Index Advisor 015
2/20/2007 8:35:25 AM

Recommended Trades:

Sell shares of QQQQ short at market at the open.

Open Positions:

In general, once we have entered a position, we will issue an alert to exit the position. We will note likely target areas for a trade, but we buy and sell on signals, rather than target areas. The same, generally applies to stops, as we don't use classical stops, but rather rely on the signals generated to reverse or exit our positions.

Overview:

This past week was highlighted my mostly benign economic reports, some merger news, and a lot of focus on Fed Chairman Ben Bernanke's two day meeting with members of Congress. Bernanke seems to have the magic touch, not ruffling feathers of Congress people, and being able to say things that don't spook investors. Somehow, he was able to thread the needle on suggesting that inflation is still a risk, but lessening and it doesn't mean that the Fed will raise rates.

This seems to have caused the bullish camp to once again believe that the Fed may lower rates, to compensate for the continued fall of the housing market. No one at the Fed communicated this, but it seems to be the popular theme espoused late in the week.

Let's take a look at the week in review:

Monday: There were no economic reports released.

Tuesday:

Tuesday's sole economic report reflected the trade balance. The trade deficit grew to $-61.2B in December from November's $-58.1B. The deficit peaked in August of 2006. Exports have been at record levels for five months in a row, but imports increased in December, due to higher oil prices, autos, and consumer goods. China's deficit represents 31% of the total.

There was a rumor that Dow component, Alcoa (NYSE:AA) is the target of two different $40B buyout bids from BHP Billington (NYSE:BHP) and Rio Tinto (NYSE:RTP) respectively. This helped the market to open higher and spurred further buying interest on merger prospects.

Wednesday:

Fed Chairman Ben Bernanke addressed Congress Wednesday. His comments were essentially that the economy continues to grow at a moderate pace and that inflation pressures are easing, due in large part to moderating oil prices. This was enough to send interest rates down in the bond market and sent equities soaring. Microsoft (NASDAQ:MSFT) and Intel Corp (NASDAQ:INTC) both rallied strongly and since they are the only stocks listed on all three major indexes, there was a correlation as all three major exchanges advanced.

Thursday:

There were a large number of economic reports released, including the following:

• Export prices rose 0.3% while import prices were flat
• Initial jobless claims jumped to 357K versus an expected 315K
• NY Empire State Index rose to 24.4 versus an expected 11.0
• Net Foreign Purchases increased by $15.6B versus and expected $60B
• Industrial Production fell by 0.5% versus an expected 0.0%
• Capacity Utilization fell to 81.2% versus an expected 81.7%
• The Philly Fed Index came in at 0.6 versus an expected 4.0

Friday:

PPI fell 0.6% (consensus -0.6%) in January, due to a drop in energy prices. Core PPI rate (excludes food and energy) rose 0.2%. This is as expected dropping the year over year rate to 1.8%. This supports the Fed's outlook that inflation pressures are easing. There was more bearish news from housing, as housing starts fell 14.3% to 1.41 mln (consensus 1.60 mln). This is the lowest rate in ten years. Building permits fell 2.8% to 1.57 mln (consensus 1.59 mln). Finally, Michigan Consumer Sentiment was reported at 93.3 versus an expected 96.5.

Oil fell fifty cents from its close a week ago, ending the week at $59.39. Natural gas fell more than thirty-two cents to close at $7.503. Both energy products continue to find support above their uptrend lines.

Last week we stated we believe the Fed is prepared to raise rates yet again if the markets don't react to their jawboning on inflation concerns. The market has, in fact, chosen to react to the hawkish tones of the Fed by worrying that they may raise rates soon. With Bernanke himself convincing investors that the Fed won't be too hasty to raise rates, equities have moved up.

If equities continue to rise unabated, we would expect that the Fed will actually raise rates just to get everyone's attention. However, we could be seeing a pause in that rise, or perhaps even some sort of the oft discussed pull-back. It is unlikely that the markets will make a strong move up next week, as, except for Tuesday, there is little in the way of earnings reports that could influence the market much. It is probably a bit more likely that stocks could drift sideways or downward.

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

Market Climate

The market began the week with a continuation lower following Friday's downward move. The market then began moving upward on Tuesday with the largest move occurring after Ben Bernanke's prepared remarks were read on Wednesday. Thursday continued the upward momentum, while Friday saw a stall of further upward momentum.

We have noted that price moved up in the last week, while volume moved down. The strength of this rise is suspect and we believe that price is getting ahead of itself a bit, and we would be looking for a consolidation or pull back in the market here.

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.

The DIAmonds continue to move upward. We would expect for this run to continue, but we are looking for a pull back to a likely area of support, around $126.80. The DIAmonds continue to hold in an uptrend, although the regular test just below their intermediate term trend line.

We reiterate that the DIAmonds have consistently moved up for eight months without a pullback of as much as two percent along the way. Shorting the DIAmonds for any length of time is an almost certain way to be on the wrong side of a trade.

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

The SPYders have been moving in a channel since the beginning of the year. They are currently retreating from the top of that channel. The bottom of the channel tends to correspond with the 50-day moving average, which has been tested toward twice this year in early and late January. The most recent test downward found support at the 20-day moving average and never reached the 50-day MA. The channel appears to be in a steeper incline than the 50-day MA, so in order to test to that level, the channel would have to be broken.

Examining the Fractal indicator, the strong upward move that began in January may still have something left to play out, as the indicator hasn't yet reached the area where trends tend to be completed. However, we believe that there will be a consolidation move before the final surge in the uptrend.

This week's NASDAQ 100 ETF (QQQQ) Weekly and Daily Charts are below:

The weekly QQQQs shows that QQQQs are pushing up against the horizontal resistance line drawn from the top in late-November. The Fractal indicator suggests a strong trending move may be getting ready to start.

The chart for the daily QQQQs reinforces the idea of pressing up against that resistance line with a Hirami pattern shown on Friday. As we have often discussed, a Hirami indicates a braking of the trend move. In this case, it suggests further upward moves in the short term may be difficult. Hirami's require confirmation, so we will have to watch Tuesday's trading for that.

The Fractal indicator suggests a trending move is getting underway. With a strong downward move followed by a series of upward moves, it is difficult to determine what direction the trend is in.

The most recent highs were at $45.40, while the lows have seen trading down to the $43.30 range. We would be surprised at a breakout of this range in the coming week, even though we believe the QQQQs are getting ready to start a new trending move.

Note that there has not been any net accumulation or distribution of the QQQQs since late January, even as the price has climbed. This negative divergence makes us believe the QQQQs are susceptible to a sell-off.

This week's Russell 2000 ETF (Amex:IWM) Weekly and Daily Charts are below:

The weekly chart of the IWMs shows an unbroken uptrend since the summer. There was a consolidation phase from November through mid-January. In fact, the last three weeks of upward movement looked like a new trend upward was kicking off, but the Fractal indicator shows that might have been a bull trap. The IWMs are readying for a strong trending move, but the direction can't be discerned from the weekly chart.

The chart for the daily IWMs shows upward testing above the $81.00 level six out of the last eight trading days. Resistance has held the IWMs to limited gains as the Fractal Indicator is moving in position for the IWMs to instigate a new trending move.

Conclusion:

Q3 growth was unexpectedly strong. Q4 growth appears to be coming in around 11% for the S&P-500. Q1 is only expected to show about 5% growth, so this is quite a haircut off of the Q3 and even the Q4 numbers. That slow down in growth may lead investors to take some profits in order to reduce risk. Growth is still growth, and the economy continues to grow, and inflation appears to be continuing to be reduced.

Bonds don't look particularly attractive, with their value moving inverse to interest rates. Since the Fed has made it pretty clear they do not intend to cut rates any time soon, and they have reinforced that they are more likely to raise rates, this means the value of bonds is more likely to move down in the short term.

The biggest concern for the economy is housing and the weak domestic automobile industry. If the housing slump were to spill over further into the economy, this may cause the Fed to act to reduce interest rates. In fact, this is the crux of a new bullish argument why stocks will continue to rise. You have to hand it to the bulls, as they find a slowing economy as the reason to be bullish on stocks and other investors seem to continue to believe in that scenario.

This economic growth and the run-up in stock prices has a lot of parallels to the late nineties. Of course, there is the noted difference that stock prices were trading at much higher multiples, especially the dot come flyers. We actually believe that many of the Dow stocks are trading at significant discounts to their fair value at this time, so this uptrend could actually continue for a very long time. If this run wasn't already a bit long in the tooth, we would probably see more bulls beating the drum. This may be the wall of worry that allows the market to continue climbing into next year.

Regards and Good Trading,