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Market Wrap

Lump Of Coal In Your Stocking

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The markets appeared fearful that Santa would leave them a lump of coal in their stocking for Christmas. The economic Christmas cards traders received during the week contained multiple warnings that the New Year may be rocky. This dampened expectations for market performance and traders continued taking profits in winners ahead of the holidays.

Dow Chart - Daily

Nasdaq Chart - Daily

The Durable Goods report for November rebounded with a +1.9% headline gain. This put the report back on track after two months of monster imbalances. In September there was a spike of +8.7% followed by a dip of -8.2% in October. Those numbers were obviously anomalies due to huge orders for Boeing planes in September (+21%) and are now just a footnote in the past. However, the news was not as good as it appeared on the surface. The +1.9% headline number dropped to a loss of -1.4% for capital goods and -1.1% for durable goods once transportation orders were removed. The +40% increase in defense aircraft orders and +7.2% gain in civilian aircraft orders distorted the headline number significantly once again. Orders ex-transportation have fallen four of the last five months. Orders for core capital goods, a proxy for business investment spending fell -1.4% following a drop of -3.9% in October. This suggests businesses are pulling back from investing for 2007 until they see where the economy is going. Inventory levels continue to rise and present the biggest risk to the manufacturing sector with the inventory to sales ratio for autos the highest it has been since 2000. Other categories are also at multiyear highs many at their highest level since 2003. This is not a good sign but one that is consistent with an economic slowdown. The key is to manage it into a soft landing rather than a crash. You may recall the ISM Manufacturing Survey for November showed a contraction for the first time since mid-2003. There is no question the economy is picking up speed to the downside.

Personal Income rose +0.3% in November while spending rose +0.5%. That should be no surprise to anyone that consumers are still spending more than they make. The savings rate fell -1.0% while wages and salaries rose +0.3% to stretch their gains to +6.3% over the last 12 months. The key indicator in this report was an unchanged Core PCE deflator, which brought down the 12-month change to +2.2%. This is the number one indicator used by the Fed to gauge inflation and any drop is a welcome sign. This was the first drop since the high of +2.4% was reached in August. That high held unchanged for three months. Core prices were also unchanged and this was the first time since Oct-2002 they have not risen. Top line inflation did rise by +1.9% after having fallen to 1.5% in October. This is still well below the highs of 3.5% seen back in June.

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The final reading for December Consumer Sentiment rose to 91.7 from the preliminary reading of 90.2 but was still below the November level of 92.1. For all practical purposes both readings were an insignificant change. Rising gasoline prices are being offset by holiday cheer with the minor rebound in the housing market letting consumers breathe easier. The rise in wages seen in the personal income report is also good news for workers.

Earlier this week we saw the GDP revised downward to +2.0% growth from +2.2% and the Philly Fed Survey drop -9 points into negative territory at -4.3 and the Chicago Fed National Activity Index posted its 3rd consecutive month in negative territory with a -0.26 reading. In only a week the economics have done a complete 180 reversal and the potential for a Fed rate cut rose once again. This weekly reversal in economic data is simply demonstrating that economic volatility is increasing and nobody has a firm grip on direction. The markets are not likely to continue their upward direction until this economic haze clears.

Next week we have another manufacturing survey on Tuesday from the Richmond Fed followed by the Kansas Fed survey on Thursday. The Chicago Purchasing Managers Index (PMI) also on Thursday will give us another look at prices paid and inventory levels. Last months PMI reading of 49 was the first reading under 50 since April-2003 and well off the cycle high of 69 in March-05.

Economic Calendar

Ten-Year Note Yield Chart - Monthly

Stock news was almost nonexistent with most traders, analysts and news desks more concerned about leaving for the holiday rather than some obscure earnings warning. RedHat (RHT) was the big winner with a +25% gain after reporting earnings that beat the street. Revenues jumped +43% with earnings of 14 cents. The stock had been trading down since May on fears that Oracle was going to take over that space.

Micron (MU) gained +3.4% after an earnings report that showed margins were benefiting from stronger sales of memory chips. Sales rose +16% with earnings of 25 cents well over the analyst consensus of 20 cents. Micron said the demand for DRAM chips was strong and they had shipped everything they could make ahead of the user version of Vista due out next quarter.

Research in Motion (RIMM) fell -3.70 after it missed earnings by a penny and gave weaker guidance than analysts had expected. RIMM said Q4 earnings would be in a range of 92-99 cents where analysts were expecting the high end at 98 cents. RIMM added 875,000 subscribers in Q3.

February Crude Oil Chart - Daily

Oil finished down only slightly at 62.45 with no material events to provide motive power. Shell finally gave up on the Sakhalin-2 project and turned control over to Russia. It was either give them control or lose their investment entirely. Russia decided several months ago they wanted a piece of this project and began pressuring Shell and the two Japanese investors who owned the project to sell a 51% stake to Russia. Shell refused and promptly had their license threatened and were charged with environmental violations. With the threats increasing and no help forthcoming from ruling bodies outside Russia Shell finally agreed to "sell" half of the project to state owned Gazprom. Under the deal Gazprom will buy 50% plus 1 share in the $22 billion development for $7.5B. The current investors will each see their stake cut in half. Shell will end up with 27.5%, Mitsui 12.5% and Mitsubishi 10%. Once Russia set their sights on owning a controlling interest in Sakhalin-2 it was a losing battle for the original investors. They were going to lose no matter how hard they fought and at least this way Russia was forced to pay them something for their investment due to the high profile news surrounding the takeover. It was nice that Russia waited for the $22 billion project to near completion before deciding to take control. No need to jump in early and have to pay those pesky start up costs. Of course Putin disclaimed any involvement in the blackmail leading up to the deal. "The fact that Gazprom has taken a decision to participate in the work of Skahlin-2 is a corporate decision," Putin said. "The government of the Russian Federation has been informed about this and we have no objections." If you believe that you are dumber than a box of rocks.

Russia is quickly gaining control of every energy project within its borders with BP the next company under siege with new environmental charges being levied against its project in northern Russia. The lesson should be clear to any private firm thinking about doing business in Russia. DON'T DO IT! Some analysts think this is just the first stage of the energy grab and once Russian workers understand the technology and the complexities of running the various projects there will be another round of charges against the minority owners forcing them out altogether. This is the main reason I quit recommending ConocoPhillips over a year ago once they started pouring money into Lukoil to acquire a 20% share. Russia basically told them if they wanted to do business in Russia they would be required to make the investment. That investment can now be erased with the stroke of a pen.

Friday was a ghost town in the markets with volume across all markets only 3.2B shares. This is well off the 6 billion level seen the prior Friday. Nobody expected it to be any different but the direction was the surprise. Sellers appeared to overpower what few buyers had lingered to see the final bell. Internals were better than 2:1 to the downside.

The name of the game for the week was selling winners and I am surprised the indexes did not fall any further than they did. Examples of profit taking included Apple Computer (APPL) -5.2%, Wynn Resorts (WYNN) -4.2%, Google (GOOG) -5.3% and Chicago Mercantile Exchange (CME) -4.5%. This was happening on a broad scale and the Nasdaq seemed to bear the brunt of the selling.

The Dow Transports fell all the way to 4500 from last Friday's high of just over 4750 for a -4% drop. Only the oil sector suffered larger losses with the oil indexes down more than 4% and the oil service index down nearly -6%. Whatever had been a strong performer for the last quarter was taken to the cleaners ahead of year-end. I warned everyone for the last three weeks that this was coming and we still have a week to go although most of the portfolio shuffling should already be done. The funds try to make the changes before the holidays and maintain a skeleton crew from now till year-end.

Dow Transport Chart - Daily

For the next seven days the average gain since 1950 is +1.5% as year-end retirement contributions and holiday bonuses are put to work in the market. While Santa is making his rounds it is investors who are making a list and checking it twice of the additions they want to make to their portfolios for the coming year. At this point I would definitely wait until mid January before making any long-term commitments. Odds are increasing that you will have a chance to buy them lower over the next five weeks.

The Dow, with only a -102 point drop for the week was the best performing index. After coming within 1.7 points of tagging 12500 on Wednesday it was all down hill but 12350 emerged as decent support on Friday's swoon. Stronger support remains 12250-12300 followed by 12000-12050. Personally I believe if we break 12250 we could see a much bigger correction appear.

The Nasdaq literally crumbled from Monday's 2471 high to close just over 2400 on Friday. The -2.28% drop on the Nasdaq Composite was beaten by the Nasdaq-100 with a drop of -3.3%. Nasdaq 2400 should be decent support but with the weakness in chips we could easily see this support break and a new plunge to 2325. The Russell-2000 actually firmed slightly midweek and I thought for a day or so we might be seeing a change in sentiment by fund managers but the flush intraday on Thursday convinced me otherwise.

The S&P-500 performed almost exactly as I expected with another half hearted attempt to retest the highs and then a complete roll over into Friday's close. If you recall I told you on Tuesday I had turned bearish and exited my long positions in preparation for going short on any rebound weakness or a break of 1418. Tuesday afternoon's rebound from 1418 managed to hit 1429 before a solid bout of selling took hold pushing the index to 1410 on Friday. It was a perfect setup and follow through and I hope you followed my suggestion.

SPX Chart - Daily

EBAY Chart - Daily

I also mentioned last Sunday that I felt a short/put on Ebay was a wise move. Unfortunately I was targeting the 2-3rd of January for an entry. If you were watching it after my mention you would have seen a strong pattern of selling appear beginning on Monday morning that pressured EBAY to close at the low for the week on Friday at $30.24. This resulted in a -9% drop for the week but I don't think it is over yet. We could easily see EBAY continue downward to real support at $26. January is typically weak for Ebay and with this dive beginning early we could see a lot of follow through once January appears. I missed getting in at the top this week but I did buy some puts a week earlier than I had planned once I saw there was not going to be a rebound.

For next week I would remain cautious. I know the next seven days are historically bullish but any rebound may just provide fund managers another bounce to sell. Hopefully they are done with year end portfolio shuffling as I mentioned earlier. The end of year rally typically occurs on the last five days of the year and the first two of the new year. In 2006 the early January bounce lasted seven days before a two-week slide began. December had closed weak. In 2005 the January bounce lasted one day before a three-week slide appeared. 2004 had closed with a bang after the markets went nearly vertical gaining +1100 points on the Dow from the October correction bottom. It was only logical that profit taking would occur once safely into the new tax year. In January 2004 the opening January bounce lasted 5 days before a week long profit taking session appeared. December had been very strong and that carried over into January with the eventual January high being made on the 26th.

I laid out all that Dec/Jan history to illustrate what I expect to happen this January. The markets have been very strong since July with only four light bouts of profit taking. Basically they were better described as dips to buy rather than decent selling pauses. The last one lasted only two days right after Thanksgiving. I believe there is a huge amount of profit still being held in portfolios and we could see that profit taken in January once safely into the 2007 tax year. It is one thing to be bullish and another to be stupid. We should prepare for the worst, a sharp drop to Dow 12000 or so where traders would then pause to view the economic surroundings and the beginning of the January earnings cycle. Next week is the beginning of the warning period so we could get our first taste of investor sentiment should any material warnings appear. The markets are still very overbought and bullish sentiment was at multiyear highs just last week. I missed buying calls on the VIX when it bottomed at 9.39 last Friday but I remedied that on Wednesday when it returned temporarily to 10.03. The 12.50 calls were cheap thanks to all the bulls buying the Tuesday afternoon dip. I exited my shorts on Friday given the historical gains for the week after Christmas but beginning Tuesday I will be looking to enter new short positions on any end of year bounce. If you are looking for direction it would be to short a break of SPX 1410 or on any weakness should a holiday bounce actually appear. I would NOT go long the broader market for any reason until reassessing in mid January. We did get the dip in energy stocks I was expecting and I do continue to hold energy stocks and add to them on the dips. After doing weeks of additional research for my end of year energy update report I am even more convinced that energy is the only reasonably safe long-term investment. There will always be peaks and valleys regardless of what you own but the trend in energy should always be up.

I am sure everyone has received the end of year renewal offer by email and I strongly suggest taking advantage of the steep discount and renewal premiums. I deeply appreciate your continued support of the Option Investor family of newsletters and I look forward to the many opportunities ahead of us as investors in 2007. As Santa would say, "Merry Christmas to all and to all a good night!"
 

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