A stronger than expected drop in the Philly Fed survey was blamed for the two-day drop in the markets. While that was an unexpected drop in the Philly numbers there were numerous other factors also contributing to the market weakness. High on the list was the strong overbought conditions as the markets rebounded to retest the multiyear highs. This was stretched even further as traders anticipated the Fed would remain on the sidelines and pushed the markets higher. Once the Fed announcement was made there was nothing else to motivate buyers ahead of the historical Sep/Oct weakness. The Philly Fed report was simply the catalyst that triggered the much needed profit taking to return the indexes to primary support levels. Now that the overbought conditions have eased next week will be a critical test of bullish convictions.
Dow Chart - Daily
Chart - Daily
The dramatic drop in the Philly Fed from +18.5 to a negative -0.4 significantly shocked analysts and investors. Sometimes you have to be careful what you wish for or you might just get it. Everybody wanted the Fed to be done cutting rates and that required a significant deterioration in economic fundamentals. The Philly Fed was the first of what could be many evidences of that economic slowing. Basically investors got their wish but now they want to retract it. This was the first time the survey has been in negative territory since April 2003. It was also the largest drop since the -19 point drop in January 2001 only two months before the last recession. The headline number at -0.4 hid more serious negatives in several components. Shipments fell from 22.3 to -6.8. New orders fell to -1.3 from 15.7 and unfilled orders dropped to -5.3 from 0.6. The Philly Fed survey is normally seen as a leading indicator of national manufacturing activity. Negative numbers are seen as slowing activity while positive numbers represent an expansion of activity.
The sharp drop in the Philly Fed numbers will put more emphasis on the Chicago PMI next Friday and the National ISM the following Monday. Unlike the Philly Fed any number over 50 on these reports is considered expansion while a number under 50 indicates a contraction. The Chicago PMI came in at 57.1 last month and the ISM was barely expansionary at 53.5. The economic bears came out of the woodwork this week with predictions of gloom and doom in every sound bite.
Chart of Ten-Year Note Yields - Daily
Bonds suddenly found favor again and the yield on the ten-year note fell to 4.59% and a level not seen since March 2nd. With the Fed funds rate at 5.25% there is a serious disconnect between the economic outlook of bond buyers and the outlook of equity traders. The chances of another rate hike are less than zero. With meetings in Oct, Dec and January the February futures are now pricing in a 40% chance of a quarter point cut at one of those meetings. The November futures are showing a miniscule 4% chance of a cut in October. However, the most likely scenario is a continued pass for the rest of 2006 to avoid any political connotations surrounding the elections and then a cut at the January meeting. The sharp drop in yields, -25 basis points since the Monday high at 4.85% and the largest drop in 17 months, is very bullish for the housing sector. Part of Friday's drop in yields was attributed to comments from Greenspan that were interpreted as dovish for future rates. He also said that the current low rates would provide support for housing and help slow the current housing decline.
Bonds are finding favor as a safe trade ahead of potentially rocky economics. Next week the calendar starts off with Existing Home Sales on Monday and New Home Sales on Wednesday. With homebuilders very oversold and real interest rates crashing it may be time to speculate in some long-term calls. Any bad news will probably be ignored. The key economic reports are the three manufacturing surveys, the Chicago PMI on Friday and the ISM on the following Monday.
Next week is earnings warning week. The quarter is basically over for accounting purposes and companies now know if they are going to hit their forecasts. We have seen a flurry of warnings over the last week with warning ratios rising. These companies warned on earnings or cautioned on guidance, DCX, MAS, FBN, STLY, LEA, BWA, FDX, BSX, NYT, YHOO, MCHP, XLNX, MXIM, AATI, MSCC and of course the homebuilders continued to predict the earth would open and swallow their various projects. The ratio of negative to positive warnings rose to 2.4 compared to 2.09 in Q3-2005 and the historical average of 2.2. This means the number of negative guidance announcements is rising above historical norms. Analysts still don't think this is a major problem and Thomson Financial is still predicting S&P earnings growth of +14.2%. There have been some sector downgrades such as consumer discretionary companies from +20% growth to only +9%. Holding up the averages Thomson is expecting earnings from the materials sector to rise +46%, finance +28% and energy +17%. Remember Q3-2005 was a strong quarter for energy stocks after the sharp price gains surrounding Katrina. This will make earnings comparisons difficult. Thomson says this will be the 13th straight quarter of double-digit earnings growth and only the second time this has happened with the other being the streak from 1992-1995.
According to the analysts earnings will not be a problem but in reality the overall average will be held up by a few strong sectors. Nothing new but there will be individual problems that could sour investor sentiment. Remember Dell is expected to warn and their frantic attempts to regain share and unload inventory could cause profit shrinkage in the rest of the PC sector. As you can see by that list of warnings above many of those are chip stocks. I am not going to spend a lot of time speculating on which stocks or sectors could cause problems next week because we have another problem facing next week us that will be more evident.
That problem is the end of quarter portfolio games. The third quarter is a critical quarter for funds with the Q3 portfolio statements seen as a setup for the next year. Funds do not want to show losers in their Q3 statements. They want to show recent winners so investors think they are smarter than they really are. This means the next week should see more selling in those losers already down hard and more buying in the recent winners. The sector hardest hit is of course the energy sector. I would say homebuilders as well but the selling has already moderated in those as bottom fishers have already created support. That leaves energy as the scapegoat and the sector most likely to get dumped again next week. Sectors likely to find additional buyers would be financials, broker dealers, drugs and telecoms. Fund managers trying to mark up their portfolios will be buying more of stocks like Goldman Sachs (GS), Morgan Stanley (MS), MetLife (MET), Electronic Arts (ERTS), Apple Computer (AAPL), Nvidia (NVDA), Corning (GLW), China Life (LFC), AT&T (T) and takeover target BellSouth (BLS), Verizon (VZ) and the Telecom Holders (TTH). Their plan will be to push those stocks they already own higher in order to dress up their end of quarter statements. This buying should be spread out early in the week since the SEC has begun monitoring the last couple days of the month for fund abuses.
November Crude Oil Chart - Daily
Helping to push energy prices lower next week was the drop to $60 in the November contract for crude and a new two-year low for natural gas at $4.59. We saw a nice attempt at a rebound once the selling related to the expiring October contract had passed but $62 remained firm resistance with another flush into Friday's close. This could be a really rocky week for energy but that could change the first week in October. We are seeing that end of quarter flush stimulated even more by the lack of any outside events. No hurricanes, BP will restart production in Alaska next week, Iran is talking nice to anybody who will listen and inventories are at multiyear highs. It will not be a permanent drop but funds will probably dump some of their window dressing stocks once September ends and start buying energy again for the winter rebound.
Tanker tracker PetroLogistics said OPEC shipments have dropped -400,000 bbls per day in September, mostly from Saudi Arabia. This could be a leading indicator that OPEC is already reducing output to support the price above $60. Saudi can get nearly the same revenue by selling 8.1 mbpd at $65 as they can by selling 9.1 mbpd at $58. The difference is only $1.3 million. A drop in the bucket compared to the $527.8 million or so they currently receive each day. (Those numbers are based on the price of light crude and Saudi actually sells a mix of crude at a lower average price but you get the idea.) The Saudi Oil Minister Ali Al Nuaimi said in one interview that oil prices were still lucrative for producers and at a satisfactory level. In another quote he said current prices are "fair" which was a change in stance from "unreasonable" in prior comments. This is probably another clue that $60 is going to be supported and maybe slightly higher. Of course he also said Saudi was still producing its full OPEC quota of 9.1 mbpd and nearly everyone on the planet knows this is not true. Shipments in August had fallen to about 8.1 mbpd and if Petrologistics is correct they have slipped even more in September. Time will tell but you can bet they have grown very accustomed to receiving $65 and above. EIA senior analyst Doug Macintyre said on Friday the EIA expects prices to return to the mid to upper $60s later this year and possibly back over $70. Goldman Sachs also maintains their $70+ price target for Q4. I hope they are right and I plan on adding to positions on weakness next week.
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I saw an interesting statistic this week about the new "low" gasoline prices. According to the bean counters the average price for a gallon of unleaded fell to $2.44 last week. While I would bet many of our readers have not seen prices that low yet you can rest assured they are coming. The statistic in question showed that US consumers were paying $266 million less per week for gasoline than just a month ago when the average price was $3.10. $266 million is a huge number and that is about where the Powerball lottery will be by next weekend if nobody wins the estimated $203 million jackpot this week. If you find yourself pumping that cheap gas this weekend you might reconsider not buying that Powerball ticket. I know it is a tax on the mathematically impaired but what the heck you are saving $266 million a week. Splurge a little and remember me if you win.
Natural gas inventories grew by +91 BCF last week to 3,177 BCF. This is the highest level of gas in storage for this time of year as seen over the last 13 years. If we only see injections at the average rate for the next five weeks it would be an additional +264 BCF and raise gas in storage to theoretical levels of 3,541 BCF. There has never been this much gas in storage before and nobody knows if it will fit or will the increased pressure cause leaks in the underground caverns. The EIA recently did a study of the maximum gas ever stored at each of the individual locations. Each operator was asked what was the most gas they ever stored in their current configurations. Those results were tallied to produce a theoretical "Peak Volume" capacity of 3,608 BCF. It has never been that high and because of pipeline limits and current usage trends it may never reach that high. For instance if one pipeline serves a lot of power plants the drain on that pipeline may be such that storage on that line never reaches maximum levels. Other pipelines could theoretically max out while others continue to supply consumers at peak pipeline rates. The official capacity estimate for the entire system is 4,054 BCF but many of the storage areas have never seen pressures required to reach that level. It should be interesting as we near the assumed safe capacity of 3,500-3,600 BCF. We are already seeing gas price competition and prices are going to continue to fall as suppliers compete for the remaining available storage. On the positive side cold weather is barreling down on the plains and mountain states. It is snowing in Colorado today and we have a winter storm watch for the weekend. It may not be winter yet but it is coming. The cooler weather will consume more gas than the prior two weeks suggesting injections into storage will slow. That would be bullish for prices but don't expect any real rebound until late October, early November.
Temperature Map of the US - Friday Night
Stocks headlining the news on Friday were HPQ, FDRY, COGN, FDX and BSX. I will spare you the Hewlett Packard soap opera and focus on real news. Foundry (FDRY) joined the stock options crowd with an announcement they were going to review results to correct prior back dating events. Cognos (COGN) beat estimates on Friday and several analysts raised guidance on the company. COGN rose +3.17 on the news. FedEx broke even after posting a stronger than expected +43 cent increase in earnings to $1.53 per share. The problem was a cautious outlook saying the economy was moderating although still growing at a healthy and sustainable pace. This is a prime example of FedEx managing earnings expectations. They typically under promise and over deliver then give cautious guidance. UPS stunk up the sector back in July after they forecasted slower growth despite strong Q2 profits. Merrill cut UPS to a sell at the time after UPS cut estimates to nearly a dime under those of analysts. Boston Scientific fell about -10% on Friday after warning that sales could drop as much as -10% below analyst's estimates. Earnings were still expected to be in the range of 15-19 cents with analyst expecting 16 cents. Downgrades fell like rain as the stock was hammered to a new 4-year low at $14.85.
Seems like just yesterday I wrote about the indexes being at multiyear highs, the lack of bullish conviction and the potential for a historical October dip. But, two trading days have passed since I penned that Wednesday commentary with the talking heads projecting 1450 on the S&P and 12500 on the Dow. I did not hear much talk about those new highs as the markets rolled over for two consecutive days. Now the talk has reverted to recession worries and the rally in the bond market. It seems traders are not happy regardless of the circumstances. When the markets were testing the highs it was tough to find any bullish conviction or bearish conviction either. It was as though both sides were content to wait passively while the stealth rally added points in stutter steps to reach those highs. For next week we are faced with the end of quarter window dressing scenario. That should see buying early in the week followed by slowing support as the week/quarter draws to a close.
The indexes could not have performed the script more perfectly than they did. The Dow eased off its highs at 11625 to coast to a stop on support at 11500. Every dip below that level was bought with just enough intensity to hold the line but still without conviction. The S&P relinquished its hold on 1325-1328 and plunged back to support at 1315 and exactly where we had decided to draw the line on Wednesday night. Friday's trading saw it vacillate just under 1315 all day but never out of reach. Buying at the close put the index at 1314.68. Close enough for me. The Nasdaq did exactly the same thing with 2220 after a -45 point drop from just over 2260. In each case critical resistance held despite being under attack for most of the day on Friday. Support on the Russell at 715 and the Wilshire 5000 at 13100 mirrored the other indexes. You would almost think traders were actually watching their charts. In reality it was the fund managers holding the line and preparing for next week's costume party. As long as they could close them at support they have a good chance of a rebound when the window dressing begins in earnest next week. If they had let that support fail it would have been a race to the exits and out of their control. For the retail bulls it simply appears that profits were taken and it is time to buy the dip again.
Russell-2000 Chart - Daily
Wilshire-5000 Chart - Daily
SPX Chart - Daily
Based on the end of quarter scenario I am neutral for next week. I am going to
follow my own advice with only a slight modification. On Wednesday I suggested
buying a dip to 1315 and go short/flat below that level. Since we traded -2
points under 1315 nearly all day Friday that line in
the sand was erased by
millions of hoof and paw marks making it unreliable as a dual trigger. I am
changing the recommendation to 1310 as our short indicator. The new plan will be
to remain long over 1315 and short under 1310. That makes it easier to
differentiate the signals since both triggers can't be touched at the same time.
It also makes stop losses easier since each becomes the stop for the other.
Since nobody can accurately predict how next week will play out in the absence
of a normal September dip scenario we will put our biases on the shelf and
simply follow the plan. The early week economics should not be a factor but
additional earnings warnings could disrupt the window dressing plan. Economic
reports later in the week could produce additional weakness so be aware in
advance that the ice gets thinner as the week progresses. I would love to see a
rally appear on Monday that takes us to new highs but that is my bias talking
and we know how unreliable
biases can be. Follow the plan and it will not matter
which direction we trade because we will be following the trend.
General Dynamics - GD - close: 70.61 change: -0.89 stop: 69.74
Why We Like It:
BUY CALL OCT 65.00 GD-JM open interest= 42 current ask $6.00
BUY CALL NOV 65.00 GD-KM open interest=1463 current ask $6.50
Picked on September 24 at $ 70.61
Maxim Integrated - MXIM - close: 28.29 chg: -0.08 stop: 30.05
Why We Like It:
BUY PUT NOV 30.00 XIQ-WF open interest=3535 current ask $2.80
Picked on September xx at $ xx.xx <-- see TRIGGER
Textron - TXT - close: 81.61 change: -1.98 stop: 84.01
Why We Like It:
BUY PUT OCT 85.00 TXT-VQ open interest= 361 current ask $4.20
BUY PUT NOV 85.00 TXT-WQ open interest= 5 current ask $4.90
Picked on September xx at $ xx.xx <-- see TRIGGER
Cymer Inc. - CYMI - close: 42.42 chg: -0.88 stop: 41.95
Burlington Nor.SantaFe - BNI - cls: 68.72 chg: +0.12 stop: 71.01
Hartford Finc. - HIG - close: 84.94 chg: -0.66 stop: 84.95
Johnson Controls - JCI - close: 68.40 chg: -0.79 stop: 74.16
Imagine that you've been watching a rally and you think it's extended too long. Some market watchers began feeling that way just before September's option expiration. The SPX looked as if it had outrun its short-term support. It had been testing possibly significant long-term resistance, too, and doing it with pronounced price/RSI bearish divergence. The VIX had punched to new recent lows and then rebounded off those lows. Many mentioned negative news that the market just hasn't digested yet, but soon must digest. The SOX did not participate in the Nasdaq's rally.
Contrarians had begun shorting the markets, and that included many retail traders who chose the cheapest options, September's. Some of those got caught when September's options expired without a significant downturn in the markets. A simple chart might have saved them. Take a look at a couple of charts snapped at the close of trading on September 13, when the conditions described above existed.
Annotated 10-Minute Chart of the SPX:
Annotated 10-Minute Chart of the Nasdaq:
Annotated 10-Minute Chart of the Dow:
If charts of the TRAN, Russell 2000 and Wilshire 5000 were posted, their behavior at the close on September 13 would have mimicked this action. The RLX's behavior was similar.
What can we tell about these charts? The break back above the 10-minute 100/130-ema's on September 11, the Monday of opex week, was a sign that upward momentum had increased. That signaled danger in assuming that bearish positions would work. Of course, would-be bears might point to the straight-up rise that had far outstripped the potential support of the 10-minute 100/130-ema's by September 13. Those averages have clearly been important in providing either support or resistance, so bears might reason that the SPX, Nasdaq, Dow, TRAN, Russell 2000 and Wilshire 5000 were all due for either sideways consolidation while those averages rose underneath them or an actual pullback occurred to test their support.
A more cautious trader might have pointed out that however logical that conclusion might be or how likely such action was based on recent historical evidence, these indices were still clearly bouncing from the 10-minute 21-ema's as of the close on September 13. Indices were maintaining their strongest rally mode, not even pulling back to the stronger and more important support of the 100/130-ema's. As long as that kind of momentum continued, any eventual testing of the 100/130-ema's support was likely to be accomplished by a sideways/sideways down movement rather than a stronger pullback. As long as that kind of momentum continued, it was dangerous to assume bearish positions would profit.
Another conclusion might be reached, drawn from the strange congruence of the actions on these indices. This was clearly program, institutional or--if you're the suspicious type--even PPT (plunge-protection team) buying. Someone or several someones with deep pockets were buying baskets of stocks each time indices hit certain key support levels.
Would you really want to bet against those someones, especially with options that were about to expire? Would you really want to enter a trade based on a VIX move, when it's well known that such VIX moves can presage a market movement by days or sometimes even weeks, and when a low VIX can go lower? Should you factor in any possible option-expiration influences on the VIX's behavior anyway?
On the night of September 13, I mentioned all these points in the Wrap. I told traders to watch those averages the next day, but cautioned that a likely action would be some disorganization, a trading back and forth across the 10-minute 21-ema's that wasn't as much a violation of that average as it was a knitting of prices across it, indicating some disorganization. Since both the daily candle's shape and the opex Thursday pin-them-to-the-action behavior that typically begins about mid-morning on opex Thursday hinted at possible consolidation, and since such a period of disorganization was sometimes seen in consolidation, bears shouldn't be too quick to believe that a minor violation of the 10-minute 21-ema's meant a plunge was next. It wasn't.
Annotated 10-Minute Chart of the SPX:
Those who held September puts through that Thursday, when they stopped trading, were not to be rewarded with a drop that would re-inflate the value of those options that were out of the money.
Watching such a chart would have saved traders from entering short-term positions with September puts any time opex week. Traders would have had a clear benchmark that told them that upward momentum remained strong. Many other signs might have been pointing to the need for a pullback, but watching prices bounce from these averages showed it wasn't happening.
That violation of the 10-minute 100/130-ema's wasn't to occur until Tuesday of this week.
Annotated 10-Minute Chart of the
This is how the 10-minute chart looked at the close of trading on September 19. When I wrote the Wrap that night, Tuesday, I pointed out this action and told readers to watch how the SPX reacted with relationship to those 10-minute 100/130-ema's the next morning. If the markets were to pull back and the SPX to actually gap down and open beneath them, then it had likely just overrun that resistance. If it continued climbing, then the retest of likely resistance was unsuccessful in establishing that resistance.
Conservative traders would have been rewarded for their patience in waiting for the results of the retest. The resistance didn't hold.
Annotated 10-Minute Chart of the SPX:
It wasn't until Thursday that the SPX was to fall finally complete all steps that indicated at least a short-term trend change: falling through those 10-minute 100/130-ema's, rising to retest them, and then falling back again, with those averages serving as resistance.
Annotated 10-Minute Chart of the SPX:
The retest of the 10-minute 100/130-ema's was more pronounced on the OEX, which I was watching at the time of the retest Thursday afternoon, because it had been the big-caps that had been leading the rally, to some extent. The OEX rose exactly to the 100-ema and fell back.
I won't have watched the action on Friday because a trip will have taken me away from my computer, but if I'd been watching, I would have paid particular attention to the action of the SPX with relationship first to the 10-minute 21-ema and then the 100/130-ema's. I'd have expected those 100/130-ema's to eventually be retested, either Friday or Monday. Bears should hope that any such retest occurs with a sideways/sideways-up movement that allows the falling 100/130-ema's to play catch-up, rather than a swift rise such as that seen on the September 19. Such a swift rise would have hinted that the bullish fervor hadn't yet been worked out of the markets.
These charts were each snapped as the action occurred. The charts that referred to the end of the day September 13 were snapped at the end of the day, for example. The chart that referred to the post-FOMC action was snapped at the end of the day of that decision. Each of the other charts was snapped at the end of the day to which they referred. I wanted you to see that I wasn't scrolling through charts, picking out something that worked, but rather starting with the action as it unfolded and following it through.
There's nothing too technical on these charts, just a simple examination of price action with regard to key moving averages, with those averages discovered through a testing of various time periods. Sometimes you don't have to be too technical. A study of these charts would have saved some from jumping into bearish trades too soon, especially with options about to expire.
If you did that, I'm certainly not chastising you for doing so. Been there and done that in the past, so who am I to chastise anyone? Many indicators suggested that it was time for a trend change. I'm merely suggesting a tool that might help you better time such trend-change plays.
Nothing is foolproof, either. Friday, when I'm gone, the SPX may shoot right
back up, with bullish fervor reestablished. Stops are always needed, no matter
what the charts say.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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