Weekly Trader Alert #77
11/5/2006 11:47:33 PM

Overview

Approximately 80% of S&P-500 companies have completed their earnings reports with average year over year growth in earnings of 18%. This is really incredible growth. Let's consider once more, how companies (hence stock in public companies) are valued. It is a combination of expected earnings versus inflation and interest rates.

We have seen incredible earnings, and while some companies have been taking down guidance for next quarter and next year, the earnings have really been incredible. Many companies are flush with cash and have been increasing dividends and stock buy back plans. With a reduced number of shares out there, the value of each remaining share goes up. So, present earnings are great, and projected earnings, while perhaps slowing, still look pretty good.

Interest rates fluctuate, but the Fed Funds rate has been steady now for months.

Inflation is a constant source of concern, as the Fed could raise interest rates to combat it. The Bond market seen rising interest rates lately, until Friday's labor department report which revised the number of jobs created over the last two months by an increase of 139,000 jobs, while reporting a disappointing 92,000 jobs in the last month. The strength of an economy that could support this sort of job growth has moved back the possibility of a Fed rate hike anytime soon. In fact, the 0.4% monthly increase in the labor rate has investors concerned about inflation again, and a possible Fed rate hike!

Putting it all together, when earnings are improving, and interest rates and inflation are neutral, then stock prices should rise along with expected growth in earnings. (this excludes stock buy backs as this artificially raises the value of each share of stock). However, the key here is on expected earnings, expected interest rates, and expected inflation. A rise in inflation will trigger the Fed to raise rates, while a strong economy will do the same. Can earnings continue to rise slowly enough so the Fed doesn't feel they have to put the brakes on, while inflation drops into a range they are comfortable with? If so, what is that amount? If you know the answer, then you can predict a rise in stocks.

There is one thing that the above discussion doesn't factor in. That is liquidity. With money flowing into the U.S. equities market from the US bond market, from foreign capital, from the commodities markets, from cash, etc., this can see stock prices continue to rise, as these funds find homes. If oil, food, and metals start/continue their rise, then this can move funds back into commodities and away from stocks. If foreign central banks begin to raise interest rates, then funds may be diverted there, away from US equities.

We have droned on about the fact that investors seem to be ignoring signs that all may not be well. The Philly Fed's and the Chicago Fed's reports on manufacturing activity showed slow downs and these reports were ignored. Finally, on Wednesday, the ISM report came out at 51.2. Anything above 50 shows growth, but there isn't too much room left before activity is seen as contracting.

This follows on many months of negative housing data. Whenever we hear an economist employed by the National Association of Realtors we get ready for the best possible spin on the housing market. This time, their report was that the housing market hasn't rebounded as fast as they had predicted. From our experience reading their remarks, they are always overly optimistic, as they are paid to be optimistic. This was finally enough that the markets sold off a bit.

The question remains, if government reports are subject to large statistical errors, such that they go through significant revisions, such as Friday's labor report, why are traders so hung up on acting on them when they are released? I mean, a month ago, the report said that 51K jobs were created, but that was revised up by 97K jobs to $148K jobs. In other words, the number supplied originally was revised to nearly 300% of the original report. That is so far off as to be essentially meaningless, but these reports seem to generate trading activity. This seems somewhat ludicrous, given that traders are risking real money for seemingly unreal reported numbers.

Looking at the energy markets, since last week, oil has fallen about $1.70 to $59.14. Natural Gas rose ten percent during the week to $7.88.

Canadian Royalty Trusts were affected in a huge way on an announcement by the Canadian government that they intend to tax existing royalty trusts in four years, and new royalty trusts from this point forward. This caused a sell off, with estimates of CAN$26B (US$23B) in lost market capitalization on Wednesday alone, which was followed by additional selling on Thursday, and a recovery of sorts, on Friday. The Canadian government stated that it believed it was losing tax revenues on the order of CAN$0.5B annually. A number of prominent, non-government financial persons have raised questions of whether it makes sense to crush the markets to the tune of $20B or more in lost wealth, in order to try to get an additional $0.5B in annual taxation proceeds.

We believe the answer is obvious, and that this idea was not well thought out. But since we don't hold influence with the Canadian government, and since Canadians can impute these taxes, and therefore not pay further taxes, it really is targeted primarily at foreign investors, mainly Americans. The Canadian government has a history of targeting foreigners in their tax policies, and this should serve to discourage foreign investment in Canada, which can't be good in the long term.

Turning from Canada to the United States, next week's mid-term elections will see changes in State and local elected officials, as well as U.S. House and Senate members, who are up for re-election. The election is held next Tuesday, so votes will be tallied and most, if not all results will be available before the market opens on Wednesday.

American politics are dominated by a two-party system, with Democrats on the left (liberal) and Republicans on the right (conservative). Tradition holds that democrats are less fiscally responsible (they like to tax and spend) and that Republicans are friendly to business. Currently, the Republicans control the Executive branch (President Bush and Vice President Dick Cheney), the Senate (two members per state with the Vice President presiding over it and breaking tie votes), and the House, with the number of representatives determined by the size of a states population.

There is conjecture that the Republicans will lose control of the House, and possibly the Senate. Without trying to weigh in on who will win, or what will happen to the market if a certain party wins the following things are likely:

• Having opposite parties will likely apply more checks and balances between the Executive Branch (President Bush) and the Congress (House and Senate).
• Democrats will push healthcare benefits and will squeeze healthcare company profits.
• Democrats will try to tax U.S. Oil company profits (An example of this is former President Bill Clinton, former Vice President Al Gore, and many prominent Democrats are supporting a $4B tax on Oil pumped out of California wells to fund alternative energy research. (Since oil is a commodity, this places a burden on California oil companies, forcing resources to locate elsewhere).
• Democrats will push for U.S. troops in Iraq to be brought home. This could mean more unrest in the middle-East, if security and stability aren't sufficient when troops are withdrawn.

You can see that the election is looked at as an important one, but we wouldn't want to predict the outcome and the market direction because of it. We believe, however, that the market will react to the elections in some manner, and we should try to take advantage of that as it becomes clear.

To understand more about our view on the markets, we will have to look at the charts.

Market Climate

The market sold off modestly last week. It was inevitable that some sort of move other than straight up would eventually occur, and that is all we have seen last week. The uptrend is still intact, for the most part, but a lot of rotation among industries has been taking place. The last week has seen more embracing of risk, as traditional defensive industries no longer dominate the leaders, and it appears smaller cap stocks are being snapped up as bargains.

A chart of the composite of over 8,000 stocks traded on the U.S. Stock markets continues to be included.

The U.S. stock market composite chart:

Last week we suggested that last Friday's move could be a blow-off top. It was. With that said, the U.S. Composite is telling a different story than the major indexes, which moved lower on Friday and more so earlier in the week. Small caps, and the U.S. Composite as a whole moved up on Friday (mildly) while the major indexes moved lower.

RSI broke its trend line early in the week then RSI moved up on Friday, but is at a middling level. MACD crossed to the downside on Wednesday, confirming downside action. The 20-day MA has been tested, and held support, for two days. Price moved up four cents on Friday.

We would now either expect a lift off of the 20-day moving averages, or follow through to the downside, causing a downward shift in the Bollinger Bands and price should challenge or start walking that band.

Now, let's take a look at the charts for the major indexes.

A look at the chart for the Dow Industrials is represented by the Diamonds ETF (Amex:DIA).

Abbreviations and color key appears below:

Note the following order is Red, Yellow, Green, just like a stop light, so it might be a helpful mnemonic:
Thick Red line represents the 200-day simple Moving Average (200DMA),
The yellow line represents the 50-day simple Moving Average, (50DMA)
The green line represents the 20-day simple Moving Average, (20DMA)
The light blue line represents the 3-day Moving Average, moved forward three days in time, (3x3MA)
The thick blue line indicates the exponential 13-day Moving Average (13DMA)
Bollinger Bands are abbreviated as BB. There is an upper and a lower Bollinger Band that varies in distance from a central moving average (shown as light red/pink) based on the volatility of stock price movements.
RSI stands for Relative Strength Index. It is an oscillator, which can be used to determine how overbought or oversold a stock may be.

The trend has been up since mid-July and the DIAmonds closed toward the lower end of the range in their uptrend channel. Last week's evening star warning proved to be accurate.

Thus far, we have only seen the 20-day moving average tested. Important support levels, the lower Bollinger Band, and the lower range for the uptrend channel lie just below.

We expect a test down to around $119 and either a reversal higher, or a failure of the test and support will be broken. We will have to watch trading action to determine whether there is more upside yet in this trend.

We have included the Choppiness indicator in all index charts this week, to illustrate the trending move we saw through much of this uptrend, and that another trend is building energy to get started shortly. We would look for the indicator to start above 60 and move down to indicate the start of the next strongly trending move.

The S&P 500 ETF, known as the Spyders (AMEX:SPY) is shown in the chart below:

The SPYders also moved to the downside, following their evening star pattern. The SPYders, however, broken an intraday low, and have technically broken the uptrend pattern of higher highs and higher lows. Many technicians use closing priced to determine the price that has to be broken for such an indication. In that case, price must close below $136.41 to achieve a lower low. Friday's close at $136.54 doesn't leave a lot of room to the downside.

This week's NASDAQ 100 ETF (QQQQ) Chart is below:

The QQQQs moved down through the week and have challenged their intraday pattern of higher highs and higher lows and were successfully rebuffed by the bulls. Friday's close at $41.93 was not to far above the higher low put in on the 18th of October at $41.80. With the close on the uptrend line (coming up from below), this could act as resistance to a move higher, even as the lower low acts as support. There isn't a large price range to trade between, so the battle should heat up almost immediately between the bulls and the bears to force a move in one direction or the other.

The Choppiness indicator for the QQQQs is at a high level (around 70). When it starts to move lower, it will signal the start of a new trend, and the markets should get quite a bit more active following that.

Fundamental Trends

The top screen (31 industries) dropped from six to five retail industries with these five dropping off markedly in rank, two steel industries that are in second and seventh position, and two transportation industries (airlines and rail, the same as last week). Metal Product Distributors fell from second place to twenty-seventh place. The telephone industry leapt into fourth place. The fertilizer industry leapt into first place and the Internet Networking industry placed fifth.

What does it mean? There is rotation as the market has been selling off, on the surface, but small caps are starting to get nibbled on, and what happened to the defensive stocks? There isn't a Finance industry or Healthcare industry to be seen in the top screen. Airlines are supposed to be strong at this time of year, so they were somewhat predictable, but there has been a wholesale change where excess capacity has been eliminated and airlines are raising fares. Foreign Banks continue to be in the top ten industries, which may be a bet on a falling dollar.

One last thing to note, is that US Integrated Oil companies are in the top screen (moved up from 28th last week to 10th this week). We believe that it is time to buy a U.S. Oil company for a longer term play.

The Industry leaders (ranked 1st-5th out of 190) are:

Examining the laggards, we see Healthcare continuing but drug stores were pulled up by M&A activity. Canadian Exploration/Production companies are in last place. This is primarily due to the Canadian Governments decision to tax Canadian Royalty Trusts. These stocks will rally back and are worth picking up cheap now. International Specialty Petroleum stocks are also worth looking at now.

The Industry laggards (ranked 186th-190th out of 190) are:

Trade Recommendations

We received the awaited pull back. The small caps began moving up on Friday. NASDAQ had a ratio of advancers to decliners of nearly 3:2. In fact, the vast majority of stocks we follow moved up on Friday, after selling off through most of the week. Contrast that with the major indexes moving down, and the lack of defensive stocks in the top screen, and we believe the markets are set to spring upward.

We would like to see this confirmed on Monday and would look to enter new long trades this week. If the up move isn't confirmed, then we would look to add short positions.

Current Portfolio

Our steel related stock, FDG was pummeled on Wednesday and Thursday due to the Canadian government decision to tax royalty trusts in four years. It bounced back significantly on Friday and the reaction was an over reaction on the part of investors. It represents good value at these levels, having gained $1.35 on Friday putting in a bullish engulfing candlestick.

Our short position on SPY is looking good, having improved about 1% with the market sell-off. We will exit this trade if the market looks like it will begin a new move upward from here.

Generally, our model uses set stop prices to control risk. Index ETFs, including DIA, SPY, QQQQ, and IWM are managed somewhat differently, in that trades will be reversed to time the market, as opposed to using a set stop limit.

Unlike the majority of position trades in the fundamental trader, our ETF trades may see us exit positions prior to specific profit goals being achieved, as we are more concerned with positioning for the correct direction of the market more than with achieving a specific profit level. The reason for this is the profits come over time with a fair number of exchanges for long and short trades.

* Initial stop prices are set to cause us to exit our positions if they close below these levels. You will note they are generally kept pretty tightly the opposite side of the trades we initiate. Historic volatility would imply that intraday price action may trade outside of these values, so that condition is insufficient to cause an exit from an existing position. On significant movement beyond our stop prices, we may issue an intraday message to exit the position or to maintain the position. You may chose to implement an absolute stop below these suggested stop values, but that stop should be wide enough to take care of the daily volatility for the stock in question. You can examine the candlesticks for an idea of intraday price fluctuations.

Entry prices are adjusted to account for dividends paid. The stock price was adjusted by your broker, to reflect the dividend taken out. The non-adjusted entry price reflects the actual entry price, without the adjustment for dividend values.

LVPB Concept: The concept is a Light Volume Pull Back, where a stock's price will pull back to a support level on light volume. Obviously, heavy selling is a sign of weakness, and we would not want to buy on a heavy volume pullback. However, we will occasionally place stocks on the LVPB (Light Volume Pullback List) to indicate a "re-entry" buying opportunity, when we have already entered a position. This should be used to add to existing positions, or to enter a position if you missed the initial entry.

LVPB Portfolio Stocks:

Conclusions

We believe there may be a stealth rally underway, with the major indexes continuing to move lower, but small cap and many NASDAQ stocks moving up. There isn't yet clear industry leadership, so it would be hard to pick a trend to follow now.

With the major indexes at support, it is important that support is confirmed and a new uptrend started, or that support is broken, to safely enter short trades. Either way, we should be in for a healthy trading environment for the rest of the year. If the move into risk on Friday continues and leads the market upward, then things could really heat up.

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Regards and Good Trading,