts' expectations of 38 cents/share. Even accounting for the 3 cent options expensing difference, that's a miss.

The reaction to TXN's earnings was negative. They dropped from $31.68 at the close today to a low of $30.50 before closing at $31.00 at 6:00 PM. But equity futures began to bounce after they reopened at 7:15 PM so it's hard to tell (as usual) how the market will react after the cash open tomorrow. I'm expecting a continuation of the sideways consolidation that started today but it could easily rally a little higher instead of going sideways. It won't change my expectations (unless it rallies strongly in an impulsive fashion) for another leg down once the correction is finished. It should correct in either additional time or price (as in a little higher), or both, before we get another leg lower to finish the move down from the high on Jan 11th. That decline will then set us up for an upward correction into February so don't get too bearish after another leg down. Instead get ready to play the long side into February from which an excellent short play should then set up.

But I'm getting way ahead of myself. Tomorrow should consolidate a little further and I'll be watching it for a setup to get short. I'd like to see the DOW drop to its 200-dma near 10550 and SPX may get down near its January low of 1245. If you like playing the short side, get ready for another leg down. If you only like playing the long side, wait for another drop and then start looking for your opportunity to scalp a long into February. Good luck with your trading and I'll see on the Futures Monitor.

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