Option Investor

Daily Newsletter, Tuesday, 11/3/2009

Table of Contents

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

Market Wrap

Calm Before the Storm

by Jim Brown

Click here to email Jim Brown

The markets wandered aimlessly on Tuesday and alternated between gains and losses as we await the results of the Fed meeting on Wednesday.

Market Stats Table

The markets could not make up their mind about direction today with longs exiting ahead the Fed on worries that the event could turn negative. Shorts were also exiting on worries the Fed statement would be market positive. Basically there was a huge cloud of indecision hanging over the market with the Fed and Payroll events just ahead.

There was little on the economics calendar today to stimulate traders. The weekly chain store sales were flat at +0.1% and completely ignored. The Factory Orders for September rose +0.9% to offset the -0.8% decline in August. This was a lagging report and was also ignored despite some relative good news. The gain in September pushed orders to an annualized rate of +8.8% in Q3 compared to only 2.3% in Q2. Inventories continued to decline sharply with a -1.0% drop and the 13th consecutive monthly decline. Capacity utilization was 67.7% and hovering near the postwar low set in June. The pre-recession level was 79%. The low capacity utilization will keep inflation levels low and increase the odds that the Fed will remain on hold for several more months.

The last report for the day was the auto sales for October. Sales actually increased in October to an annual pace of 10.46 million units compared to the 9.22 million pace in September. The annual rate for August was 14.1 million due to cash for clunkers. Chrysler was the drag on the sector with a sales drop of -30% year over year but they still managed to post a 6% gain from September. Chrysler said it would implement another zero percent sales drive in November. Chrysler normally posts decent sales in Nov/Dec because SUV sales pickup as winter arrives with nasty driving conditions. The Jeep brand is one of the most popular SUV brands in the USA.

GM said sales rose +4% year over year and the first YOY gain since Jan 2008. On a monthly basis sales rose 13% from September. The month-month gains in sales were due to the horrible September sales after the cash for clunkers ended in August. September sales were so low it would have been hard not to beat those levels. GM said its four core brands accounted for 95% of its sales.

Ford said sales rose +3.1% YOY and +21% from September. This was the third monthly increase in Ford sales. Ford also said it gained market share for the 12th time in the last 13 months. The Taurus sedan and crossover SUVs were the reason. Ford said 80% of sales were coming from new 2010 models. Ford posted an earnings surprise of nearly $1 billion for Q3 and said it would be solidly profitable by 2011. Ford was the only one of the big three to avoid bankruptcy and a government bailout.

Economic reports for Wednesday include the Mortgage Applications, Challenger Employment, ISM Services, Oil & Gas Inventories and the Fed statement. Obviously the biggest one is the Fed statement at 2:15. Nobody expects a rate change but there is a real possibility there could be a bias change in the statement. The "exceptionally low -- for an extended period" statement is the cause for concern. Once that statement changes the Fed conversations will take on an entirely different context.

In the last statement the FOMC members indicated they thought the recession was over but mentioned constraints on growth of the labor market, weak income growth, lost housing wealth and tight credit. The statement also said "substantial resource slack" would limit price increases and prevent inflation. That should not have changed given the data in the factory orders today. The Fed completed the purchase of $300 billion of long-term treasuries in October. Analysts are wondering if they will add to that total with another announcement this week. The purchase of treasuries keeps mortgage rates low. The Fed still has a planned $1.25 trillion purchase of mortgage backed securities and up to $200 billion in GSE debt that has been lengthened from "before year-end" to the "end of Q1-2010." It will be very interesting to see how the Fed crafts its statement this week and what impact it will have on the market.

The big news on Tuesday and probably the biggest support for the market came from news that Warren Buffett was buying Burlington Northern (BNI) for $26 billion. The deal would value BNSF at $34 billion but Berkshire already owns a significant amount of BNSF stock. This is the biggest deal Buffett has ever done and could force him to liquidate some other assets to raise the cash. Buffett said BNSF would benefit from a recovering U.S. economy. Buffett said it was an all out bet on the economic future of the USA. Buffett will pay $100 per share in cash and stock and a premium of 31.5% over Monday's closing stock price BNSF stock spiked +$21 to close at $97. It is rare for Berkshire to do a deal for stock. The proceeds will be paid from $16 billion in cash, $8B from its own funds and the rest from debt. Berkshire also owns 1.9% of UNP and .5% of NSC. The American Funds mutual fund family owned 9.5% of BNSF so shareholders in those funds woke up to a nice surprise.

Probably even more surprising was the announcement of a 50:1 stock split on Berkshire class B stock. (BRK.B) The stock closed at $3,325 so a 50:1 split would put it around $65 per share. The class A shares still trade for more than $100,000 per share. Buffett is not a fan of stock splits but needed to do this one to make the share exchange for BNSF easier to complete for small BNI shareholders. Berkshire can't do an all stock deal for BNSF because it would drop Berkshire capital below the regulatory requirements for his insurance company. BNSF is the number one railroad by revenue ($18 billion) and the company said recently that freight volumes were increasing.

This is also is a bet on the future of coal. The main BNSF east/west route runs from Chicago to San Francisco and right through the big coal fields in Wyoming. This allows coal to flow in both directions but the critical point is that it can flow to China from San Francisco. China completes 10 coal-fired plants a month and will have an even bigger appetite for coal as the growth continues. BNSF is also a key shipper of Asian goods into the heartland of the U.S. from those western ports.

Berkshire Class B Shares Chart

Dow Transports Chart

The increase in M&A activity suggests the corporate world believes strongly that the bottom is behind us. The BNSF deal today along with Stanley Works (SWK) buying Black and Decker (BDK) on Monday is putting a floor under the market. We just don't know yet if that floor is temporary or long-term.

It was another fun day for YRC Worldwide (YRCW) shareholders. Shares in the company fell another 7% after a -64% drop on Monday. The company is trying to survive after the recession cut their cash flow to nearly zero. YRCW is the surviving company from the Yellow Freight and Roadway merger. YRCW is proposing a debt to equity swap that will essentially turn the company over to the bondholders and wipeout the existing common shares by diluting them to nearly nothing. To execute the debt exchange YRCW would have to create/issue 1.6 billion shares. This dwarfs the current shares outstanding of only 60 million. That equates to about a 27:1 dilution on a stock that is worth barely more than a buck at today's close. YRCW traded over $64 just a couple years ago.

YRCW Chart

Gold broke over $1000 again back on September 8th and then struggled for a month to hold those gains. When October began the yellow metal finally broke free of that $1000 restraint and heading higher. $1065 became the next level to retard the upward progress but that ended today. The IMF announced it had sold 200 metric tonnes of gold to India for $6.7 billion. The sale was for an average price of $1045 per ounce. No volume discounts even on a monster sale. A metric tonne is 1,000 kilograms or 2204.63 pounds.

The IMF announced some time ago that it was selling 403.3 tonnes of gold or about one-eighth of its inventory. The news kept a lid on prices because investors did not know how the IMF would liquidate the position. If it was dumped on the market it would have had a significant impact on prices. Gold analysts were very bullish on the deal saying India's purchase at basically list prices would keep that 200 tonnes off the market and push India's central bank to the 10th largest gold owner in the world. The Reserve Bank of India said the gold will be held in reserve and not disseminated and was purchased as part of their reserve management program.

The purchase was important because it signaled a willingness by central banks to beef up reserves at the current price and that suggests $1000 gold s here to stay. Many people expect China to buy the other 200 tonnes. If they don't the IMF said it will sell it on the open market and that would be disruptive to prices. China recently announced it had raised its gold reserves to 1,054 tonnes from its 2003 level of 600 tonnes.

I view this as dollar negative even though analysts are mixed on the subject. If central banks are stocking up on gold it suggests some cautious central banker are not expecting some currency challenges ahead. The announcement about India this morning knocked the dollar index back after it traded at a high of 76.81 and a four-week high.

Gold Futures Chart

Chart of Dollar Index

Merck (MRK) and Schering Plough (SGP) completed their $41 billion merger today and SGP closed for trading at the bell this afternoon. They will begin operations as the combined company on Wednesday. Remaining SGP shareholders will receive 0.5767 shares of the combined company and $10.50 per share in cash.

Schering Plough Chart

Morgan Stanley put the squeeze on tech stocks today after the company downgraded chip stocks. The Semiconductor index moved even closer to support at 285 after the analyst downgraded the sector to cautious from attractive. The analyst said a lot of the good news is already baked into the price. He warned that inventory levels were rising and revenue growth could peak in early 2010. Stocks downgraded included Intel, Altera, Xilinx, Micron and Nvidia. He said there was pent up demand for IT equipment but businesses were still not buying.

Without a positive chip sector the Nasdaq will have trouble posting gains.

Semiconductor Index Chart

Research in Motion got a bounce today with a nearly $4 gain. The bounce came after analysts discussed the extreme under valuation now associated with RIMM and a forward PE of 12. Other stocks in the segment sport PEs from 35-50. RIMM was knocked for a loss on Monday when a Citi analyst downgraded RIMM due to expected stiff competition from smart phones running Google's android operating system. Investors should remember that RIMM still sells most of its phones in the $300 price range and that it has the only business email service of all the major smart phones. RIMM has plenty of value left and I believe once this week's volatility passes it would be worth a speculative position. I would be thrilled to see the current decline continue but today's short covering suggests bears are getting scared.

RIMM Chart

Cisco (CSCO) reports earnings after the close on Wednesday and hopefully the Fed will not have stirred up the market beforehand. Cisco is expected to report earnings of 31-cents on revenue of $8.75B. Of course the guidance will be the key. With the majority of big earnings reports behind us it would really help if John Chambers would say something really positive about the economy. Since he is normally a cheerleader any cautious comments will be magnified. I suspect he will try to focus on the new alliance with EMC and WMware in the $350 billion data center infrastructure market. This was announced on Tuesday. They also squelched rumors that Cisco might be readying an acquisition of EMC. The stock of both companies was flat on the day.

I thought today's market action was clearly indecision ahead of the FOMC announcement and Payrolls. The Dow closed down, the Nasdaq up and the S&P nearly flat. The star of the day was the Russell-2000, which posted a +1.5% gain. Obviously I am thrilled that the Russell is finding buyers. This means cash is rotating out of the blue chips where the money was safely stored for the October fiscal year end for funds. The money is leaving big caps, hence the Dow was down and the S&P flat. The Russell posted the largest gain of any index with the exception of transports and that was due to the Burlington acquisition not independent buying.

I view this buying in the Russell as a sign that we have reached a bottom in this correction. Fund managers would not be buying small caps if they feared the rest of Q4. This is a bullish sign. Now all we have to do is get past the FOMC announcement and Friday's payroll report. I wrote on Sunday that the Russell could test 550 and we needed to pray that if tested that support would hold. The intraday low on Monday was 553 and the Russell closed today at 570. At this point I would almost like to see some post FOMC volatility to give us another chance at buying the 555 level for a potential Q4 rally. Resistance is still well above at 625.

Russell Chart

The Dow was almost evenly split between winner and lowers with only two stocks losing more than 60 cents. (KO, HPQ) As I described above this was more of a cash rotation day than any material impact from an individual Dow stock. The Dow declined to initial support at the 50-day average on Friday and remains very close at today's close. This average produced a decent rebound back in early October but the coming earnings cycle was the main driver. That no longer exists as a motive force today. Support appears to be 9700-9750 with resistance at 9850.

Dow Chart

The S&P respected support at 1035 but has failed to produce any respectable gains. This is probably due to the cash rotating out of big caps and into the Russell.

S&P-500 Chart

The Nasdaq managed to post a minor gain despite the semiconductor downgrade. The RIMM gain helped! Tech stocks appear to be mixed with some sectors weak while others are stubbornly positive. Support at 2040 appears to have held and resistance is now in the 2100 range. The Nasdaq stocks are going to be motivated by positive comments in the Fed statement about the economy and by the Cisco earnings on Wednesday night. I would be surprised if the Nasdaq rallied much ahead of the Cisco news but it is possible. If initial support fails we still have that broad range of congestive support just below.

Nasdaq Chart

I am bullish tonight. Of course I want to get past the FOMC statement and the Payroll report on Friday before making a full commitment but I think the action in the Russell is positive confirmation that fund managers are not afraid of the market. The average 5% correction over the last week, -10% on the Russell, was a buying opportunity as long as the Fed does not do something stupid. Jobs are a toss up but as long as they did not implode I think almost everyone understand that 10% unemployment is a given and jobs may not improve until mid 2010. At least I hope everyone understand this. We saw an improvement in the manufacturing ISM on Monday and automakers actually sold come cars. I would view any material post FOMC dip as a buying opportunity.

Jim Brown

New Plays

Copper Near One-Year Highs

by James Brown

Click here to email James Brown

Editor's Note:

The market's recovery off today's intraday low is bullish but I think it's only short-term bullish. Stocks look poised for an oversold bounce but I don't think the rebound goes very far. Thus I'm reluctant to add new positions either bullish or bearish. I am adding one new play but if you do choose to jump in use small positions to limit risk.

Wednesday could see a lot of volatility. The ADP employment report will be a precursor to Friday's jobs report. Plus the FOMC will conclude their two-day meeting. Their announcement on interest rates and their comments on the economy should be released around 2:15 p.m.


Southern Copper Corp. - PCU - close: 32.71 change: +0.71 stop: 30.95

Why We Like It:
Copper miner PCU has found support near $31.50 for several days in a row. Today's bounce from its 50-dma also produced a bullish engulfing candlestick pattern. This reversal needs to see confirmation. I'm suggesting a trigger to buy PCU at $33.80. If triggered our target would be a new 52-week high at $39.50.

Commodity-related stocks are bound to be volatile with the dollar moving so much. I'm suggesting small positions (25% to 50% your normal size).

Annotated chart:

Entry on  November xx at $xx.xx <-- TRIGGER @ 33.80
Change since picked:     + 0.00   			
Earnings Date          10/22/09 (confirmed)    
Average Daily Volume:       3.5 million 
Listed on  November 03, 2009    

In Play Updates and Reviews

Intraday Recovery

by James Brown

Click here to email James Brown

BULLISH Play Updates

Reynolds American - RAI - close: 48.17 chg: -0.21 stop: 47.40

The market looks poised for a little oversold bounce. If the RAI doesn't show some strength tomorrow I'll probably close it early. I'm not suggesting new positions at this time. There is resistance at $50.00 but I'm keeping the target at $53.50.

Entry on   October 29 at $48.63 (small positions)
Change since picked:     - 0.46   			
Earnings Date          10/22/09 (confirmed)    
Average Daily Volume:       1.5 million 
Listed on   October 29, 2009    

UltraShort Russell - TWM - close: 31.23 change: -0.97 stop: 28.49

The market is starting to see an oversold bounce. I would expect the bounce to continue. That means the TWM should correct a little. We could expect a dip back toward $30-29 before things reverse again. More conservative traders may want to exit early.

TWM has already hit our first target. We're currently aiming for $34.00. I am not suggesting new positions at this time but the TWM might be an ETF we trade in an out of over the next few weeks.

Entry on   October 24 at $28.41 
Change since picked:     + 2.83
                            /1st target hit @ 31.90 (+12.2%)
Earnings Date          00/00/00 
Average Daily Volume:       4.2 million 
Listed on   October 24, 2009    

BEARISH Play Updates

Emerging Market iShares - EEM - close: 38.19 change: +0.06 stop: 40.25

The bounce in the EEM was pretty small today. Shares are still holding on to support near the $37.50 zone. I would expect a small oversold bounce so look for a rise toward $40.00. Readers can launch new positions on the rebound or wait for it to roll over first. Our plan called for very small positions (25% of normal size).

Our first target to take profits is at $33.55. Our second target is $31.00.

Entry on   October 31 at $38.13 /gap open entry
                   /originally listed at $37.57 (1/4 position size)
Change since picked:     + 0.06   			
Earnings Date          --/--/-- 
Average Daily Volume:        77 million 
Listed on   October 31, 2009    

Navistar Intl. - NAV - close: 34.92 change: +1.43 stop: 38.05

NAV is also seeing an oversold bounce. Shares rallied 4.2% but the trend is still down. Look for resistance near $36.00 and near $38.00. More conservative traders may want to use a stop closer to $36.00 instead. Our first target is $30.50. Our second target is $27.75.

FYI: We initiated this play with half a position.

Entry on   October 24 at $35.41 (buy half a position)
Change since picked:     - 0.49   			
Earnings Date          12/30/09 (unconfirmed)    
Average Daily Volume:       1.5 million 
Listed on   October 24, 2009    

Ross Stores - ROST - close: 45.25 change: +0.46 stop: 46.55

ROST continues to bounce even though the RLX retail index closed in negative territory. The stock is near round-number resistance at $45.00 and today's close above that level is short-term bullish. I would watch the 50-dma near $46.50 as overhead resistance. Look for a failed rally before launching new positions. Our target to exit is $40.25. We will plan to close this play ahead of the earnings report.

Entry on   October 31 at $44.29 /gap open entry
                           /originally listed at $44.01
Change since picked:     + 0.96   			
Earnings Date          11/19/09 (confirmed)    
Average Daily Volume:       2.1 million 
Listed on   October 31, 2009    

Seagate Technology - STX - close: 14.34 change: +0.18 stop: 15.55

The oversold bounce in STX continues. I'm suggesting readers focus on the $15.00 level, which should be resistance. A failed rally there would be a new entry point for bearish positions. The plan was to use small positions (50%) to limit risk. Our first target is $12.05. Our second target is $10.50.

Entry on   October 31 at $13.95 (small positions 1/2)
Change since picked:     + 0.39   			
Earnings Date          10/21/09 (confirmed)    
Average Daily Volume:        13 million 
Listed on   October 31, 2009    

Toro Co. - TTC - close: 39.19 change: +2.18 stop: 38.25

Wow! TTC really out performed the market with a 5.8% gain. The sharp rally looks like short covering. I didn't see any specific news to account for the rally but it could be a reaction to the Black & Decker and Stanley Works merger that was announced last night. I warned readers that TTC looked ready to bounce. That's why I suggested a trigger to open positions.

Thus we're still on the sidelines. Our trigger to open bearish positions is at $35.75. However, if TTC closes over $40.00 it would be a bullish development and we might want to switch directions. If triggered at $35.75 our target is $30.50. I am suggesting small positions to limit risk.

Entry on  November xx at $xx.xx <-- TRIGGER @ 35.75
Change since picked:     + 0.00   			
Earnings Date          12/08/09 (unconfirmed)    
Average Daily Volume:       293 thousand
Listed on  November 31, 2009    

Western Digital Corp. - WDC - close: 34.34 change: +0.22 stop: 35.65

WDC, much like STX, is slowly trying to bounce. The stock should have resistance near $35.00 and its 50-dma (at 35.54).

I suggested traders start positions about 1/4 (25%) of their normal trade size. I would actually add to positions (another 1/4 position) at these levels. Our initial target is the $30.50 mark. Our second target is $27.75.

Entry on   October 28 at $33.58 
Change since picked:     + 0.76   			
Earnings Date          10/22/09 (confirmed)    
Average Daily Volume:       4.2 million 
Listed on   October 28, 2009    

Financial SPDRs - XLF - close: 14.20 change: +0.04 stop: 15.51

Financials were initially weak. A worse than expected earnings report from UBS and news of an additional $40 billion plus bailout for the Royal Bank of Scotland cast a bearish shadow across the sector. Yet banks managed to recover and close in positive territory. The group is a little oversold and due for a bounce. Watch for resistance near $15.00. Our target is $13.10.

Entry on   October 26 at $14.71 (small positions) 
Change since picked:     - 0.51   			
Earnings Date          --/--/-- 
Average Daily Volume:       102 million 
Listed on   October 26, 2009    


Netlogic Micro. - NETL - close: 38.41 change: +0.09 stop: 40.25

Morgan Stanley downgraded the semiconductor sector this morning. Yet NETL managed to rally in spite of the news. Today was our last day to hold this stock. The plan was to exit at the closing bell to avoid earnings. The company beat expectations and shares are trading near $40 after hours.


Entry on   October 27 at $39.53 
Change since picked:     - 1.12 <-- early exit @ 38.41 (-2.8%)
Earnings Date          11/03/09 (confirmed)    <-- amc -->
Average Daily Volume:       392 thousand
Listed on   October 27, 2009    

Steel Dynamics - STLD - close: 13.82 change: +0.34 stop: 15.26

STLD managed a strong oversold bounce today. The move produced a bullish engulfing candlestick pattern. I'm suggesting an early exit now. However, I'd keep STLD on your watch list. A failed rally in the $15-16 zone might be a new bearish entry point.


Entry on   October 24 at $15.03 
Change since picked:     - 1.21 <-- early exit @ 13.82 (-8.0%)
Earnings Date          10/19/09 (confirmed)    
Average Daily Volume:       8.0 million 
Listed on   October 24, 2009