Index Advisor 018
3/5/2007 8:18:05 AM

Recommended Trades:

There are no trade recommendations at this time.

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 method applies to stops, as we don't use classical stops, but rather rely on the signals generated to reverse or exit our positions.

Overview:

The rise of volatility was clearly the theme of the last week, or perhaps it can be simplified as fear. Volatility has to do with price action and its behavior relative to a current norm. Implied volatility is determined by the premium charged to put buyers. Sometimes the two are used interchangeably, but they are clearly different terms, and have different meanings. With that said, both rose in the last week.

The VIX and VXN moved markedly higher in the last week, closing at levels not seen since the bottom in mid-July '06. One thing to note about the implied volatility that the VIX and VXN represent, is that bottoms are marked by reversals from high readings, not by absolute high readings. We will have to monitor these as indictors that a bottom has been reached.

A week ago, trading ended the week on a down Friday in the markets, which generally indicates a down Monday, which was indeed how the week started. However, Tuesday's gap lower was extreme, as was volume and follow-through to the downside as a sell-off began. What caused this to happen?

Well before the open, the Shanghai market closed down 8.8%, the largest one day decline in ten years. This infected all other equity markets as all that we track closed down. It was a record day by a number of measures, but as a percentage move, wasn't as extreme as seen in the past. The Shanghai market was up 150% in the last year and a half, so a correction is relatively small, especially given that the market was up some 13% over the previous six trading days.

It is worth shining a spotlight on the nascent market in China. The Shanghai market is only about 15 years old. It is a market of speculators, rather than the more sophisticated market you see in U.S. exchanges. There are stories of middle-class people mortgaging their homes to trade the markets. Essentially, trading in the Shanghai market is more akin to gambling. Only about 1% of stocks traded on the Shanghai exchange are held by foreigners. So how could one market, 99% held by Chinese traders affect so many others?

The Asian economies, like the world economy, are intertwined, so worries of an Asian Contagion are being discussed. This stems from the last meltdown in Asia in the 90s, due to monetary policies in the 90s. These aren't a factor now, but there is general nervousness anyway.

So what was the real factor in the sell-off in all markets on Tuesday? We would attribute it to complacency on the part of investors coming to roost. A correction has been long overdue, so the markets were psychologically ready to act on a catalyst. What was that catalyst?

Certainly the sell-off in China and the other Asian markets was part of it, but what really caused that to occur? Former Fed Chairman, Alan Greenspan, happened to be addressing a conference in China at the time and suggested the U.S. could enter a recession by the end of 2007. This may have been taken out of context, but you may recall Greenspan's "Irrational Exuberance" speech which started to market collapse in 2000. The Maestro, as Greenspan is sometimes known, may have spoken candidly, but he is still a figure of great import in the financial world, and could very well have been the catalyst to cause the sell-off in China and other markets as well. This builds on the fact that the US consumer has driven a large part of China's export trade, that is a mainstay of its economic growth.

After Tuesday's sell off, Fed Chairman Ben Bernanke addressed Congress on Wednesday to calm the markets as he suggested that nothing had changed fundamentally in the economy since he addressed Congress the last time. He suggested that the sub prime lenders problems wouldn't spread to the broader market. The market moved up noticeably while Bernanke was answering questions on the stock market and he is being credited with helping to calm concerns.

Before we go deeper into what the rest of the week held, lets review economic reports released during the week.

Monday: There were no economic reports released on Monday.

Tuesday: An hour before the open, durable goods orders were reported at a -7.8% annual rate for January, with a -3.1% with transportation excluded. Expectations were for a -3.0% headline number and a +0.2% ex-transportation. Probably the most important is that business spending is down 6%, which is quite bearish. Housing starts were above expectations at an annualized 6.4M versus and expected 6.24M. Finally, Michigan Consumer sentiment was reported at 112.5 versus an expected 109, which in itself is quite bullish.

Wednesday: Wednesday's economic reports were disappointing. GDP was revised down to 2.2% annual growth, down from the preliminary number of 3.5% a month ago. The February Chicago PMI was reported at 47.9%, its lowest level since April 2003, and an indication of a contracting manufacturing sector. New home sales for January fell an astounding 16.6%, its largest drop in thirteen years.

Thursday: Reports came in two waves on Thursday...

Economic reports released an hour before the open included:

• personal income rose 1% increase in January, versus an expected 0.3%
• personal spending rose 0.5% in January, versus an expected 0.4%
• initial jobless claims were reported at 338K versus an expected 325K

Economic reports released during the trading day included:

• Construction spending (Jan) at -0.8% versus expectations of a drop of 0.4%
• ISM Index came in at 52.3 versus an expected 50 (manufacturing is growing)

The optimists will cheer all of this except the construction spending, which suggests that housing continues to weigh on the economy. The jobless claims have been elevated for three weeks now, so becomes a concern that a new higher level is being established.

Friday: Michigan consumer sentiment was reported at 91.3 versus an expected 93.3. You will recall that two thirds of the economy is related to consumer spending, so any retreat in sentiment here will cause great concern among investors.

After the markets moved higher from the open on Wednesday, the market opened markedly lower on Thursday due to worries over the Yen carry trade. The chief financial official in Japan suggested that the trade was not one way, which after Tuesdays 2% rise in the Yen's value versus the dollar, drove the Yen up even higher. Some investors took this as a sign to repay their Yen loans and thus closed their US equity trades to create the funds necessary to repay those loans.

This is bigger than it may appear on the surface, as now the worry is that all the hedge funds that have been using inexpensive Yen loans will look to unwind these trades at the same time, causing further weakness in the markets as these positions are liquidated to generate funds to repay the loans. This is a rather serious concern, as it has been obvious during 2006 that we had a liquidity fueled rally, based on private equity monies, hedge funds (using the Yen carry trade), and foreign investors. If any/all of these are withdrawn, the equities markets could collapse.

Oil rose fifty cents for the week closing at $61.64. The next resistance level above lies at $64. Natural gas fell by a like amount, closing at $7.243. Both energy products continue to find support above their uptrend lines.

If you will recall, a week ago, the major bullish argument was that the Fed wouldn't raise rates due to concerns over the collapse of the sub-prime lenders, and its possible effect on the rest of the economy. This was meant to counteract the Fed's need to raise rates in the face of rising inflationary pressures. Reflecting on this only a week later, it is clear that the level of risk in the market continues to rise as prices have been since last summer.

You may recall that by Tuesday, Iran's defiance of the UN was in focus, an assassination attempt on US Vice President Dick Cheney was unsuccessfully carried out in Afghanistan, in addition to the comments by Alan Greenspan, and the market sell-offs experienced around the world. Add in the back pedaling from the Yen carry trade and risks are clearly on the rise. The market seems to have finally shifted to begin to confront those risks rather than continuing to ignore them, which is causing the markets to retreat, as risk is starting to be priced into the markets.

Oh yes, we almost failed to mention that all of this is happening as the markets are slowing from the average S&P-500 company double digit earnings gain in the last reported quarter to an expected 5% gain and a soft landing or recession in the cards for later in the year. Don't mistake that we continue to believe that company profits will continue to grow, and growth is good. It is just that there are a lot of risks out there that have been overlooked, and until these come into focus, we believe the markets are vulnerable to a continued sell-off.

Last week, after suggesting that investors have been ignoring risks, we acknowledged that this had been going on for some time, and that some catalyst would be required to cause a change in the relentless bullish behavior. We received that by last Tuesday, so we now have to wait for the dust to settle.

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 of its move lower at the end of last the prior week. The common saying in the markets is that weak Fridays lead to weak Mondays.

On Tuesday, the bottom fell out, and as we discussed in the Overview, risk is starting to be acknowledged. The behavior that has been rewarded since the summer of '06 was followed, but may no longer be working. Buying on the dips in a bull market tends to be a rewarding strategy early on in the bull market, but become riskier the longer the market continues, as it eventually becomes more bearish.

Volume has increased, similar to what happened a year ago at the end of February '06. Last week we noted that the small caps and NASDAQ continue to move upward, and the adoption of risk may mark the end of this uptrend. You can never be certain of how far a move will continue, but we do expect follow-on downside action, so we should look at the individual charts to gain further understanding.

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.

We have introduced a new indicator to readers, known as the Commodity Channel Index. Using a 100-day (20-week) CCI indicator, a longer term perspective is provided. You can see that historically, CCI can reach significantly lower than it is today, and we also have the lower Bollinger Band to be tested not far below.

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

The daily chart clearly shows price moving below the lower Bollinger Band and also the Fractal Indicator is already in the area where most strong trends dissipate. With the 200-day moving average lying just below $118, we are looking for this level to be tested before the downturn is complete. Price is now below the 20-day, 50-day, and 100-day moving averages. In addition, the 20-day moving average is threatening a bearish cross of the 50-day moving average, which would lend momentum to downside action shortly.

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

This chart looks quite similar to that for the DIAmonds, with CCI just below 0, and the lower Bollinger Band not far below. Price gains since October '06 have been erased.

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

The daily chart also looks similar to the DIAmonds chart as price is walking downward outside of the lower Bollinger Band. A snap back up inside that band would signal a likely reversal back upward. Price is below all moving averages we regularly report on, with the exception of the 200-day moving average, which lies below the $135 area.

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

Once again, the pattern of the other major indexes is holding in that price gains since October have been erased, and price is not far above the lower Bollinger Band with CCI just negative. We would be looking for a continuation lower to test the lower Bollinger Band.

The chart for the daily QQQQs suggests that a challenge all the way down to the $41.60 is likely or even to the 200-day moving average around $41.

Last week we noted the divergence between price and accumulation. With the failure on Monday, the bears took charge and the lower open amid concerns over the Chinese market was really just putting kerosene on the fire.

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

Once again, the pattern of the other major indexes is holding in that price gains since October have been erased, and price is not far above the lower Bollinger Band with CCI just negative. However, the difference is that the IWMs never broke below recent lows and this level has to be tested before a further move down would be possible. This could keep price above $76 and would cause us to exit the short trade. If that level is broken, we would be looking for a continuation lower to test the lower Bollinger Band around $74.70.

The chart for the daily IWMs suggests that a challenge all the way down to the $75.50 is likely or even to the 200-day moving average just above $74.

Conclusion:

We believe that the markets are headed lower still, to test the areas indicated in the chart analysis we have provided. Oil remains above the $61 level, which will cause consumers to tighten their wallets. Given current consumer sentiment, this may affect buying behavior, which will affect the markets more than is currently factored in.

Last week's cautious message was well-timed as we raised concerns over various risks, of inflation, geopolitical risk, housing, and the financial sector. We deliberately provided for the possibility of a continued bullish move, if the NASDAQ-100 was able to break out. We have to provide both sides of the argument, allowing for the market to choose its own path.

All of our index trades were short by the end of last week, so our subscribers recorded significant gains in the last week. Eventually, these trades will be reversed to long positions to catch the next uptrend.

Stay tuned for more.

Regards and Good Trading,