Option Investor
Market Wrap

Amazing Resilience!

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Caterpillar (CAT) really stunk up the place on Friday morning with weaker than expected guidance and a massive -$10 drop. This equates to roughly -70 Dow points and that knocked more than -100 points off the Dow's opening highs at 12048. The Dow shook off the pounding and returned to positive territory just prior to the close. While it could not hold the gains it did manage to close over 12000 and guaranteed top billing in the weekend papers. It was an amazing show of resilience after three months of gains.

There were no material economic reports on Friday but earnings were creating enough of a mess without economics adding to it. Next week we will see two manufacturing reports from the Fed from Kansas and Richmond. We will also have the National Activity Index on Wednesday and the Q3-GDP on Friday. The GDP is expected to fall to +2.2% from the 2.6% growth we saw in Q2. The really critical economic event for next week is the FOMC meeting on Tue/Wed. With five Fed heads making hawkish comments over the last week or so it is obvious there is no overwhelming urge to cut rates. It appears there is growing sentiment for further tightening and that has pushed bond yields higher over the last two weeks. The Fed funds futures are only showing a 6% chance of a rate cut through February and that is down from a 50% chance about three weeks ago. The economic picture is very mixed with some indicators firming and others holding at their lows. If the Fed feels the soft landing has morphed into a quick touch and go they could shift back into hike mode to make sure the inflation rate does not rise with the economy. The growing feeling among Fed speakers is that although inflation has cooled slightly it is far from under control and it would be worth taking additional measures to accelerate its decline and guarantee it won't soon come back. If the Fed statement on Wednesday has any clues suggesting the Fed could reenter the hike cycle the equity markets will not be pleased.

Economic Calendar

The big winner for the day was Google with its blowout earnings report and +$33 gain to $460. Brokers were falling all over themselves to raise price targets with Citigroup raising theirs to $600. S&P raised its target to $500 from $370 and Stifel Nicholas & Co raised their target to $554. With the demise of Yahoo as a search/advertising competitor it appears Google is alone at the top and poised to gain market share with acquisitions of page views like their recent YouTube.com buy. They are currently sitting on more than $10 billion in cash and more pouring in every quarter. Buy the dips and hope for that $600 price target from Citigroup.

Losers were a lot more prevalent on Friday with massive over reaction sell offs in multiple sectors. Leading the headlines was Caterpillar with a warning that knocked -$10 off its price. CAT called an anticipated sales slowdown in 2007 a pause, not the end of a sales run that more than doubled revenues since 2002. CAT posted profits that rose +15% but fell short of analyst's estimates. CAT also lowered its full-year earnings forecast citing high operating costs and lower than expected sales volumes. CAT also cautioned that the weak housing market in the US and a drop in sales of truck engines would restrain earnings in 2007. The new diesel emissions laws take effect next year and many buyers stocked up on the old engines ahead of the new rules. They said business would rebound after the potential 2007 pause due to strong global sales, energy exploration, mining and infrastructure improvements. They said strong worldwide growth would continue to push demand higher. The key sentence came from an analyst with Morningstar. He said, "It is a lot better to under promise and under deliver" and with predictions for a slower economy this was simply insurance against that possibility. CAT could still surprise to the upside if the economic decline continues to flatten rather than fall lower. I bought the CAT dip and will be recommending it to LEAPS Subscribers this weekend.


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There was also a slaughter in the chip sector with SanDisk disappointing investors with its outlook. SNDK fell -$12.58 after saying pricing was down -25% due to tough competition and heavy promotions and would decline another -15% to -20% in Q4. That added to problems in the chip sector with the SOX plunging from its high of 477 on Monday to Friday's close at 447 for a -6% loss. M-systems Ltd (FLSH) also fell off a cliff with a -$9.61 drop. FLSH is being acquired by SNDK. I am sure FLSH investors are really happy about that acquisition today. The chip sector was already under pressure after AMD disappointed analysts on Wednesday with lower margins and lower selling prices. Intel appears to be winning the processor war and AMD is going back to gathering the scraps. Intel has been kicking out new models in rapid-fire mode with rapid increases in processing power. XLNX was the only major supporter of the SOX on Friday with a +1.45 gain after beating the street by a penny. XLNX looked like the only port in the storm for chip investors on Friday. Without gains in chips we will not see any material gains in the Nasdaq.

Financials also took a hit after weaker than expected results from UnionBanCal (UB). The bank warned for Q4 saying raising capital had become more expensive and margins were shrinking. UB lost -4.73 on Friday dragging the sector off its highs. We had seen most of the brokers and major banks hitting news highs early in the month but those are starting to trend lower ahead of the FOMC meeting on those fears that the Fed could come back into the picture. With the long-term outlook still positive for the economy I feel it is only a dip that should be bought if the Fed does not spoil the picture on Wednesday.

I put together a top ten losers/gainers list for Friday and you can see with the exception of Google the amounts lost were significantly more than those gained.

Top Ten Losers/Gainers

Not all outlooks were negative with UPS giving a big boost to the Dow transports after reporting profits, which rose +8.9% in Q3. UPS CEO said the quarter was stronger than they were expecting and they were expecting a strong Q4, which was shaping up to be a solid holiday season. UPS rebounded +$4 off its Wednesday lows. Ryland (RYL) shares rose slightly after their earnings fell less than expected and they affirmed their full year outlook. Imagine that, a homebuilder without a warning. Could this be a sign of things to come?

The other big news for the week was the OPEC production cut. After weeks of wrangling they finally agreed to cut 1.2 mbpd starting Nov-1st. Yawn. The futures spiked +$1 on the news to $60.50 in overnight trading. Before the smoke cleared for the week the contract was trading at the low for the year at $56.82 and better than a -$4.25 loss from the highs. You are probably asking "what happened?" There were several reasons for the drop. First, it was a typical sell the news event that had been hyped for three weeks. No surprise there other than the slightly higher total cut. The breakdown of the cut by country is shown in the table below.

OPEC Member Production Cut

The Dept of Energy said it would actually amount to a real cut of only -660,000 bpd. They correctly realized that some of those countries had already slowed production and some have not been able to make their quota for sometime making their cuts less likely to be honored. It is still a move in the right direction and OPEC also warned that they could cut another -500,000 bpd when they meet in December. The real challenge with the production cut is the timing. If it starts on November first it will be 30-45 days before it is felt at the refineries. That is the normal transit time for OPEC crude. That means every bbl they can pump for the rest of the month will be floating to its destination until well after Thanksgiving. Secondly Saudi has not modified any of its contracts for future delivery suggesting they have not yet notified anyone their deliveries will be cut. Until that happens there is no teeth in the cut and traders will continue to be rightly suspicious of OPEC. Another reason oil prices crashed into the close on Friday was the expiration of the November futures contract for trading. All those traders who have been hoping for a huge post OPEC spike found their dreams shattered and rushed to the exits trying to salvage their remaining investments. The December contract begins trading as the current month contract on Monday and it went out at $59.37 on Friday, +2.55 over the expiring November contract. That is right at strong support at $59. Cold weather has produced a strong rally in natural gas with Friday's close at $7.30 compared to the low of $5.27 just three weeks ago.

December Crude Chart - Daily

On Thursday the Dow closed above 12K with lots of fanfare and the expectations by many that an immediate bout of profit taking would appear. When CAT warned and knocked -100 off the Dow at the open the bears were positively drooling with excitement. Before the day's end they were licking their wounds and calling for reinforcements. The market resilience is positively amazing and the talking heads are giddy with the current earnings parade. Year to date the Dow is up +12%, S&P +9.5% and Nasdaq +6% with no profit takers in sight. Earnings have been very strong with the majority of announcements stronger than expected. So far 151 S&P companies have reported with only 15 missing estimates. This means a whopping 90% either reported inline or beat estimates. That breaks down even further showing that 74% beat estimates and only 16% reported inline. Earnings for the quarter to date have come in at +17.3% growth and well over the +16% expected at the beginning of the announcements. Margins are running at 8.8% compared to the average at 7.5% with revenue growing at a +9.5% rate. This is about as good a quarter as could be expected in light of the slowing economics. In fact it might be too good and convince the Fed the economy was not as weak as they thought. However, before we get too enthusiastic we need to remember that the early reporters are normally the best reporters and earnings quality declines as the cycle continues. That should bring us back inline with estimates over the next several weeks. The only qualification there is energy earnings. Those begin in earnest next week and so far the early reporters have been very positive. That is not what analysts expected. They felt the comparisons to the 3Q of 2005 would be tough and we could see some earnings weakness. So far that has not happened and the three biggest companies, Exxon, Chevron and Conoco report next week. Those three companies make up a whopping 9% of the entire S&P. I believe we may see some continued strength and that could push the S&P earnings growth for Q3 even higher. The table below lists only a few of the more than 500 earnings announcements next week.

Earnings Calendar

For next week I have continued mixed feeling about market direction. As I stated above the market resiliency has been very strong. This strength was even more amazing when you consider some pretty weak readings on the internals. Despite the Dow hitting highs the internals were barely able to stay neutral with declining volume winning the battle 3 of the last 4 days. Volume was higher, over 5 billion shares on Tue/Wed/Thr but that is disconcerting considering most of it was declining volume. The Dow shows literally no signs of failure but the internals are showing signs of distribution typical of a market top.

I don't want to get everybody excited and create a storm of hateful emails because I am calling for a bear market. I am not doing that at all. I simply believe the market needs a rest before we can move much higher. The earnings news has been great but it is already priced in at this point. The Fed meeting on Tue/Wed only has the potential for bad news. The only good news would be a rate cut and that is not going to happen. Those hawkish comments from five Fed members suggest there will be some heated discussions about letting the situation ride much longer without a material drop in inflation. Since they can't cut/hike in the October meeting due to political concerns they may choose to issue a hawkish statement and try to warn the markets there is a change in status ahead. This would be very bad for equities and with the earnings news almost past tense for Q3 there is nothing left to provide motive power. I believe the markets could begin to price in a hawkish statement early next week now that option expiration is over. I would tighten stops on any long positions.

The Dow set a new closing high over 12000 on October 19th. This is an important historic date that few remember. This was the 19th anniversary of the 1987 crash where the Dow lost -22% on one day. That would be the equivalent of -2600 points if it happened today but that chance is nearly impossible due to circuit breakers instituted after that event. The indexes can still bankrupt a lot of unprepared traders even under its current movement restrictions. Remember the Boy Scout motto and always be prepared!

Dow Chart - 1987

Dow Chart - 180 min

The Dow has been on a mission since its low on July-18th. Over the last month the dips have been getting shallower and uptrend resistance tested on almost a daily basis. Eventually the Dow must rest and retest uptrend support. With the FOMC meeting next week it would be a very good opportunity for traders to pocket some profits. Nothing prevents the Dow from moving higher in the short term but there is simply no reason for it to move higher now other than funds chasing performance as the threat of an October decline quickly evaporates.

The Nasdaq presents nearly the same picture only not as steep. The spike above uptrend resistance last week lost traction as it approached the stronger resistance at 2375. The multiple train wrecks in the chip sector greased the skids and the Nasdaq is struggling to remain within reach of that 2375 resistance. With Microsoft the only major non-chip tech to report next week the Nasdaq is going to suffer from the dozen or so chips still to report led by Texas Instruments on Monday. I know, TXN is not a Nasdaq stock but it will color the outlook for the remaining chips still to report. The network sector will also report next week with FFIV, LU, FDRY, TLAB, AKAM, etc reporting. They could pick up some of the chip sector slack or apply more grease to the skids if they stumble. Fortunately the Nasdaq has decent support at 2300 so it would take more than just an intraday dip to cause any real damage.

Nasdaq Chart - 180 min

SOX Chart - 180 min

The S&P-500 is a mirror image of the Dow gains but only if looked at on a long-term chart. The S&P rise has been on a rocky road with several sharp dips followed by sprints higher. Like the Dow and its 12000 battle the S&P has been waging one of its own at 1368. This appears to be the line in the sand and IF I was only going by the chart I would say a breakout was imminent. The consolidation just under 1368 is showing the typical higher lows and wedge of pressure building with every intraday dip bought. If there was no Fed meeting next week I would be more optimistic given the very short-term signals. Long term I believe, like the Dow and Nasdaq we need to retest support around 1345 very soon.

SPX Chart - 180 min

While these chart patterns appear to be bullish they are all very overbought and over extended. They can continue higher only as long as somebody is willing to buy the tops but in periods of rampant bullish sentiment like we have now that can continue to even greater extremes of overextension. As traders we need to try not to anticipate what we think the market SHOULD do and simply react to what it does. Despite all the gyrations the SPX only gained +2.40 for the week and my recommendations from last week still stand. We want to remain long until the market tells us otherwise. We want to buy dips to 1350 and go short/flat under 1345. In order to buy dips to 1350 we need to tighten current stops to something in the 1360 range on any longs. Take your profits if the market decides to rest and then get back in on a dip.

I would continue to buy energy stocks on the dips despite what the crude futures are doing. The strong winter demand season is just ahead and the OPEC cuts will take effect just as that demand kicks into high gear. Oil prices are not going to fall much further before the herd begins to shift back into energy for the next wave higher. With dozens of energy companies reporting this week it should be simple to spot the good ones and there is plenty of value to go around.

Russell Chart - 60 min

Be wary of the Fed on Wednesday and Microsoft earnings on Thursday. Watch the Russell on Monday for signs of a retreat by the funds. Equity funds took in $1.4 billion in the prior week and $2.7 billion on the week ended on Wednesday. From the bounces in the Russell that began on the 4th and 12th it appears they put that money to work. Nothing attracts new money better than a market making new highs and nothing causes sudden outflows faster than a market losing its grip on those highs. Currently initial support is 760 on the Russell with real support well below at 735. Small cap internals have been weakening the last two days and it is just possible the Russell could be the canary in the cold mine this week.


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