Option Investor
Market Wrap

Another Piece of the Puzzle Falls Into Place

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The major indexes started the week off mixed, but the small caps of the Russell 2000 Index (RUT.X) 833.65 +1.21% were a standout and look to play "catch up" after Friday's revelation that China continues to take steps toward revaluation of the yuan against the U.S. Dollar and level the playing field for global trade.

The broad S&P 500 Index (SPX.X) 1,525.10 +0.15% challenged its March 24, 2000 all-time closing high of 1,527.46 intra-day after another impressive display of buyer enthusiasm into last week's option expiration for May.

Could it be that the "lagging" we've seen in the Russell 2000 Index (RUT.X) relative to the large cap indexes was simply due to a greater focus among bulls to increase their exposure to the large caps? A focus so great, where various market internals mentioned in my April 30th market wrap, "Run on Mouthwash Due to Bull's Bad Breadth," was only a near-term phenomenon?

Large caps, where a greater extent of their products/services would eventually benefit should Chinese currencies see strength against the U.S. dollar? A shift, where a stronger Chinese currency might further drive greater demand for U.S.-made products and services?

It didn't make sense, in recent weeks that the "junk bond" Pacholder High Yield (PHF) $10.18 -0.09% had been holding tough, and trading at a discount to its net asset value, as many smaller capitalized stocks struggled to move higher.

But Friday's "China revelation," and perhaps a tidbit of news out of China today, suggests U.S. equities may be in a sweet spot for further M&A activity.

Volume at the big board was notably heavy today.


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NYSE-listed shares of Elan Corp. (NYSE:ELN) $18.69 +12.59% were a big part in today's above-average volume at the NYSE. Elan's shares rose sharply for a second-straight session on heavy volume of 61.6 million shares, which is well above average daily volume of 3.2 million shares. The Dublin, Ireland-based company and US-based Wyeth (NYSE:WYE) $58.41 +3.60% said that they were initiating a Phase III trial for their Alzheimer's drug Bapineuzumab.

The companies said that there was no conclusion about the current Phase II trial underway, and that no conclusion would be reached until 2008. In a joint press release, the companies said "This decision (Phase III) was based on the seriousness of the disease and the totality of what the companies have learned from their immunotherapy programs, including a scheduled interim look at data from an ongoing Phase II study, which remains blinded."

Meanwhile, drug maker GlaxoSmithKline (NYSE:GSK) $53.18 -7.84% fell sharply on heavy volume of 13.6 million shares after the New England Journal of Medicine reported that Avandia, a drug used to treat Type-2 diabetes, "significantly increases" the risk of heart attacks.

The U.S. Food and Drug Administration (FDA) said it was reviewing the safety of Avandia, but regulators have not yet determined the significance of risks reported in the study. The agency said it was not asking GlaxoSmithKline to take any action at the present time but would ask a public advisory committee to weigh in at a later date.

A blockbuster M&A deal in the telecom sector also added to today's volume at the NYSE.

Shares of Little Rock, AR-based Alltel Corp. (NYSE:AT) $69.60 +6.73% surges as high as $70.45 after the wireless voice and data communications provider said it had agreed to be bought by TPG Capital and GS Capital Partners in a deal valued at $27.5 billion, or $71.50/share in cash.

Dow component General Electric (NYSE:GE) $37.10 +0.37% edged higher after the conglomerate said it would sell its GE Plastics unit to Saudi Basic Industries Corp. in a deal valued at $11.6 in cash plus the assumption of liabilities.

One of today's "tidbits" I found of interest was China saying it had agreed to place $3 billion (U.S. Dollars) of its massive foreign exchange reserves with US-based private equity group Blackstone. Foreign equity watchers see the move as a signal out of Beijing that the government is starting to switch investment focus from US Treasuries into more "risky" equity holdings and that China is testing the water for a much bigger investment in private equity.

U.S. Market Watch -

Treasuries? Did somebody mention Treasuries and the shifting of "risk?"

The benchmark 10-year Treasury Yield ($TNX.X) rose to a 3-month high at 4.816% in early morning action, but buyers gobbled up that yield to today's close as the benchmark bond reversed course with its yield finishing down 1.6 basis points to 4.788%.

Despite the rise in Treasury yields over the past week, the Dow Jones Home Construction Index (DJUSHB) 641.33 +1.51% has gained 4.11% since last Monday's close. Sector and industry watchers will be tuned in to Thursday's earnings out of luxury homebuilder Toll Brothers (NYSE:TOL) $28.81 +0.91%.

China, A Piece of the Puzzle

On Friday, my trader/investor juices were flowing! I was scrambling to begin putting together this important piece of the puzzle. A piece of a puzzle that has been roiling the U.S. and global financial markets for the past couple of years.

One thing that I immediately had to do was to step back for a moment and review some of my recent analysis.

Here's a quick table of various U.S. major market indexes, as well as currency observations that you have undoubtedly read something about in recent months.

Could it be that China is actually willing to try and begin leveling the playing field for global trade?

US Large Cap, Small Cap, China and Japan

I can't forget the "sudden" and sharp weakness in the U.S. Dollar versus Japanese Yen ($/yen) in late February that seemingly pulled the rug out from under the large cap S&P 500 Index (SPX.X).

If you were long or short the S&P 500 (SPX.X) on February 27th, I know you won't forget that day.

But I do feel, and begin to tie together some of those events with Friday's "China revelation."

You may also have to believe that the MARKET is a forward-looking instrument, that tends to know something about the future.

Since that time, I and others have noticed/mentioned how the U.S. large cap indexes such as the Dow Industrials, S&P 100, NASDAQ-100 and even the broader S&P 500 have been outperforming the small caps as depicted by the Russell 2000 Index (RUT.X).

In the above table, I "benchmarked" these major U.S. equity indexes to their March 30 close, April 30 close, and now tonight's close.

From 03/30 to 4/30, we can perhaps begin to "grasp" the notable percentage change of large cap (INDU, OEX, NDX and SPX) relative to the small caps (RUT.X).

And even with today's handsome 1.21% gain for the small caps, the RUT.X still "lags" the large cap indexes from as recently as April 30th to tonight's close. I will note that the RUT.X is even with the large cap NDX.X.

What I really want traders/investors to be alert to, is that Friday's "China revelation" may have some small cap BEARS quickly making some adjustments.

I do tend to be more BEARISH a "weaker" group of stocks, be it sector, or MARKET CAP, but the junk bond strength we've been noting in my wraps just didn't make sense relative to how the small caps had been trading.

Again, I may be painting things with a broad brush to equate "junk bond" with "small cap equity," as there are some large cap stocks, whose debt carries a junk rating. And there are certainly some small cap stocks that have no/little debt, where debt is rated A- to AA+.

My "gut feel," based on that junk bond/small cap observation, and today's rather notable gains for the RUT.X has me thinking that some small cap bears may be putting the piece of the puzzle together that there wasn't anything BEARISH about the small caps, but there was such a focus among smart money in regards to China's steps to level the playing field, that small cap shorts begin to step up their short covering, and keep losses small.

But lets also take this a step further.

Wouldn't it also make some sense, that if China were going to level the playing field on global trade (revalue yuan against the dollar, or Hong Kong Dollar against the dollar) that their equity markets begin to "lag" U.S. equity markets?

That is ... If US exports to China pick up further on Chinese currency gains, but China exports to US level off, or don't grow as rapid pace, then China's Hang Seng Index ($HSI.X) begins to "lag" a bit?

I'm only mentioning the U.S./China relationship tonight, but it would behoove a trader/investor to also consider other global markets.

In fact, in recent Market Monitor commentary at OptionInvestor.com, Jane Fox has been noticing how Germany's DAX and the Dow Industrials have been "mirroring" each others strength in recent weeks.

Could German multi-nationals also benefit from yuan revaluations and the leveling of the playing field with Chinese exports? That is ... Chinese made goods/services versus German made goods and services?

I would think so.

And what about Japan? One of the "Asian Tigers?"

It is at least somewhat notable that Japan's Nikkei-225 ($NIKK) is lagging the other equity benchmarks in the above table.

Nikkei-225 ($NIKK) - 50-point box

If there's going to be "trouble" for the bulls, even here in the U.S., I think it is going to start overseas, and with the $NIKK "lagging," this is a market to monitor.

Remember, while the Fed has been holding steady at 5.25% on fed funds here in the U.S., the Bank of Japan's key interest rate is just 0.5%. They have little room to "stimulate" monetary policy with rate cuts.

I would NOT want to be short a trade at 17,700 as that could unleash a strong round of short covering. See the developing lower highs and lower lows? A jump above 17,700 breaks that pattern.

A trade at 17,200 becomes quite bearish and would break some very meaningful support. This would be THE level in the $NIKK that I think U.S equity traders need to keep an eye on.

As noted in the above chart, you can see the SHARP 4-session declines in the $NIKK starting on February 27th.

If U.S. equity bulls are going to start locking in bullish gains, then further WEAKNESS in the $NIKK may be the trigger.

Russell 2000 Index (RUT.X) - Daily Intervals

I think the small caps of the Russell 2000 Index ($RUT.X) may be set to play "catch up," and could actually outperform the big caps if we see profit taking in that portion of the market.

In last week's Market Monitor, I was posting some of Dorsey/Wright's 10-week and 30-week bullish % charts.

I haven't shown these types of bullish % charts in my nightly market wraps before, but what they were suggesting to me was that the 10-week, or 50-day SMA were starting to see some near-term weakness.

The 30-week, or 150-day SMA was also starting to soften up a bit.

What I started to do then was "tie" individual stock's charts, as well as the various major indexes bar charts to both the 50-day SMA and the 150-day SMA. Usually, I show my bar charts with a 200-day SMA.

But check out the RUT.X with a 50-day and 150-day SMA on its chart.

Jim Brown and I have both commented on how the "small caps" tend to not be as impacted by a monthly option expiration.

Look how "clean" the small caps trade relative to these 50-day and 150-day SMAs.

I moved my 0% retracement to the 2/26/07 close, which would have been the day just before the USD/yen trade unfolded, where we might have expected the LARGE caps to have been more sensitive to currencies, which can impact global trade trends.

I think market participants may be "putting together the piece of the puzzle," that the small caps were left out of the bigger picture, only due to a focus on bullish large cap exposure.

Not it is time for the small caps to shine.

If not, then stop a close just under the rising 50-day SMA, with an assessment of near-term DOWNSIDE RISK to the rising 150-day SMA.

The Russell-2000 Index (RUT.X) was actually the 1st equity-based index in my MONTHLY Pivot Matrix to see a trade at its MONTHLY R1 (833.77) for the month of May!

The RUT.X's MONTHLY R2 is at 852.97, and the small caps could get there fast on a break to new all-time highs, where overhead supply becomes non-existent.

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