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Market Wrap

It's All About Earnings, Maybe

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We entered earnings season with such high hopes. At least the analysts gave us high hopes. They're now saying "well, what I really meant to say...". There have been too many warnings and it's making the market jittery. The fact that it hasn't pulled back more is actually a testament to the underlying bullishness that remains in the market. It's been a volatile week with some large swings intraday and day to day. Tomorrow could be set up for another reversal to the upside but it can't waste time doing it. We could see a little more pullback but it must turn itself around and rally again, otherwise the bears will begin to come out of the forests and give up their grubs and instead go for some juicy steak.

I was asked at the end of the day (thanks for the question Alan), "Is today's action the start of a multiday/week decline or a one-day wonder like January 20th?" My short answer is that it's like the January 20th decline. If you look at the patterns of the declines from January 11th to the 25th and the one from the 30th to today and possibly tomorrow, and you squint, you can see a smaller fractal of the first drop. Does this guarantee a rally tomorrow? If only it were that easy. But in my opinion it's time for the bulls to run the ball back up the field. Again, if they don't do it early tomorrow, it could be lights out for them. I'll obviously cover more in the charts.

It was a quiet morning that started somewhat in negative territory after the futures pulled back last night. The initial claims and productivity numbers barely registered in the futures pre-market. Initial jobless claims dropped by 11K to 273K and the 4-week average fell by 4,750 to 284,250 which is the lowest number since June 2000. Continuing claims dropped 64K to a seasonally adjusted 2.5M, the lowest since March 2001 which was when the last recession began. Knowing that economists generally don't recognize recessions until we're on average 4 months into one, I wonder if it's possible we'll see something similar again. Seeing the lowest employment numbers since June 2000, and knowing what happened in 2000 also gives me the heebie-jeebies. I continue to believe we're very close to a stock market high, if not already there, and the correlation between these is eerie. Anyway, the 4-week average for continuing claims dropped 46K to 2.58M. Initial claims are down about 14% year-over-year. Continuing claims are down about 5%.

These unemployment numbers are good and let's hope they continue. Some economists theorize that initial claims might have been down in January because hiring in the retail sector was weaker than usual this past holiday season, which meant fewer workers were laid off in January. We also had one of the warmest Januarys on record and this may have kept more construction and other outside workers on the job. Economists are expecting strong payroll growth for January, looking for around 241K after only 108K in December. That number will be reported tomorrow morning at 8:30 a.m. so it could move the market if it's significantly different.

Productivity fell at an annualized rate of -0.6% in Q4, the first decline since the recession in 2001, and much worse than the expected +1.2% that had been expected. Is this all starting to register now? At the same time we had unit labor costs rising +3.5% annualized, the most in a year. The economists, quick to protect themselves from an embarrassing error in their guesswork, came out and defended their estimate and, like the GDP number, pointed out why it can't be the correct number. They're now saying they expect a quick rebound in the productivity number in Q1. Well of course they do.

Amazingly the hurricanes are still getting the blame, with some saying there weren't any specific factors that they could identify but they're sure the hurricanes had a negative impact. For all of 2005 productivity increased by +2.7%, the lowest increase since 2001. Unit labor costs increased by +2.4% for 2005 so productivity still outpaced labor costs and that's a good thing since it lessens the inflation risk, which of course the Fed is watching with keen interest. Real hourly compensation (adjusted for inflation) rose +1.8% in 2005, the 5th year in a row it has risen less than 2%. The American worker is falling further behind each year and this doesn't help the American consuming machine help prop up GDP.

As far as inflation worries go, Jeff Nafoff, president of Naroff Economic Advisors, said "With energy costs sky high and compensation [costs] increasing, it is going to be very tough to keep inflation from accelerating this year. If you were wondering why the Fed keeps raising rates, wonder no more."

So let's see what the charts are telling us and why I think the bulls are on the ropes here but have a chance to save themselves if they do it early.

DOW chart, Daily

Price has pulled back to the downtrend line from January 2000 which coincides with its 50-dma at 10855, closing slightly below it today. Bulls need to stand up and be counted tomorrow otherwise their kin may be taken out and shot tomorrow. A close below today's low will be bearish whereas a dip below it and recovery in the green tomorrow will be a stick save. The short term pattern for the pullback since January 27th shows that it could be finished with a minor new low tomorrow in which case it could be setting up a new rally leg to challenge the January high. Tomorrow is critical.

SPX chart, Daily

Price has pulled back to the uptrend line from October which, like the DOW, also coincides with its 50-dma at 1269. As with the DOW, SPX bulls must step forward tomorrow and start some buying. A break of this uptrend line and 50-dma will put the scare into the bulls and it could be lights out for the rally. If the bears blink here and the bulls regain control of the ball, there's that upper target of 1304 calling.

Nasdaq chart, Daily

When looking for the 50-dma for the COMP, it's at least not sitting on top of it this evening, as it is with the DOW and SPX. However, after Amazon's earnings after hours, the techs may feel the pressure tomorrow. Like the SPX, the uptrend line from October and its 50-dma should provide support in the 2265-2270 area. This is a must hold for the bulls since a new low below 2241 on January 23rd would make it more likely that we've seen the high for this market. The short term pattern for the pullback from January 27th shows Fib support just below 2277 which suggests only a minor new low tomorrow before rallying. It would be in the face of bad new from AMZN and could catch the bears off guard.

Nasdaq chart, 120-min

I'm going to start watching this pattern on the shorter time frame since we could see the COMP consolidate in a sideways triangle. This would set up a bullish resolution and would make a good long trade. Support by the lower trend line is at 2270 and resistance by the upper trend line is at 2309.

SOX index, Daily chart

After gapping up and running into the top of its parallel up-channel, the SOX pulled back to close its gap and has been chopping up and down just above the 535 level so this is support for now. It could be consolidating to make another run higher (Fib projection target is 573) or continue lower/sideways to its uptrend line from October. This is still bullish until the uptrend breaks. The bearish thing I see is the negative divergence at the last high.

BKX banking index, Daily chart

A bearish kiss goodbye against its 50-dma will be confirmed with a break below its last low of $101.37, which is where this looks like it's headed. This index is not promising for the broader market and deserves watching as a heads up for what the major indices are going to do.

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

The housing index is weaker than I thought and I know I've been bearish this index for a long time now (since last summer). The small retracement of the drop from its last high is bearish. Its inability to hold its major moving averages in the 940-950 area is bearish. Daily MACD in negative territory is bearish. There's just not much to like in the home builders, unless you're short that is. I see the next leg down as being relatively swift and it should break its long term uptrend line currently near 820.

On Tuesday I had mentioned a little bit about being a contrarian and how difficult it is to be one. Unless you're a momentum player, looking for where the buying and selling are heavy and jumping in with the flow, you're likely to be one who is looking for turning points, trying to catch tops and bottoms and getting in on the beginning of a new move. This is contrarian thinking and while many of us like to believe we're contrarians we're really still following the crowd in many respects. How difficult do you suppose it was to short the home builders last summer? Most people were considered crazy if they even thought about it. When everyone was bullish that sector it was time to think bearishly about it. The trick of course is in the timing and that's where we try to help with the charts.

Those of us who study the charts diligently are probably a little better adept at identifying oversold and overbought, seeing negative divergences at new highs and lows and seeing the breaks of trend lines and moving averages that tell us we have an imminent trend change close at hand or one already in progress. But most of the investing public base their opinion about the market on what they hear their friends and family talking about, what they're hearing on the news and CNBC (the cheer leaders of the stock market) and their "gut".

As the market approaches what I think is a high in both the stock market and the housing market, I've talked to family and friends about the need to protect oneself from a continuing bear market in stocks and a possible large price correction ahead in the housing market. My friends and family kindly pat me on the head and tell me what a nice boy I am. They think I'm being too pessimistic (I'm an eternal optimist but I also like to think I'm a realist and one who can profitably trade the market in both directions) and they proceed to tell me what they read or heard and why I can't possibly be right (usually there's a "it's different this time" within their explanation).

But this brings to mind how difficult it is to be a contrarian. When you're a contrarian you are by choice ostracizing yourself from others. Human beings are social animals, some more so than others, and we seek to be part of a group. Going in the opposite direction to the one the crowd is headed does not come naturally to us and quite frankly most of us find too difficult to do. Two neuropsychologists, Naomi Eisenberger and Matt Lieberman, did a study and found that social pain (the pain of not being included in the in-crowd) is experienced in exactly the same areas of the brain as real physical pain. When you're being a contrarian you're in pain. Some might say that's because you're short the stock market while it's rallying. Been there, done that. The neuropsychologists said following a contrarian approach is akin to having your arm broken on a regular basis.


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So here we are today trying to be contrarians (using tools that identify overbought and oversold, investor sentiment, put/call ratios, etc.) so that we can better protect positions and catch turning points to reverse our positions. One would think the professionals (fund managers) in this business would be able to accomplish this better than us retail traders. After all, they have the most powerful computers and software, analysts and expert consultants, research, you name it. But interestingly, a study was done that shows they're actually some of the best crowd followers out there. They don't like having their arm broken on a regular basis either.

A new paper was written by Lehavy and Sloan (Lehavy and Sloan (2005) Investor recognition and stock returns, available from www.ssrn.com) which describes their investigation into the performance of stocks that fund managers were buying and selling. By researching the stocks' performance from 1982-2004 during the periods of accumulation, holding and selling by the major funds (those holding $100M or more) they discovered some interesting results. Basically stocks did well while the funds were buying, which makes sense. And of course stocks did poorly if funds were selling en masse. But it's what the stocks did after each of these periods that's interesting, and actually also makes sense. The stocks that were accumulated and held during a 3-year period did poorly as compared to the group of stocks that had been sold off or ignored in the first place. After the fund managers did their buying there was no one else left to buy and the stocks tended to underperform the market. Conversely, once stocks had been sold off there was no one left to sell more so those stocks tended to outperform the market over the next 3-year period.

Therein lies the secret to outperforming the market and is the essence of contrarian thinking--buy those stocks the funds are either ignoring or dumping (don't do it too early though) and sell the stocks that the funds are holding or buying (again, wait until buying volume dries up). As Maynard Keynes put it, "The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive." But understand that when you're going against the crowd all your water-cooler conversations will be painful because everyone will laugh at your stock picks and wonder about your ability to trade the market. You'll be filled with self doubt and you'll feel huge pressure to conform. You'll want your friends to stop breaking your arm because it's the same kind of pain being registered in the brain.

In the interest of space I'll continue this contrarian discussion next week citing some additional research on it. Pretty fascinating stuff and gets right to the heart of what we as investors/traders try to do every day. We're in a period of low volatility when it feels comfortable for most people to own stock. It happens to be the riskiest time as well. I'll get into more of that next week.

In the meantime, we're continuing to see more volatile price action as we kick off a new month. 2005 was a relatively narrow range year and it's likely 2006 will see greater price swings. That should help those of us who like to play swings in both directions. The challenge, as always, will be to figure out which way it's swinging. The chart of oil shows that it might have finally reached a swing high.

Oil chart, March contract, Daily

After challenging its January high, and leaving a huge negative divergence in the process, oil has dropped swiftly back and closed the gap from January 17th at $64.69. This could of course turn around now and make a new run for the roses but with the uptrend line for the leg up from December 27th broken yesterday I think the high for the rally is in. My interpretation of the larger pattern is that the rally from November was a counter-trend rally against a decline that we will see in oil. The next leg down should be relatively quick with an initial downside Fib target of $55.70. Just for reference at this point, a 38% retracement of oil's rally from mid-2003 is just above $53 and a 50% retracement is at $48, which matches a Fib projection for the next leg down. I'm thinking oil will eventually head down towards $50 and if it does it will because of the lack of demand for it. And lack of demand for oil comes from a slowing global economy. And that's what I see coming.

Natural gas inventories were reported today. There was a net decline of 88 Bcf to 2,406 Bcf over the past week but stocks were 296 Bcf higher than a year ago and 529 Bcf above the 5-year average. The price of NG (March contract) closed the day down -0.36 at $8.34. This looks like it's trying to find a bottom and looks ready to bounce back up soon. I don't know if propane gas follows the price of NG but if it does, those of you with propane tanks may want to think about topping off your tanks now.

Oil Index chart, Daily

I thought we'd see the oil stocks bounce up to the top of their short term up-channel and a Fib target near 613 but the drop in the price of oil started profit taking in this index a little earlier than I had thought it would. Like oil, this index looks like it has now peaked. The type of correction it's in, since the high in September, gives me a Fib projection down to about 435 but obviously it has lots of support along the way. First on the list of support is its 20-dma at 574 and then its 50-dma at 549. If you're long the oil stocks, I would move into profit protection mode now. If you like to play the short side, find some of the weaker stocks in this index and try shorting them. It should be a pretty good ride back down.

Oil Index chart, 120-min

The shorter term 120-min chart shows the up-channel for the rally from December 27th. Having price break the uptrend line is a signal this leg up is finished. It's possible we'll see just a correction of that rally and then watch it press higher again. That will have a lot to do with the price of oil and what the broader market are doing, neither of which support the idea of higher highs in this index. And the larger pattern tells me this rally should have been counter-trend to an expected decline in both oil and this index. Watch for resistance and kiss goodbye with a retest of the uptrend line, currently at 586. A 38% of the latest drop is at 586.78. It would form a H&S pattern in the process.

Transportation Index chart, Daily

Could it be? Is that a top in the Trannies? I think this one will stick. The move counts out well from an EW perspective. It overthrew some important Fib projections and the projection out of the previous sideways triangle that played out last year, and has now dropped back below that level (right about 4300). This looks like a sell signal to me, with bearish MACD divergences to help confirm.

Transportation Index chart, 60-min

I will rarely pound the table on a trade since I don't want anyone to enter a trade blindly without their own due diligence but in Tuesday's Wrap I had mentioned this chart was the most bearish setup of all the charts I reviewed. That was me pounding the table to get short this index (find the weak stocks in the index). The Trannies were on the verge of breaking their uptrend line as of the closing price on Tuesday and the negative divergences supported the bearish ascending wedge interpretation. This is one of the most reliable trading patterns I know. Of course they fail some times but the trading range is typically so tight as price nears the top that you can have a relatively tight stop. OK, we got the breakdown and price also dropped below the uptrend line off the two lows on Jan 18th and 23rd. It's still very early in the setup but until I see something to change my mind I believe THE high for the Trannies is in and it's time to pick on your least favorite Transport and short 'em.

U.S. Dollar chart, Daily

The dollar should continue its upward path until it finds resistance at its broken uptrend line from March 2005 which is where it will also bump into its 50-dma. Then we'll get to see if there's going to be more rally left to the dollar (I think it's headed up to the mid-90s before the 1-year old bull market in the dollar is over. But if the 50-dma rejects price and it drops back below the 200-dma, it could be all over for the dollar. The way the Fed is printing money, that's a real concern I have. The Fed has a strong incentive to devalue the dollar (so as to pay less to buy back our debt).

Gold chart, February contract, Daily

Like the Transports, I have been challenged to find a high in gold. But the negative divergences are showing up, the final rally leg is getting choppy (and indication of an ending pattern) and I'm thinking we're very close. We could hit $580, or even higher, but it looks that close to me. The uptrend line from December 21st is being challenged every day now for the past week. It's going to break soon (currently at $570) and when it does it should mark a top as in. At that point I'll be shorting gold (with e-mini futures) since I expect a quick decline. If you're long the shiny metal, and trade it vs. holding it for long term investment or insurance, I would be in profit protection mode here.

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

Tomorrow will be busy with economic reports any of which could move the market. We'll have a potential hangover from Amazon's earnings so if there is any disappointment from these reports, it could turn nasty. That's not the way I currently see it but my opinion will change to bearish in a hurry if the market drops much below DOW 10800 and SPX 1265.

Today looked bearish when looking at some of the internals--declining issues swamped advancing issues more than 2 to 1. Declining volume was almost 3 to 1 greater than advancing volume. But interestingly 52-week highs were 386 compared to 52-week lows at 89. Might there be some quiet accumulation going on behind the scenes? While everyone is distracted by the major averages, it seems someone is doing some buying. This is by no means assurance that the current pullback is just that and we should expect higher because of it, but when I see that kind of discrepancy, in either direction, it makes me suspicious and wary of the move.

As shown in the charts above, we are at or close to major support levels. The market simply needs to hold here otherwise several interpretations, all bearish, become more likely. Amazon's (AMZN 42.84 -1.16) after-hours earnings announcement cratered its price and took the futures down with it. What we don't know of course is how the cash market will react tomorrow. Remember what happened to the market on Wednesday after Google announced Tuesday night. We just never know and it's a worthless exercise to prognosticate the market's move based on after-hours futures.

Speaking of AMZN, it slightly disappointed investors (said tongue in cheek). It reported its net income fell during Q4, which includes the holiday selling season, to $199M, or 47 cents per share, compared with $346.7M, or 82 cents per share, in the year-ago period. Sales rose to $2.98B from $2.54B a year earlier but its free-shipping program for special customers and other expenses appear to have hurt them. Expectations were for net income to be 21 cents per share and earnings to be 27 cents per share, excluding items. Wall Street had been expecting sales of $3.08B, which would have been a rise of 21% over the year-ago period. AMZN dropped to a low of $37.35 after hours and closed at $39.22, so down -3.62 from its 4:00 close, or -8.5%.

AMZN share have been expensive, trading at 59 times estimated 2006 earnings and have been valued more in line with internet stocks rather than retail. Their P/E ratio is more than triple that of the S&P Retailing Index and the S&P Consumer Discretionary 25. Maybe after tomorrow that will start to change. EBay and Target, by comparison, trade at 42 times and 20 times estimated 2006 earnings per share, respectively. It's just one more sign that not a whole lot has changed after the stock market correction of 2000-2002. While prices got hammered during that time, and haven't recovered that much, peoples' bullish expectations are just as dangerous today (perhaps more so) as they were in 2000. GOOG and AMZON are only two small reminders of the fluff that's once again in the market. One has to wonder if we really do learn from our past mistakes.

Look for a buying opportunity tomorrow but only if we see a relatively minor new low. Remember the support levels that I showed for the DOW, SPX and COMP. This market can not tolerate a lower close tomorrow. But we're at support. Feel like a contrarian this evening? Go out and buy tomorrow when it looks the scariest and just doesn't feel right. Just remember to use your stops, don't play in traffic and don't eat yellow snow. Good luck and see in the Monitor.

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