Option Investor
Market Wrap

Profit Taking or Change in Direction?

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The first three days of 2007 had more in common with a thrill park ride than a bull market. Some say the bull has gone into cardiac arrest and this volatility is evidence of fund managers applying the paddles to try and shock some life back into the corpse. Others claim this is just profit taking and the bull will regain its strength and charge higher before the month is out. Those of us watching from the trenches want this battle to be resolved before we venture back into the market. Adding to this volatility will be Q4 earnings, which begin next week. Several warnings suggest this could be a rocky earnings cycle so volatility may increase before it gets better.

Dow Chart - 180 min

Nasdaq Chart - 180 min

Friday started out with a bang after the employment report showed that +167,000 jobs were created in the US in December. This was well over the consensus estimate for a gain of +113,000. There was also an upward revision to November of +22,000 and +7,000 to October. The unemployment rate was unchanged at 4.5%. The continued low unemployment rate helped push average hourly earnings up by +0.5% to $17.04. The manufacturing sector lost -12,000 jobs and posted the sixth consecutive month of losses. Overall the report was long term bullish for the markets because it suggests the economy remains stronger than expected. On the flip side it was negative for short term Fed expectations and the bond market quickly moved any hint of expectation for a Fed rate cut out to July rather than the March meeting. Expectations had been creeping closer over the last couple weeks due to some weaker than expected economic reports.

Friday's employment report showed upward wage pressures and that will prevent the Fed from relaxing their tightening bias. Added to the stronger than expected ISM on Wednesday and the unusually low level of layoffs in Thursday's Challenger report Friday's jobs picture suggests the Fed may have to wait a lot longer to cut rates. The markets reacted negatively with a sharp opening drop and very little end of day buying. None of the economic reports next week are potential market movers.

Economic Calendar

Also depressing the markets on Friday was the earnings warning by Motorola (MOT). Motorola fell -1.61 after warning that its earnings would miss estimates due to an unfavorable mix of sales. Motorola said the product mix favored the low-end models despite strong sales of its RAZR phone and other high-end models. The KRZR and RIZR models, which are evolutionary versions of the RAZR have failed to catch on due to their high price. Motorola said expectations were now in the range of 13-16 cents on average sales of $11.7 billion. Their prior range was from $11.8 to $12.1 billion. Nokia also took a sharp -5% tumble on Motorola's news.

Helping Motorola push the Semiconductor Index lower on Friday were downgrades on several chip stocks. CSFB downgraded Intel saying the market had already factored in its Core 2 Duo chip line. They also cut Broadcom to underperform saying there was a product cycle lull for the Broadcom line. JP Morgan cut Dell to an underweight rating saying there were rough waters ahead for the box makers. Nvidia was cut to neutral by American Technology Research and lost -2.25 on the news. Openwave Systems (OPWV) was cut to a hold by Jefferies and Co after the company warned for the quarter. EBAY was cut by CIBC World Markets on fears of slowing auction growth and weakness in advertising results. This flurry of warnings and tech downgrades suggests there could be some rough spots ahead once the earnings cycle begins next week.

RIMM continued to buck the tech tide and moved higher gaining +2.73 for the day but ending the week at $141, nearly +17 points off the Wednesday low at $125. This came after news that two members of the options audit committee were recused. A Canadian pension fund cited conflicts of interest by the audit members prompting Douglas Wright and Kendall Cork to withdraw. The gains appear to be short covering and new buying by funds for 2007. Short interest had been very high after the +$80 rally from the August lows. On Wednesday RIMM did announce a licensing agreement with Kodiak Networks to offer a Push-to-Talk (PTT) option on the Blackberry.


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The big news for the week was the collapse in commodity prices. Metals and energy were literally slaughtered over the holiday-shortened week. Copper captured the headlines in the metals sector with a close at a 9-month low of $2.53. This was a -35% drop from the May high of $3.95 and an acceleration of the sell off that started in November. Analysts were trying to pin the blame on many things but I believe it is simply profit taking from an overblown rally. Most people fail to realize that copper traded as low as .69 cents in 2003. 50% of that rally to $3.95 came in March/April of 2006 and was begging for a correction. There has been no material change in copper demand over the last six months only a change in the number of investors who wanted to invest at the top. There is also more supply coming to market to offset the rising demand. When prices moved higher so rapidly, +400% gain, the mining companies quickly moved to bring new production online to capture those prices. Now that production is catching up with demand it is only normal for prices to seek a new level. There were also the tax implications that kept many funds invested until the start of the 2007 tax year.

The second hottest topic this week was the implosion in oil prices. Crude fell from the Dec-29th close at $60.85 to Friday's intraday low of $54.90 in less than three days of trading. This -$5.95 drop or -9.7% came on top of a -$3.30 (-5%) drop the prior week. Unlike copper there is no flood of new production coming to market until 2008. This was strictly a profit taking event now that the 2006 tax year is over. Funds managed to hold over support at $60 for two months as 2006 expired. Once that clock struck 2007 there was no further need to risk their gains and everybody headed for the exits. The press was talking about the failed OPEC production cuts but it is more a temperature problem at this point. OPEC will cut production by Feb-1st and while it may not be the full -1.7 mbpd they advertised it should do the job. The problem is still the weather. December in the US was the warmest December in 111 years. There was little need to burn heating oil and natural gas inventories remain near record levels. Until this mismatch between winter fuel supplies and warm weather ends there will continue to be weakness in prices. However, that was only a side note to the selling this week. Fund managers simply protected their gains until 2007 began and then ran to the exits. Never forget we are only one truck bomb away from sharply higher oil prices.

February Crude Oil Chart - Weekly

The key for oil is what happens next week. The OPEC basket of crude fell to $53 and below their stated support level. This should bring the OPEC hawks out of the closet and we should start hearing about actual production cuts being made. Oil supplies are well above what is needed for the rest of the winter and quick action by OPEC will be needed to prevent any further declines as we head into the Feb/Mar demand slump. I believe $55 is a critical support point for light crude and I bought the dip on Friday. Those taking profits should be done by now and the bottom fishers should be moving in to cleanup the leftovers. Don't forget Iran is still simmering on the nuclear issue. China issued a call on Friday for Iran to quit playing the rope-a-dope and get back to the bargaining table. Of course it was ignored but the fact China went public with a demand for Iran to sober up is a major event. China has been an ally of Iran so that suggests there could be increasing tensions ahead.

Another impact to oil prices was the rising dollar. Assuming the value of a barrel of oil remains fairly constant the rise/fall in the value of the dollars used to buy that oil will cause volatility in prices. If a barrel of oil cost $50 today and the dollar doubled in value that same barrel would only cost $25. If the dollar lost 50% of its value that $50 barrel would then cost $100. While nobody expects that kind of volatility in the dollar the example is still valid. A sharp drop in the dollar's value will cause oil prices to rise. Over the last month several nations have said they were decreasing dollar denominated reserves, which are used to buy oil. This pressures the dollar and theoretically raises oil prices. The stronger ISM and Employment report produces a stronger dollar on feelings that the US economy is stronger than previously expected. This week's jump in the value of the dollar also contributed to the falling price of oil. The dollar has appreciated nearly +2.5% over the last four weeks and produced a corresponding drop in the price of oil but it is only one of the factors moving the price.

There was also a lot of airtime given to the falling emerging market indexes. "The global boom is over, commodities are showing us that demand is dropping sharply. Run for the hills!" That may not have been the exact words but that was the general sentiment. The Emerging Markets iShares (EEM) dropped -5% from its historic high of $116.41 set on Wednesday. The FTSE China/25 iShares (FXI) tumbled -13 (-11%) from its high of $118 also set on Wednesday. These sharp drops were given as evidence that emerging markets were dying. This is total crap. An entire economy does not turn around from record highs to recession in three days. The FXI was up +79% for the year! An -11% drop in the first three days of a new tax year is simply profit taking. Economies don't conveniently implode on the first tax day of a new year. I never cease to be amazed by the stupidity of some analysts and reporters.

FTSE China/25 iShares ETF Chart - Daily

In the case of the FXI the reporters gave the new reserve requirements for Chinese banks as the cause for the implosion. I heard it reported twice that China raised the bank reserve requirements by +50% to reduce liquidity. It was not +50% but +50 basis points or 1/2 of one percent to a 9.5% reserve requirement. It was also the fourth time in the last seven months they raised the rate and their economy did not implode on the first three. China is just trying to slow its 11% growth rate to something a little less obscene but raising the reserve rate by 50 basis points is only a political move not a material long term impact to Chinese banks or consumers. The move was already expected after China's central bank telegraphed it in a statement in its last quarterly monetary report. China's A-shares market doubled in 2006 making it the top performing market on the planet. This prompted a surge of bank deposits into the equity market and fears of an asset bubble is prompting the central bank to tighten the liquidity in hopes of cooling this trend. Credit Suisse and ABN Amro said they expected no impact to the growth of the Chinese economy and any impact to the Chinese markets would be short-term only. The major Chinese banks fell limit down in a knee jerk reaction on Friday sending the major indexes and ETFs to strong losses. This should be seen as a buying opportunity as the first quarter gets underway.

Our own central bank, the Federal Reserve, is probably more confused about what to do in the US that the Chinese central bank is about China. The different economic reports continue to send Fed funds futures on wild swings from no cut to quick cut and back again. The futures for March were showing a 20% chance of a March rate cut before the employment report and that was down from over 30% before the ISM earlier this week. By Friday's close that was reduced to only a 6% chance of a March cut suggesting that the Fed was still on the fence as to whether the next move would be a cut or a hike. Bill Gross of Pimco said on CNBC that he expected four rate cuts by the Fed before the year was out with a year end Fed rate of 4.25%. Bill may have an inherent bias since he manages the largest bond fund in the world. He also should have a pretty good idea of where rates are going. The indecision by investors about general Fed direction could be a continuing problem for the equity markets.

When reviewing the indexes the Dow looks like it changed its character at the close on Dec-29th from a mild mannered blue chip index to a small cap index with Attention Deficit Disorder. The calm rolling trends turned into sharp volatility spikes and direction was filled with numerous reversals. A new historic high was made at 12580 on Wednesday morning followed by a support test just above 12350 on Friday morning. Friday's close at 12400 was near the low end of the range for the week but did not necessarily indicate that the market is going lower.

Dow Chart - 60 min

Nasdaq Chart - 120 min

The Nasdaq chart looks like the Dow chart on speed. The upper end of its range was tested twice with a test of the monthly low in the middle. Friday's loss of -19 points came the day after a close at a three week high. The Nasdaq was extremely volatile and that volatility was accented by the numerous warnings and downgrades on the tech sector. For next week support remains 2400 and it has been tested four times in the last six weeks.

The Russell-2000 was the weakest performer with a Friday close right on support at 775. There appears to be no buying interest by funds as we begin the new tax year and that is normally the kiss of death for the broader markets. Unless the Russell rises from the dead on Monday this could be an ugly week. Joining the Russell was the NYSE Composite, which closed right on support at 9020 and a five-week low. This compares to its new historic high of 9209 set on Wednesday. That is a -189 point drop in three days! The collapse of the Russell and NYSE Composite is not a positive sign for equities.

Russell-2000 Chart - Daily

S&P-500 Chart - Daily

I was on vacation the week after Christmas and the last commentary I wrote before leaving for a week was Tuesday 12/26. The S&P-500 had closed at 1418, our directional indicator at the time. I advised remaining long over 1418 for only a short-term trade and suggested going short on any weakness just below 1430. Over the next three days the S&P tried three times to tag 1430 and failed on each attempt. Wednesday's failure at 1429.42 was a perfect opportunity to get short in 2007 ahead of funds exiting their winning positions and dumping their end of December window dressing choices. For next week I would retain that short bias under 1420 with the potential to test support at 1385. Once the funds start putting end of year retirement contributions to work we should see the Russell and NYSE Composite begin to catch a bid and we can start thinking about long positions once again. Without any material economic reports to muddy the water next week the markets should be focused on any remaining earnings warnings and the beginning of actual earnings with Alcoa on Tuesday. The real flood of earnings won't begin until the following week (15th) so that leaves the week ahead as a cleanup week for whatever portfolio changes the funds have in mind. Avoid trying to trade the volatility and look for major support points like S&P 1385 as a potential buy target and a breakout or failure at 1420 for a directional decision on the upside.

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