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Market Wrap

An Aversion to Risk

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There are signs that the major indices are trying to stabilize, but at the close, market participants still depict an uncertainty that a near-term "bottom" is in.

As I reviewed several sector indices this weekend, one test for strength, which would give sign of stability, was where great weakness has been found the last few weeks. The Semiconductor Index (SOX.X) 469.16 -4.19%!

But from the opening bell, the SOX easily relinquished the 477 level, a first level of support I felt a test for buyer's conviction would be tested. Mind you, not just a "bull's" conviction, but more importantly, a short-covering bear's convictions.

No, a 10% drubbing of chip equipment maker KLA-Tencor (NASDAQ:KLAC) $40.54 -10.38% didn't help the sector. Needham downgraded the stock to "hold" from "buy," even after the stock had retreated 10% from its early May highs of $51. Adding to, if not exacerbating today's weakness was the company's CFO saying it had been served with a subpoena by federal prosecutors seeking information on stock options grants.

Juniper Networks (NASDAQ:JNPR) $15.49 +2.85% was another technology company reportedly being reviewed by federal authorities as to the improper pricing of executive stock-option grants.

KLA-Tencor and Juniper join more than a dozen companies that over the past two months have faced probes about the improbable timing of executive option grants. Both companies are currently among 17 found at "high risk" of having backdated options issued last week by the Center for Financial Research and Analysis.

At issue is that high-level management may have received stock option grants prior to significant run-ups in the company's stock prices.

Just after 02:00 PM EDT, the majors did show some bullish life with the S&P 500 (SPX.X) springing off its lows near 1,256 after Federal Reserve Bank of Dallas President Richard Fisher issued some hawkish concerns regarding inflation.

"Inflation is running too high for my comfort," Fisher said in comments after a speech Monday before a group in Dallas. And while he didn't say what that meant for Fed rate policy, Fisher noted "our job is to keep inflation at bay. I'm very harsh on that front" and inflation "cannot be allowed out of its cage."

But he did offer that in deciding what to do next with rates, "we have to impute into our discussion, obviously, the time lag of previous tightening initiatives and many other variables." Mr. Fisher said "we shall see what ensues in the data and the anecdotal evidence that we pick up between now and the next meeting."

Mr. Fisher's words followed a speech in which he tackled the topic of globalization, and how that force has changed many of the ways policy makers must evaluate the economy. He also said in his speech that globalization has helped reduce U.S. wage gains, but added that better global growth was helping to boost inflationary pressures.

U.S. Market Watch - 5/22/06 Close (04:45 PM EDT)

So here we are, a week after my last Market Wrap and the Dollar Index (dx00y) 84.37 is relatively unchanged (5-dayNet%), but many of the major indices, and sector indices viewed in the U.S. Market Watch continue to "overshoot" relative to the dollar's attempt to stabilize.

I can "feel" trader's voting intra-day with their buy/sell decisions based on the dollar's apparent strength, then weakness. At this point in time, I feel it would take a dx00y close above 85.00 to even begin to think the major indices are trying to find a bottom from the recent decline.

My point is this, and it comes very much from a supply/demand relationship.

It is as if market participants are "OK" with the thought that the dx00y ranges between 84.00 and 91.00, but current levels have EQUITY market participants sitting on pins and needles.

It is almost as if the dx00y is the "piggy bank" that holds the cash, or dollars for purchase of equities.

Not just Dow Industrial components, or the more volatile NASDAQ-100 components. And as you can see from the U.S. Market Watch, many precious metals equities that comprise the Amex Gold Bugs Index ($HUI.X), which has fallen 7.3% since Monday's chat.

It is as if "there just isn't enough cash to go around," and "what cash there is, has been flowing into Treasuries."

Here we are. The FOMC has set its target for the fed funds rate at 5.0% and the 10-year YIELD ($TNX.X) is at 5.036%, where last Monday, the 10-year YIELD ($TNX.X) closed at 5.153%.

It is difficult to explain, but we've seen this before, and noted it in past Market Wraps I've written. It is as if the MARKET is working off an equation of EQUITIES = (+/)- Dollar (+/-) Bonds (+/-) Oil.

As it stands tonight, and on a week-to-week basis, the Dollar is unchanged, Bonds have found BUYERS (+), Oil is unchanged, and that leaves equities in need of cash, perhaps dollar strength.

An equation such as EQUITIES = Dollar , bonds, oil is very simplistic for sure, but let us remember the CURRENCY markets are "gargantuan" relative to the bond markets, and the bond markets are "huge" relative to the equity markets.

With equity markets under some selling pressure of late, lets take a quick look at how the MARKET has removed some BULLISH risk the past week.

In my opinion, the point and figure methodology and Sector Bell Curve is an excellent way for a trader/investor to visualize how a MARKET (you, me, institutions around the world) view things from a RISK perspective.

Sector Bell Curve Comparison (05/12/06 to 05/19/06)

From time-to-time I'll review the Sector Bell Curve from Dorsey/Wright & Associates. If it has been your observation that there's been "nowhere to run, and nowhere to hide" from the bullish side in recent weeks, the above time comparison gives credence to that observation for just the past week. Yes, this is what many would refer to as a "stock picker's market."

The thought behind the "bell curve" is that the MARKET, say the S&P 500 Index (SPX.X), will have some point of equilibrium (generally the mid-point of the bell curve), and the MARKET is very, very good at assessing and managing risk.

From the perspective of HIGH RISK, it hasn't mattered that the dollar index (dx00y) is unchanged, when the PRECious metals sector, say the AMEX Gold Bugs Index ($HUI.X) was shifted far to the right and perhaps held the greatest amount of BULLISH sector RISK.

BANKs and RESTaurants have held together reasonably well from a sector bullish % observation, but a lower TIDE can have bearish implications.

Yes! The S&P Banks Index (BIX.X) 386.26 +0.80% was a sector of "strength" today, and as has been the case the past couple of years, has been a sector/index that tends to lead the majors out of a decline.

BIOMedics, perhaps best depicted by the Biotechnology Index (BTK.X) 658.19 +0.30%. Now enters into a more "oversold" area. See how it was weaker, perhaps lacked the sponsorship of BULLISH cash at 05/12/06 bell curve benchmarking?

Look at OIL stocks playing "catch up" to the downside? RISK being removed? Profit taking? I'd argue BOTH!

So what does a trader/investor do?

Tread lightly, trade SMALL POSITIONS and take profits when you get them!

One indicator I want to address this evening is the Market Volatility Index (VIX.X) as it is doing something that "surprises me."

I've never been one to say a "fear" indicator should be ignored. Lack of "fear" for excessive "fear."

For those traders/investors that like to trade OPTIONS, don't only think "fear," but also think PREMIUMS of the options you're trading.

Market Volatility Index (VIX.X) - Weekly Intervals

I personally DON'T CARE, that the VIX.X action of late depicts that MARKET PARTICIPANTS are either "worried" or "fear" further downside for the S&P 500 (SPX.X).

What I DO CARE about is this.

OPTIONS are a derivative that came to fruition as a TOOL for institutional investors as well as individual investors to HEDGE RISK.

In the spring of 2003, a trader noted that the VIX falling sharply below 25.00 as the major indices began to rebound in what was still viewed as a recession was a VIX indication that the "oversold bounce" would soon reverse. That was around SPX 925.

Last week, I was really looking for the VIX to see a rather sharp reversal back lower, a signal to me that PUT SELLERS were seeing some type of "value" on the recent pullback in equities.

I may focus, or provide EMPHASIS on PUT SELLERS as it would be the NAKED PUT SELLER that during a decline takes on a greater degree of RISK!

I have to ask myself "is there an explanation as to why MARKET PARTICIPANTS aren't as willing to sell these higher premiums as depicted by the VIX?"

One "reason" I sense, based on observation (Pivot Analysis via Market Monitor and week-to-week benchmarking) is that the dollar index (dx00y) is at a level where further weakness could "suck" further cash from the equity markets.


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One other reason will strike home with option traders and my noting of "Max Pain Theory" levels for Friday's recently completed option expiration.

I haven't had a chance to read Friday's Market Wrap, but I would note that for an April Friday expiration, VOLUMES at the NYSE and NASDAQ were VERY HEAVY at 3.03 billion and 2.59 billion shares respective.

The S&P 500 Index (SPX.X) closed below its April "Max Pain" theory value of 1,300 and out of curiosity, I started checking future month's "Max Pain" Theory values. "Max Pain" Theory is simply based on a "sum" of all put/call option open interest for a particular month that options expire. One think I found at Friday's close was for several months into the future (June, July, August and September), the SPX's "Max Pain" Theory value was 1,300.

Now, Friday's April expiration isn't the first time we've seen the SPX, or other major indices finish an option expiration BELOW their Max Pain Theory levels since this great bull market began in 2003. But it does suggest that at the LEAST, the MARKET (SPX) is digesting gains, resting and in need of some type of consolidation.

S&P 500 Index (SPX.X) - Daily Intervals

Imagine at SPX 1320, or 1325 that there was "excessive" PUT SELLING at the 1300 strike, where some traders/investors were betting that the SPX would surely close above 1300, or near that level and the NAKED PUT sellers were even WILLING and ABLE to take possession of this basket of stocks at 1300 less any PREMIUMS received.

Just like that, we can envision a bunch of trader/investors find their coffer filled up with stocks.

This could be a reason that we haven't seen the "sharp reversal" back lower in VIX, where over the past several months, it has been common to see a sharp reversal back lower.

Various market internals like the advance/decline line and NH/NL ratio (5-day and 10-day) have VERY SIMILAR readings as found at the inflection lows of October 2005 and has me thinking that at a minimum, we should expect some of the same trade action found in October near-term, perhaps the next couple of weeks.

Some strategies I've been implementing of late in my OptionInvestor.com Market Monitor profiles is to SELL PREMIUMS if the trade "makes sense."

Yes, it is stock option related where today for instance, shares of "oil-related" shares of PetroChina (PTR) $104.40 -7.20% have now fallen from the $120.00 level, where I look to SELL PUT OPTION PREMIUM at a level I don't think the stock will trade by June's expiration (June 16) and SELL just one (1) of the OUT-THE-MONEY June $95 Puts (PTR-RS) for $1.10.

What I'm saying by doing this is ... "I'm willing and ABLE to buy 100 shares of PTR at $95 - $1.10 = $93.90." And "I think PREMIUMS are too high, and I want to sell PREMIUMS where I don't think a stock should trade."

I'm not selling NAKED PUTS on 10 stocks in one day.

NAKED PUT, or NAKED CALL selling is NOT a strategy for EVERY TRADER/INVESTOR. Some avoid it as it may not fit their RISK profile.

But if nothing else, PRETEND for a week or two that YOU are an institutional investor and might be willing to nip away at SELLING PREMIUM or a higher VIX on a particular security. Maybe the NASDAQ-100 Tracker (NASDAQ:QQQQ) $38.97, or the Energy Select Spdr (AMEX:XLE) $53.71 -0.57%, both trade options.

And PRETEND to "sell the strike you don't think it can trade by June expiration." Then each night, or every couple of nights, check to see where the security is trading and what the VIX.X is doing?

If the VIX is falling and the security you PRETENDED to sell NAKED PUTS on rising, then you've got the feeling that institutions are in agreement with you on one of the RISKIER trades an options trader could be implementing.

And remember .... institutions and the MARKET are very, very good at SELLING and MANAGING RISK.

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