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Market Wrap

Initial Earnings Increase Confusion

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Despite mostly positive earnings reports the market have failed to respond positively. Individual stocks have been hammered after posting better than expected earnings and some with earnings misses actually rose on the news. For instance GE more than doubled their profits for the quarter and gave positive guidance but lost -$1.05 on the day. This is not unusual in earnings cycles but the severity of some of the post earnings losses has emphasized the uneasiness in the market.

Dow Chart - 30 min

Nasdaq Chart - Daily

Falling gas prices, warm weather and a bounce in housing expectations combined to send Consumer Sentiment for January soaring to 98 compared to the 91.7 reading last month. The consensus estimate was for only a small gain to 92.8. Friday's headline reading was the highest in three years and the second highest since 2000. The expectations component jumped from 81.2 to 88.7 and the present conditions component rose from 108.1 to 112.5. Clearly consumers are expecting better times ahead. Analysts said the highly publicized drop in oil prices and the new market highs were instrumental in pushing sentiment higher. Consumers equate $50 oil with gas under $2 and relief from monster gas bills. Year-end bonuses were also reported to be the largest in years as corporations flush with cash rewarded employees. Year-end retirement statements also reflected the Q4 rise in the markets, which produced many smiles I am sure. Next week is a light week for economic reports but there will be plenty of earnings to review.

Economic Calendar

It is too bad that strong bounce in sentiment did not carry over into the markets. With even good earnings being punished I am sure company executives will be putting on body armor before stepping in front of the camera next week. IBM was the most recent casualty losing -3.28 after reporting very strong earnings that beat estimates. They showed the best revenue growth in five years with bookings of $17 billion in their service business. The problem was a forecast of 10% to 12% growth that fell short of some optimistic expectations by analysts. IBM was the biggest drag on Friday's Dow accounting for more than -25 Dow points.

Citigroup posted earnings that beat estimates but fell -26% and the stock ended up for the day. Citigroup promised to bring down costs and evidently investors bought the story. GE posted profits of $6.8 billion that more than doubled the $3.2 billion in the comparison quarter. GE lost -$1.05 after their positive guidance disappointed investors. GE also said it was going to restate financials from 2001-2005 to adjust accounting on some debt. The restatement will erase -$343 million in earnings for that period.

Motorola rallied on Friday after disappointing investors earlier with a -48% drop in profits due to shrinking margins on cell phones. Everyone felt the stock was already beaten with its drop to an 18 month low in early January. Nokia, Qualcomm and Texas Instruments all report next week and they will have to overcome the negative impact of Motorola's claim of weakness in the handset market.

Earnings have been mostly positive despite the tepid market reaction. According to Thomson Financial 15% of the S&P has reported and 57% beat estimates, 20% were inline and 23% missed expectations. Of those that reported, earnings have risen +14.5% and that is about +6% over estimates for those companies. However, Thomson is still projecting Q4 earnings for the entire S&P to only hit +9.3% and break the 13-quarter string of double-digit earnings growth. Thomson also revised their estimates for Q1 earnings. On Jan-1st the Q1 earnings estimate for the S&P was +8.7%. That number has now fallen to only +7.3% based on the guidance received. 51 S&P companies have issued guidance for Q1 and 12 were positive, 7 inline and 32 guided lower. This is not a positive sign for the markets long term.

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According to one analyst we were seeing a perfect setup with decent earnings, weak inflation, a growing economy and oil prices at 18 month lows. Even Bernanke's positive testimony on Thursday failed to impress anyone. According to him if that is not enough to push stocks higher then there is nothing on the horizon to improve the picture.

In early January investors sold oil and commodities and bought tech. This week that role reversal changed again with the energy sector the winner for the week. The Energy Select SPDR (XLE) gained +4.6% this week with Exxon holding up the Dow with a +3.7% gain. The perception that $50 was the bottom for oil and strong earnings and guidance from Schlumberger (SLB) helped put a floor under energy stocks. SLB said its Q4 profits jumped +71% due to significant price increases, heavy exploration activity worldwide and business bookings for years in advance. SLB beat estimates by +7 cents with profits of $1.13 billion. SLB did not just predict strong growth for 2007 but said they continue to see "high growth" through the end of this decade and into the next. SLB also squashed rumors that lower prices would depress earnings.

"While we remain of the opinion that there is no overall shortage of oil and gas reserves, the world is realizing that the period of cheap hydrocarbon energy has ended and new and higher sustained levels of investment are necessary to meet demand and guarantee future supplies," according to Chairman Andrew Gould.

SLB has repeatedly guided analysts higher but many fail to understand the reality of current exploration efforts. Current discoveries cost more to find and produce and these costs will continue to rise. SLB jumped +$3.10 on the news.

February Crude Oil Chart - 30 min

Cold weather blanketing the US and snow in the northeast helped to propel oil and gas prices higher. Oil closed right at $52 and natural gas rose +9% to close at $6.88. The weather service modified their forecast for February saying a weakening El Nino would produce colder weather than previously predicted. The American Petroleum Institute (API) said the warmer weather had cut oil demand by -3% in the US.

All the posturing by the weatherman, API and even a lowered OPEC forecast for 2007 had little real impact on oil prices. The real reason for the bounce was simply short covering ahead of futures expiration on Monday. With $50 seen by some as a potential bottom there was little to gain by holding shorts over the weekend and risk some geopolitical event producing a spike in Monday's thin market. Next week will be the key with the March contract closing at $53.39 on Friday. March will become the current month on Tuesday. It remains to be seen if its lows of $51 will be tested or if traders decided that last week's low was a buying opportunity. Most oil stocks quit declining in the prior week and began trading higher as this week progressed.

On the downside the semiconductor sector was the biggest loser with a loss of -5.3% for the week. This came after earnings from Intel and Motorola and warnings from several small chipmakers. The SOX broke several levels of support and fell -37 points from last Friday's high of 488 to this Friday's low of 451. This problem is not likely to be resolved in the near future. Multiple chip companies report next week and warnings last week suggest there is trouble ahead. One company said large orders were either being cancelled or pushed well into the future due to lack of demand. This is not a good sign for chip stocks or techs in general.

SOX Chart - Daily

Last week we had a flurry of analysts tell us to prepare for a tech high in late January. According to them techs typically peak between Jan-15th and Jan-31st and decline into summer. These were probably the same guys that were telling everyone to buy tech back in December. Unfortunately history does prove this trend but there is nothing to prevent that trend from being broken.

Despite the lackluster performance of the indexes on Friday the market internals were very positive. Advancers beat decliners by nearly 2:1 and volume was also positive at better than 2:1 on 5.3 billion shares. This was a significant reversal from Thursday when volume was nearly 3:1 negative. Has the tide turned in favor of the bulls after a weeklong tech wreck? I would strongly doubt it because the +8 gain on the Nasdaq was not even a decent dead cat bounce given the huge bout of selling that left the Nasdaq down -2.6% for the week.

Next week we will be faced with earnings from tech giants like YHOO, EBAY, MSFT, QCOM, TXN, AMD, SYMC, NVLS and dozens of others. Over 250 companies report earnings and the outcome will be very important. If the quality begins to decline then we could see some rough sledding ahead. As always the guidance will be key and 63% of guidance received for Q1 over the last two weeks has been negative. If that trend continues we could see a serious bout of profit taking. EBAY appears to be setting up for a break of $29.50 ahead of earnings and a significant drop if they disappoint. I warned everyone in December that EBAY was famous for a Q1 swoon and the chart is setting up perfectly.

EBAY Chart - Daily

Another problem ahead is going to be the Fed. Since the last rate hike in June 2006 investors have been expecting the next move to be a rate cut. Due to the stronger than expected economic results we have seen in January there is almost zero chance of a rate cut through September as evidenced by the Fed funds futures. In reality, if the economy continues to strengthen the next move could be another rate hike and that could come as soon as May. That would of course mean the economy had shaken off the weakness we saw in late 2006 and was heading back into strong growth mode with inflation rising. The problem is not the hike or the economy since strong growth can occur during a hike cycle. It is the perception that no rate cut will be forthcoming. That could change the momentum in the bond market pushing yields back over 5% and produce an overhang in the equity market. Yields over 5% put a strain on equities. All of this will transpire over time, months instead of weeks, and is not something we need to worry about today. It is just something to keep on the radar if the economy continues to strengthen. As long as equities are rising investors will ignore the hike prospects until the Fed begins to warn in their speeches.

Guidance will be the short-term key and plenty of companies will give guidance next week. The Dow is continuing to hold near its highs and blue chips should do better than small caps in this environment. 12525 is the key support on the Dow that needs to hold if the current rally is to continue. However, we could even stand a drop to 12350 and still maintain the bullish bias on the Dow. Next week 9 Dow components report and there will be plenty of chances for a smack down if somebody else disappoints.

The Nasdaq lost -2.5% but came to rest just above decent support at 2420-2440. I believe the majority of the selling was a major fund asset allocation program on Thursday with the Apple earnings as a trigger. Maybe quite a few funds were planning to exit on the typical January peak in techs. While there was no material bounce on Friday there was also no follow through on the selling. I am not saying the tech selling is over but I believe much of it was program trades. The Nasdaq like the Dow is still very near its highs with strong support from 2400-2420. We could easily see both indexes pull back a little further without any damage to the overall market.

Russell-2000 Chart - Daily

SPX Chart - Daily

Should the Dow break 12350 and the Nasdaq 2400 the entire picture would change. Until then it is just profit taking and digestion of recent gains. The S&P-500 has been attracted to 1430 like a moth to a flame. We have spent time on both sides but never more than 5 points either way. This remains the purest indicator of broad market health. On Friday the rebound in the oil patch rescued the S&P from a small Thursday decline but it could not push the index back over 1430 despite a 2:1 advance decline ratio in Friday's trading. The S&P seems to be clinging to 1430 as we await earnings in hopes of a sudden burst of earnings enthusiasm that will launch it higher. Conversely a few more earnings disappointments and lowered guidance announcements and that hold could easily slip. Remember last week I showed that this market was on 4th longest streak without a correction since 1928. We are due and corrections typically occur unexpectedly. They are blamed on some external event but normally the orders are already in place and funds are just waiting for somebody to knock out the props. With limited economics next week the focus on earnings will be the key. Given the damage to Apple, IBM, GE, etc, on strong results what will happen if a couple reporters suddenly miss sharply? While that is not expected it is always a possibility. I would rather believe that the bulls are alive and well and waiting for a real buying opportunity. If you believe the various talking heads on CNBC everybody is expecting a decline and waiting to buy the dip. This sets up another possibility. If something did spark a sudden burst of buying it could send those same funds racing into the market to buy stocks rather than miss out on a continued rally. It is one thing to sit on investor's money while waiting for a buying opportunity but another problem entirely if the market starts to run away from you. Obviously nobody knows which event will come to pass but we only need to watch S&P 1430 to make the right decision. I am amazed by the lack of volatility in the market and that suggests a complete lack of fear in traders. Despite the Nasdaq sell off complacency is rampant. The VIX has barely budged in a week and remains stubbornly low at 10.50. It has been six months since there was some decent volatility in the high teens and mid June since it was over 20. This is not a normal event and one that should end badly for the bulls.

I received several emails asking what to do since the SPX continues to trade several points on both sides of 1430. How should I trade that? In circumstances like this I suggest moving your entries five points on either side of what has become a critical pivot point. Go long on a break over 1435 and short on a break under 1425. That allows the index to continue moving sideways without triggering any trades. This will allow you to sleep at night and not be worried about being short or long with the S&P resting on 1430. I will continue to use that level as my line in the sand but readers should decide for themselves when they enter any trades based on a movement away from that level. Either way I do expect a major move relatively soon.
 

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