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The bears appeared to be taunting the bulls with that classic line from the "Twilight Zone" movie as the indexes clung precariously to support. The Dow fell to a seven day low and internals were rapidly deteriorating. Bulls were starting to get that worried look as the market instability stretched into its third day. Economics are weakening and there are bigger reports still ahead. The "really scary" event could be an ISM below 50 on Wednesday or a negative jobs report on Friday.

Dow Chart - 30 min

Nasdaq Chart - 90 min

The morning economics started out with the Employment Cost Index rising +1.0% in Q3 with a +1.1% jump in benefit costs. The gains were only slightly more than expected but the internals had some surprises. Year over year wage compensation costs rose +3.2% in Q3 and the fastest growth since 2002. On the flipside benefit costs, despite the +1.1% rise in this period, rose only +3.3% compared to the year ago period. That was the slowest pace in five years. This was a neutral report for the Fed.

The biggest surprise came from the Chicago PMI, which dropped sharply to 53.5 in October from 62.1 in September. This was the lowest reading since August 2005. Production fell to 59.2 from 67.4 and New Orders fell to 54.1 from 67.3. The Order Backlog component fell below 50 to 47.5. Six out of eight components fell while only Employment and Inventories rose. A rise in inventories at a time when the economy is slowing is actually a negative. Prices paid fell to 62.5 from 69.8 and that was a strong positive indicating the pass through of energy prices and inflation is slowing. The PMI is a leading indicator for the ISM due out tomorrow. This suggests the ISM could be lower than the current consensus of 53.1 and a drop under 50 could be a real shock to the market and the soft landing scenario.

There was no slowdown in the NY area with the NY-NAPM showing another rise to 425.3 from 421.0 in September. However, some components suggested a slowdown could be just ahead. The current conditions component rose +10 basis points showing that the current business conditions are still positive. However, the six-month outlook fell from 75.0 to 62.5 indicating the fear of a 2007 recession is growing. The quantity of purchases component also took a huge hit falling to 70.0 from 87.5. Corporations appear to be scaling back on purchases. These negative internals again point to a potential problem in the national ISM on Wednesday.

Consumer confidence fell slightly to 105.4 for the final October reading but nothing to get excited about. You could probably chalk it up to the negative campaign ads where the politicians not in office tell you how bad the economy is doing. Chain store sales fell -0.2% for the week after a -1.1% in the prior week. All of these are just symptoms of a slowing economy.

The bond market extended its gains to five days as the concern over problems with the soft landing continue to grow. The growing prospect of political gridlock for the next two years is also bond friendly. Yields on the ten-year note fell to 4.6% from nearly 4.85% last week. This is a major drop and brings it very close to the 8-month lows at 4.53% we saw in September. It is also very positive for the housing sector since it makes refinancing an option again. The Fed funds futures are now projecting a cut at either the March or May FOMC meetings. The dollar index has fallen back to 85.50 and well off the 87.02 high set back in early October.

10-Year Note Yields - Daily

In stock news Dell was upgraded to "neutral" by UBS on expectations that margin pressures had bottomed. Dell gained +95 cents to $24.30. The new target on the upgrade from UBS? $25. UBS really went out on a limb with that target.

The World Semiconductor Trade Statistics industry group warned that global chip sales would fall to +8.5% growth, down from the +10.1% growth the WSTS had predicted last May. The most notable decline was in microcomputers with memory and analog chips providing the largest growth at more than +16%. The WSTS blamed the price war between Intel and AMD for some of the decline in dollars of global sales. The group expects +8.6% growth in 2007, down from prior estimates of +11% and a return to +12.8% growth in 2008. The SOX took an early hit but recovered on end of day buying to close slightly positive.

Baidu.com (BIDU) reported earnings after the close that disappointed traders and investors were rewarded with a -$12 drop in its stock price. Earnings beat the street by a nickel but they warned on revenue growth with numbers significantly below analyst's estimates. When your stock trades at a PE of 150 any warning about those earnings produces painful results. You would think investors would be happy about the +900% growth in profits for the quarter but they have short memories. The high for the day was $99, with a -9 drop into the close. After the earnings report the price fell to $77 but rebounded to $84 after the initial shock passed.

Apple shares rose +66 cents after announcing that their 1GB iPod Shuffle would be on dealer's shelves before the holidays. It had been widely expected but the date had not been released.

Another one bites the dust! Hedge funds Archeus Capital Management announced it was closing its doors after losing a huge amount of money. Archeus managed more than $3 billion but now will liquidate with roughly $700 million in assets. The fund said it suffered significant investor redemptions that were sparked by record-keeping problems and poor performance in its investments.

Merck (MRK) announced it was buying Sirna (RNAI) for $1.1 billion. That is a +100% premium to Sirna's $6.45 close on Monday. Not a bad deal to wake up and find your stock doubled overnight. Sirna had been in the news after Andrew Fire and Craig Mello, the discoverers of the technology upon which Sirna's drugs are based, won a Nobel Prize for their work. The technology uses a form of gene silencing that could lead to an entirely new class of medicines for a variety of diseases. Analysts were divided over the wisdom of the purchase but Merck felt they gained significant technology. Sirna was formerly called Ribozymes and nearly went under in 2001. The stock dropped to 23 cents, they had $2 million in cash and were burning through $60 million a year. Howard Robin was recruited as CEO from a lesser position at Schering and what he found was a disaster. He cut two thirds of the employees and refocused the company to expand the siRNA (short interacting RNA) technology. The rest as the say is history and Sirna has 50 existing patents and 250 filed patents on the siRNA technology and dozens of companies are racing to capitalize on this technology.


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Procter & Gamble reported earnings that beat the street by a penny and raised its guidance for 2007. Unfortunately analysts were already expecting better performance and JP Morgan issued a note to clients suggesting a pullback was in the cards. PG dropped nearly -$2 at the open but recovered by day's end to lose only -42 cents.

Eastman Kodak posted its eighth straight quarterly loss but conditions do appear to be improving. Earnings from its growing digital business helped offset shrinking revenue from the film business. EK lost -13 cents in Q3 but that was light years ahead of the -3.18 per share it lost in Q3-2005. After special items Kodak actually made +44 cents. This was double the +19 cents Thomson Financial surveyed analysts had expected. EK soared +2.69 at the open to $26.44 but declined to retain only +65 cents at $24.39 by the close.

Pfizer fell to a new two month low at $26.62 after receiving some poor results from an experimental cholesterol drug. IBM rose +83 cents to a new 52-week high after announcing a new $4 billion stock buyback. This is in addition to a remaining $2.4 billion from a previous plan. Hey, brother can you spare us a buck? Must be nice to have billions sloshing around in your cash drawer. $13 years ago IBM was trading at $10 but today's $92 is still well below the $140 we saw in 1999.

Oil prices took a serious tumble this week from last Thursday's high of $61.70 to today's low of $57.05. The rebound at the close was sharp and jumping +1.68 off the lows and right back above support at $58. The reason for the sell off was given as no visible signs of production reductions from OPEC members and new forecasts of a warmer than normal winter. We also had the reduction in risk premium from the warnings about Al-Qaeda we heard last week. The military is seen to have it all under control and there is plenty of oil still flowing. The official production cuts are supposed to begin tomorrow but contracts for November oil have been in place for a long time. This is not something that will just happen overnight. It will be a gradual process that should begin to show impact about the time prices are firming on winter demand. Another factor in this week's sell off was the expiration of the November heating oil and gasoline futures contracts at the close of trading today. Heating oil plunged -10% from last Thursday's high to Tuesday's lows at $1.57. Natural gas also fell even further to $7.06 from last Friday's $8.46 high. The natural gas contract expired on Friday and this was just futures equalization pressures. Gas consumption is expected to rise over the next two weeks as colder weather descends across the Midwest and Northeast. Continue to buy energy stocks on the dips. Despite the massive drop in oil only 23 energy stocks out of the 150+ I monitor on a daily basis ended the day with a loss. It was a great buying opportunity.

December crude chart - Daily

Merrill Lynch and Citigroup made headlines on Monday by calling a top in the market. Citigroup said not to expect a typical end of year rally because it has already happened. Merrill said the hedge fund short squeeze is over and it is time to take money off the table. Since Q4 began 30 days ago the number of stock downgrades has been running 3:1 over the number of upgrades. 1,218 stocks have been downgraded and only 410 have been upgraded. This is an acceleration of a trend with the prior 90 days only 2:1 bearish with 2,411 downgrades to 1,296 upgrades. As we get farther into the end of this earnings cycle the downgrades will increase even more as the smaller companies with marginal results close the earnings cycle. Obviously Merrill and Citigroup have no crystal ball that guarantees they are right but they are only two companies out of dozens that have been turning increasingly bearish.

It is simply time for the markets to rest. The Dow is up +13% for the year, the S&P +10% and the Nasdaq is up +13% over just the last three months. The markets have been accelerating higher since July and without a material pause. Common sense suggests it is time for that pause. Unfortunately common sense rarely has any impact on the markets. Having two of the largest brokers turn bearish could be a contrary indicator. That could prompt tens of thousands of traders to adopt a bearish posture giving the bulls another opportunity to jump from one short covering squeeze to another and even higher highs. There are two things that I believe will pressure the markets. The first is the mutual fund fiscal year end that occurred today. If the last several weeks gains were due to the year-end positioning by funds then we could see some house cleaning begin as early as tomorrow. Secondly, with those monster gains on the boards we could start seeing fund managers begin to lock in profits to secure their fat performance bonuses. They are going to be a lot less aggressive in chasing returns when they are already sitting on big gains with only 40 trading days left in 2006. I am not going to go out on the limb with Merrill and Citigroup because there is no reason to risk being wrong. All we need to do is continue following the market and let it tell us which direction is right.

The Dow closed at 12080, +55 points off its seven-day lows at 12025 set this morning. The Dow has been getting progressively weaker since its high at 12167 set last Thursday. However, given the magnitude of its gains we are still only scratching the surface of any potential profit taking. We could easily see 11900 without breaking a sweat or the long-term trend. Resistance is firmly established around 12150 and support is nicely aligned in 100 point increments at 11900, 11800, 11700, etc.

The Nasdaq has actually taken over a leadership role over the last week with progressively higher highs although by only a handful of points each day. Despite bad news in the PC and chip sectors the Nasdaq is chipping away at the strong resistance at 2375. The Nasdaq looks far closer to another breakout than any of the other indexes. Even the SOX rebounded off its lows today on the lowered expectations for chip sales over the next two years. The bad news tech bulls are definitely getting restless. Initial support is solid at 2330-2340 and dips are definitely being bought.

SPX Chart - 60 min

The S&P-500 has been trading in very narrow intraday ranges with Friday's drop only the fourth decent dip in over a month. The others were Oct-2nd, 6th and 17th. Resistance at 1380 appeared to have been broken last week with the spike to 1390 on the 26th but it was short lived and 1380 reasserted itself this week as a solid top. Support at 1373-75 has held and were it not for the fund year-end I would have a positive outlook for the SPX. The game plan for Mon/Tue was to buy dips to 1363 and go short/flat under 1360 with a new buy target at 1350. We never saw that 1373 level break so our bias is still long. However, given the end of the earnings cycle and several high profile economic reports on the horizon I am going to raise the short/flat indicator to a break below 1370 and continue to target 1350 as a probable bounce point and a dip to buy.

The challenge for the remainder of the week, other than possible fund house cleaning, will be the ISM on Wednesday and the Jobs report on Friday. The ISM at 53.1 in September was already very close to 50 and under that level represents economic contraction. After seeing the recent Fed reports and the PMI today I am concerned that we could see a break of 50 possibly this week. If not we could veer even closer and the market would not see this as a positive sign of a soft landing. The Jobs report on Friday is expected to show a gain of +130,000 jobs and anything over 100K should be positive with the mandatory press conferences by the administration bragging about how many jobs have been created in the last few years. Should we see a repeat of the 51K from last month it could be grim. The markets would likely not implode unless the number goes negative but only 50K two months in a row would not be market positive. As I mentioned on Sunday I would not be surprised to see big numbers on both reports this close to the election. Since they are both only estimates the incentive to over estimate ahead of an election would be a minor shenanigan compared to some that have been pulled over the years by both parties. Whatever happens the rest of this week could be highly volatile and a market where angels fear to tread much less average investors.

Have a spooktacular Halloween and let's hope the mayhem does not carry over into the markets for the rest of the week.

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