Index Advisor 008
1/29/2007 7:45:54 AM

Recommended Trades:

None at this time.

Open Positions:

We have the QQQQs short from a legacy Fundamental Trader recommendation. Once this trade is closed, we will report all index positions here.

We exited the SPYders trade at our entry price of $142.54 near the open on Friday.

Overview:

With earnings season in full swing (about one third of S&P-500 companies reported last week), the focus is generally on earnings reports and guidance. At this time, it appears that companies will report, on average, a bit more than 10% growth, year over year. That is about a half percent higher than expected. In recent quarters, companies have exceeded expectations by 3-5%, so from this perspective companies are underperforming, even though growth will still be double digits, for the 14th quarter in a row!

Housing, undeniably the weakest sector in the economy, is showing some signs of improvement. While clearly a drag on the overall economy, home inventories are slowly being worked off and there are signs that housing is recovering. Recall that a week ago, building permits and housing starts both came in higher than expected.

New home sales rose by 4.8% in December, registering a fall of 17.3% on the year with 1.0631 million units sold in 2006, the largest drop in 16 years. Note that to sell these homes, an average of $47K in incentives was included. Also, unit sales are reported at contract signing, so these numbers do not include contracts broken where delivery was not taken by the buyers. Existing home sales fell by the largest amount in 17 years, with 6.48 million units sold for 2006, which is down 8.4% year over year.

With rising interest rates, it appears that home buyers are retreating a bit more, with mortgage activity declining 8.4% for the week ended January 19th.

Leading economic indicators inched higher by 0.3% in December. A Fed favorite metric, this indicates a modestly expanding economy. Durable goods orders rose 3.1% in December, which was weaker than the expected 3.5% rise. For the year, durable goods orders rose 7.0% versus 2005's 8.6% gain.

With crude inventories rising modestly (by 700K barrels) and gasoline inventories also rising, you would think that price would fall. Rather, oil prices rose nearly $3.50 a barrel to $55.42 with natural gas prices rising to $7.175 per MBTU. The unseasonable warm weather has defied expectations and moderated use of fuel allowing oil to fall more than $20 from its peak close of nearly $77 in the summer of '06.

Next Tuesday and Wednesday is another Fed meeting with the dutiful policy statement issued on January 31st that is widely expected to hold rates unchanged. With the latest sentiment expecting no change in interest rates for 2007, this policy statement will be more closely watched than most. As of last week, expectations were for a likely 0.50% rate drop by June. With the economy strengthening, Fed watchers expect no change and even fear a possible rate hike, so will be watching to see if inflation hawks win out in Fed debates over policy.

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

Market Climate

The market is exhibiting signs of wandering. Whether moving higher or lower, volatility is increasing as one day's large move is reversed the next day. We saw a bull trap in the markets as a two day advance on Tuesday and Wednesday was reversed on Thursday.

The mood of investors has clearly grown wary. With investors fretting more over whether the Fed may retain current interest rates for 2007 versus enjoying better than expected earnings, the pendulum appears to have moved to the negative side. Complacency is certainly not the way to describe investor activity as put/call ratios continue at relatively high levels.

Once again, we will remind readers that while the ETFs continue to hang in there, investors are continuing to react more strongly to negative news than positive news. The NASDAQ continues to show signs of distribution. The Dow and S&P-500 only began to show distribution from Thursday. This would have to be confirmed with a continued slide in the coming week to amount to anything.

We believe it is a time to be cautious and to protect profits.

The U.S. stock market composite chart:

Resistance continues to be seen for the U.S. market overall. Friday's doji reflects indecision, but the shallow uptrend hasn't yet failed. The markets appear to be climbing a wall of worry.

Examining both RSI and MACD, both are clearly positive suggesting a continued move higher. Most of the move upward has been powered by a rise in small cap stocks. There is often a pronounced move into higher risk (small cap) issues just prior to a market top.

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

A look at the weekly 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.

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

The Hirami formation noted last week was confirmed with this week's trading action. The set-up we noted last week has also come to pass, with the short DIAmonds trade being profitable if entered at the failure to break through resistance at around $126.10 as noted a week ago. Note that Wednesday's move to close at $126.12 was the signal to monitor a failure to break through. Thursday's move up to but failure to break the $126.12 level was a signal to short the DIAmonds.

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

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

The weekly chart for the SPYders shows a confirmation to the downside following the Hirami pattern of a week ago. Three other Hirami's have been circled during the summer uptrend. None of these were confirmed and the upside continued.

The daily chart showed a break up through resistance on Wednesday on average volume. This turned out to be a bull trap with heavy volume selling on Thursday and Friday marking the first signs of more than one day of distribution for the SPYders since December. Other than the one day move up through resistance, the tweezer top resistance level indicated a week ago still holds.

We again note that the Fractal Indicator showed the beginning of an upward trending move which has been in conflict with our other indicators.

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

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

The weekly chart for the QQQQs shows follow-on downside to the week prior's bearish reversal sign. The tweezer top saw downside follow-through which could see a further acceleration downward. However, with plenty of support lying not far below, we aren't sure of the extent of any downside action. The Fractal indicator on this chart shows it is readying for a new trend to get started, but it isn't there yet.

Examining the daily chart, the 20-day moving average is coincident with the 50-day moving average. This has been the case for a week, so there has been no confirmation of a bearish cross to the downside. We did see price move decidedly below these two moving averages in the last week (twice).

Conclusion:

As stated last week, earnings season moves the market. If we continue to see companies taking down forward guidance, we believe a negative mood will persist and the market is vulnerable to a sell-off. With companies beating expectations by a modest average 0.5%, versus recent quarter 3-5% beats, we believe the market is vulnerable to a sell-off.

At this time, we believe that the market is overdue for a correction of some sort, and is more vulnerable to downside action, than it is poised for significant gains. We believe investors should take precautions to protect profits from long positions and should consider shorting the market as conditions warrant.

Regards and Good Trading,