Option Investor
Newsletter

Daily Newsletter, Saturday, 03/03/2007

HAVING TROUBLE PRINTING?
Printer friendly version

Table of Contents

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

Market Wrap

Oops!

Tuesday's dip was supposedly an external event caused by a drop in Chinese markets. OK, no harm, no foul. Back to business as usual on Wednesday. Oops! A -200 point drop at the open on positive economic data shocked quite a few traders but the sharp rebound was thought by many to be indicative of a climax bottom. The correction is over now that 12100 has been tested and Thursday should be the beginning of the rebound. Oops! Thursday also started ugly with an even deeper test of 12100 and another sharp rebound. Traders were now convinced the double dip was the end of the selling and were being urged by respected analysts to go shopping for stocks. Oops! Friday failed to produce a rebound and the markets closed at the lows for the day. This is not a positive scenario and the outlook for next week is questionable at best.

Dow Chart - Daily

Nasdaq Chart- Daily

Friday's economics consisted of the final Consumer Sentiment report for February. It fell from 93.3 to 91.3 but nobody was watching. Those who were watching failed to care. Volatility had captured the attention of everyone still in the market and it was rising to close at the high of the week despite Friday being a relatively calm day. The VIX closed at 18.61 and less than a point below Thursday's intraday high at 19.40. After eight months of negligible volatility it has returned with a roar and if the charts are right there are rocky times ahead.

It won't be economics that captures attention early in the week with the only really important report, Nonfarm Payrolls, not due out until Friday. After last week's heavy calendar this week will be positively boring. Wednesday's Fed Beige Book may attract attention but Bernanke has already blessed the recovery so the report will only be informational not major news. On Friday the February jobs report is expected to show a gain of +100,000 jobs, which would be a slight decline from the +111,000 added in January. I think the more important informational tidbit here is the falling consensus estimates over the last couple of months. Last fall estimates had risen to 133,000 but that number has been in decline for several months despite a constant upward revision in the actual numbers. Analysts are becoming concerned that the jobs situation is growing less positive as the months pass. The slowdown in housing and the continued layoff news at the automakers is reducing expectations. Personally I don't think Friday's number matters unless it drops below 50,000 or suddenly spikes over 150,000. Without a major surprise it is just going to be another economic report worth slightly more than 15 min of airtime.

Economic Calendar

The crisis for the week is going to continue to be subprime loans. The sector took another hit on Friday when the Federal Reserve and four other Federal agencies called on lenders to exercise caution in making subprime loans and strictly evaluate the borrowers ability to pay. They proposed stiffer guidelines that if formally adopted by the agencies and followed by lenders would result in significantly fewer subprime loan approvals. In 2005-2006 nearly 17% of mortgage volume was subprime loans or nearly half a trillion dollars. Add in Alt-A loans, those just slightly better than subprime, and that number rises to something in the 23% range. Remove that mortgage volume from the market and the housing sector is going to tank even further.

The proposed guidelines were similar to the Freddie Mac announcement earlier in the week. Basically every subprime mortgage product now comes with much stricter requirements that will prevent many subprime borrowers from qualifying. The agencies said they wanted to make sure that borrowers could repay the loans without refinancing and without flipping the property. According to once analyst I heard on Friday the delinquency rate is continuing to rise with 19% of Countrywide Financial's subprime loans are currently delinquent. This rising default rate is expected by many to eventually cause problems farther up the financial ladder. These defaulting loans are like millions of termites eating away at the financial foundation of the banking system and unless the problem is addressed very quickly those foundations could crumble.

Fears of an impending announcement by a major institution in subprime trouble have helped pushed the yields on the ten-year note to 4.5% and better than a two month low. On Friday credit default swaps tied to brokerages traded at their highest level in 19-months as fears of a default rose. Goldman Sachs default swaps are up +30% since the subprime problem began. Merrill Lynch stock is under pressure because two subprime lenders they financed over the last two years have filed for bankruptcy and they bought a subprime lender, First Franklin, for $1.3 billion. All the major brokers package and securitize subprime loans. As part of the deal they keep a portion of those loans for themselves. Reportedly Bear Stearns has loans equal to 13% of their capital, Lehman 11% and others don't disclose the numbers. These firms are not in trouble because of their exposure to subprime defaults but those defaults will impact profits at some point in the future. GM disclosed this week that it had $67 billion in subprime loans in its GMAC subsidiary. We could see hits to GM earnings when they are released sometime in the next couple weeks. 27 subprime lenders have closed their doors in the last year. Quite often when loans default the initiating lender has to buy them back from the investors. This puts severe stress on the cash flow at the initiating lender and this has forced many to close their doors.

New Century Financial (NEW), the second largest subprime lender, announced after the close on Friday they will likely breach a major lending covenant with its financial backers. This poses new questions about the potential for its survival. Their stock price fell another -10% in after hours trading to close at $13.15. NEW said minimum profit requirements to remain in compliance with its loan covenants would not be met for the two quarters ending in December. NEW said it had received waivers from six of the 11 lenders but had not been able to get the waivers from the remaining five. If the waivers are not received the lenders have a right to walk and this could force NEW to shutdown operations. The company's auditor KPMG said without the waivers their ability to continue as a going concern was doubtful.

China may have recovered from its Tuesday meltdown but the US markets failed to attract any real buyers. I could understand the dip on Wednesday and chalk it up to margin selling. Outstanding margin loans rose to a record $285 billion in January. This was higher than the prior record levels of $278.5B we saw back in March 2000 just before the crash. I could easily understand how Wednesday morning's dip was related to margin calls. That does not explain the rest of the week.

There was a major change in sentiment from buying dips to selling the rallies. The bulls tried several times to buy the dips and were successful in the very short term but sellers continued to appear as each bull run began to run out of steam. The resulting decline pushed the markets to their worst weekly performance in the last four years. The Dow ended down -535 points or -4.24% for the week. The Nasdaq lost 147 points or -5.85% with the NDX losing -6.13%. The brokers were the hardest hit with a -7.61% drop followed by the transports at -7.30%. This is only the result of one week of selling. Several of those indexes started declining several days earlier. As of Friday's close the Transports were down -8.2%, Russell -6.6% and Dow 5.4% from their highs. The S&P has been down 7 of the last 8 days. According to Merrill Lynch weakness in the financial sector accounted for 31% of the market drop with tech stocks accounting for another 19%.

Advertisement

Get 50% of your trades wrong and still make big profits in the stock market!

We'll show you exactly when to buy and sell stocks with a proven method used by professional traders to manage risk, nail short-term gains, and pile up amazing profits. Master short-term trading with our expert analysis, detailed technical charts, and precise trade setups including specific entry, stop, and target prices. Now Completely FREE for 30 Days!

CLICK HERE: http://www.hotstix.com/public/default.asp?aid=10383

Greenspan's comments about an impending recession in the US last weekend weighed heavily on the markets. So heavy that he was quoted later in the week as saying the prospect was "not likely" as he tried to smooth over the reaction to his original comment. Bernanke also tried to cool the frazzled nerves when he spoke and his positive economic comments had immediate impact with a sharp rebound. That rebound was short lived. In the case of Greenspan you can take back the words you said or try to spin their meaning but it is much harder to make investors forget the initial shock.

About the only entities that benefited from the market decline was companies with a stock buyback program in place and those buyout firms with takeover targets in their crosshairs. Thomson Financial said there were $56 billion in stock buybacks announced in February and that was the 2nd highest month on record. Those contemplating a buyout are said to be lowering target prices after this weeks decline. Thomson also said that 731 deals were announced in February for a total of $161.4 billion. It was the best February on record for M&A and the 12th best month ever. The decline in the markets should accelerate that trend.

For next week the outlook has turned negative. The failure of the market to rebound from Tuesday's China event is a major red flag. Chalk some of it up to margin selling but that is only a temporary pressure factor. The lack of bargain hunters at Friday's close suggests the bulls are in shock. After buying the dip three times last week and seeing their rebound quickly blunted they may have paused to reconsider their trading plan. In point terms Tuesday's drop was the 8th largest one-day point drop in history. However, it was only the 237th worst percentage drop. It may have been a big news item but it was not really a material move. There is an average of 8 one-day -2% drops per year. It had been about 160 trading days according to Ned Davis Research (32 weeks) since we had one of those drops. We were way overdue.

When the market does not rebound from an external event like China's 9% sell off it suggests a dramatic change in sentiment. That is also normal after a long run. Historically a market event that is not quickly dismissed tends to lead to several weeks of higher volatility and large point swings. Basically the drop is a wakeup call for millions of investors. The quick rebounds on the following days are similar to hitting the snooze alarm. Buy the dip and go back to sleep expecting the same rebound we have seen on every dip for the last 8 months. After repeating this process several times with an unsatisfactory result investors finally wake up to the realization that maybe this time is different and quit hitting the buy/snooze button.

With investors now wide awake and staring at some really ugly charts the reality of a sentiment change begins to take hold. Positions they loved for months and where sizeable profit had been accumulated are now giving back those gains on every successive drop. Investors probably added to those positions on the first drop and maybe even the second dip. Now all those positions are underwater or heading there fast and investors have to make a decision. It is no longer a question of capturing remaining profits but of rescuing shrinking capital. This is how a 4% dip becomes a 7% dip or even worse. The farther we fall the more stops get hit and a larger correction becomes a self-fulfilling event.

The charts are clearly indicating more negativity than they did when the smoke cleared on Tuesday. The Nasdaq has broken below strong support at 2400 to close at 2368 and appears to be targeting 2325 for its next support test. The Dow closed right at support at 12100 and looks very weak. We could easily test 12000 on Monday and a break there has trouble written all over it. 11250 will become the next target. The S&P-500 dipped to 1380 on Thursday and rebounded +30 points before tanking once again. Friday's close at 1387 is right on critical support. The 100-day average at 1408 has been broken and is now substantial resistance. The break of the 100-day average typically indicates a secondary correction ahead. All internals are negative and getting worse. 457 S&P stocks declined on Friday compared to only 36 with gains.

Tuesday was the all time record volume across all markets at 8.3 billion shares. Wednesday and Thursday rank 2nd and 3rd with 7.17B and 7.39B shares respectively. A 5% loss for the indexes spanning the top 3 volume days ever is never a good sign. Friday's volume was a paltry 5.66B shares but that would have qualified as heavy only a week ago. It definitely appears there has been a change in sentiment. Whether that sentiment is temporary or lingering is still undetermined. Bank America warned investors on Friday that the time was not right to put fresh money to work saying cheaper valuations were possible.

S&P-500 Chart - Daily

On Tuesday I recommended buying dips to 1385/2400/12000 but cautioned to run for the exits if those levels broke. The Nasdaq closed at 2368 on Friday as the first index to break critical support. With the S&P at 1387 the odds are good it will be the second index to crumble. I still suggest buying the dip over those levels but reversing to a short as those levels are broken. Obviously with the Nasdaq already failing I would be extremely cautious about any dip buys on the other two indexes. At this point I would probably not commit capital to the long side of the market until we see if those levels are going to hold. The key for the markets next week will be Thursday's low on the Dow and S&P. If those lows break it would indicate another leg down and that leg could be steep. Professional traders would like nothing better than a washout early next week. They would like a textbook climatic drop to clear the rest of the margin holders and weak stomachs. Note the Russell-2000 came to a dead stop at very strong support at 775. This is a critical level and a key inflection point for gauging fund manager sentiment. If this level fails then funds are fleeing the market rather than buying the dip. TrimTabs said fund withdrawals on Mon/Tue alone were $3.2 billion. If that snowball is still growing then funds will be forced to sell positions to raise cash for withdrawals.

The economic outlook may have improved slightly in the short term and that is market positive. In light of the subprime problems and the market dip the Fed may be tempted to move to a neutral position when they meet in two weeks and that would be very market friendly. There is the potential for another quarter in Goldilocks mode before the fall 2007 housing worry really begins to take hold.

Dow Transport Chart - Daily

Russell-2000 Chart - Daily

I believe this is going to be the straw that eventually breaks the markets back. Depending on what statistic you read the impact of the new mortgage rules could take 15-20% of homebuyers out of the market as of Sept-1st. With delinquency rates rising and foreclosures soaring we could see an additional 20% of homes purchased over the last three years come back onto the used market through forced sale or foreclosure. My son lives in an affluent suburb of Denver where starter home prices average about $365,000. There are 109 homes in the foreclosure process within a 2-mile radius of his house. These will all be on the existing home market soon and there are probably many more headed for that process. Multiply this by all the metropolitan areas in the country and that is a lot of homes coming to market. I believe the spring selling season will be frantic as subprime borrowers race to buy before the new guidelines shut them out from purchasing another home. Once September 1st arrives it will be a true buyers market and only for those who can pass the tougher rules. Home prices will fall sharply until supply and demand return to balance. Some estimates I heard this week suggested declines in the 15% range. Consumer sentiment will plummet and builders will face another round of cutbacks. Greenspan may have been right about the potential for a recession in late 2007. I believe it would only be a mini recession if it occurs and we should rebound in 2008. I believe this subprime cancer will continue to eat away at the economy and the market and this was the real reason for the market drop last week. China may have accelerated the process but the subprime problem has been quietly eroding the economic outlook for months. Last week the supports finally began to crumble.
 

New Plays

Most Recent Plays

New Plays
Long Plays
Short Plays
None A
  CNX
  FD

New Long Plays

None today.
 

New Short Plays

Agilent Tech. - A - close: 30.72 chg: -0.72 stop: 32.55

Company Description:
Agilent Technologies Inc. is the world's premier measurement company and a technology leader in communications, electronics, life sciences and chemical analysis. The company's 19,000 employees serve customers in more than 110 countries. (source: company press release or website)

Why We Like It:
The recent market weakness has been a strong enough catalyst for A to breakdown from a bearish head-and-shoulders pattern. The Thursday-Friday decline pushed shares under the simple 200-dma and what appears to be the neckline (support) for the H&S pattern. We're suggesting shorts right now. Traders have a choice to either watch for an oversold bounce and failed rally under $32.00 or wait for a new decline under potential support near $30.00. The H&S pattern projects a $26.50 target. We are aiming for the $28.50-27.50 range since A might have additional support near its September 2006 lows around $28.50. The P&F chart points to a $14 target. There doesn't not appear to be any significant amount of short interest in the stock.

Picked on March 04 at $30.72
Change since picked: + 0.00
Earnings Date 05/17/07 (unconfirmed)
Average Daily Volume: 2.6 million

---

Cons Energy - CNX - close: 34.98 chg: -0.73 stop: 36.86

Company Description:
CONSOL Energy Inc., a high-Btu bituminous coal and coal bed methane company, is a member of the Standard & Poor's 500 Equity Index and has annual revenues of $3.7 billion. It has 15 bituminous coal mining complexes in six states and reports proven and probable coal reserves of 4.3 billion tons. In addition, the company is a majority shareholder in one of the largest U.S. producers of coalbed methane gas, CNX Gas Corporation. (source: company press release or website)

Why We Like It:
It seems like coal stocks should be great long-term performers given the earth's rapidly depleting stores of crude oil. Yet the sector seems to be struggling thanks to high-level of inventories. That might change if the world starts building more cleaner-burning coal plants. Short-term it looks like CNX has peaked under resistance near the $38.00 level. Aggressive traders may want to consider shorts now following the Thursday and Friday failed rallies under the simple 10-dma. We want to see a breakdown under short-term support at the $34.00 level first. We are suggesting a trigger to short the stock at $33.95. More conservative traders may want to wait for a decline under the 50-dma near $33.75. If we are triggered at $33.95 our target is the $30.50-30.00 range.

Picked on March xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume: 2.4 million

---

Federated Dept. - FD - close: 44.25 chg: -0.04 stop: 45.05

Company Description:
Federated, with corporate offices in Cincinnati and New York, is one of the nation's premier retailers, with fiscal 2006 sales of $27 billion. Federated operates more than 850 department stores in 45 states, the District of Columbia, Guam and Puerto Rico under the names of Macy's and Bloomingdale's. (source: company press release or website)

Why We Like It:
We are surprised that FD did not sell-off more following its recent earnings report given its lackluster guidance. The stock has turned in a strong rally from its January 2007 lows but the momentum has come to a dead stop near its October 2006 highs. We suspect that given this market environment the next move will be down. However, nothing is guaranteed and FD has shown some relative strength the last couple of days by not selling off (much). Aggressive traders may want to consider positions now. We are suggesting a trigger to open plays at $43.43. If triggered our target is the $40.50-40.00 range.

Picked on March xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/29/07 (unconfirmed)
Average Daily Volume: 6.3 million
 

Play Updates

Updates On Latest Picks

Long Play Updates

eBay Inc. - EBAY - close: 30.83 chg: -1.10 stop: 29.49

Monday looks like it will be the day that EBAY falls into our suggested entry range to consider long positions. The stock produced a failed rally near $32.00 on Friday morning and plunged 3.4% by the closing bell. We see potential support near $30.00 and its 200-dma (currently 29.80). Our suggested entry range is the $30.50-30.00 zone. We strongly suggest that readers wait and watch for a bounce first before initiating positions. It would not take much for EBAY to plunge right past the $30 level and hit our stop loss a $29.49 but we don't want to use a wider stop loss at this time. The stock lost over 9% last week so we're expecting some sort of oversold bounce soon. If triggered we will have two targets. Our first, more conservative target, will be the $33.85-34.00 range. Our second, more aggressive target, will be the $37.00-38.00 zone.

Picked on February xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/25/07 (unconfirmed)
Average Daily Volume: 18 million

---

Level 3 Comm. - LVLT - cls: 6.29 chg: -0.04 stop: 6.46

There has not been any change from our LVLT new play description from Wednesday night. The stock's overall trend is still bullish. However, short-term the bounce is struggling and shares look poised to retest technical support at its rising 50-dma near $6.14. If the 50-dma fails then the next level of support is the $6.00 mark. Aggressive traders might want to consider buying a bounce from either level. We're still suggesting that readers wait for a new relative high over resistance near $6.75-6.80. We're suggesting a trigger to buy the stock at $6.81. If triggered our target is the $7.35-7.40 range as LVLT has long-term resistance near $7.40. More aggressive traders may want to aim higher near $8.00. The P&F chart is very bullish with a $12.75 target.

Picked on February xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/10/07 (unconfirmed)
Average Daily Volume: 37.8 million
 

Short Play Updates

Avid Tech. - AVID - close: 32.95 chg: +0.20 stop: 34.25*new*

AVID bounced again on Friday and the relative strength was something of a surprise. Friday's rebound did stall under Wednesday's close so it was just enough to "fill the gap". However, we are not suggesting new positions at this time. Please note we are adjusting the stop loss to $34.25. Our target is the $30.50-30.00 range. FYI: Readers should note that the most recent (January) data puts short interest at 12.2% of AVID's 40.9 million-share float, which is relatively high and raises the risk of a short squeeze.

Picked on February 05 at $34.65
Change since picked: - 1.70
Earnings Date 02/01/07 (confirmed)
Average Daily Volume: 677 thousand

---

Comptr.Prog.&Sys - CPSI - cls: 27.49 chg: -0.78 stop: 30.05*new*

CPSI is breaking down to new eighteen-month lows. Shares lost 2.75% on Friday and volume spike to above its daily average. The close under $28.00 looks like a new entry point for short positions. We are adjusting our stop loss to $30.05. Our target is the $25.50-25.00 range. The P&F chart's bearish target has fallen from $18 to $16. The most recent (January) data puts short interest at 10.3% of the company's 9.3 million-share float. That is a high amount of short interest and with such a small float it really increases the risk of a short squeeze so trade cautiously!

Picked on February 06 at $29.52
Change since picked: - 2.03
Earnings Date 01/27/07 (unconfirmed)
Average Daily Volume: 97 thousand
 

Closed Long Plays

Aetna - AET - close: 44.21 change: -0.64 stop: 42.95

We are choosing to cut our losses in AET. The stock produced a very clear failed rally on Friday under $46 and near its 10-dma, now overhead. Shares look poised to drop toward $43.00 near its rising 50-dma. AET might bounce from its 50-dma or it could slip lower toward more tested support at its 100-dma around $42.00. We'd rather exit now and watch for a bounce near $42 as a potential entry point.

Picked on February 18 at $45.61
Change since picked: - 1.40
Earnings Date 05/10/07 (unconfirmed)
Average Daily Volume: 2.8 million

---

Intl. Speedway - ISCA - cls: 52.77 chg: -0.38 stop: 52.64

It's time to let go of ISCA. The stock produced its third failed rally in three days under its simple 10-dma. The stock looks poised to dip toward the 100-dma near $52.36 and possibly lower. We told readers on Thursday that if ISCA didn't show some strength on Friday we were cutting it loose.

Picked on February 21 at $54.51
Change since picked: - 1.74
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume: 117 thousand

---

Ross Stores - ROST - close: 32.32 change: -0.31 stop: 31.45

Retail stocks struggled on Friday following a disappointing earnings report and guidance from Gap (GPS). Shares of ROST produced a very clear failed rally and look poised to retest support in the $31.50-31.75 zone. We're suggesting an early exit now to limit our losses. Readers can keep an eye on ROST for a rebound down the road if support holds above $31.00. We warned readers on Thursday that if ROST didn't breakout over the $33 level on Friday that we would probably drop it.

Picked on February 14 at $33.75
Change since picked: - 1.43
Earnings Date 03/13/07 (unconfirmed)
Average Daily Volume: 1.2 million
 

Closed Short Plays

Cash Amer. - CSH - close: 39.51 chg: -1.17 stop: 43.55

Target achieved. Market weakness on Friday helped influence CSH and shares produced another failed rally. The stock dropped back under the $40.00 level and toward technical support at its rising exponential 200-dma. Our target range was the $39.50-39.00 zone. We would keep an eye on CSH. A breakdown under its simple 200-dma near $38.70 or its January 2007 lows near $38.17 could be used as another bearish entry point.

Picked on February 11 at $42.51
Change since picked: - 3.00
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume: 390 thousand
 

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

DISCLAIMER

Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.

To ensure you continue to receive email from Option Investor please add "support@optioninvestor.com"

Option Investor Inc
PO Box 630350
Littleton, CO 80163

E-Mail Format Newsletter Archives