Option Investor

Daily Newsletter, Monday, 08/01/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

Another Quiet Monday

Market Wrap, Monday, August 01, 2005

Another Quiet Monday

After a quiet open this morning the market appeared to be waiting for the ISM report at 10:00, and then following the numbers the market barely rippled. The ISM number came in at 56.6% versus 54.5% expected, up from 53.8% in June, and was the highest ISM manufacturing reading since December 2004. This suggests that we're experiencing a recovery in the manufacturing sector. The other parts of the ISM report showed prices paid at 48.5% versus 50.5% expected, and was a drop from June's 50.5%, so it showed a little price depression indicating the buyers have more power at the moment. The new orders component rose to 60.6% versus 57.2% so again a little bit of growth but not too much.

Had the ISM numbers been much better than that there would have been fears that the Fed was going to get too aggressive in raising interest rates. Had it dropped too much then the market would have been worried about a slowing economy. So the temperature was just right and the equity market went sideways for much of the day. The bond market was not as happy with the more bullish ISM numbers and dropped to new recent lows early after the release. This of course drove yields higher and indicates that the bond market believes the Fed will become more aggressive with its rate increases. The benchmark 10-year note closed down 9/32, leaving the yield above 4.3% for the first time since April 14th. Higher yields will get many fund managers thinking about reducing their risks in stocks in favor of higher and safer bond yields. But the equity market is still in lala land and the bulls were happy to buy this morning's dip. Unfortunately for them they weren't as willing to hold onto the highs and the market sold back off to the daily lows. The Nasdaq had a reasonable day, up 10.55 but the other markets combined finished closer to the flat line for the day.

June's Construction Spending number was also released and it showed slower spending than had been expected, falling 0.3% versus an expected rise of +0.7%. This was the fourth consecutive monthly decline and therefore raises some caution flags in the growth department. May's number was also revised lower to -1.7% from previously reported -0.9%. But this number typically has little effect on the market due to its volatile readings month to month. The trend over the past four months though is troubling.

Several economists raised their Q3 and FY05 outlooks for GDP based on last week's Q2 GDP report, raising Q3 GDP forecasts to between 4 to 5% based on the impact that depleting inventories had on last week's Q2 GDP report. The difficult thing about trusting economists' forecasts is that they base so much of their analysis on rear view mirror observations and then calculate what that must mean as far as where we're going. They're often telling us information that's already old and making projections based on it. It reminds me when I was in business and we'd bring in consultants for specific tasks. The standard joke about consultants is that you hire them to tell you what time it is and they ask for your watch. That's like a lawyer joke so please don't send me hate mail (wink). But the fact that economists are feeling bullish about the numbers causes market participants to feel the same way and when they feel bullish they buy. Very few buyers really study the market or the economy so many are not aware of the present dangers of buying near a high for the market.

The surge in oil prices this morning, hitting a high of just over $62, and rising bond yields initially depressed equities this morning but it was not enough to embolden the bears. We can probably expect renewed concerns expressed about the overbought nature of the market, the slow summer months, and the fact that we were supposed to go away in May (we can see how well that worked out--July was the best month of the year!). And now that over 70% of the S&P companies have reported earnings, earnings season is winding down as a major influence. But what if that wall of worry causes more shorts to get more aggressive while their nervousness causes them to keep covering which just keeps powering this market higher. It's always too hard for me to predict the market's direction based on these what-ifs. I much prefer the charts--it's much more objective. And if I'm wrong, that's what stops are for. And speaking of charts, let's have a look:

DOW chart, Daily

The DOW is consolidating near its 10600 support/resistance level where there's a real bull/bear battle going on. A few stocks spoiled the party for the DOW today (PG and HD) as compared to the other indexes but basically it's marking time. Notice the daily stochastics heading down while price works its way sideways. This is often bullish. Corrections can be price pullbacks or time consolidations (backing and filling) so the longer the DOW hangs out around this level the more bullish it will become. The weakness is there though so longs need to be cautious. Any drop from these levels could happen quickly.

SPX chart, Daily

SPX has been consolidating in an upward bias. You only need to go back as far as the May-June rally to see a similar pattern. I wouldn't be surprised to see the same outcome here. There are so many looking for 1253 Fib target that it worries me but sometimes the obvious happens. The other possibility is that SPX will rally up to an internal Fib projection at 1275. Talk about short covering if that happens!

SPX chart, 60-min

Zooming in a little closer you can see the SPX must rally out of the gate tomorrow morning in order to maintain its uptrend from July 18th. I show a potential price path here that calls for a high of only around 1250 which is certainly close enough to 1253. And the longer the choppy rally lasts, the higher the top of this channel rises.

Nasdaq chart, Daily

Small daily candles tells the underlying story--there's a major battle going on. This is typical of distribution from the big funds to the little retailers so be careful doing any new buying. Scalps only and be ready to bail quickly. The upper trend line across the highs at about 2215 is the first resistance level on this chart (other than the psychological level of 2200). If that's exceeded (meaning the SPX could be headed to its 1275 potential target) watch the Fib projection at 2248.

RUT chart, Weekly

The weekly candles give the impression of slowing momentum but stochastics and MACD do not--they look like they're still pointing strongly higher (but don't forget weekly indicators can take a while to reverse after price does). The RUT is very close now to its upper trend line and the Fib projection of 690 so longs should be cautious. This kind of ascending wedge typically sees a throw-over above the top of it and then a collapse back down inside the pattern. So watch for 690 to get exceeded and then a drop--that would be a sell signal. It's a long way down to the lower uptrend line around 610 before we'd get a confirmed sell signal.

SOX index, weekly chart

The weekly chart of SOX shows how it has been hanging around its resistance level at the top of its flag pattern and near a Fib projection of 481 (which is also the 62% retracement of the drop from January to August 2004). This pattern continues to look bearish even if it manages to press a little higher first.

BKX banking index, daily chart

After banging into the broken uptrend line again, the banks have pulled back sharply, certainly more so than the general market. This could be a heads up for what the broader market will do so again, longs be careful. Banks closed on its 200-dma so a bounce would be expected tomorrow. The 50-dma is just below and therefore there's potential support right here. Now we'll see how well those averages support price.

The rising bond yields are not going to help interest rate sensitive markets, be they banks, utilities (they do a lot of borrowing) or the housing market. There was a recent article in U.S. News & World Report addressing the housing market. This is a mainstream media publication and the appearance of articles on investment subjects is almost always the mark of a high in the market. Last week's home sales numbers included reports of record unit sales. Though existing home prices have been steadily rising, prices on new homes have quietly started to drop. The year-over-year new home sales prices were down 0.4%. This year's drop in the median sales price on a new house has been more severe. In May the median price was $217,000, down from $232,000 in April and $237,000 in February. If prices continue to fall, it will be cause for concern for both homeowners and the stock market.

I don't think the buyers of new homes on no money down, interest only loans are going to be happy about these price drops but there's very little being reported on this at the moment. The whole premise of these riskier mortgages has been that the buyer need not worry about paying off principal since housing values will just keep going up. And now if they have to start paying more on their adjustable rate, interest only loans, that they barely qualified for so that they could buy a house they couldn't afford, it spells enormous risk for the housing market and in turn our economy. The inventory of unsold homes rose 3.8% to 2.653 million, equating to a 4.3-month supply at the current sales rate and this will be a key number to keep an eye on over the next several months as that will obviously have an effect on new home sales prices. The fact that lumber prices have declined 20% since March is another indication of the slowing building boom. Lumber companies are citing oversupply as the main reason for the drop in prices and oversupply results from too much lumber hitting the market at the same time orders for lumber are slowing down. So it appears that house building is getting ready to slow down right at the time the housing market has climbed to a frothy top.

The overall median price of homes rose 14.7% year over year to $219K and that number too is likely to start coming down if the market is peaking. That 14.7% increase is the fastest price appreciation since November 1980. Like the chart for the housing index below, housing prices are clearly on a parabolic spike. Just like in anything in the market, parabolic spikes tend not to end well. The rapidly increasing price climb is increasingly based on fluff. It becomes the greater fool theory, a massive Ponzi scheme, musical chairs--you name it it's not pretty when the music stops. Tech buyers learned this painful, oft repeated, lesson in 2000-2002. While new home owners, speculators, or people who may be forced to sell in the next couple of years would obviously be hurt by a downturn in the housing market, our economy is now so dependent on this industry that it won't be only the homeowners who are hurt.

The residential real-estate market is playing an increasing role in the health of the domestic economy. It's one of the reasons I believe Greenspan has pulled out the stops and is doing everything he can to stoke the housing fire, to the detriment of the American homeowner I might add. We of course know about direct relationships between lumber prices and home building, as mentioned above. But they're by no means not the only industry. Since 2001, 2 out of every 5 jobs created in the private sector have been tied to the real-estate boom, according to Merrill Lynch economist David Rosenberg. If the housing market slows down, or worse crashes, there will be an enormous negative impact on the job situation. People losing their jobs will be forced to sell their homes, either to move to a new location for work or because they simply won't be able to afford their home anymore. This would further exacerbate the homeownership problem and you can see the vicious circle that would be created, something even the Maestro wouldn't be able to stop.

As for personal wealth, it is now estimated that 70 percent of the rise in people's net worth in recent years can be attributed to gains in home values. Do you remember similar reports in 1999-2000 about net wealth increases due to the stock market? This was especially true for holders of the wild and crazy tech stocks. The bear market of 2000-2002 took care of that situation. All those who figured they'd retire at age 50 or 55 are now thinking 65, maybe (depending on what happens with Social in-Security). In a few years we may be saying similar things about the wild and crazy home market. It's no wonder economists are worried about the health of the housing market (except for Greenspan who tells us not to worry).

Crude spiked to a new high early this morning and this is another component of our economy that can only hurt overall economic performance. It hit a new all-time high ($62.15/bbl ,+$1.58), surpassing the previous record of $62.10/bbl (reached on July 7), after the news of Saudi Arabia's Kind Fahd died. While the king's death dominated energy headlines, refinery outages over the weekend as well as concerns about Iran restarting its nuclear enrichment program also prompted buying which was on top of last week's 3.17% surge in oil price. The oil stocks got an early boost as well and even though they only make up 9% of the total weighting on the S&P, they were able to hold the S&P in positive territory for most of the day while the DOW spent much of its time under water thanks to the large influence of PG and HD. Crude oil futures closed the day at $61.55/bbl, up $0.98

Oil chart, August contract, Daily

The chart shows that oil managed to rally back above the mid-line of its up-channel which is bullish. The top of its channel is now up near $68. It'll probably get up there by Labor Day ensuring that travelers get one last zing before the summer ends. It'll be $3.00 ($4.00 in CA) gas nationwide if that happens. The gas-wasting SUVs and larger trucks will be a fraction of their previous value.

Oil Index chart, Daily

When oil was getting a deeper pullback, the oil stocks were saying they were confident oil was going to continue its rally. This is common--watch this index for a heads up for what's going to happen to oil price. If it manages to rally above the top of its channel, it'll be time to hunker down and drive less. But if you're long stocks in this group. Think about profit taking should this index hit the top of it up-channel near 540.

Transportation Index chart, TRAN, Daily

The Trannies are marking time as well. Daily stochastics appeared to be rolling over but has now lifted slightly. This could be an indication of a trending move. The climb off the June low looks like too much too fast so it should be ready for a correction at a minimum. It could be a blow-off move to the upside in these stocks before it starts heading to earth. Keep an eye on the Fib projection just under 3900 for an ultimate high. I've noticed the TRAN does a good job at meeting Fib targets.

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

Can you hear the beating of that drum (the Energizer Bunny's)? While stochastics has headed south price has consolidated sideways and stayed inside its tight up-channel. Eventually this steep climb will spell trouble for the housing market and as discussed above, there are some internal and peripheral measurements that say the market has peaked. This index just doesn't know it yet. We could get one more high out this consolidation but at that point I like the Elliott Wave count that would call the rally complete and I would aggressively begin shorting some of the weaker stocks (use appropriate trade size and stops, don't eat yellow snow and all the other standard warnings and disclaimers here).

U.S. Dollar chart, Daily

The dollar has pulled back/over to the bottom of a potential parallel up-channel and therefore if it's to get another rally leg started out of it month long consolidation, it should begin it very soon and near current levels. If it instead breaks down here, keep an eye on gold for an opportunity to get long the yellow metal.

Gold chart, August contract, Daily

The descending triangle pattern that appears to be playing out in gold would normally have me bearish the metal. But the longer term uptrend in gold, followed by this long consolidation has me bullish. So when in doubt I sit it out. Playing a break of this pattern could work for a longer term trade. If the US dollar is to get more rally then gold could break down out of this, and vice versa so keep an eye on both together to see if you can get confirmation before taking the trade.

If you look at the internals of the market you'll see that advancing volume and advancing issues beat declining volume and issues. Closing prices don't tell the whole story. Whether today saw accumulation or distribution, it's hard to say but there were actually more buyers than sellers so there was an underlying bullishness to today's consolidation. There were 652 new 52-week highs as opposed to 46 new lows. Sector action was mostly green today. Whether or not this will translate into a rally tomorrow is too hard to know but it warrants further caution from the bears. Today's leading sectors were the healthcare indexes, the energy indexes, airlines (odd with oil price up) and then followed by nearly all the rest. The only losing sectors today were the Utilities, Networking, Software and the SOX was red by 0.01.

Procter & Gamble (PG) beat Q4 forecasts by a penny and issued in-line FY06 guidance but concerns of higher commodity prices weighing on future earnings caused a lot of selling early in the day. It was saved somewhat towards the end of the day with some late day buying. There was a 1.5% decline in Home Depot (HD) making it the day's worst performing Dow component, which lost ground after receiving a grand jury subpoena related to hazardous waste handling. Humana (HUM) soared 7% when it matched analysts' Q2 expectations and reaffirmed its FY05. Guidant (GDT) shares climbed after receiving FDA approval to re-enter the heart failure treatment market. A Deutsche Securities upgrade provided a boost to Medtronic (MDT) while Pfizer (PFE) rallied after the FDA approved a new use for Celebrex. A 2.3% rally in Amgen (AMGN), following fast-track FDA approval for its co-developed cancer drug panitumumab, also provided support to the healthcare and pharmaceutical indexes today.

Tomorrow's economic reports include the following:

August has been the worst month for the S&P over the last 15 years and I'm sure this is going to have many market participants nervous about buying it here. Going all the way back to 1950 shows August has typically been a flat month and even though flat looks better than a 0.7% decline for September, the low volume that's expected while many investors will be on vacation tends to make for a very volatile month. For the past few weeks economic data has taken a backseat to earnings, which could result in Q2 operating EPS growth for the S&P 500 of about 12% (or about 4-1/2% above initial forecasts), the focus will begin to shift back to economic data and many traders are worried about the unknown there.

Therefore any further rallies this month could be tough sledding. There will likely be a strong battle between the sellers and buyers and the increased volatility on low volume could create havoc with your trades. There's a reason so many leave the market behind and take vacation. Don't be bashful about sitting on the sidelines and use the time to practice new trading tools. Read some good trading books. Education is a key component of what we do for a living and August is a great month to follow up on your goals in that regard. Good luck and continue to trade this market lightly and take profits quickly.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

New Calls

None today.

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Las Vegas Sands - LVS - close: 40.27 chg: +0.05 stop: 38.25

Don't forget... we are exiting this play on Tuesday at the close to avoid holding over LVS' earnings due out on Wednesday.

Picked on July 21 at $ 40.31
Change since picked: - 0.04
Earnings Date 08/03/05 (confirmed)
Average Daily Volume = 934 thousand


Pediatrix Med Group - PDX - cls: 78.68 chg: +0.26 stop: 76.10

Almost made it! PDX hit a high of $79.16 today but it wasn't enough for our $79.50-80.00 target. More conservative traders may want to exit immediately. We are exiting on Tuesday at the closing bell to avoid holding over PDX's earnings report on Wednesday.

Picked on July 11 at $ 76.10
Change since picked: + 2.58
Earnings Date 08/03/05 (confirmed)
Average Daily Volume = 158 thousand

Put Updates

AutoZone - AZO - close: 97.89 chg: +0.45 stop: 100.01

AZO produced an early morning spike but the rally failed very quickly near the $99.00 level. We would use this as a new bearish entry point. More conservative players may want to wait for a new relative low under $97.00. Our target is the $93.00-92.50 range.

Picked on July 25 at $ 98.13
Change since picked: - 0.24
Earnings Date 09/20/05 (unconfirmed)
Average Daily Volume = 748 thousand


Fedex Corp - FDX - close: 84.76 chg: +0.67 stop: 86.01

No change here. We are on the sidelines waiting for FDX to roll over from the current bounce. Our suggested entry point to buy puts is at $82.85. Our target will be the $76-75 region.

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 09/22/05 (unconfirmed)
Average Daily Volume = 2.0 million


Fannie Mae - FNM - close: 55.85 chg: -0.01 stop: 59.01

No change from our strategy here. FNM was looking rather weak this afternoon. We are targeting the $51.50-50.00 range.

Picked on July 27 at $ 56.49
Change since picked: - 0.64
Earnings Date 00/00/05 (unconfirmed)
Average Daily Volume = 3.3 million


Google - GOOG - close: 291.61 chg: +3.85 stop: 300.01

GOOG managed to rebound back toward the $292 level, which was minor support last week, but the bounce was starting to fade into the later afternoon. We are still sitting on the sidelines waiting for GOOG to breakdown even further and hit our trigger to buy puts at $284.50. Our target will be the $255.00-250.00 range. Remember, this is a very aggressive, high-risk play.

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 07/21/05 (confirmed)
Average Daily Volume = 13.6 million


Infosys Tech. - INFY - cls: 71.15 chg: -0.03 stop: 74.05

No change from our weekend update. We would not suggest new bearish positions until INFY trades under the $70.00 level.

Picked on July 20 at $ 69.92
Change since picked: + 1.23
Earnings Date 07/12/05 (confirmed)
Average Daily Volume = 922 thousand


Lehman Brothers - LEH - cls: 105.53 chg: +0.40 stop: 108.01

The tug-of-war continues near the $105.00 level. We noticed that the bounce today was rather weak and had begun to fail by this afternoon. We see no changes from our weekend update. Remember, this is an aggressive, speculative play.

Picked on July 21 at $105.13
Change since picked: + 0.40
Earnings Date 06/14/05 (confirmed)
Average Daily Volume = 2.7 million


3M Co. - MMM - close: 75.31 change: +0.31 stop: 76.77

No change here either although we continue to look suspicously at this bounce. If MMM push above $75.40 more conservative traders may want to start eying the exits. A move over its 50-dma and we may be eying the exits too.

Picked on July 19 at $ 74.29
Change since picked: + 1.02
Earnings Date 07/18/05 (confirmed)
Average Daily Volume = 3.4 million


Nike Inc - NKE - close: 82.86 chg: -0.94 stop: 85.51

NKE is off to a poor start for the first day of August. The stock failed the early morning bounce under its simple 200-dma and broke down under its simple 100-dma. Shares also pierced their exponential 200-dma as well. Our entry point to buy puts was at $83.39 so the play is now open. Our target is the $77.50 level.

Picked on August 1 at $ 83.39
Change since picked: - 0.53
Earnings Date 09/26/05 (unconfirmed)
Average Daily Volume = 1.5 million


Panera Bread - PNRA - close: 58.07 chg: -0.18 stop: 60.01

Ding! And the race is on. PNRA dipped under the $57.50 level to tag our entry point at $57.49 to open the play. Shares did manage to bounce back but still closed for a loss on the session. We now have eight days to see how low PNRA will trade before exiting ahead of its earnings report.

Picked on August 1 at $ 57.49
Change since picked: + 0.58
Earnings Date 08/09/05 (confirmed)
Average Daily Volume = 601 thousand

Dropped Calls


Dropped Puts



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