Option Investor
Market Wrap

Blue Chips Finish Unchanged, Small Caps Weak

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Stocks opened higher spurred in part by a stronger dollar after the Commerce Department said the current account deficit widened to a record $225.6 billion in the third quarter, which was slightly less than economists' forecast for a deficit of $228.0 billion.

The current account, also known as the balance of payments, is the broadest measure of international flows of goods, services and capital in and out of the U.S. In other words, the current account measures just how much Americans need to get in investment and lending from abroad to fund their consumption and investment.

A look inside the numbers from July thru September showed the deficit on goods and services trade increased to $200.3 billion from $193.1 billion. Meanwhile, the deficit on goods alone rose to $218.6 billion from $210.6 billion as goods imports totaled $480.7 billion compared to goods exports of $262.1 billion.

While goods were running a deficit, services ran a surplus, with the surplus increasing to $18.3 billion from $17.5 billion.

The Commerce Department also noted a deficit on income, which increased to a record $3.8 billion from $2.2 billion as U.S. investment income from assets owned abroad rose to $160.01 billion from $155.3 billion, while foreign investment income from assets owned in the U.S. rose to $162.2 billion from $155.8 billion.

The Commerce Department said foreign acquisition of U.S. assets increased by $400.2 billion after falling to $364.6 billion in the second quarter. Foreign acquisitions hit a record $527.5 billion in the first quarter.

Foreign accounts were net buyers of Treasuries, purchasing $138.8 billion of U.S. paper, which was up from $127.3 billion in the second quarter. On the equity front, foreigners bought $22.4 billion in U.S equities after selling $1.4 billion in Q2. Purchases of corporate bonds fell to $90.7 billion from $100.6 billion, while purchases of agency bonds edged lower to $25.7 billion from $28 billion.

Additional data showed foreign direct investment in the U.S. increased $44.1 billion compared to $45.8 billion in the second quarter, while U.S. acquisitions of foreign assets increased by $223.8 billion.

Current-Account Balance and Its Components - 1998 - current

Reading the Commerce Department's quarterly current account balance report would likely put most to sleep, if not have our eyes glazing over. However, the above graph does a very good job in my opinion of giving investors a view of what goes into the current account balance. As you can see, the DEFICIT is created largely by the U.S.'s appetite for GOODS, while foreigners' appetite for SERVICES offered here in the U.S. runs a surplus.

One of the "economic concerns" that has been mentioned for years, not just for the U.S., but on a global level, is the DEFICIT currently represented by the balance of goods.

Few economists believe a current account deficit of 6.8% GDP is sustainable, and global economic policymakers have said the U.S. current account deficit (and corresponding surpluses in China) represent a major threat to global growth.

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And it is for this reason, that I (Jeff Bailey) believe there will be great focus on talks between the U.S. economic delegation and China, where the U.S. is "gently prodding" Chinese leaders to take further steps toward that country's economic reforms. One item of focus has been China maintaining a close link between the yuan and the dollar. To maintain the link, China must intervene in foreign exchange markets to buy dollars with their yuan.

To date, China has been able to avoid increases in domestic money supply through sterilization, selling bonds for yuan, but Mr. Bernanke has warned "if it continues to use this strategy it will eventually encounter problems."

Sometimes, I (Jeff Bailey) feel that Mr. Bernanke's words of caution are taken as the U.S. trying to flex its muscle on world monetary systems, but when the realization sets in that U.S. demand for global goods and services may also be at risk, then the global economy is at risk.

U.S. Market Watch - 12/18/06 Close

The U.S. Dollar Index (CEC:DXY) has risen notably (+1.10%) since last Monday, and while it finished Monday's session relatively flat with Friday's close, early morning gains to 84.22 were the best level for the dollar-weighted index since 11/24/06.

Additional economic data released today had the National Association of Home Builders' index of builder confidence for sales of new homes slips one point in December to 32, near its lowest level in 15 years. However, expectations for sales in next six months rose three points to 48.

Last week, the Mortgage Bankers Association said its purchases index rose to its highest level since January 2006, increasing 8.7% for the week ended 12/08/06 to 463.8.

Merger news also gave a morning lift with $90 billion worth of deals announced today. With only 13 days left in the year, announced deals have already amounted to almost $4 trillion worldwide, beating out $3.33 trillion set in 2000.

Some of the bigger deals had Express Scripts (NASDAQ:ESRX) $69.97 +1.90% launching a bid to buy Caremark Rx (NYSE:CMX) $55.58 +10.49% for $26 billion in cash and stock, an offer Express Script says represents a 15% premium over CVS Corp's (NYSE:CVS) $30.01 -1.67% all-stock offer from early November. Analysts say CVS could still sweeten its offer.

Harrah's Entertainment (NYSE:HET) $82.18 +3.37%, the world's largest casino company, also agreed to a $16.7 billion buyout offer from two private equity groups, said a person with knowledge of the negotiations. The deal reportedly values Harrah's at $90.00 a share.

Realogy Corp. (NYSE:H) $30.40 +19.21%, which owns the Caldwell Banker real estate franchise, said it agreed to be acquired by private equity firm Apollo Group for about $6.65 billion.

Health care equipment manufacturer Biomet (NASDAQ:BMET) $41.59 -0.97% said it agreed to be acquired by Blackstone, Goldman Sachs Capital and KKR for $44 a share. Shares of European rival Smith & Nephew (NYSE:SNN) $50.58 +7.27%, which had been a suitor of Biomet rose sharply.

So what happened to the rally? Upgrades, downgrades and Google.

Large caps seemed to be the focus of broker upgrades and downgrades, where energy names Exxon/Mobil (NYSE:XOM) $75.51
-2.31% and Schlumberger (NYSE:SLB) $65.07 -3.67% were cited as "overvalued."

Weakness in the energy complex didn't help the Oil Service HOLDRs (AMEX:OIH) $143.94 -3.78%, or the CBOE Oil Index (OIX.X) 650.46 -2.59% which gave back the bulk of last week's gains and then some. Warmer temperatures across much of the nation had January Natural Gas futures (January Crude Oil (cl07f) settling down $0.334, or -4.51% to $7.07 and a new multi-year low. January Heating Oil futures (ho07f) settled down $0.061, or -3.42% at $1.7207. January Crude Oil futures (cl07f) ended its 3-day winning streak, settling down $1.22, or -1.92% at $62.21.

Meanwhile, Citigroup (NYSE:C) $55.44 +2.53% and General Electric (NYSE:GE) $38.00 +1.71% built on recent gains and positive comments from brokers.

Internet search giant Google, Inc. (NASDAQ:GOOG) $462.80 -3.64% fell $17.50/share, its biggest drop in more than a month after The Wall Street Journal Analysts reported that analysts remained concerned that the company cannot maintain the kind of earnings power it has seen in prior quarters.

Have bears cried "wolf" one-too-many times?

For months, some may have been hearing words of caution and predictions that each new high was the last and a major decline was soon to be found.

Often time, the continued bearish calls, which see higher highs and higher lows, eventually lead to bullish complacency.

Yes, the very bullish complacency that bears have been warning about since early September soon becomes a "cry wolf" call.

However, there is one sign that some weakness, or internal damage is starting to evolve, and it is among 4 and 5-lettered stocks.

In Tuesday evening's Market Monitor at OptionInvestor.com, I was reviewing some of the market's internals, where Stockcharts.com's NASDAQ Summation Index ($NASI) on a 10-point box chart gave its first "sell signal" at +210 at the conclusion of that day's trade. Its first "sell signal" since giving a "buy signal" at
-590 on 08/18/06.

What is this NASDAQ Summation Index? In simple terms, it is a way of measuring the advance/decline line, where recent measures suggest to me that on a broader scale, internals are starting to weaken.

Now, you've certainly heard the term "bullish complacency" for a couple of months. And you've seen the major indices, including the NASDAQ Composite march to new 52-week highs, if not all-time highs.

Due to vertical limitations, I can't fully capture a picture of the $NASI's 10-point box here, but if you want to actually see what this supply/demand chart looks like, and the "buy signal" back in August (after red 8) and recent "sell signal" at the 210 measure, then here is the http://stockcharts.com/webcgi/Pnf.asp?S=$NASI&Y=U&B=10&N=C&C=2

Now I'm going to increase the $NASI's chart to 20-point box size (that's the scale on the left) where here I can capture the vertical picture.

NASDAQ Summation Index ($NASI) - 20-point box

Looking at the "internals" is just as important, if not more important than looking at the EXTERNALS, where the externals represent the PRICE of an index.

But a market technician, like a good doctor won't just look at his/her patient and diagnose them. If a patient doesn't "feel well" then a good doctor my run some tests, take a blood sample, and see if anything comes back "negative."

Hopefully, the above chart will give you three important observations.

The first is the "sell signal" back in early May, just after the "red 5." That may have been interpreted by the "good doctor" as a warning sign that the patient (NASDAQ Composite) wasn't feeling too well.

The second is the "buy signal" in early-to-mid August, after the "red 8" where the $NASI rises, and the column of X (demand) surpasses a prior column of X at 580. Here the "good doctor" might well observe that the patient is showing signs of life again, and starting to strengthen.

And now, the "sell signal" just witnessed. Here the "good doctor" is saying the lab tests show something might be wrong and the internals of this patient once again weakening.

Now that we recognize some HISTORICAL signs of internal weakness and strength from the $NASI's point and figure style of charting, let's take a look at the patient itself.

Here's a 20-point box chart of the NASDAQ Composite ($COMPQ) from Stockcharts.com. The NASDAQ Comp. was down 21.63 points today and closed at 2,435.57.

NASDAQ Composite ($COMPQ) - 20-point box chart

When comparing the "internals" of the $NASI against the "externals" of the NASDAQ Composite ($COMPQ) directly above, the term "bearish divergence" would be used. That is, the recent deterioration of the $NASI and its "sell signal" at measure 200 suggests to me that there is pending weakness in the $COMPQ itself and a $COMPQ trade at 2,380 on the $COMPQ would then "confirm" the internal weakening.

At this point in time, I could NOT recommend that bears get aggressive, BUT, if you're a bull, that has been "cried wolf" to, too many times, then I need your attention!

Don't be complacent. Get OFF long margin, and as the saying goes, don't be a "hog and get slaughtered" should the $COMPQ give a PRICE "sell signal" with a trade at 2,380.

Once, or IF the $COMPQ gives a "sell signal" at 2,380, THEN a bear could initiate some partial short positions. PUT options are a better way to control risk, if looking to play the BEARISH side. Just don't over leverage your account.

Asside from the NASDAQ Summation Index ($NASI), another EXCELLENT, yet slower moving supply/demand measure that I STRONGLY SUGGEST traders and investors monitor is the NASDAQ Composite Bullish % ($BPCOMPQ) from Stockcharts.com. This bullish % SHOULD BE VIEWED on a conventional 2%-point box size chart.

Here is a http://stockcharts.com/webcgi/Pnf.asp?S=$BPCOMPQ to the NASDAQ Composite Bullish % ($BPCOMPQ). Imagine you were charting roughly 3,000 stocks that were listed on the NASDAQ Composite, not just the advance/decline line of those 3,000 stocks, but the actual supply/demand charts of those stocks.

As of tonight's close, approximately 58.69% (1,761) of the stocks listed at the NASDAQ still had a point and figure "buy signal" associated with their chart. That means, approximately 1,761 of the 3,000 charts still showed a supply/demand "buy signal" still intact. For further sign of weakness, this very broad measure of market strength/weakness would need a reversing lower reading of 52%.
 

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