Option Investor
Market Wrap

Dizzy Yet?

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Traders bought Monday's dip and the bears were beaten back again and again as the indexes spiked to new highs on Wednesday. The rally surprised everyone and looked for a while like it had legs. On Thursday negative news in the housing sector was blamed for a triple digit loss but I doubt that was the case. On Friday positive housing news was unable to produce a rebound. If housing was really the cause of Thursday's drop then a sharp spike of nearly 5% in new home sales should have erased the small -0.8% drop in existing home sales we saw on Thursday. Something does not add up. What does add up is a 200-point range on the Dow for the week that produced motion sickness for the bulls. Add in the fear of future Fed rate hikes and you get an Excedrin headache along with that upset stomach.

Dow Chart - Daily

Nasdaq Chart - Daily

The bottom in new home sales appears to be firmly in place with the July reading of 1.01 million homes on an annualized basis. The sales in December spiked to 1.12 million units for a +4.8% jump. November sales were also revised higher to 1.07 million from 1.05. The monthly supply of homes on the market dropped to 5.9 months from a high of 7.0 months back in October. This appears to be great news for the sector since December is hardly seen as a month to buy new homes. For the entire fourth quarter home sales increased +24% quarter over quarter and nearly reversing the -27% drop in Q3. For all of 2006 sales still declined by -16% and the sharpest drop since 1989. The strong sales were blamed on unseasonably warm weather in the northeast where sales spiked +27.3%. Couples out for a drive in the sunshine must have stopped at the model homes and made that impulse buy. Prices have not declined significantly on the surface but the official price does not account for promotional costs of free furniture, decorating, upgrades and discounted mortgages.

Mortgages are still a problem with rates rising again and more than a trillion dollars in ARM loans headed for a pricey reset in 2007. Subprime lenders are watching their loan portfolios rot on the vine with foreclosures accelerating. Analysts fear a flood of upside down foreclosures where the loan balances are more than the property is worth. Just before the bell on Friday news hit the wire that Bank of America (BAC) was in talks to acquire Countrywide Financial (CFC). Countrywide has heavy exposure to subprime loans. An acquisition would be in the $30 billion range and fill a hole in Bank of America's portfolio. BofA bought Fleet Boston Financial for $48B in 2004 and MBNA for $34B in 2006. BofA is the largest branch bank with 5,747 branches, the largest credit card issuer and controls 9% of all U.S. banking deposits. Countrywide claims loan originations of $462 billion in 2006. When the news broke CFC spiked +12% and the options activity exploded. 35,850 calls and 28,920 puts were traded and that was six times the daily average.

Real interest rates continued to climb with the yield on the ten-year note hitting 4.9% intraday. This is a six-month high and shows no signs of fading. This number is being fed by strong economics and accelerating signs of growth. The Durable Goods numbers for December rose +3.1% to a four month high. Core Capital Goods rose +2.4% after two months of decline. Add that to the spike in New Home Sales and it appears the economic rebound is gaining speed. Next Wednesday we will get the first look at the GDP for Q4 and estimates are as high as +3.5% in some circles. Officially the forecast is 3.0% but even that is well above the +2.4% expected just last month.


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The stronger growth is bringing the Fed back into the picture with a 2-day FOMC meeting next week. The chance for a rate cut through July has shrunk from 90% to only 4% in just two months. The expectations for 3 or possibly 4 rate cuts in 2007 has changed to expectations of either ONE or NONE and possibly even another hike later this year. The bond market is factoring in the Fed expectations resulting in the rising yields. This is actually positive since bond yields impact the economy significantly more than the Fed funds rate. It can impact the economy faster than a Fed hike and essentially do the Fed's work for them.

The outcome of the FOMC meeting next week is likely to be some strong language regarding inflation as the Fed takes a get tough stance in light of the accelerating growth. The Fed will try to talk rates higher rather than actually hike again. To do this they will have to emphasize the inflation risk of an economy that really did not cool off as much as they wanted. If it appears GDP for Q1, currently estimated at +2.1% is actually going to spike back over 3% then the Fed will come out with guns blazing at the May meeting. The only meeting between next week and May is another 2-day in late March. Currently there are rumors that the Q2-Q3 GDP for 2006 could be revised substantially upward. That would erase all the soft landing conversations of the last 9 months in one blow. It would also light an even hotter fire under the Fed for 2007.

There are a lot of critical economic reports next week other than the Q4-GDP. The Chicago PMI is also on Wednesday with expectations for a positive reading of 51.8. You may recall that it fell under 50 in November and substantially off the 62.1 high in Sept. Next up of special importance is the ISM on Thursday with expectations of a positive 51.5 number. On both reports any number under 50 represents economic contraction. The ISM also hit a low of 49.5 in November before a slight rebound to 51.4 in December. This is where the rubber meets the road. If the economy is really heating up it should show in the ISM. Last but not least is the January Nonfarm Payrolls on Friday with expectations for a slight decline to 140,000 jobs. This has been San Francisco Fed President Janet Yellin's hot button. She has questioned several times in speeches why jobs continue to rise if the economy was supposed to be slowing. Evidently she had it right and the economy was not slowing as much as the Fed had expected. Friday's number could be better than expected and that would continue to increase the Fed cloud over the market.

Weekly Economic Calendar

In stock news Microsoft gained a whopping 15 cents on Friday after reporting better than expected earnings despite the delay in Vista. MSFT has risen nearly +45% since June after they warned the last time about Vista being delayed into 2007. They were due for some profit taking and that could appear next week. Vista is due to be released on Monday to the general public. One local store had 600 Vista equipped laptops in the backroom this week waiting for the embargo to be lifted and only a couple of WinXP laptops on the shelves for sale at highly discounted prices. They were effectively giving the WinXP models away to avoid the XP/Vista question on future sales. Once the doors open on Tuesday it will only be Vista for sale. Rumors continue to abound that it takes a gig of memory just to boot it and 8-10 minutes on some computers. Memory manufacturers must love the coming upgrade cycle. Once this is available for existing computers there will be a massive upgrade cycle similar to the Y2K buying binge if Microsoft expectations can be believed. Don Hays was on CNBC on Friday saying the SOX could double over the next 12-24 months. That is a monster prediction and would suggest a huge Vista driven rally.

MEMC Electronics (WFR) spiked +$8.59 after reporting earnings that more than doubled and guided the street significantly higher. MEMC makes the silicon wafers that chip companies use to start the production process. MEMC is also feeding wafers to the solar power crowd at good prices whenever capacity is available. This fall back market is free money when the demand in the normal chip sector slows. There is a shortage of silicon and MEMC appears to be in the right place in the supply line.

CDW Corp (CDWC) lost -6.17 after missing estimates on rising costs. CDW retails more than 100,000 technology products including names like Adobe, Apple, Cisco, HPQ, IBM, Lenovo, Sony, Symantec, etc. Average daily sales of $28.95 million rose +13.5% year over year and profits of $284 million increased +14.2%. Earnings fell -22.1% primarily to higher expenses and several special items including a litigation settlement and an acquisition. Business was good and growing but evidently traders saw "earnings down -22%, missed by a nickel" and headed for the exits. They should do well selling upgrades once Vista hits the retail shelves.

AMGN lost -3.35 after reporting mixed earnings results and negative results on three of its potential new drugs. KB Homes lost -1.14 after the SEC turned an informal inquiry into a formal inquiry regarding their stock option granting procedures. Google gained +7.75 ahead of its earnings due out next Wednesday. They are expected to beat the street but the real interest is how YouTube is going to benefit them in the future. Shares of aluminum products maker Novelis (NVL) jumped +7 after a +5 jump on Thursday after saying it was in talks to be acquired for something in the $6 billion range.

The exchanges continue to soar with the CME gaining +9.86 on Friday. It helps to be nearly a $600 stock to post that type of gain but it is near a new high once again. The Intercontinental Exchange (ICE) gained +3.43 to $135.

Next week earnings will begin to lose the big names on the reporting schedule. 40% of the S&P has reported and most of the recognizable household names like Intel, IBM, Microsoft have already reported. The list will begin to decline in quality but not in quantity as the smaller companies step up to the microphone. About 40% of S&P companies have reported. 68% have beaten the street, 17% reported inline and 15% have missed estimates. With the quality declining as January comes to a close we can expect those ratios to change in favor of those missing estimates.

Crude Oil Chart - 60 min

Oil prices surprised everyone with a continued rise to close at 55.50 for a +1.20 gain. Everything was blamed including cold weather, continued Nigerian attacks, U.S. posturing against Iran, Chavez threatening to kick the U.S. ambassador out of Venezuela and the filling of the SPR. For whatever reason it rose I am not complaining. The complaints are coming from the Dow Transports, which lost -146 points or -3% for the week. It was just a week ago that the transports were testing resistance highs just over 4850. I warned last Tuesday that this was strong resistance and a failure there could weaken the Dow. I don't know which fell first the Dow or the Transports but both definitely headed south. The airlines were the loss leaders with AMR -11%, US Air -11%, UAUA -12%, CAL -15% and XJT -16%. Earnings disappointments abound within the sector after the storms closed airports across the country.

Dow Transports Chart - Daily

The Dow and S&P made a really nice run on Wednesday and I was almost ready to relinquish my bearish bias by the close. I think I was more in shock than simply surprised to see the new highs. When the futures started turning negative Wednesday night I saw the writing on the wall and Thursday turned out even more bearish than I expected. I was really surprised to see the post speech bounce since there was nothing earthshaking in the speech. All the ethanol stocks rolled over right on cue Wednesday morning but the broader markets continued higher to the surprise of nearly everyone. But, that is what makes a market. If everyone "knew" exactly what would happen there would never be anyone to take the other side of the trade.

The Dow respected initial support at 12450 but the nearly -200 point decline from Wednesday's high had to hurt investor sentiment. Every material dip since August has been bought and the bulls rewarded for their efforts. Anyone buying the Monday dip had a nice trade but the buy and hold guys got killed. The rebound at the close on Friday could be attributed to short covering more than eager buyers. There were two minor buy programs that produced most of the rebound.

The Nasdaq erased all its gains for the week to touch a new three week low at 2420 and the following rebound was weak at best. For me it would be a sure bet that 2400 gets tested next week. The S&P tagged 1440 on Thursday and 1417 on Friday. That was a serious implosion that was followed by only a minimal +5 point rebound into the close. That spells trouble for me. It reinforced my short-term bearish bias and increased expectations that we could see 1405 next week. A dip to 1405 would only be -2.5% off the highs so hardly a real correction. It would not even qualify as indigestion in the greater scheme of things. A dip to strong support at 1385 would still be less than a -4% retracement.

S&P-500 Chart - Daily

I heard a lot of talk late in the week about support on the S&P from the 50-day moving average. I have been showing this average on my charts for the last couple weeks. I think the 30 and 50 are critical and we can expect major moves when they cross. The S&P has not even touched the 50 since late July while the 30 has provided short-term support several times. Currently the 50-day is at 1413 with decent horizontal support at 1405. This suggests a break of that range would trigger technical selling from a variety of different scenarios. However, the bulls are alive and well as evidenced by the nearly complete lack of movement in the VIX. After trading as low as 9.86 on Wednesday we did see a small bounce to 11.50 on Thursday's drop but that just put it back into a neutral range. I hate to think what it is going to take to produce a true volatility spike. As long as the bulls are in dip buying mode rather than put buying mode the major indexes are not going much lower. Eventually that trend will break but there is nothing visible on the horizon to make me think it is imminent.

The recent evidence suggests the economy is stronger than expected and improving. The Fed will try to talk rates higher next week and that could cause some additional spasms as traders change sides but unless there is fire and brimstone in the FOMC announcement it should be business as usual. A strong economy can withstand 5% Fed funds and the market should celebrate until the Fed steps off the sidelines later this year. Even if we saw weaker than expected ISM numbers or non-farm Payrolls it should not deter the bulls. That would be Fed positive and give the bulls another excuse to buy. The only real hurdle on my radar is the fear of a normal correction. Corrections don't normally warn in advance. They come when least expected and continue until fear returns to the market. It is worry about a pending correction that could keep the bulls under control. We have not had a even a minor 4% retracement on the S&P since July making us definitely overdue. That would be a minimum of 1385 on the S&P. In the long term view that would just be a step back to the launching pad for an even stronger move higher later this year. We are under 1430 so maintain a short bias with a buy target around 1385. Expect a pause at 1405 if traders really do decide to take that -4% dip.

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