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Market Wrap

An AAPL a Day Keeps the Buyers Away

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Huge profits by Apple (AAPL 89.07 -5.88) that exceeded expectations just weren't enough. Their guidance was less than the market wanted to see and sellers took a big bite out of AAPL today. This followed a disappointing Intel (INTC 20.67 -0.38) earnings report the day before and the 1-2 punch to the belly of the big rally we've seen in techs this month had the tech index doubling over. But the small cap index (RUT) has taken it on the chin the past three days and has given up most of January's gain.

While AAPL's revenue was up 24.5% ($7.1B) from a year ago its forecast for the coming quarter, between 54 and 56 cents a share, is lower than the average forecast. J.P. Morgan also lowered their rating on AAPL from overweight to neutral, citing concerns that iPod sales may suffer in the next quarter or two as consumers wait for the iPhone (or ApplePhone if Cisco keeps the iPhone name). Basically it appears we're getting good old fashioned earnings runs on these stocks and then profit taking following earnings announcements. This used to be a winning strategy for call option plays before the tech bust in 2000.

After the bell IBM (99.45 -0.57) announced its earnings and the after-hours price action looks the same as the others this week. After making a very nice run from $90 to $100 (a very common move for a stock) since November it looks like it's getting punished. Another earnings run about to turn to dust. They announced a profit rise of 11% in the past quarter to 3.54B, or $2.31/share (which was earned the old fashioned way as opposed to the mega banks' and their trading teams). They beat analysts' expectations but unfortunately it's all in the guidance and there they disappointed. But it almost seems it doesn't matter what is said--we're seeing selling following these earnings runs.

While techs and small caps have given up most of January's gains, the DOW has consolidated sideways (that may change a little tomorrow if IBM drags the DOW down). This is another clear case of rotation out of the high-beta stocks into the bluest of the blue chips. But the NYSE and S&P 500 have been holding up relatively well with a pullback that hasn't even reached 38% of their rallies. While today may have looked bearish (any selling in this uber-bullish market starts to look bearish) the price patterns don't hint of anything major yet. The past two days have looked more like profit taking, rotation and some distribution perhaps.

Merrill Lynch (MER 95.40 -1.41) reported their earnings this morning and, no surprise, blew away previous earnings. We all know these mega bank brokers have been making money hand over fist with their trading departments and that continued to be true for MER. Net income was up +68%, boosted by a "big gain in principal transactions and a healthy investment banking business." That means their trading teams did well (with their own money, not their clients'). They raised their dividend 40% to 35 cents a share from 25 cents. That was mighty white of them after lavishing huge bonuses on themselves.

To show how out of whack (greedy) this bunch has become, consider these numbers from Morgan Stanley (change the name and they're all in the same boat): The firm posted net income of $7.4B in 2006 an increase of $3.7B from 2003. But at the same time, total compensation at Morgan Stanley last year was more than $14.3B, a rather significant $5.8B more than in 2003. This means employee compensation was almost twice the firm's net income meaning it has jumped 60% more than net income since 2003, this while the number of employees has DROPPED since the end of 2002.

Some more numbers to consider (thanks to Joe for digging these out of MER's report):
Principle transaction [trading] revenues up 209% year over year -- $2.193B vs $710M (note the B from an M).
Asset management and portfolio fees down 20%
Commissions up 7%
Revenues from consolidated investments down 18%
Global Wealth Management revenues up 13%
As Joe commented to me, "Amazing that MER's expertise in trading their own money does not spill over to the money they manage for others. Crooks!!"

And now Treasury Secretary Paulson wants to create a consortium company that includes members of these major banks so that they can work together and trade more efficiently. Hellooo! Can anyone say collusion fully supported by our government. It'll be interesting to see whether or not Paulson's idea flies. But to even suggest such a thing shows the audacity and arrogance of these people in the higher echelons of our banking system. Grrr...

It was a busy day for economic reports so let's move onto those.


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Economic Reports

Unemployment numbers
showed initial claims dropped by 8K to 290K which is the lowest level in 11 months. The 4-week average also dropped by 6,500 to 308,000. The numbers in December and January can be a little misleading so we'll see how the numbers look next month. Continuing claims rose by 120K to 2.53M which is the highest level in nearly a year. The 4-week average of continuing claims was up 4K to 2.47M. Comparing this period to last year shows initial claims are up +4% but continuing claims are down -6%. The initial claims measures job destruction while continuing claims measures how difficult it is to get reemployed so we have a bit of a mixed picture here.

New construction in homes rose for the 2nd straight month in December and many are calling a bottom in the housing market. With housing starts up +4.5% to an annual rate of 1.64M units, that makes for the highest number since September so it certainly looks bullish on the surface. But if you look under the hood it's not quite so rosy. First of all, most of the new construction was in apartment buildings--multifamily housing jumped +42.1%, the biggest gain since April 2005 (just before the peak in the home building index).

A good portion of these apartment buildings started out on paper as condominium projects. The condo market is collapsing faster than the single home market and if the condo projects haven't been cancelled outright many of them are being converted to apartments. Many apartments-turned-condo are now turning back into apartments.

Building permits were also up and normally that's a good sign. They were up +5.5% to an annual rate of 1.60M. Very likely a lot of these permits are in preparation for building in the spring as many people believe spring will be a time of recovery for the housing market. I believe spring will be the uh-oh moment for the housing market. As more homes post "For Sale" signs on their lawns and begin to realize their homes are not selling we'll start to see the heretofore reluctance to lower selling prices vanish in a hurry. Excess inventory, from new construction as well, will only add to the pressure on sellers to lower their prices. I may be speculating somewhat about this but it fits the longer term pattern that I'm expecting to see in this market.

Yesterday we got the results of the latest home builders survey and it was reported in a very positive light. This is an optimistic bunch I must say. The index improved to 35 in January from a low of 30 in September. This means less than 1/3 are bullish on the housing market and yet it was hailed as a sign of a bottom in the housing market. Talk about a bunch of people seeing the glass as half full! My kind of people but we need to consider the reality of the situation. Even the weekly chart of the home builder index will show what looks like a bear flag for price action since the low in July.

Core CPI rose +0.2% while CPI was up +0.5%. Higher gasoline prices (have you noticed how slowly, if at all, prices for gas are coming down with the BIG drop in oil prices?) and higher clothing and tobacco prices were the culprits behind the CPI number. Removing food and energy prices gave us the +0.2% core CPI but even this number, which was the biggest increase in 3 months, is an annual +2.4% and above the Fed's "comfort" number. This will keep the Fed heads out there pounding the table that they're concerned about inflation. A rate cut is not anywhere close at this point. By the time they recognize the negative impact of the slowing housing market they'll be way too late, again, in cutting rates to stem the economic slowdown.

Crude Inventories
Inventories were up in most oil components. Crude was +6.8M barrels, gasoline +3.5M (up for a 5th week in row so we should be seeing gasoline prices come down any day now, any day...) and distillate stocks +900K. The February contract for oil traded briefly below $50 before closing at $50.48.

Philly Fed Index
The manufacturing sector in the Philadelphia region was up slightly in January and a little better than had been expected. December was revised slightly higher than the originally reported -4.3 to -2.3 so at least January was a positive number. Any reading over zero indicates growth.

Other than techs and small caps taking a hit today the market was holding up fairly well until Fed Chairman Ben Bernanke's comments hit the air waves. Speaking before Congress he pretty much spelled out the economic hurt locker we're in if we don't get our fiscal house in order. He made specific comments about the need for Congress to put in place a way to pay for future spending obligations, primarily the entitlement programs (Social Security, Medicare/Medicaid, prescription drug program, etc.). He made reference to the official forecast which shows the budget deficit moderating over the next few years. He said this was simply the "calm before the storm" for the deficit since the projections do not capture the long-term government obligations.

He would not answer questions about which way the budget should go as he has made it very clear he will not side with either side (as Greenspan often did). He wants to remain neutral so that he can be critical of any plan without being accused of taking political sides and I applaud him for that. When asked about why long term bond rates have stayed low, considering the budget picture, Bernanke offered two possibilities. "Either this is a trading phenomenon, and holders of the bonds are not really thinking about 30 years in the future, but the other possibility, which is that, one way or another, the bond holders do expect that Congress will take whatever measures needed to ensure the bonds are paid off and it is done in a context of price stability."

Expecting Congress to do the right thing. Hmm, might have to think about that one. The Fed has been concerned for quite some time about the bond market not following their lead (in raising rates) which is a whole discussion by itself but basically the bond market has been anticipating a slowdown in the economy which will result in the Fed lowering interest rates. They've seen it before and are anticipating the same thing happening again. Some of the recent rise in rates is recognition by some that that scenario may not play out. In other words if the Fed is forced to stay on the sidelines out of concern for inflation that won't come down then longer term interest rates will start to rise and that could be what we're starting to see happen.

And with that let's look over today's charts.

DOW chart, Daily

The DOW held up the best today. Over the past 3 days it has pretty much gone flat. Compare that to what happened to the techs and small caps and it's obvious what's going on--big time rotation out of the high-beta stocks and into the more liquid blue chips. Other than the spurt higher earlier this month in the techs we've seen this defensive action for quite a while now. So the daily chart still looks bullish for the DOW. What looks bearish though is the continuing negative divergences on the oscillators as shown on RSI. But that's been true since October so clearly we can't make a trading decision here based on that.

Ideally we'll get a pullback and then another push higher to complete the rally. I had hoped we'd get a pullback before now in order to set up a 2nd leg up for the rally from the January low that would then end up near a Fib projection of 12630 for a market high. It got close at 12614 on Wednesday but the short term pattern leaves me thinking we still need the down-up sequence to finish this. We could see a pullback hold above 12500 if this scenario is going to play out.

SPX chart, Daily

While SPX pulled back a tad more than the DOW it presents a very similar picture to the DOW. It's pullback has found support at the 10-dma (1424) and could find support a little lower tomorrow at its 20-dma (1420). The more I look at the daily and weekly charts the more I'm beginning to think SPX will head for a Fib projection near 1455. As shown on the weekly chart at the end of this report, two equal legs up from October 2002 (for a big A-B-C correction to the 2000-2002 decline) is at 1455. That's only a 2% rally above today's closing price (as I hear the bears giving me a collective groan). This scenario could take a couple more weeks to finish. But, if SPX breaks below the January low of 1404 then all bullish bets are off the table and it will time to think only short.

Nasdaq chart, Daily

This has to be a big disappointment to the bulls. After a nice breakout to the north from its 6-week consolidation the COMP has come crashing back inside that pattern. By breaking back below 2470, the top of the sideways pattern, that's a sell signal. The daily stochastics is about to give a sell signal and RSI dropped below 50. What more could a bear want? How about a break below the 50-dma and a failed retest of it. Until that happens this could be a head fake pullback and we'll see this turn right around and head higher again. In fact the short term price pattern has me believing it will do just that. I'm thinking it's going to chop its way higher over the next couple of weeks and form an ascending wedge in the process. This one could become very difficult to trade unless it breaks down so be cautious for now (obviously for QQQQ trades as well--watch out for whipsaws if this bounces and starts heading back up).

SMH semiconductor holder (ETF), Daily chart

The semis almost made it. I have been saying for weeks it needed to get above $35 in order to turn more bullish and I thought it was going to do it. What took 3 weeks to get up to $35 took 3 days to reverse. Now SMH is testing the November/December lows and with daily oscillators rolling over it doesn't look hopeful for semi bulls. But it's also possible we'll see this index continue to trade sideways as it's been doing since September. I see nothing here (yet) that I'd want to trade. I wouldn't want to be long but I'm not so sure about the short side yet.

BIX banking index, Daily chart

I mentioned the past two weeks that a broader market rally without the banks doesn't look right. While this hasn't held the market down I continue to view the banks here as bearish for the economy and market. This looks ready to roll over to new lows and I think it will head for the uptrend line from October 2005, currently near 397. Notice the 100-dma (black) that's been riding up with the uptrend line and how it has supported pullbacks since August.

XBD brokers index, Daily chart

The brokers have been very bullish and until this week have been making new all-time highs. They've been pulling back a bit this week but that looks more like profit taking after the big brokers reports earnings. There's nothing bearish about this chart yet and the short term pattern looks like it needs a small pullback and then press higher again. The top of the parallel channel that has held price down since October (albeit with new highs each time) will likely continue to act as resistance. If it does pull back a little and then rallies as depicted, I'd be all over it with a longer term short play once it tagged the top of its channel again (which should be loaded with bearish divergences).

Brokers vs. NDX comparison

Thanks to Joe (the one who sent me some numbers on MER that I referenced above) who sent me this chart (and sorry for lack of clarity after squishing it to fit the page), it's a very interesting comparison. The similarity of the brokers to what the techs did in the late 1990s is probably very telling. I think there's a good chance we'll see a similar post-bubble move for these brokers (shown on the chart are MER, LEH and GS). What could cause a post-bubble collapse in these guys? How about the failure of one of them after their collapse from being too exposed to risky derivatives, especially in the credit swaps area? Or from their heavy involvement with risky hedge funds? They're all chasing higher and higher risk in order to keep improving their returns and beat the other guy. This will very likely catch one or more of them with their pants down and it won't be a pretty sight.

U.S. Home Construction Index chart, DJUSHB, Daily

With the continued optimism (hope) that we're hearing from some home builders and the National Association of Realtors, we have a lot of people bottom fishing in this index. I continue to believe we're simply in a dead cat bounce on a longer time frame (look at the weekly chart and it will look very much like a bear flag since July) and that it will continue much lower once it breaks down again. Short term it looks like it could be in a small bull flag since the December high and if it resolves to the upside then I see the possibility for a rally up to 800 or perhaps to the 50% retracement at 836. But if it breaks down from here and drops below the uptrend line from July, currently near 660, then we'll likely see it accelerate lower.

Oil chart, January contract, Daily

The bulls have been chasing this lower, thinking they're buying the bottom and they then create more selling pressure as they quickly cover at any price. It's just the opposite of what the bears have been doing in the stock market. The bottom of the parallel down-channel is approaching $48 and may be where oil is headed before it gets an appreciable bounce. It may be eventually headed for $45 for two equal legs down from its August high but I don't think directly from here.

Oil Index chart, Daily

The oil stocks have made a little bounce as bottom fishers try their luck at support around its 200-dma. I don't think it's put in a more last low yet and believe we'll soon see it head for its uptrend line near 586. As I thought back in September, we should get a bounce from that uptrend line but then a continuation lower that heads for 500. But that's a ways off. Shorter term, a new low should be met with oversold conditions on the weekly chart and lead to a bounce that could take us into the spring.

Transportation Index chart, TRAN, Daily

The Trannies are close to breaking out of its longer term sideways triangle pattern and that would likely be bullish for a run to another new high (above 5000). But it's looking like resistance might hold at the downtrend line from May. As long as the November high at 4891 holds then I'm looking at this more bearishly--the bounce from December's low should have been only a correction (albeit a big one) of the November-December decline and this should turn back over and start heading down in a 3rd wave (so it should be a relatively strong move).

U.S. Dollar chart, Daily

The US dollar's rally may be over for now. After turning back down from its 200-dma, as it did October, the dollar should now head back down for new lows, below $82. I've been longer term bearish the dollar but lately I've begun to think that a new low, perhaps by March, could lead to a very large rally, one that takes it up near $100. I've read countless articles about why the dollar will tank and why it will rally to the moon. But when I look at a weekly chart it's looking to me like the dollar is forming a descending wedge from its November 2005 high. The dollar had a 5-wave move up from its December 2004 low as wave-A, this potential descending wedge pattern from November 2005, which needs another leg down to finish it, as wave-B and then we'll need a big rally for wave-C that could take us into 2008. The reason this may be important is because of what that might mean for gold longer term.

Gold chart, February contract, Daily

If the US dollar is getting ready to drop to a new low then we'll probably see gold rally. After a 3-wave corrective pullback from December, it looks like gold may be starting its next rally leg. If it were to match the October-December rally then we get an upside target of $693. That would be a nice trade. But after that is where the bigger question comes in. If the US dollar will set up a big rally into the end of the year then it's possible gold will turn around and head for new lows for the pullback that started after the May high. A drop to around $500 would be a typical move in that case. Just some things to keep in mind if you like the idea of accumulating some gold in your investment portfolio.

Results of today's economic reports and tomorrow's report are the following:

It will be a quiet day tomorrow with only the Michigan Sentiment report and there shouldn't be much of a reaction to this. It will be more about IBM and how the market reacts (or not) to it. Earnings continue to put a damper on the market but other than techs the market is holding up.

SPX chart, Weekly, More Immediately Bearish

As I discussed briefly with the daily chart above, this weekly chart shows the Fib projection at 1455 which is based on two equal legs up from the October 2002 low. This would be very typical for an A-B-C correction to the 2000-2002 decline. If we get slight pullback and then another leg up to match the one in January then we could there very quickly. While the weekly oscillators are looking weak and the techs and small caps are looking bearish, which is all tempting me to just get short, I don't think we're at the top yet. It's absolutely amazing to me how long this is continuing but we can't argue with price and right now price is still bullish. It takes a break below the January 1404 low to suggest the bulls are done and the bears have taken over.

We know the market is vulnerable and I'll continue to strongly caution investors about the long side here. While I'm expecting "one more new high" I know very well that the "one more new high" is often a no-show. Being long, especially if you can't watch the market intraday, could be dangerous. We're slowly inching our way higher but we know that the market that took months to build can lose it all in a matter of hours. You don't want a nasty surprise when you come home from work.

Bearish sentiment has reached record lows and from a contrarian sense that in itself is very bearish. I'll leave you with a piece I found from Jay Shartsis, an options pro at R.F. Lafferty in New York. As he said, "The relentless rally that started last summer is thinning the bear ranks to near zero. "The Russell Investment Group survey of 87 money managers found 80% bullish. Elsewhere, USA Today opened the New Year trumpeting, "10 Reasons Why the S&P 500 Could Hit a Record High in 2007." The following days headlines proclaimed: 'Up,Up,Up' and '10 out of 10 market gurus interviewed by USA Today say stocks will post gains.'..."There wasnt a single bear!" Shartsis exclaimed. "Not one person calling for a loss!"

"Perhaps the most astounding observation of all comes from the Elliot Wave Financial Forecast," Shartsis continued. "They produced a chart showing the 60-day moving average of bears, as reported by the Daily Sentiment Index Survey. Current reading: 12% bears! For perspective, the readings for this gauge, going back to 1987, before the crash, show nothing like the present 12% reading. Figures near 20% bears were the most extreme ever recorded. So a contrarian interpretation of this survey would point to serious market trouble dead ahead."

Keep those stops tight and buy some insurance if you want to stay long in this market (holding through the ups and downs). I happen to believe the next down will take us below October 2002's low so consider that fwiw. Good luck tomorrow (opex Friday) and I'll see you back here next Wednesday instead of Thursday as Linda and I switch nights.

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