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Market Wrap

Negative Open? Not So Fast

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The excuse for the spike up off this morning's negative open (to the tune of +110 DOW points before pulling back some and then rallying higher) was Bernanke's speech where he assured Congress (and investors) that the Fed could/might/maybe/perhaps/possibly be willing to hold back on a rate increase after the next one. But he let it be known that that would not mean they're necessarily done with raising rates. If the data continues to come in strong Bernanke reserved the right to continue raising rates whenever the Fed saw fit to do so.

But this morning's down open was all the Boyz needed to pull the trigger and start the massive buy programs that we have now come to expect. With the higher short interest ratio the mega-banks' trading teams, flush with cash from the Fed, merely have to flip the buy switch, watch the shorts scramble to cover, and voila, instant rally. The PPT risk intervention chart continues to show we're vulnerable to these short covering rallies (if you missed the chart I showed of this, see Monday's Wrap).

But we have a change in character and this may be our heads up that we're close to topping out. Instead of ramping the market higher and higher without letting the shorts out or new buyers in, we got a choppier rise today with deeper pullbacks. As Jane has observed on the Monitor, the selling seems to be getting stronger and the bulls are having a tougher time driving the market higher. I believe this is a result of a more concerted effort buy fund managers to sell into these rallies now. Many take seriously the "sell in May and go away" and they look at each of these rallies as gifts to unload inventory (to unsuspecting retail traders who are the weaker hands if and when the selling starts to hit harder).

The fund managers want to lock in profits and I think that's why we're seeing larger pullbacks now. They'd like to see a market swoon into September/October so that they can get back in at a much lower level. I don't think we're done rallying but I do think this bull market's day are numbered, possibly on one hand. We've got one more day for end of month buying and then new money coming into the market for the first couple of days of May and that could do it for the buying. We'll take a look at the charts to see how that might play out.

We only got two economic reports today and of course a slew of earnings reports but other than stock specific reactions to earnings the market doesn't seem to be paying much attention to earnings. It's more like a "Oh yea, we expected that. Next!" Setting the early negative tone today was the futures market which was down hard from overnight selling after Europe started trading. The reason given was China's decision to raise their interest rates +0.27% from 5.58% to 5.85% which likely marks the first in a new round of tightening to slow down their growth. It was the first rate increase since October 2004 and was unexpected The reason the market reacted negatively is because of concern about a slowdown in global economic growth. Very soon we will be worrying about when China sneezes which will cause rest of the world to catch a cold.

Initial jobless claims rose by 11K to 315K, which was more than had been expected, and was up from an upwardly revised 304K (from 303K). The 4-week average also climbed, up 2,750 to 308,500. Continuing claims also rose unexpected by 22K to 2.449M vs. expectations for 2.43M.

The Help Wanted Index was the only other report this morning and it dropped a point to 38 vs. expectations for it to remain the same at 39. It was also at 39 a year ago.

Exxon Mobil Corp (XOM 62.50 -0.68) announced their earnings and disappointed investors. The stock opened down and dropped almost $2 before bouncing into the green mid day but then falling off into the close. They reported earnings for their 1st quarter of $8.4B, or $1.37 a share, up 7% from a year-ago profit of $7.86 billion, or $1.22 a share. But this was down from the 4th quarter ($10.7B) and therefore disappointed investors. Actually it's more likely simply profit taking after a nice run up from last fall.

Bernanke's speech and discussion with Congress this morning was obviously listened to carefully. As mentioned above, he supposedly lifted the markets this morning by hinting that the Fed might pause in their interest rate increases if the data supports the pause. In a very carefully choreographed script the mega-banks (the Fed's primary dealers) then unleashed a slew of buy programs to magically lift the market over 100 DOW points before letting it settle back a little. Take a bow Boyz, you were right on cue. This game is getting old but it was also very predictable. Now that we're on to what they're doing the game will be changed but I hope many of you didn't fall for the bear trap this morning. If you're able to follow in the Monitor I made it very clear you shouldn't trust the selling this morning.

Bernanke went on to say that he reserves the right to tighten as necessary even if he decides to pause for a rate cycle or two. As he has often said, it will be data dependent. Some specific comments included the following:
-- there could be a "small risk" of a disruptive currency account adjustment (this has to do with our debt level and I'm not so sure about the "small risk" part
-- there is a risk for a sharper housing slowdown (in my opinion this was a major warning in disguise and one look at the housing index below will show that investors in the home builders thought so too
-- the data since the last FOMC meeting hasn't changed significantly (read: rate increases will continue as long as this remains true)
-- energy prices pose a risk for inflation to kick in and slow down our economic growth
-- he sees economic growth moderating later in the year
-- inflation "vigilance" will be the key to our economic health

Basically there was nothing much new from Bernanke since we weren't told anything that we didn't already know. That's why the ramp job this morning was all a farce. It's a game the manipulators are playing so that they can continue to rake in billions for their banks. This is a case where you have to try to guess the games that are being played and ignore some chart signals, and that's not an easy way to trade. I use EW analysis to help provide me with a road map and obviously it isn't always accurate either but it did help me look for an opportunity to buy the dip today. The EW pattern is what tells me to expect higher still but not for long. Let's move to the charts.

DOW chart, Daily

The DOW continues to chug higher towards resistance marked by a Fib and Gann target at 11465. Just above that is the trend line along the highs since last November, which marks the top of a potential bearish ascending wedge. Normally the last leg up in these patterns does a throw-over and that would take the DOW to just above 11500. Therefore I'm looking for a high in the DOW within the next few days somewhere in the 11465-11515 area.

SPX chart, Daily

SPX is in a very similar bearish ascending wedge but a little shallower. Fib and Gann resistance for the SPX falls into the 1324-1332 area but even with an over-throw above the top of its wedge would give us a potential top closer to the 1324 level. DOW 11500 would also mean SPX closer to the low 1320's.

Nasdaq chart, Daily

The COMP has been struggling more than the large caps and while they got a little more of a boost today, it didn't amount to much on the daily chart. It's possible this has already made a high so tech bulls need to be very careful. Obviously a break below the 50-dma and October uptrend line near 2311 would be bearish. Until then, stick with the up trend but keep your stops tight.

QQQQ chart, 240-min

The tech large caps got a nice bounce today and it took the Q's right up to its old broken uptrend line that marked the bottom of its flag pattern. Kiss goodbye. It was a good place to try shorting it with a tight stop just above. It could continue to a new bounce high if the broader market can continue its rally. But like the COMP, this one may have already topped and failure could occur at any time.

SOX index, Daily chart

The SOX also got a nice bounce today but again, on the daily chart it doesn't amount to much. The 50-dma isn't doing much except act as a pivot around which price is oscillating. The bounce clearly looks corrective here and is telling me it will fail.

In my previous discussion about the experiments done with grains of sand and sand piles, and the "fingers of instability" that developed (Market Wraps April 17th and 20th), the main point of the discussion was that a very stable environment became more unstable the longer it was stable. As it applies to the markets we trade that sounds strange at first but the basic premise is that long term stability tends to get investors overly comfortable and over-confident that risk has been removed from the market. Investors begin to feel that they can do anything and still make money, that the downside risk is minimal. This breeds complacency and we all know complacency is a dangerous commodity in the market.


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"When the VIX is low it's time to go and when it's high it's time to buy." That saying came about from many cycles in the market and it didn't take long to identify complacency (low VIX) as a warning sign to investors. It's not just a low VIX reading though that tells us to get out of the market. If that were true you should have been in cash since the beginning of 2004, with perhaps a foray into the stock market in April and October 2005 when VIX spike up. Come to think of it, with the DOW around 10800 at the beginning of 2004 and currently pressing up around 11400, that's a 5.6% return for a little over 2 years of risk. Perhaps you could have done just as well in a 2-year bank CD and not worried about the ups and down in the market.

This brings us to the crux of the matter--how much risk investors are currently willing to take on, how much they're willing to pay for it, and how little they expect back in return (relative to the high risk and high cost). The problem is that most investors don't feel like they're taking a lot of risks. The environment in which we find ourselves at the moment has been so steady and stable that it has bred overconfidence in the system and has increased most everyone's appetite for more risk. This is why Greenspan, Paul McCulley and many others have been sounding the alarm that long periods of stability lead to rapid and surprising changes that quickly leads to instability. The usual reaction from people is "where did that come from?" Many pundits are now describing our economy as a Goldilocks economy. This just feeds this sense of stability in the market place.

I believe we're not far from the time when the rug will get pulled out from under the market to expose the trap door. That's not because I'm a pessimistic kind of guy and constantly looking for doom and gloom. I'm actually just the opposite. But I keep my eyes open and my ears on the train tracks. I didn't do this in 2000 and I paid dearly for it and I vowed to never ever let that happen to me again. The market is now set up the same and is in fact more vulnerable than it was in 2000. The reason it's more vulnerable is because our country and people are in more debt than ever before in history and have no cushion to fall back on. I'm often asked why I don't think the market will just continue higher considering all the money coming into the market. A big reason is all the debt that has been incurred--it will act like one big vacuum that sucks up all excess liquidity. The money will go towards paying down debt instead of buying things, including stocks.

There are a lot of arguments going around right now about how to value the market and it seems those who are trying to make a point use values to support their argument. It would be nice if there was one standard that we could all agree on but that wouldn't help us make a market. We need disagreement so that we have two sides to make a market. But here's what I like to use--trailing earnings instead of forward (forward gets modified too much since it's really just a guess) and GAAP (Generally Accepted Accounting Principles) earnings instead of proforma or "operating earnings" or any of the other games that are played.

I retrieved the following data from decisionpoint.com (thanks for forwarding to me Joe). These are the most recently reported and projected twelve-month trailing (TMT) earnings and price/earnings ratios (P/Es) according to Standard and Poors:

Est Est Est
2005 Q4 2006 Q1 2006 Q2 2006 Q3
TMT Earnings (GAAP)........: 69.93 72.31 74.04 76.27
TMT P/E Ratio (GAAP).......: 18.8 18.1 17.7 17.2

The following are the values of the S&P 500 for where it would be trading at different P/E ratios (calculated by multiplying the GAAP EPS by 10, 15, and 20):

Undervalued (SPX if P/E = 10): 699
Fair Value (SPX if P/E = 15): 1049
Overvalued (SPX if P/E = 20): 1399

Therefore by this method we could say there's a little more room to run to get to overvalued (SPX 1399 vs. the current price of 1309). But clearly we're a lot closer to overvalued than even fair valued and that makes the market a higher risk at the moment. When we combine this with the fact that earnings are very likely at their cycle peak, we are out of whack with history.

For the past 65 years we've seen stock prices already pulled back at earnings peaks because it was recognized that earnings would cycle back down. Investors today believe cycles have gone away and that we'll continue to build from here. This is where the long term stability of the market gets participants in trouble. When things finally change the instability created by that "unexpected" change will only be worse and the market will very likely experience a "dislocation" event.

Now we'll look at dividend yield. The yield for the S&P 500, DJIA and DJTA (Transports) has historically been between 3% (overvalued) and 6% (undervalued). The normal yield range for the DJUA (Utilities) has been between 3% and 12%. DecisionPoint expresses this range as an RVR (Relative to Value Range) value between 0 (undervalued) and 100 (overvalued). If values fall outside this range, it indicates an even greater extreme in market valuation. Here's a comparison of P/Es and dividend yields for the major indices:


Price/Earnings Ratio...: 19 20 36 21 20 19
Dividend Yield.........: 1.7% 1.8% 0.3% 2.3% 1.0% 3.6%

Now look at the various numbers and notice the calculations for RVR which is typically between 0 and 100 in the normal market swings:

------- ----- ----- -----
Closing Price (4/20/06)...........: 1311 11347 4706 398
Current Yield.....................: 1.7% 2.3% 1.0% 3.6%
Current P/E.......................: 19 21 20 19
Current RVR.......................: 142 124 168 94

As you can see all the indices are grossly overvalued. So when you hear the market is fairly or undervalued, don't believe it. That's coming from people who have a bullish bias and want you to buy their stock or recommendations.

Lastly, here are some normal ranges and current readings for the DJIA. There is nothing bullish here whatsoever.

DJIA Yield (Norm Range: 3% - 6%)..................: 2.28% -- Bearish
DJIA P/E (Norm Range: 10 - 20)....................: 21.28 -- Bearish
T-Bill Yield/DJIA Yield (Norm Range: 1.6 - 2.0)...: 2.03 -- Bearish
Price to Dividend Ratio (Should be less than 30)..: 43.86 -- Bearish

Basically all these numbers tell us the 3+ year rally has been a bear market rally instead of part of a new bull market. We never "cleansed the system" in the 2000-2002 decline. Instead that was only the first leg down in part of a larger bear market. I know a lot of people don't want to hear this and think I'm just a permabear. I prefer to think I see and listen to what the market is telling me, not what I want it to do. The former will make you money; the latter will kill your trading account.

On Monday I'll get into some specifics to show how fearless investors have become. They've become enamored with high-risk, high-beta and even junk OTC stocks in their search for returns. Greed is never a good thing in the market and I'll show you how prevalent it is. It has always been one of the two primary components driving the market--fear and greed--and the danger is how quickly greed can turn to fear.

The bulls still rule though. The banks dipped this week and found support at the October uptrend line (and 20-dma) and had a good day today. The bounce off the 20-dma reminds me to mention the importance of this moving average. If we're in a strong trend, that 20-dma is key. You will almost always see a bounce off it (or a pullback if in a down trend). If it breaks, then you have a heads up that the trend is in danger. Then the 50-dma is your next line of defense. So we have the 20-dma holding so far and that tells us we still have a strong up trend. Until that changes, stay with it.

BKX banking index, Daily chart

The banks got a strong lift following Bernanke's commentary, as a steepening yield curve helps their bottom line. JP Morgan Chase (JPM 43.95 +1.29) hit a 52-week high and better than expected earnings and guidance from Countrywide Financial (CFC 39.30 +1.35) helped lend support. The index bounced above the top of its potential ascending wedge and closed right at the top of it. It also Bullishly closed above its December 31, 2004 high. This could clearly make a run for it which would obviously be bullish for the broader market. Or it just topped out today. Keep an eye on this one.

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

The home builders look to be in trouble here. The break of all trend line support and the March low now confirms the break down. It should find resistance now at its uptrend line so any bounce up to there (about 860) would be a good short with a relatively tight stop just above, such as above the dropping 50-dma (879).

Oil chart, June contract, Daily

Oil finally started its pullback. It's not because Iran decided to make nice or because Nigeria will stop threatening oil workers or other reasons like that. It's selling off because traders are taking profits. It's just part of the normal cycles. So now we'll see what kind of pullback we get. It might be very brief and then continue up towards $80 or it could be deeper and follow a path similar to what I've depicted on the chart. I believe it will chop lower until it finds support at its rising trend line and 200-dma, probably to around $65 before it heads higher again into the summer.

Oil Index chart, Daily

Like the commodity the oil stocks are experiencing some profit taking now. It's not because Exxon Mobil missed earnings, though that's the easy excuse. It's just time for a correction. If it chops lower like oil, it should find support at its uptrend line and 200-dma, probably around 560 by the time it gets there. Keep an eye on oil and the stocks for any potential divergence as a heads up something is about to change. Right now they continue to track very closely.

Transportation Index chart, Daily

The Trannies rally when oil spikes higher and then sells off when oil drops. And you thought you could trade one off the other? Not for very long. Same with the dollar and gold, bonds and equities, oil and equities. Each must be traded by its own chart. And the Trannies are looking tired but of course they've been looking tired since November's high and meanwhile they've added almost 600 points (+15%). Not bad for a tired index. This is still in an uptrend but watch that uptrend line (tested it today). The current pullback since its last high looks corrective and gives me the impression we haven't yet seen the high for the Transports.

U.S. Dollar chart, Daily

Here's our indicator for the Fed's debt monetization efforts--printing lots of new money (and hiding the fact without the need to report M-3 anymore) will depress the value of the dollar. It's falling more sharply than I thought it would and the way the decline started from the March high could be indicative of a lot more downside in a stair-stepping fashion from here as it complete an EW pattern to the downside. All those trend lines may only be good for a bounce before continuing lower. Obviously a break below $86 would be very bearish. Until that happens though we could certainly see a sizeable bounce at any time.

Gold chart, June contract, Daily

Gold and silver were down today which is a little out of character considering the sharp drop in the dollar. I don't know if it's just a 1-day disconnect or if something else is happening. It could have been just normal profit taking as gold tests its high. It will either consolidate sideways here with another relatively small pullback or it will continue to chop higher which is what it appears to be doing. If it pulls back and goes sideways for a little longer, that will be a good time to trade it to the long side. If it chops higher, and one more small push higher could do it, it will look like an ending pattern to the upside. In that case we could have a very good tradeable short in gold coming up. The answer to that is not clear yet but we might have an answer by my Wrap on Monday.

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

Tomorrow will be busy with economic reports and these numbers are the ones the Fed watches so any of them could move the market. If the numbers come out near expectations we probably won't see much of a reaction. And as we saw this morning, even if we get an early negative reaction that won't necessarily last long.

Market internals pretty much matched price action today--a slight bullish bias by the end of the day. Up volume and advancing issues slightly beat out down volume and declining issues. We had a high number of new 52-week lows which is indicative of further distribution as more and more stock is unloaded. We received another Hindenburg Omen signal, the 8th this month and it continues the streak for the week with a signal each day of the week. These multiple signals tell us the market is particularly vulnerable to a steep sell off.

But shorter term picture could still be bullish. A rise in the put/call ratio means too many traders are jumping in short in hopes of catching the drop. This is what the Boyz look for when they want to hit the market with buy programs--they need the short covering fuel to provide the fast rallies which they're probably using now to further unload their inventory. This is probably what's causing the choppy advancing pattern that we saw today. That pattern will likely continue and it's why I'm guessing we'll see bearish ascending wedges on multiple time frames as the market tops out.

Sector action was mixed but also with a bias to the green side. The green sectors were led by the financials, software, utilities, SOX and other techs, drugs and pharmaceuticals. The red sectors were led by HMOs (-5.9%), gold and silver, oil service, networkers, energy and transports. The HMOs got crushed today thanks to Aetna (AET 37.00 -9.43) which dropped 20% following disappointment over its medical cost ratio. They beat estimates by a penny and raised their FY06 outlook but got taken out behind the woodshed and shot anyway.

Microsoft (MSFT 27.28 +0.15) reported after the bell and said profits were up 16% on stronger demand for its software used to run corporate servers and personal computers. Sales were up 13%. Net income for the fiscal 3rd quarter rose to $2.98B, or 29 cents a share, from $2.56B, or 23 cents, a year earlier. The results included a legal charge of 3 cents a share. The results were shy of expectations for 33 cents a share. Revenue rose to $10.9B, up from $9.6B but below expectations for $11B. The results were also at the low end of a forecast issued by Microsoft in late January. MSFT sees 4Q revenue of $11.5B-$11.7B and earnings of 30 cents a share. FY07 revenue is projected to be $49.5B-$50.5B with earnings of $1.36-$1.41 a share. These numbers were below what Wall Street was expecting.

So MSFT was taken out to the public square and stoned after hours. The stock dropped to $25.50 by the close of after-hours trading which was only 2 cents off its low. There could be follow through selling out of the gate tomorrow morning. But watch this one carefully. There's a long term uptrend line from July 2002 that price dipped below back in October 2005 before rebounding after a couple of weeks below the line. The line is currently at 25.75. Opening anywhere near $25.50 will look like a huge gap down and there's a way for me to count, from an EW perspective, the gap down as the start to a vicious decline in MSFT that's kicking off. It would be an initial gap that won't get filled for many years to come. So I wouldn't run out and buy it just because it might find support at its uptrend line but nor would I sell it after a huge gap down. We'll need to see what kind of bounce it gets before we can get an idea as to what's next.

And that goes for the market in general. We are perched very near the top I believe. Surprises, like MSFT, will be to the downside. Being long here is very risky in my opinion. I'd be looking over what stocks or indexes you'd like to short and perhaps begin legging into a few positions with the knowledge that you may have to stop out if the DOW continues rallying much beyond 10500. Mostly it's a time for extreme caution. Picking tops is always dangerous whereas waiting for a breakdown and selling the bounces can be a lot easier and more conservative way to get short. The flip side is that if you're long, stay there but have a foot holding open the exit door. If you can't watch the market intraday, have some stop orders laid in to get you out in case a surprise drop occurs while you're away. Be careful out there. Good luck and I'll see you on the Monitor.

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