Index Advisor 011
2/5/2007 8:15:42 AM

Recommended Trades:

We missed our QQQQs entry, so we will be patient while we look for a set-up.

Open Positions:

Overview:

The last week saw a focus on the Fed and what they might do in relation to a strengthening economy and signs of inflation. The key sentiment change for the market was when the Fed released its policy statement on Wednesday, which indicated inflationary pressures were subsiding, while the economy was strengthening.

Even though we are in the middle of earnings season, companies seem to be reporting as expected, with a lesser number of upside surprises than has become the norm. With that as a back drop, the focus has turned to the strength of the economy and inflationary pressures. A day-by-day account of economic report releases follows:

Tuesday: The Conference Board's consumer confidence number came in essentially as expected, reported as 110.3 versus an expected 110. Last month's 109 number was revised upward to 110. Essentially, consumers are confident because there are jobs out there and they aren't hard to get.

Wednesday: GDP was reported at 3.5% annualized growth for Q4 versus an expected 3.0% figure. The Fed's most important inflation gauge, the Chain deflator, advanced only 1.5% versus an expected 1.6% and compared to last month's 1.9% rate. The employment cost index was reported at 0.8% versus an expected 1.0%. Chicago PMI showed a contraction in manufacturing activity, reported as 48.8 versus an expected 52.0. This is down from a 51.6 reported for December. Anything below 50 represents a contraction. Construction spending was reported as contracting as well, with a -0.4% growth, versus an expected flat number. December's number was revised upward from -0.2% to 0.1%. Finally, crude inventories grew just below 2.7M barrels last week.

Thursday: Before the open, personal income and spending were reported at 0.5% and 0.7% increases in December, matching expectations. Initial jobless claims unexpectedly dropped, showing the strength of the job market, which investors have been worried will contribute to inflation pressures. They were reported at 307,000 versus an expected 315,000. The ISM Index showed an unexpected contraction in manufacturing activity, which contributed to the early morning sell-off, when it was released a half hour into the trading day. It was reported at 49.3 versus an expected 52.0. Anything below 50 shows contraction. Finally auto and truck sales came in essentially as expected. They were reported as 5.3M and 7.4M versus an expected 5.4M and 7.4M respectively.

Friday: Non-farm payrolls were reported at 111K versus an expected 150K. However, December's numbers were revised up to 206K from 167K essentially making up for January's shortfall. The unemployment rate increased to 4.6% from 4.5% (0.1% higher than expected). Hourly earnings, reported at 0.2%, rose less than the expected 0.3% and the prior months number was revised downward from 0.5% to 0.4%. This reduces inflationary pressure from wages. Decembers factory orders were reported at 2.4% growth, versus an expected 1.8%, while the prior months numbers were revised upward from 0.9% to 1.2%. The Michigan consumer sentiment numbers dropped to 96.9 versus and expected 97.8. The prior month was reported at 98.0.

Oil rose $3.60 on the week closing at $59.02, its highest level since late 2006. Natural gas also rallied to close at $7.476 a 5% improvement over the close last week. Natural gas seems to have found support on an intermediate term trendling traced back to September 2006. Oil has found support on a short term trendline and has broken through resistance. The next resistance is about two dollars higher than Friday's close with local highs and the next level of resistance about five dollars higher than current price.

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

Market Climate

The market snapped out of its doldrums and moved decidedly higher to close out January in positive territory. The bulls will consider this good news, as there is a positive correlation to stock market performance for the eleven months following a strong January versus a weak one. The week finished mixed, as all major indexes reported gains, but Friday saw the Dow Jones Industrial Average give some of those gains back.

All of the major indexes showed signs of accumulation last week. We'll have to monitor accumulation versus distribution carefully as it can be an early warning of a divergence between price behavior and underlying currents in the market.

The U.S. stock market composite chart:

Resistance was clearly broken through and the market moved to new highs. Friday looked a bit weak with the market looking a little tired. RSI fell on Friday but MACD (which tends to be a lagging indicator) continued higher. Volume dropped of the final couple of days of the week, so we will have to monitor future moves for volume correlation.

The wall of worry continues to be climbed. Friday saw another doji candle reflecting indecision. This isn't surprising as we will find the markets were mixed on Friday, with the Dow dropping, while the S&P-500, the NASDAQ-100, the NASDAQ, and the Russell-2000 all posting modest gains.

We are a bit wary, as late stage moves into tops tend to see an increased move into small caps just prior to the top. We have certainly seen a lot of buying interest in small caps, but that doesn't confirm a top.

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

A look at the daily 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.

We would expect a lower open on Monday. There should be support at the $126 level. If that fails, there is further support above $125.50. We believe the most likely path is for sideways trading early in the week and we will watch for signs of a continued uptrend or a reversal.

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

The daily chart shows four days of advance. In fact, there is a specific candlestick pattern known as an advanced block pattern which indicates the uptrend is in trouble. This doesn't mean that there will necessarily be a reversal, however the odds of an immediate continued advance are low. We believe that the SPYders are likely to see some consolidation at this time.

Support may be found just below the $44.00 level. If this holds then we would expect the advance to resume again after a consolidation period.

The Fractal Indicator again showed the beginning of an upward trending move. With our expectation for a consolidation, this contrasts directly with this indicator, which has been in conflict with our other indicators for awhile.

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

Examining the daily chart, the 20-day moving average has advanced back up from the 50-day moving average, leading the way higher. Price sits just below the 20-day moving average and just bounced off of the 50-day moving average.

We are getting no help from the Fractal indicator, which is currently in "no-man's land" between trending and non-trending states.

Conclusion:

Expectations for slower earnings growth have finally come to pass. It appears that earnings will show between 10% to 11% growth for Q4. Given the previous thirteen quarters of double digit growth, and Q3s delivery way above expectations, Q4 doesn't look that strong.

A longer term perspective, however, shows continued growth, an economy looking to strengthen from what appeared to be a burst housing bubble induced recession, and inflation that seems to be somewhat under control. We believe that there is a risk the Fed may actually raise rates before they lower them, and that the chances for them to lower rates in 2007 is low. It all depends on the data but the housing market appears to be ready to move back into growth mode, albeit a slow one, with increased inventories to be worked off.

Regards and Good Trading,