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Daily Newsletter, Thursday, 10/27/2005

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Table of Contents

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

Market Wrap

Follow the Bouncing Ball


Today was just another reversal, and another DOW 100+ point move again, nearly 120 points in fact. Too bad these reversals don't announce themselves--there's been some serious money to be made if you were able to catch each of the swings over the past two weeks. The advance/decline issues have been swinging 3:1 sellers to buyers and then buyers to sellers and then back again. Today the advance/decline volume was nearly 6:1 in favor of the sellers and total volume was heavy. It was a bearish day. Ready for the next reversal in a bounce tomorrow? That's what I see coming. But I only see a relatively minor bounce before the selling resumes. If you don't like to read bearish updates, read no further. But I have an obligation to report what I see, not what I'd like to see. The market is bearish and we need to deal with that. Now is the time to protect capital. If you like playing the short side, it's dangerous, but now is the time.

Two weeks ago the DOW closed at 10217 (on October 13th); one week ago it closed at 10282; and today it closed at 10231. Yawn, pretty boring two weeks, eh? Hardly. In that time the DOW has swung greater than 300 points with multiple triple digit swings between that. To say we've been in a volatile period is a gross understatement. It's likely to get worse before it gets better in that regard. So fasten your seatbelts, strap those helmets on tight and hang on because this is going to be a 5-ticket ride.

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Today was relatively quiet as far as economic reports go, or at least the few reports seemed to be largely ignored by the market. Oddly enough, a negative tone was set before the market opened by activity that happened last night in the futures. For reasons yet unknown, the futures got hit pretty hard, climbed slowly back up and got sold off again, climbed back up into the open again and the got sold off hard from the open. The market never really looked back all day. In fact it's been a pretty hard sell since yesterday's high. So the negative tone had already been set this morning and when the economic reports came out it was a "so what" response.

Unemployment numbers showed initial claims fell 28K to 328K while hurricane related claims totaled 24K last week. Continuing jobless claims rose to 2.9M. The Help Wanted Index had its prior number revised up to 38 from its prior 35 and the latest release showed 39 versus 36 expected. So the employment situation is not that bad--it at least shows some small growth.

The durable goods orders numbers were also released and showed orders were down -2.1% versus -1.1% expected. That was clearly negative. Shipments were up +0.1% while goods inventories were down -0.1%. The previous orders number was revised up to +3.8% from 3.4%.

Home sales numbers were also released and September new home sales were up +2.1% to 1.22M versus 1.24M expected. August new home sales were revised down to 1.197M from previously reported 1.23M. This enabled them to report growth month to month. How convenient, as the Church Lady would say. The new home inventory is up 3.1% to a record 493K units, making for a 4.9-month supply. While the median new home price is up +1.9% year-over-year, I suspect this will start to see some downward pressure as the home builders work to reduce their inventory. Have you seen the latest ads for 0% mortgages? The next tactic will be no money down, no payments due until 2010. Then you'll be able to stock it with all the furniture that's on sale and no payments due until 2012. Nothing like free living. What a country.

Also adding a negative tone to the opening this morning was a report that General Motors (GM) had received subpoenas from the SEC regarding its pension accounting and insurance practices. This dropped GM's shares 4% in the early morning and it closed down -1.98, -6.8%. Needless to say that put the hurt on the DOW. Not helping the DOW was Eastman Kodak (EK), down -4.5% and a few others down more than -2%.

Something that should have helped the market today (if you listen to BubbleVision reporters) was the drop in energy prices. This morning the EIA reported that natural gas inventory rose 77 bcf to 3139 bcf. Analysts were expecting a rise of 66 bcf and the added inventory sent the price of natural gas down -1.7%, closing at $13.45. The price of oil was marginally higher after initially running higher this morning and then spiking back down. I've always contended that you can't trade equities off what oil is doing because they don't synch up well. But one thought is that we'll see equities and oil trade more in synch than counter-cyclically since the drop in oil could be forecasting a drop in demand and that would signify a slowing of the economy, and of course the stock market doesn't like the idea of a slowing economy.

We're still in the middle of the Q3 earnings season and over 150 companies released results ahead of the bell. The vast majority continues to exceed expectations and reflect solid growth. What's been hurting is many of the companies are lowering guidance as to what's coming down the path and it reflects lower growth. As I mentioned above, this is what traders in oil may be sniffing out and would explain the drop in crude oil prices. This morning Exxon Mobil (XOM) and Verizon (VZ) announced upbeat earnings reports and they helped their sectors in the early going. Although XOM fell $0.07 short of analysts' EPS estimates, its 75% profit growth enticed some early buying. Healthcare was supported by a rise in HMO's following Aetna's (AET) better than anticipated Q3 report. Helping financials, upside earnings reports from Countrywide Financial (CFC), which matched analysts' expectations, and an announcement of a 1B share buyback from Moody's (MCO) got some early buying going and helped the financial sector weather the selling today, down marginally relatively speaking.

So after a wild couple of weeks let's see if the charts make any sense:

DOW chart, Daily

Consolidating like it is at support (the uptrend line from October 2004) is not bullish. Each bounce over the past week has met resistance at the shorter term uptrend line from April and that makes it look like support turned resistance at that trend line. The DOW couldn't even make it back up to its 50-dma, let alone its 200-dma. The fact that the 50-dma has crossed back down below the 200-dma is also bearish. I get no bullish feelings from this chart and believe the DOW is headed below 10K sooner rather than later. And any sell off that starts from here could panic the fund managers who have been doing a lot of buying in anticipation of a 4th quarter rally.

SPX chart, Daily

SPX also looks bearish. A failure at its 200-dma, as well as its uptrend line from August 2004, makes it look like a kiss goodbye. There's a decent chance for support to provide at least a bounce at 1160-1163 but the larger downside pattern is now looking like the April low near 1136 will likely be tagged (if not lower) before the end of the year.

SPX chart, 120-min

Looking a little closer at the SPX, the 2-week consolidation has created an expanding bear flag, or an up-sloping megaphone pattern, either of which is bearish. The megaphone pattern suggests more volatility than usual. Seen a little of that lately? Tomorrow could get a bounce off the short term uptrend line and if it does, keep an eye out for resistance in the 38-62% retracement zone (1188.61-1194.49). It could set up an excellent short play opportunity.

Nasdaq chart, Daily

The COMP first struggled around its 200-dma and then failed at its 50-dma, another kiss goodbye so far. Even more bearishly, the COMP was unable to close above its 200-dma. The bounce off its last low now looks clearly corrective and is pointing to new lows. First potential support would be at its 62% retracement of the April-August rally, at 2015, and then its uptrend line from August 2004, currently near 1990.

SOX index, Daily chart

While the COMP was bouncing the SOX was languishing just above its 200-dma and how has decisively closed below it. This is likely headed down to its uptrend line from October 2002, currently near 410.

In looking at the longer term picture of the market, we try to look for signals that tell us a top or bottom might be in. For example, right now there are a lot of investors buying this October low, convinced that we're going to see a rally into the end of the year. After all, it almost always happens. There's the 'year-ending-in-5' that portends an up year this year. Also, in the past, when we've had 3rd quarters that have been positive for the S&P (like this past 3rd quarter) the 4th quarter has also ended up positive about 83% of the time since 1926. The S&P has also been positive in the 4th quarter for the past 9 out 10 years. All of these things present quite a record and if you were a fund manager you'd play those kinds of odds every day. So it's no wonder we see strong buying interest as we approach the end of October. The question of course is whether or not it's different this time. I contend that it is and the disappointment could get ugly.

One of the things we use as a contrarian indicator is investor sentiment. Whether it's put/call ratios, VIX or bullish versus bearish advisors, we try to get a sense when too many investors are leaning too far over to one side of the boat which tends to flip it. The trouble with most of these readings is that they are so widely used and analyzed to deduce investor opinion that they have lost some of their value as a contrary indicator. The sentiment now needs to become so lopsided for it to be useful. Merely high levels of bullishness or bearishness are not that useful anymore and in fact we've seen these readings stay pegged for long periods of time before we get any reversal.

With that caveat, one reading that has become extreme again is the amount of cash that mutual fund managers are holding. The mutual fund managers are a good proxy for their investing fund holders, so evaluating their cash position, especially relative to the past, is a good reflection of their bullish/bearish opinion. As of right now, the ratio of cash to total asset values of mutual funds is very low--a level not seen since March 2000. We all know what happened after March 2000. At the current time, with so many money managers nearly fully invested, do you think they will get themselves onto business shows and warn of the risks in stocks right now? Is it any wonder the masses never know a top is in? The fund managers are doing everything they can to keep the public's money. But with practically no cash left to fuel a continuing rally, we are in danger of a repeat performance to 2000.

But as I mentioned, these kinds of indicators are longer term oriented. They don't help us necessarily figure out what will happen tomorrow or next week. But they do give us a great heads up that it's not all rosy and wonderful out there. I still believe the 4th quarter of 2005 will be down and when that's generally recognized, the exit door will not be wide enough to accommodate the mass exodus. However, for now the bulls are romping (somewhat) so bears need to be cautious. One look at the banking index shows why bears can't blindly hold onto their shorts and hope for the best. Anyone who shorted this index near its low, and is still hanging on, has been feeling some pain lately.

BKX banking index, Daily chart

There was either some serious short covering going on or lots of people saw real value in the banks. I haven't seen a significant steepening of the yield curve to explain the super bullishness here so I find the rally suspect, even as strong as it is. Price tried to get above its downtrend line from July and its previously broken uptrend line from April but could not manage a close above either. If it can rally just a little further, the 200-dma at $96.59 is waiting to slap it silly. Other than that selling into its October low, the banks have had a hugfest with its 50 and 200-dma's all year and appears to be doing it again. Like a child going off to school who can't let go of its mother's leg. With the overbought stochastics, at resistance, I suspect the banks will continue their downward trek. It should have lightened its load of shorts with the recent buying spike.

I saw a news item the other day about the housing market that I found interesting. Going hand in hand with the "shoe shine boy" theory (which states when every Tom, Dick and Harry are in on a sure-thing investment, it's time to sell), as reported in Fortune magazine, "Tom Barrack, arguably the world's greatest real estate investor, is methodically selling off his U.S. real estate holdings as prices drive the market to nosebleed levels. He likens the current real estate market to a game of polo. "I feel totally safe playing polo on a field full of pros. But when amateurs are all over the field, someone can get killed. They have more guts than brains. They charge after every ball and don't know when to hold back." It's the same with U.S. real estate right now. "There's too much money chasing too few good deals, with too much debt and too few brains." The amateurs are going to get trampled, he explains, taking seasoned horsemen, who should get off the turf, down with them." This is an interesting take by someone in the know.

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

The new down-channel is still in play, and the bounces off the bottom of the channel have been anemic. Sellers (including inside sellers within the home builders) overpowered buyers and didn't even allow a test of the broken 200-dma. Watch for support though at its longer uptrend line near 775.

We've all been hearing about the housing bubble but what does that really mean? Simply defined, a bubble is a parabolic increase in the price of an asset. The correction to these parabolic ascents is usually not a pretty thing--the air doesn't get let out slowly but instead bubbles usually pop. History shows a consistent, and severe, decline in the price of real estate after every stock market crash. Today's housing bubble has been helped by our dear old Fed head and his easy money policy, all in an effort to keep our economy humming. A smaller correction earlier has now become a bigger problem that will likely fall harder than it might otherwise have. Unfortunately what he has created will be likely be viewed by history as very unkind to homeowners. The following chart, courtesy Robert Schiller's book, "Irrational Exuberance", 2nd Edition, takes us into 2005 and you can see graphically how far out of whack housing values have become.

U.S. Real Housing Price Index chart

Another analyst, John Mauldin, reported on this phenomenal growth and this particular chart and here's what he reported: "By linking five different home price series since 1890 and deflating them by the CPI, Dr. Robert Shiller created a U.S. Real Housing Price Index. Based on an index of the year 1890 = 100, home prices in 2005 totaled an unprecedented 186.2, 84% above the mean of the past 115 years. Previously, there were four multi-year extremes - 1894, 1955, 1979 and 1989, with an average of a much lower 121.4. Real prices fell in all three, five and ten year periods after those pinnacles. Three of those extended declines entangled the banks and other financial intermediaries, aggravating the overall state of affairs."

"A dip in the housing sector would have far ranging consequences since rapidly appreciating prices permitted consumers to extract equity that supplied substantial funds for consumer spending over most of this decade. Both the Federal Reserve and Freddie Mac have compiled estimates of this process, the former calling it "Gross Equity Extraction" and the latter "Total Home Equity Cashed Out." The Freddie Mac series suggests that equity "takeouts" constituted 31.5% of personal consumption expenditures during this decade. Similarly, Chairman Greenspan, one of the authors of the Fed study, said that "a fourth to a third" of these "takeouts" financed personal consumption expenditures directly, with another portion flowing indirectly into consumer spending. Indisputably, the housing market has played a major role in permitting the consumer to spend much greater sums than generated by income. Accordingly, the practice of taking equity out of the family home goes a long way toward explaining a fall in the personal saving rate to a negative 0.9% in July and August. The third quarter savings rate could be the worst since the 1930s, an outcome that was likely before hurricanes Katrina and Rita. A downturn in housing, with extensive ripple effects, could be at hand."

"The consumer must also confront bulging energy prices. In August, total consumer fuel expenditures were 9.1% of total wage and salary income, a level not seen in nineteen years. Total fuel expenditures now total $527 billion versus $298 billion in February of 2002. Relative to wage and salary income, consumer fuel expenditures have advanced 3.1% from the 6% low of 2002. This change is larger than all previous oil hikes including the Arab oil embargo of 1973-74 and the embargo of the late 1970s with the fall of the Shah of Iran and the Soviet Union invasion of Afghanistan. Prior to the Arab oil embargo, the U.S. imported about 33% of its oil, versus over 70% currently."

So, the homeowner has stretched himself to the limit in debt, homes have been financed with mortgages that will increase as interest rates climb, and he has less end-of-month money to pay his mortgage. It's no wonder there's currently a lot of worry about the future of home prices. To those who say it's different this time, or that housing is not like the stock market and therefore holds its value better, I say get your head out of the sand. A bubble is a bubble is a bubble. OK, moving on.

Oil chart, December contract, Daily

Oil is trying to bounce off the bottom of its down-channel and briefly broke back above its broken uptrend line but wasn't able to hold it. I'm expecting oil to make it down to its 200-dma, now just above $57. That should certainly be good for a bounce and I'm anxious to see the form of the bounce since I'm having my doubts at the moment that it will be able to recover much higher than back up to its broken uptrend line. I think we're going to see a slowing in the economy which will be reflected in a continuing drop in the price of oil. JMHO.

Oil Index chart, Daily

The bounce in the index off its 200-dma took price up to the top of its down-channel and got slapped back down. I wouldn't be surprised to this steep down-channel get broken and price get another leg up in its bounce and get up to its 50-dma. But like oil itself, I'm looking for this index to head lower so look to short rallies.

Transportation Index chart, TRAN, Daily

Of all the indices watch this one very carefully as a bullish statement here could mean significant things for the broader market and would have me retracting my claws and growing horns. I'm not expecting bullish things here but it's the closest one to giving a potentially bullish signal if it can break above its downtrend line from March. Otherwise I'm looking for a break down in the Trannies which may have started today. It should be ready for a short term bounce to correct the decline from yesterday but then get ready to short your favorite (least favorite?) transport stock.

U.S. Dollar chart, Daily

It will be interesting to watch the dollar over time because it will be our barometer for how the foreigners feel about Bernanke taking over as Fed head. If they lack confidence in what he can do, they'll repatriate their dollars (driving it lower and gold higher). Currently the chart looks like the U.S. dollar needs a pullback to charge up its batteries and make a run for new highs.

Gold chart, August contract, Daily

The pullback in gold may be over. It might have one more minor drop as part of its consolidation but I would expect it to hold above the last low of $462. If it were to drop back below its 50-dma just over $460 (which makes a good stop if you're long the yellow metal) I'd turn more bearish gold. If gold is ready to rally it should start heading to new highs in which case I'm going to watch it like a hawk because it's possible it will be THE high in gold that stands for a long time (as I duck the darts thrown by gold bulls).

Tomorrow's economic reports include the following:

One of tomorrow's reports is the revised reading on the Michigan Consumer Sentiment. There should be no surprises versus what has already been reported. The drop in Consumer Confidence this week confirmed the souring of consumer mood. As I had shown several weeks ago, the Consumer Sentiment number has broken its own H&S pattern that has developed over the past few years and the last time it did this was in the fall of 2000. The stock market did not do well after this. And now we have a more serious drop than even the one in 2000. As I've said many times, the stock market reacts to investor mood. Not earnings, projected growth, Bernanke, or anything else like that. When investor mood sours, the selling begins. When they feel good, they start buying. Right now the investor is in a foul mood so caution is the watch word for longs right now.

Every sector on my watch list was in the red today. Usually I can at least report someone who held up in the green. The best of the losers were the healthcare and drug indexes (defensive plays), the gold and silver index, and interestingly enough, the financials who weren't hit that hard today. The airlines, internet and hardware were also less than -1.0% losers today. The biggest market losers (sounds like the next TV show) were the networking, energy, SOX, retail (RLX), biotechs, securities broker and Transports. This group was down more than -2% today with the networking index (NWX) down more than -3%.

The big earnings announcement after the bell (and there were many) was Microsoft (MSFT). It announced Q1 profit climbed 24%, citing strong demand for it PC and server software. It reported earnings of $3.14B, or 29 cents per share which included a charge of 2 cents for its legal settlement with RealNetworks (RNKW). Their earnings a year ago were $2.53, or 23 cents per share which also included a legal charge. Revenue rose 6% to $9.74B, up from $9.19B. Expectations were for 30 cents a share on revenue of $9.78B so they disappointed expectations. MSFT had closed at $24.89 and then sold off to as low as $24.01 before settling out at $24.45. Futures are basically flat on the news so we'll see if the cash market has any reaction tomorrow morning.

The wild and volatile price action we've seen over the past week is not likely to let up. In fact it could get worse before it calms down a bit. Don't let a move go against you since soon it could be a 200-point DOW swing (or more) that we're facing. Longer term investors who prefer to be long the market or flat, now is the time you should be in capital preservation mode (and this goes for your parents' accounts). If we're going to rally into the end of the year, we'll have plenty of warning and you'll be able to participate. Right now the markets are warning of the opposite. If you don't like to play the market on the short side (put options, futures, short stock) then I suggest flat is a good position. Any surprises to the downside could be very nasty ones this fall because the downside is not what's expected. Whenever the market does something that's not expected it usually does it with gusto. A downside break below DOW 10K could open the selling flood gates. Foreigners could jump into the fray and only exacerbate the situation. Be very careful out there. Emotions are likely to run high and the volatility could spike to an extreme.
 

New Plays

Most Recent Plays

New Plays
Long Plays
Short Plays
None None

New Long Plays

None Today.

New Short Plays

None Today.

Play Updates

Updates On Latest Picks

Long Play Updates

Burlington Coat - BCF - close: 37.01 chg: -0.99 stop: 36.45

The action in the markets today and in shares of BCF does not bode well for the future. The RLX retail index produced a sharp 2.48% decline and is trading just above support near 420. Meanwhile shares of BCF lost 2.6% and closed under all its major moving averages. Short-term bulls may want to start inching toward the exit door right now. If BCF breaks down under the $37 level it's a good bet we'll be taken out at $36.45. Therefore more conservative traders may want to raise their stops or just exit early.

Picked on October 24 at $38.90
Change since picked: - 1.89
Earnings Date 10/06/05 (confirmed)
Average Daily Volume: 165 thousand

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HR Block - HRB - close: 24.03 change: -0.21 stop: 22.99

HRB did a decent job of resisting the market's weakness today. Yet if the markets continue to slide lower we would expect HRB to follow. We are not suggesting new plays at this time.

Picked on October 23 at $24.09
Change since picked: - 0.06
Earnings Date 11/17/05 (confirmed)
Average Daily Volume: 2.1 million


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Network Appl. - NTAP - close: 25.55 chg: -0.19 stop: 24.49

Wow! We are surprised the damage in NTAP wasn't worse. The NASDAQ lost 1.7% and the NWX networking index lost over 3%. We would still look for NTAP to pull back toward the $25.00-25.25 region and would not consider new bullish positions until we saw a bounce.

Picked on October 16 at $25.12
Change since picked: + 0.43
Earnings Date 11/16/05 (unconfirmed)
Average Daily Volume: 5.9 million

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Outback Stkhse - OSI - close: 36.25 chg: -0.50 stop: 34.99

OSI tried to rally this morning but the weakness across the market was too much for it. We would not suggest new plays at this time. Wait and watch for a bounce from the $36.00 level as a potential bullish entry point.

Picked on October 23 at $37.21
Change since picked: - 0.96
Earnings Date 10/20/05 (confirmed)
Average Daily Volume: 819 thousand
 

Short Play Updates

Educ. Mgmt. Corp. - EDMC - close: 29.74 chg: +0.01 stop: 31.05

Hmm... we admit that the action in shares of EDMC is unusual. Given the big drop in the market we would have expected the stock to follow suit and hit new lows. We see this as a major caution flag for the bears. If EDMC doesn't produce some downward momentum shortly we're going to bail out early!

Picked on October 26 at $29.73
Change since picked: + 0.01
Earnings Date 11/08/05 (confirmed)
Average Daily Volume: 493 thousand

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Elkcorp - ELK - close: 30.41 chg: -0.84 stop: 32.75

We have been triggered! ELK started the day off weak and continued to slip lower as the major averages sank deeper into the session. Our trigger was $30.49. More conservative traders may want to wait for a drop under the $30.00 level before initiating positions. Our target for ELK is the $27.00 level.

Picked on October 27 at $30.49
Change since picked: - 0.08
Earnings Date 10/21/05 (confirmed)
Average Daily Volume: 205 thousand

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Netflix - NFLX - close: 25.90 change: +0.92 stop: 25.01

That loud eruption of hisses and boos was the bear camp after another analyst upgraded shares of NFLX to a "buy" this morning. The upgrade fueled the 3.6% bounce from the $25 level and kept the stock firmly inside its rising channel. This remains a very speculative play and the lack of follow through lower on Wednesday's decline is not a good sign. We're going to watch NFLX for another day, maybe two. Today's trading action produced an "inside day" so we'll see what direction NFLX heads next. Our trigger to short this already highly shorted stock is at $23.74.

Picked on October xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 02/16/05 (unconfirmed)
Average Daily Volume: 1.6 million

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Sanderson Farms - SAFM - close: 32.96 chg: -1.01 stop: 36.11*new*

SAFM lost another three percent today and is nearing our target in the $32.00-31.00 range. We are not suggesting new plays. We are lowering our stop loss to $36.11.

Picked on October 23 at $35.17
Change since picked: - 2.21
Earnings Date 12/07/05 (unconfirmed)
Average Daily Volume: 257 thousand
 

Closed Long Plays

None Today.

Closed Short Plays

None Today.

Today's Newsletter Notes: Market Wrap by Keene Little and all other plays and content by the Option Investor staff.

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