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Daily Newsletter, Thursday, 11/02/2006

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Table of Contents

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

Market Wrap

It's That Bad News Is Good News Thing Again

After a dismal ISM number yesterday and dismal productivity/hourly costs and factory orders numbers today, which are all evidence of a significant slowing in our economy, one would have thought the stock market would have taken a severe hit. Instead it's down a relatively minor amount and today it traded basically back to the flat line after its initial drop.

The bad news about the economy means good news because the Fed won't have to worry about raising interest rates and can even entertain the thought about lowering rates. Or so the thought goes. The flat productivity and increase in wage costs is clearly inflationary but, shh, don't tell the bulls that. They're busy living in fantasy land and all that alfalfa has got to be making them high.

The good news today, as I see it, is that the stock market didn't tank worse. Yes it is down more in the past week than at any time since July and one could even say we've had a trend change based on that observation alone. Call me paranoid or untrusting but I'll believe we've had a trend change once major support lines are broken. I'll review those levels in the charts below.

Trading news or fundamentals has never been my forte. Many times the stock market seems disconnected from reality, at least my version of reality. When I look under the hood of our economy I have to wonder what the heck is the market doing up here anyway? Of course that wonderment in this case turns me bearish and then I have to fight my bias even when the charts are telling me my bias is wrong. I'm probably the only one that suffers that malady (wink). Price is king and that is of course what we have to trade. But getting a sense of the bigger picture can at least give you a heads up instead of blindly following the hype you read and hear in the media.

When I go around and talk with small business people I get the impression that not a lot of them are very happy with current business conditions. Input from several readers is telling me the same thing. Here's an example that I think is telling (thanks to Joe V. who lives in the Philly area):

"I have a friend who has his own business for sixteen years. He grosses about six mil a year and has about 25 engineers working for him. He is in the material handling business. He modernizes production and warehousing for all types of businesses around the world. He travels about 5,000 miles per week and speaks to many important people. I asked him my all important quantifying question I like to ask people like him and that is, on a scale of 1-10 how would you rate the economy. His answer was a three. He has not seen it this bad in his 16 years of business. He is in a great business, because people call him to reduce costs when things are slow and call him to expand when times are good, so he is always busy."

This is a typical story that I'm hearing as well. The lack of capital improvements by companies is one of the signs of a recession. And note that the above business is not related to housing. I have a few friends in the house building business and they're starting to suffer a lot more. Realtors are starting to lose their optimistic view that things will be better in the spring (but hope springs eternal and that's what most would still like to believe). The bottom line is that most business people seem to be expressing the same concern--the numbers the administration is using do not jive with what business leaders are seeing. Cooking the books as we head into elections? Why, that would be disingenuous don't you think?

To me it's clear that the Fed is worried about both inflation and a slowing economy. Several Fed heads have made it abundantly clear in the past month's statements about concerns over inflation. They will not let inflation get out of control. Their thinking is that a slowing economy will be followed by a robust economy in 2008 and they'd better have inflation under control before that happens. Therefore they'll be willing to slow the economy, and housing, to ensure their success against inflation.

But the Fed is also clearly worried about how higher interest rates are slowing down the economy, especially housing. There are many people who believe the Fed will have to soon start lowering rates to keep the economy and housing from slowing any further. Some believe housing is bottoming now and that the improvement there will help the economy. I read an interesting piece from Paul McCulley, a widely read bond analyst and portfolio manager at PIMCO, who stated that the housing market will show just as much "inelasticity" to lower interest rates as it showed to rising rates. Even if the Fed were to start lowering rates right away, McCulley's point was that it will take a long time for investors to get their real estate appetite back. In other words, the housing bubble will not just correct back to the mean but instead over correct below the mean.

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The Fed knows this as well and that's got to have them concerned about the negative impact to our economy. The expectation that housing will be better once the Fed starts reducing interest rates in a slowing economy is something that I believe will not happen. I have a real concern that we're going to be facing stagflation which puts the Fed in the uncomfortable task of raising rates to control inflation while at the same time knowing that higher rates are going to hurt housing and the economy. And their concern about a slowing economy is probably why they're pumping money like mad into the financial system.

Starting last March the Federal Reserve stopped reporting M-3. This is a measure of total money supply especially as it applies to what the Fed is doing with it, i.e., how much they're inserting and withdrawing from the economy. One of the methods, if not preferred method, of getting money into the system is through their primary banks, the mega banks as I like to call them. These banks can then lend it out or spend it; it just needs to get out into the financial system. A working group set up between the Fed, SEC, Treasury Secretary and primary bank heads has encouraged these banks to set up their own trading teams to "spend" the Fed's out-of-thin-air money. In other words they buy securities when the Fed has money requiring insertion into the financial system.

Some bright individuals figured out how to recreate M-3 which can be viewed at http://www.nowandfutures.com/articles/20060426M3b,_repos_&_Fed_watching.html. This chart is updated every Friday evening so the latest number is as of October 27th and is shown in the following chart:

M3 Money Supply, calculated, Weekly chart, courtesy nowandfutures.com

The bold line shows the amount of money being inserted into the economy and the light blue line shows the rate of change. The important point I'd like to make with this chart is the rate of change since August 2006. It has jumped from a +8% growth rate to +10% growth. The creation of money is increasing at a parabolic rate. First of all, seeing this chart, is it any wonder why the markets have rallied to the moon since July? Just since August a rough calculation shows the insertion of about $400B by the Fed. That's some serious money. Not all of that made it into the stock market of course but throw in the money from the mega banks' trading capital, the mutual and hedge funds chasing the market, Mom and Pops getting suckered in and there should be little doubt about the buying power we've seen in the past couple of months. If and when the Fed decides to slow down this money growth it could have a negative impact on the markets.

The other point I'd like to make, or ask, is why is the Fed creating so much money? They know it's inflationary and they know it will kill the value of the US dollar. As to the inflationary concern we now know why they've been jawboning the market about their vigilance on the inflation front. For crying out loud, they're creating the problem! As for the value of the dollar it's been suggested in more than one financial circle that the Fed would like to see the dollar devalued so that we'll be able to buy back our debt to foreigners with cheaper dollars. It's called monetizing our debt. It's not nice but I must admit creative. The trouble is how long do you think the foreigners will continue to buy up our debt if they see the dollar plunging? And without their willingness to buy our profligate spending we will be in a world of hurt. If they start repatriating their money in a hurry then a world of hurt will be an understatement.

This is not good. I don't even know how to try to sugar-coat this. Our country's fiscal house is a stack of cards waiting for the first strong wind to blow it over. A depreciating dollar and appreciating gold is starting to make a lot more sense to me and as I'll show in their charts, that's starting to show up there as well. Let's just say we're headed for some interesting times. Is your fiscal house in order? Be sure that it is.

OK, that's food for thought for what the market will have to deal with soon. And perhaps that worry is starting to show up in the VIX before we see it in price. This is the chart I've shown the past 2 weeks to point out its descending wedge pattern, a bullish pattern that suggests we're going to see a relatively rapid climb back up to the highs.

VIX Daily chart

While you can't always assume a rising VIX means a dropping stock market we know there's a close enough correlation to suggest the move higher out of its bullish descending wedge portends a sell off in the stock market may not be far away. These patterns (and we have the opposite one for stocks) tend to retrace relatively quickly so this is giving us a warning.

Let's review today's more immediate economic reports.

Initial Claims
Initial unemployment claims, at 327K, came in higher than expected and 18K higher than last week's 309K. This is the highest it's been in 4 months. The 4-week average rose to 311,250 which is the highest it's been in 3 weeks. But continuing claims, a measure of the difficulty in finding a job, dropped by 27K to 2.42M. The question about this number is whether it's because people are finding jobs or they're simply dropping off after their 26 weeks expires. And if they're just dropping off is it because they can't find a job (not good) or is it because they've decided to start up their own business (hopefully good). The 4-week average of continuing claims dropped by 6K to 2.43M.

Productivity
The preliminary number showed that productivity showed to 0% in the 3rd quarter while unit labor costs rose +3.8%. Rising productivity can absorb higher unit costs so now the concern is that these rising costs will have to be passed along to its customers. Productivity for the 2nd quarter was also revised lower (I'm shocked) to 1.2% from 1.6%. Unit labor costs were revised higher (I'm doubly shocked) to 5.4%. Over the past year productivity has slowed at its fastest pace in 9 years while unit labor costs are increasing at the fastest pace in 16 years. We're facing higher costs without the increase in productivity to absorb them. This is a deadly combination for the Fed's worries about inflation and it's clearly going in the wrong direction.

The Fed pays closer attention to the non-financial sector because it's easier to measure productivity and in this sector the previous gain of +2.2% productivity in the 2nd quarter was revised down to only +0.2%. Unit labor costs in this sector were revised higher to +6.4% from +4.2%. The figures for the 3rd quarter will come out on December 5th. If we see similar numbers as reported today then it will cast some serious doubt on the expectations for double-digit growth in profits next year. And without those expectations the frothy levels in the stock market will simply be unsustainable.

Factory Orders
Thanks to a boost in transportation equipment factory orders for September rose +2.1% but this was lower than the expected +3.6%. It was higher than the -0.3% in August but strip out the spike in transportation equipment and the number was -2.4% for September, making it the 2nd month for a decline in factory orders. Nondurable goods orders fell by -4.6% in September.

This was clearly negative data and when combined with the dismal productivity/unit labor cost data one has to wonder how the market managed to close at break even today. I wonder the same thing. For a reminder go back and look at that M-3 chart.

Retail Sales
This was not an economic report so much as it was simply a report out of the retailers about how their sales were going. Not particularly well as it turns out. But that wasn't enough to stop today's buying either. The majority of retailers reported weaker than expected sales in October and said it was due to a strong September and difficult comparisons to a year ago. Discounters like Wal-Mart were particularly weak and WMT said October sales were only up +0.5% and that they expected sales to be flat in November. This is the weakest gain for them in 6 years. The closing of the housing ATM, affectionately known as home equity, is likely starting to show up in consumer spending. Expect this downward trend to continue.

The one bright spot in the retailers' reports was that spending started to tick higher into the end of October and that many expected a solid Christmas shopping season. Maybe WMT forecasted low so that they could surprise to the upside? They're not known for doing that. And if the spending for this Christmas season does not materialize then I suspect the stock market will get a big lump of coal in its stocking by year end.

While things don't so rosy in the economy the fact that the market is holding up relatively well is bullish, whether that makes sense or not. As the charts show, we are at/near some strong support and we should get some pretty good bounces off them. The question then is whether the bounce will be just that or will it lead to another run at the highs. We'll have to let price lead the way. I'll show support and I'll even discuss in a bit why I think we might make a run for the highs. With that let's go to the charts.

DOW chart, Daily

As I mention on the chart, the bearish thing I've seen happen this week is that the rising trend line along the bottoms of RSI since the June low in RSI was broken. That's usually a strong heads up warning that the trend has changed. However, it's not a guarantee nor does it preclude another run up to test the previous high. The DOW tested its 20-dma today which is the first time it's been hit since August. This is an important moving average that many fund managers watch. A break of it (currently at 11990) on a closing basis would set off some alarms. It's uptrend line from July is near 11970 so this should be a strong area of support for at least a bounce. Then we'll have to see what the bounce turns into.

SPX chart, Daily

SPX is also testing its 20-dma. It broke briefly below it today, at 1366 currently but managed a close above it (and left a bullish hammer, actually a more bullish dragonfly doji) on its daily chart. Its uptrend line from July is at 1360 and that could be tested first thing tomorrow morning if there's a negative reaction to tomorrow's economic reports. Like the DOW the negative thing I see is the breaking of the uptrend along the lows of both RSI and MACD since the May low. That's potentially a very significant break.

Techs got a little boost today from news out of Microsoft (MSFT 28.77 -0.04) and Novell (NOVL 6.79 +0.92) and their agreement to jointly work on a project that could help Novell's Linux operating system. The agreement is not finalized but Microsoft would add sales support. Computer users would have an easier time running both Novell's Suse Linux and Microsoft's Windows. While the NAZ was barely in the red today the big cap NDX was marginally in the green.

Nasdaq chart, Daily

Using the uptrend line from August and its 20-dma has a gauge I'd have to say the techs are looking a little weaker than the DOW or SPX. It too could get an early drop tomorrow morning but if it manages to hold at or above today's close then the bulls will become braver about buying uptrend support here.

SOX semiconductor index, Daily chart

The SOX looks bearish in that it rolled back over after testing its 50-sma and 200-ema. The whole thing from early September looks like a bearish rolling top. But an alternative interpretation is that this has been consolidating sideways since September and is getting ready to rally higher. I don't particularly like that interpretation and I'm leaning bearish on this one.

30-year Yield, Daily chart

I've shown this yield chart the past couple of weeks because I was watching to see if we'd get an inverse H&S at the neckline around 4.9%. That was busted big time with the hard drop this week. The hard drop in September followed by the hard rally in October followed by the hard drop this week tells me the bond market really has no clue either. It looks like its reacting emotionally to the latest rumors and guesses. Welcome to my world boys. This week's sell off drove the oscillators into oversold so we'll see what kind of bounce develops and whether the uptrend from June 2005 holds or not.

Before looking at the charts for the banks and brokers, where I show the possibility for another run back up to the highs, I wanted to show a reason why I think another run higher is possible, even in the face of all the bearish news this market has had to absorb. In fact because of all the bearish economic news, if the Fed continues to pour money into the economy like there's no tomorrow (which will be their fault), and that money continues to pour into the markets, then it's not difficult to understand why we'd rally in the face of bad news. God help us when the music stops.

The markets respond to many cycles and while they're not always effective tools with which to trade, they can be very good at providing a heads up to a potential turn. There are several cycle and Fibonacci studies that point to November as a significant turn month, and specifically mid November. A couple of examples are the bottom-to-bottom-to-top 4-year cycle from 1998 to 2002 to 2006 which called for a top in October. That one is late. The Bradley model calls for a turn this month (this one is based on the alignment of stars and planets--don't laugh, it's been highly accurate).

I've discussed the Fibonacci relationship between previous turn dates to identify turn date windows and the next one is November 13th +/- a few days. Looking at the chart of the DOW from August 1999 shows a rather interesting relationship between the high in August 1999 and subsequent highs. As a reminder, the Fibonacci sequence is 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc., where each number is derived by adding together the two previous numbers. Now take a look at this chart:

DOW chart with Fibonacci turn dates, courtesy stockcharts.com

I apologize for the quality of the chart--it's a copy of the chart from Dr. Robert McHugh's report found on stockcharts.com. He is showing the number of weeks at various market highs, each one being a Fibonacci number of weeks from the starting date of August 25, 1999. The next Fibonacci turn date is the week ending November 17th which is opex week.

So, if we have a few cycle and Fibonacci dates pointing to the middle of November I wanted to see if the charts support another run to a new high. Like the other charts already shown, and potential support very close to today's closing prices, looking at the banks and brokers I can see the possibility for another run higher (I think I just heard a collective groan from the bears).

BIX banking index, Daily chart

If the move up from the early August low is to be a 5-wave move for wave-c as I've got it labeled then we need that 5th wave up. That would mean the current pullback is a small 4th wave in the move up from August. A final run to test the previous high, or tag its Fib target at 401.38, would complete this pattern. That's not a given but that's certainly a possibility. It takes a break below its uptrend line near 376 to convince me the rally is kaput.

Securities broker index, Daily chart

The pattern for the brokers looks very similar to the banks but this time it's the move up from July that I'm looking at. If that is to be a 5-wave move to finish wave-C then the current pullback is the 4th wave and we still need another push higher. A Fib target at 240.94 could be the end of the run if it gets there, and it might coincide with another test of its broken uptrend line, and in the middle of November. Lots of pieces fit for that short term bullish scenario. After that then I'd be betting on the selling to start in earnest into the end of the year (but with a Christmas bounce).

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

I show an immediate drop coming for the housing index because of the weakness displayed recently. Even after breaking its downtrend line it hasn't been able to muster the bulls for a call to action here. It's been more or less a sideways busting of its downtrend line. It has pulled back to rest its 50-dma so if that holds then like the others above, this could get another rally leg out of that sideways consolidation the past 2 months. A push up to the top of its bear flag around 735 would also have it testing its 200-dma. I actually like that setup but any break of the bottom of its flag pattern, currently near 610, will clearly be bearish earlier rather than later. Regardless whether we get a new high first, this is a bearish pattern and I full expect to see new lows in this index.

Oil chart, December contract, 120-min chart

Last week I wasn't sure if we'd get the "one more low" but we did. And it tagged its Fib target at 57.05 to the penny (this is where the 5th wave in the move down from July equaled the 1st wave which is very common after a big 3rd wave down). The setup is there for this to now rally out of its down-channel but it needs to do it from here. If it presses lower again it may be headed for the low to mid 50's but that's not what I'm expecting to see, yet.

Oil Index chart, Daily

If oil is getting ready to get a bigger bounce started then I have to question my bearish stance on the oil stocks. I've been expecting the bounce from the September low to be a corrective 3-wave bounce, as I've got it labeled on the chart, to be followed by renewed selling. That's the way I'm still leaning but if the current small pullback leads to another press higher you can see how that will create a clean 5-wave move up from September. That would be bullish. The new high would then call for a corrective pullback and perhaps it will do that with a broader market sell off, but then this one could buck the tide and rise against the market. For now, and for the bullish scenario I'd like to see the 500dma at 597 hold this up. Then we'll see if the new high comes or not. A drop below 594 would suggest the possibility for further highs are remote. Certainly a break below its 200-dma would spoil the potential for an impulsive 5-wave move up and it be a double-break of that support level. That would be a good place for stops on bullish positions.

Transportation Index chart, TRAN, Daily

The Trannies broke a steep uptrend line from September and if that was the bottom of an ascending wedge then they should retrace back to the 4300 area relatively quickly. But if the bottom of a parallel up-channel near 4610 holds then this too could more to another new high. I seriously doubt it will be able to even reach its May or June highs before rolling back over and that would of course continue the bearish non-confirmation with the DOW's all-time high.

Here's a piece of trivia for you. The DOW has made all-time highs thanks to only 10 of its 30 stocks climbing higher than their January 2000 highs. Of those 10 only 4 are responsible for pushing the DOW to its new all-time highs in October. None, make that none, of the DOW stocks are themselves rallying to new all-time highs. Think this one's been engineered for public consumption? Yea, me too.

U.S. Dollar chart, Daily

The US dollar dropped quicker than I thought it would back to potential support just above $35. This is the bottom of an ascending triangle (flat top, rising bottoms). In its larger pattern this triangle is a continuation pattern--down in this case. It should get another bounce back up to the top of its triangle pattern before it's ready to dive to new lows. All triangle patterns have 5 waves, labeled a-b-c-d-e and each of those is a corrective 3-wave (or more complex) move. So far that's exactly what we're getting. The downside objective out of this pattern for next year is to about $78, possibly much lower.

Gold chart, December contract, Daily

Gold has broken its downtrend line from July. It faces potential resistance at either a H&S neckline (which says gold is going to go much lower) at 626 or its broken uptrend line from August 2005 closer to 630. By not making a new low before breaking its downtrend gold too has been moving in corrective 3-wave moves. This suggests to me that we're going to see the same sideways consolidation as the US dollar. And when the dollar starts its breakdown we'll probably see gold start its rally to new highs. But first a drop back down to the bottom of its pattern means gold could drop back down to the $560 area before the new rally leg starts.

Results of today's economic reports and tomorrow's reports include the following:

The nonfarm payrolls number, especially if it's below 100K could see a negative reaction (on top of the several we've had this week). Same thing with the ISM Services number. By the same token, any positive surprises could be met with an immediate relief rally. Predicting the market's reaction to news has become increasingly difficult, especially with the false buying and selling programs that hit the market and often give is a false initial move that then gets reversed hard.

Another look at our weekly SPX chart shows the weekly oscillators threatening to roll over after price cam up to the top of its parallel up-channel for price action since 2004.

SPX chart, Weekly, More Immediately Bearish

But there's no weekly sell signal yet and on a weekly basis it could easily tolerate another small rally leg to a minor new high so nothing telling from this chart yet.

One last chart I wanted to show, also a weekly chart, is of the NYSE.

NYSE chart, Weekly

The interesting thing about this chart is that it completed a "measured move" at its high last week. The rally from October 2002 had two equal legs up and these measured moves are often very good predictors of where a market turn will occur. Again, there's nothing to say we can't get a minor new high out of this as we head into the middle of November, but this chart tells me the bulls are on borrowed time, especially if we get another push higher because then I'll have short term and long term charts in agreement for calling a market top. And if it happens in the period where several cycle and Fibonacci studies say it'll happen, all the better.

For tomorrow I'm expecting a brief new low to finish off the pattern for the leg down from last week's high. This should coincide nicely with firm support just below us. We might not get the new low though so it's tough to count on. But today's sideways/up consolidation after this morning's low makes it look like another leg down is coming. It should be the last one and I would expect at least a larger bounce back up to correct this week's decline. More bullishly we'll get that rally to another high, or test last week's high.

Good luck trading tomorrow and next week. I'll see you on the Market Monitor or back here next week. I'll be filling in for Jim on Tuesdays this month as he attends to some family matters.
 


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