Option Investor

Daily Newsletter, Monday, 10/27/2008

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Table of Contents

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

Market Wrap

Go Away in May

[Image 1] Go Away in May

Lately, on any given day, I get asked about three times a day when is the market is going to go back up. While I don’t exactly know when or why the markets while bounce, I am beginning to think that it doesn’t matter. What!? Huh?! By now most of you know that I am a big proponent of the contrarian methodology. At times the contrarian concept treads on that old “Murphy’s Law” which generally points that things happen to you when you least expect them to happen. In the beginning of this May the media began to report that the old market timing strategy that suggests that investors “Sell in May and go away” wasn’t going to work. They went so far as to have “experts” on the strategy. I use the term “experts” loosely. Because, as of late, the truth about how much the media and what is referred to as the talking heads have been wrong. In May, I watched the market advance upward while they kept talking about how the strategy doesn’t always work or it may (no pun intended) never work again. When the masses know that they are the herd, they don’t walk gleefully into the slaughterhouse. Finally, the media stopped discussing the strategy around the middle of the month and the sell off began. The other part of the strategy is that you are supposed to put your cash to work at the end of baseball season. Since the media hasn’t picked up on this story yet, there is a chance that the buy side will work once the World Series is over. Long story short, I think the market will go up when everyone stops asking when, why or how? A good example of this is when the $VIX spiked in July and the media wrote about how those levels hadn’t been seen for years and that they usually provide a buy signal. It took a little longer for the market to bottom because when people know that they are being watched they act different. Since everyone was waiting for other people to buy it took longer for the signal to occur. Once the media stopped reporting about the volatility, the market ran up.

Story Time

Verizon (VZ) helped the telecom sector’s performance today by reporting a 4.8% year-over-year increase in third quarter earnings per share that met both EPS and revenue expectations. The company said that strength in cellular and FiOS helped offset weakness in its traditional telecom business. Verizon reported third quarter (Sep) earnings of $0.66 per share. Revenues rose 4.1% year/year to $24.75 billion versus the $24.52 billion consensus. VZ closed up $2.56 to 27.61 on 33 million shares. VZ has a 6.6% yield and a PE of 13.53.

[Image 2]

At about 3:30 PM EST Moody's lowered General Motors’ (GM) rating to Caa2 and stated that the outlook is negative. The market didn’t sell off because GM’s credit was lowered. However, it is as if the market sold off when it was realized that Moody’s and Standard and Poor’s weren’t done manipulating prices. It is my opinion that the market would welcome the SEC and/or Congress halting the rating’s agencies from issuing any rating updates until there has been a complete overhaul of the system. These companies kept the ratings of the Mortgage Backed Securities, CMOs and CDOs at AAA for too long. Then when the truth of the quality of the underlying assets came to fruition the ratings were subsequently lowered. Then, the companies that owned the structured products as part of their portfolio were downgraded to reflect the true quality of their holdings. One would think that Eliot Spitzers efforts to tidy up the ratings and research reports from investment banking firms would have spilled over to other ratings agencies.

Foreign Markets had the US futures markets indicating a 30 point gap lower. The British FTSE closed down at 3855.5 while the German DAX closed off 47.8 at 4247.8. Finally in Europe, the French CAC closed the day at 3074.6, which was down 119.2 or -3.7%. In Asian Markets the Nikkei closed down 6.4% or 486.20 points to 7162.90. The Hang Seng fell 12.7% or 1,602.5 at 11,015.84.

In the US markets, the S&P 500 (SPX) was down 2.4% in early trade and then up over 1.9% as late as 1:45 PM before closing down over 3.2%. The NYSE closed down 4.29% on light volume of 1.8 billion shares. There were 701 advancing issues versus 2,507 decliners. Only 1 New 52 Week High was posted while 617 New 52 Week Lows were recorded. The TRIN or Arms Index closed at 1.81. In normal markets, this is a buy signal. Unfortunately, we aren’t in a normal market. The NASDAQ Composite fell 2.97% on 2.26 billion shares. There were 681 advancers and 2180 declining issues today. I am starting to believe that the low volume on the sell side is coming less from individual investors. They might be watching the TV and waiting for the bottom to occur. The huge sell offs at the close have been coming from sell on close imbalances from mutual fund redemption requests.

Economists had forecast New Home Sales of a month-over-month decline of 2.2% to 450,000. However, sales for September rose 2.7% month-over-month to a seasonally adjusted annual rate of 464,000. Sales are down 33.1% year-over-year. The median sales price of a new house is down 0.9% month-over-month and down 9.1% year-over-year. The inventory level declined 1.0 to 10.4 months, which is a good sign.

[Image 3]

Tomorrow morning should provide some insight into broader sentiment when Consumer Confidence is released at 10:00 am. The market expects a decline to 52 from 59.8. But all eyes are pealed on the Federal Reserve on Wednesday when they release their FOMC Policy Statement at 2:15 PM. The rest of the week is full of reports that would usually push the market around. But I think the catalyst is a revision of the SEC’s uptick rule along with a complete overhaul of the ratings systems.

[Image 4]

There are over 200 foreign and domestic companies reporting their earnings in the next 24 hours. I picked out some of the stocks that are more widely followed. Boyd Gaming is a small casino operator that generally underperforms the large conglomerates. BYD may provide some insight into the tendencies of the smaller bankroll gambler. DreamWorks and Martha Stewart are more entertainment stocks than consumer stocks. I am curious to see what medical supply companies like Dentsply and American Dental Partners will report. Royal Caribbean Cruises Ltd. (RCL) reports tomorrow as well. I don’t expect too much from travel dependent companies. Denny’s, a low cost restaurant, could actually bode well in a slowing economy. Look at how well McDonalds has done. Last week’s AAPL trade worked well. Almost any of the stocks above could be EPS short volatility trades. One should see if the front month options’ Implied Volatility is 10% greater than the December or January options.

The S&P 500

I showed an intraday chart of the S&P 500 earlier that showed the later part of today’s trading (Shown lower too). As mentioned before, the market was quite volatile today.

[Image 2]

The above chart is of the SPX where each bar is 2 minutes and the green moving average shows the 2 day average and the pink line shows the 1 day moving average. I like to see where the market is currently trading as compared to the 1 and 2 day average price. You can emulate this chart by creating a 2 minute chart for 2 or 3 days and inserting a 195 minute and a 390 minute simple moving average. When the 1 day is less than the 2 day moving average, the market is in a distribution phase. These moving averages tend to act as intraday support and resistance a lot.

[Image 5]

The daily chart above shows the Fibonacci retracement from the recent low of 839.80 on 10/10 to the high of 1045. The 127.2% retracement/extension is at $784.31. I believe that with so many people thinking we have already seen the bottom, the bottom is lower. The MoneyFlow Index hasn’t provided a clear signal until it actually dips below 20. The ADX is back to advancing which translates into confirming the trend. We could wake up tomorrow and the futures are surprisingly flat followed by a small steady advance. That would be different and possibly signal strength. But I don’t expect anything subdued with such a violent close.

[Image 6]

Yet again the RSI and Slow Stochastics are in oversold territory. If you have been trading for a little while, you should know that technical indicators can stay oversold far longer than you can stay solvent. I prefer to buy the re-emergence from oversold territory and cover/stop reverse at a test of resistance when the market is in a downtrend. The lower Bollinger band declined today which opens up the downside target range of the SPX. The Bollinger bands represent the last 21 days of actual volatility and therefore provides a hypothetical or implied range for the security should the level of volatility stay the same. The 8 day Exponential Moving Average continues to be the resistance level for the SPX. The 21 day EMA hasn’t been tested since late September. Once we have a close above the 8 day EMA a long can be established with a stop/reverse short on a break below the 8 day EMA and a profit target at the 21 day EMA. I don’t think that the first test of the 21 day EMA will be the end of the Bear Market. But these are my opinions from the analysis I have performed and witnessed.

The Russell 2000 (RUT)

While the SPX and Dow Jones have been weak, the small and mid cap stocks have been in a free fall. The RUT fell 22.72 points or 4.6% to 448.40. The lower chart is that of the RUT shown on a daily time frame with Bollinger bands and the standard oscillators. Today’s close was a yearly low for the small cap index. Usually recoveries are based upon the soldiers leading the march and the general (Large Caps) following. The small and mid caps are getting sold off because the lack of credit for these companies is likely greater than the large cap financial companies.

[Image 8]

The lower Bollinger band is at 425 and is slightly less than the 127.2% Fibonacci Extension line at 435. Therefore, the near support is at about 425 – 435 on a daily basis. The RSI and Slow Stochastics are both oversold. But only the Stochastics is looking like it might begin to move upward.

[Image 9]

The above chart is also of the RUT but it shows the longer term moving averages that I and a lot of others use which include the 50, 89 and 200 day SMA. At 652, the 50 day SMA is very far away from coming into play. The MoneyFlow Index is strongly advancing while the RUT continues to decline. However, ADX has continued to advance while the RUT has declined. The ADX is a trend strength indicator and identifies when directional momentum in prevalent. When the ADX is lower than 15 the security is trading in a choppy manner. At low ADX levels, a scalping strategy is best. While higher ADX levels indicate the security is more prone to longer duration directional plays.


[Image 10]

I am going to end tonight’s Market Wrap with a look at the CBOE 10 Year Yield or TNX. It rolled over last Monday and gapped down on Tuesday. By Friday, the 10 Year Yield had dipped to 3.5% and is back to 3.73%. The yield has been establishing higher lows and higher highs, which appears strange just before the Federal Reserve meets tomorrow and reports the policy on Wednesday. There is a gap in the yield at just below 3.9%. The higher the US Treasury can keep the yield the more likely foreign money will come in and buy US products. Watch the Euro or the Pound Sterling for signs of strength to find a point when the treasuries will begin to sell off. If the Fed lowers rates again, it may make the yield spread between currency pairs to shrink. Therefore, the desire for US dollars will reduce and the Euro and Pound should move higher. The FXE and FXB are the CurrencyShares ETFs for the long Euro and Pound, respectively. There are options available in one point increments on these ETFs. Assuming you are bearish on the dollar at $1.2455/Euro, you could buy the underlying and hedge with calls or sell the puts as a stock purchase alternative. Good night. Good trading.

New Plays

Retailers and Grocery

Play Editor's Note: I'm adding new bearish plays because the trend is still down but traders opening new positions now are at a severe risk for a short-covering rally. No one knows what will spark the next short-covering rally but when it occurs it will charge through everyone's stops. The next opportunity for some sort of surprise to spark a rally is probably the Wednesday decision on interest rates.

---------------------- NEW BEARISH Plays ----------------------

GameStop - GME - close: 25.21 change: -0.52 stop: 26.85

Why We Like It:
Analysts have started predicting that this year will be the worst Christmas shopping season in ten years. While it's possible that falling gasoline prices might alleviate some of the pressure for retailers the industry has also faced challenges getting credit to order inventory. We're not suggesting GME struggled to order inventory but the stock's trend is pricing in a very dire shopping season. The recent breakdown from its consolidation phase is forecasting another leg lower. Today's failed rally is an opportunity to short the stock. We'd use a stop just above today's high. Our target is the $21.00 mark.

Annotated chart:

Picked on October 27 at $25.21
Change since picked: + 0.00
Earnings Date 11/20/08 (unconfirmed)
Average Daily Volume: 3.3 million


Pantry Inc. - PTRY - close: 18.11 change: +1.11 stop: 18.65

Why We Like It:
PTRY showed some very impressive relative strength today with a 6.5% gain. If you're been taking notes then you already know that the best bet has been to sell the rallies. The stock's pattern is still bearish and we can set up a low risk entry point with a tight stop. We're suggesting shorts here with a stop loss at $18.65. Our target is 15.05. More aggressive traders may want to aim lower.

Annotated chart:

Picked on October 27 at $18.11
Change since picked: + 0.00
Earnings Date 11/20/08 (unconfirmed)
Average Daily Volume: 591 thousand


Play Updates

Shorts continue to perform but stocks are nearing potential support

---------------------- BULLISH Play Updates ----------------------

Broadcom - BRCM - close: 16.39 change: +0.75 stop: 14.49

It was another day of relative strength for BRCM. The stock out performed the market with a 4.8% gain at the closing bell and that was after paring its gains from this afternoon. If you're looking for a new entry point I would watch for a pull back into the $15.90-15.40 zone. Our target is $19.50.

Picked on October 24 at $16.10 *triggered 10/24
Change since picked: + 0.29
Earnings Date 10/21/08 (confirmed)
Average Daily Volume: 14 million


Ingersoll-Rand - IR - close: 16.01 change: -1.06 stop: 14.45

Right on cue shares of IR continued to sell-off. The stock lost another 6% and closed near last week's lows. We don't see any changes from our weekend comments. We're suggesting that readers buy IR on a dip into the $15.50-15.00 zone with a stop loss at $14.45. If triggered our first target is $19.50. Our second target is $22.50.

Picked on October xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/24/08 (confirmed)
Average Daily Volume: 4.8 million


Nucor - NUE - close: 31.64 change: -3.37 stop: 24.90

Friday's huge intraday bounce from $30.00 vanished in Monday's afternoon sell-off. The stock lost more than 9.6%. We suggested over the weekend that nimble traders could short NUE with a $28-26 target. Currently our plan is to buy NUE on a pull back into the $28.00-26.00 zone. We are going to list an alternative entry point just in case NUE rallies higher. That entry point is $38.05 and we'd use a stop loss at $35.75 if triggered at $38.05 with a $44.50 target.

Picked on October xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 01/22/09 (unconfirmed)
Average Daily Volume: 9.7 million


Wal-Mart - WMT - close: 49.67 change: -1.73 stop: 41.95

WMT continues to see its stock price deteriorate. A retest of the October lows is becoming a much larger possibility. Right now we suspect WMT will surpass those lows. The concept here is that one of these days we may get another horrendous, panicked sell-off and WMT sees a huge intraday spike lower. That's when we want to be triggered.

Entry point #1 is to buy a dip in the $45.00-44.00 zone. If triggered at $45.00 we will have two targets. Our first target is $49.50. Our second target is $54.00. (Note this is an adjustment. Our previous entry price was 44.50.)

Entry points #2 is to buy a breakout at $56.25. If triggered at $56.25 our stop will be $52.35. Our first target will be $59.95. Our second target will be $63.00.

Picked on October xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 11/13/08 (unconfirmed)
Average Daily Volume: 25 million


---------------------- BEARISH Play Updates ----------------------

Expeditors Intl. - EXPD - cls: 27.46 change: -0.73 stop: 30.15

The intraday rally attempt didn't even get close to Friday's high. The short-term trend in EXPD remains lower. Our target is $25.00-24.00. The October low was $24.05. More aggressive traders may want to aim lower. Note: We do not want to hold over the November 4th earnings report.

Picked on October 26 at $28.19
Change since picked: - 0.73
Earnings Date 11/04/08 (confirmed)
Average Daily Volume: 3.0 million


Marvel Enter. - MVL - close: 28.60 chg: -0.47 stop: 30.25

MVL continued to drift lower. The early morning bounce failed under $30.00. We would still consider new short positions here. The stock is facing an interesting test. Will the long-term bullish trend remain intact or will the bearish double top with the June and September peaks herald a major reversal? More aggressive traders may want to aim lower. We're aiming for $26.25. We do not want to hold over the November 4th earnings report.

Picked on October 26 at $29.07
Change since picked: - 0.47
Earnings Date 11/04/08 (confirmed)
Average Daily Volume: 880 thousand


PetsMart - PETM - close: 17.52 change: -1.01 stop: 20.05

The early morning spike higher in PETM failed at short-term resistance (previous support) near $19.00. PETM quickly returned to its path of least resistance, which is down as the stock posted a 5.4% loss. Our target is the $15.05. mark. We're starting the play with a stop loss at $20.05. More conservative traders may want to use a stop loss near Monday's high of $19.04 instead.

Picked on October 26 at $18.53
Change since picked: - 1.01
Earnings Date 11/19/08 (confirmed)
Average Daily Volume: thousand


Wal-Mart - WMT - close: 49.67 change: -1.73 stop: 54.15 *new*

WMT is not immune to the market weakness and shares lost 3.3% and closed under the $50.00 mark for the first time in several months. More aggressive traders may want to take some money off the table at $48.00 but keep a small position open and aim for $45.00. We are adjusting the stop loss to $54.15. Our target is $48.00.

Picked on October 19 at $53.77
Change since picked: - 4.10
Earnings Date 11/13/08 (confirmed)
Average Daily Volume: 25.5 million



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