Weekly Trader Alert #95
3/13/2007 9:00:09 AM

Overview

Last week's market action can be viewed as relief. The Asian markets have been able to move higher, and, as if shadowing these markets, so too have the US markets.

In reality, the market had been waiting for a catalyst to sell-off, and it was only a matter of when and how far the sell-off would go.

Implied volatility, as measured by the VIX and VXN has eased. Examining both those charts below we see that both have touched levels where bottoms have been put in over the last several years.

The VIX clearly rose to a level that has marked bottoms in recent years. Since late 2003, the VIX rose up to the level around 19 and when it reversed lower, it proved a reliable indicator of a market bottom. Note, however, that the the VIX was also bottoming anywhere from 14 to 16 so the jump up to the 19 area was proportionally less than the jump from 10 to 19 two weeks ago. The move back down to 14 shows that implied volatility has retreated significantly as the market seems once again a tendency toward complacency.

Will this mark a bottom for the S&P-500? In the past, rallies out of VIX marked bottoms have lasted as little as two weeks. Examples of failed bottoms with lower bottoms that followed are 2004s March, May, August bottoms, and 2006's April, May, June bottoms.

The VXN rose above a level that has market bottoms in the recent past. However, the absolute level is for a weekly close below 24 a week ago, while in 2004, the VXN would reach levels of 29. This has to be seen in perspective that in 2004, the VXN never closed below 19 on a weekly basis, and was mostly above 22.

Will this mark a bottom for the NASDAQ-100? We see a similar story as for the S&P-500, where when a bottom is indicated, it may be followed by another lower bottom, or a double bottom retesting old levels.

We wouldn't rule out a retest lower for either the S&P-500 or the NASDAQ-100. It is important to watch the trading action in the upcoming week to determine if we will have an imminent retest on a failure at resistance, or whether the indexes will attempt to reach the level of their recent highs.

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

Monday: There were no economic reports released on Monday.

Tuesday: Economic reports were negative and ignored by investors.

• Productivity was revised down from 3.0% to 1.6%, versus an expected 1.7%
• Factory orders for January declined 5.6% versus an expected 4.0% drop.
• Labor costs were revised from 1.7% to an unexpected 6.6% for the fourth quarter. This represents an increase of 3.2% for the year, the highest rate since 2000.

Several things combined to provide a relief rally for stocks: The dollar rose in relation to the Yen, the Asian markets rallied, and the U.S. market was clearly oversold. In addition, former Fed Chairman, Alan Greenspan restated his recession prediction for later this year as a 1 in 3 chance.

Wednesday: The Fed's beige book was released today showing modest growth in many regions but some regions showed slowing. Consumer credit rose $6.4B, versus an expected $7.0B, most of it related to auto loans.

Thursday: The only economic report released was the initial unemployment claims number for last week, which was reported at 328K versus an expected 335K, down 10K from last week's 338K. The US equities markets appear to be closely following trading in Asian markets, so an up day there on Thursday led to a gap up opening in US markets.

Friday: An hour before the open, the jobs report came out and reported 97K jobs were added in February, while the previous two months of data were revised upward to show gains of an additional 55K jobs. In addition, Fed Governor Bies suggested the sub-prime lending problem may be just starting. In a related matter, New Century Financial (the second largest independent sub-prime lender) stopped accepting applications for new loans in what may be the precursor to a bankruptcy filing. Hovnanian (a large home builder) reported a Q1 loss and took down guidance for 2007. This renewed fears over the homebuilding sector.

The Yen carry trade seems to have moved out of fear territory into a "something to be monitored" category. The concern about the Yen carry trade all being unwound simultaneously hasn't yet played out. With a number of funds still in this trade, it could still happen, and certainly there is pressure to unwind the trade by next August, which corresponds with the warning sent by the Bank of Japan.

Oil traded in a range of sixty sixty-two dollars for the week, closing at$60.05. This was a clear break of the uptrend line, and support of the 100-day and 50-day moving averages lies below at the $59 and $58 levels respectively. Above, resistance is at $64. Natural gas dropped another sixteen cents from last week in anticipation of warm weather in the coming week. Natural gas is now on the brink of support at the seven dollar level.

The bullish argument continues to be that the Fed won't be able to raise rates in the face of a slowing economy. The unemployment number on Friday came in at 97K, just 3K less than the expected 100K jobs, which indicates the economy continues to add jobs. Job creation for the previous two months was also revised upward by 55K. Perhaps most importantly, hourly earnings rose by 0.4% last week, placing the average year over year growth in earnings around 4.1 percent. This is worrisome to the Fed who have expressed concern over wage-induced inflation, especially in light of inflation, as measured by CPI, is only up around 2.1% during the same period.

The noted increase in delinquencies in the sub-prime mortgage market is of concern. The fact that New Century (NYSE:NEW) has stopped accepting applications for new loans suggests that they may be headed for bankruptcy. Given that they are they second largest independent sub-prime lender, it is a manifestation of the trouble that industry is experiencing, having extended loans to the riskiest borrowers in the face of a weak housing market where housing prices in many areas have been in decline.

The concern in the market is whether the problems of the sub-prime lenders can be contained or whether it will extend to other parts of the economy. It appears that other parts of the mortgage industry aren't experiencing these problems yet.

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 market rallied and it appears an initial bottom was put in. US Equities markets have rallied from outside of the lower Bollinger Bands to challenge resistance at important moving averages. Overall volume during last week's rally has been consistently lighter than the volumes on the large downside moves the week before.

The U.S. stock market composite chart:

The daily chart shows that a rally began last Tuesday, but we are approaching important resistance provided by the 50-day moving average. In fact, Monday's continued move up now places price coincident with the 50-day moving average.

Monday's rally was on exceptionally light volume, and was powered primarily by buying in tech, and in particular, interest in semiconductor companies.

We believe that the technical resistance at the 50-day moving average may cause a retest of the lows. Other major indexes are currently flirting with their 100-day moving averages which often provides significant resistance or support.

We have been including the index for the semiconductors as the market seems to be following their lead.

The daily chart of the semiconductor index (INDEX:SOX) is below:

It is pretty obvious that the semiconductors have been participating in this rally, if not in some way, responsible for it. It is also obvious that the index is currently in the middle of its trading boundaries and won't run into significant resistance until around 492. Monday's close of 479.30 leaves plenty of room to move higher before the bears might emerge from hiding.

Last week's observation that Monday's inverted hammer candlestick could represent the bottom proved to be true. We aren't getting any help, at the moment, from candlesticks to predict a reversal or a continuation here.

Fundamental Trends

There is one builders in the top five industries, and three others in the top screen. This means one of our builders has dropped back a bit, as there are some concerns over a slowing economy (not much concern as of yet). Funeral services have been a much proclaimed growth industry as aging baby boomers are dying to find a final resting place (yes that was a terrible pun, but I couldn't resist). Interestingly, the strength of the auto and truck tires industry that we have monitored for months continues. After doing some digging, this doesn't have anything to do with passenger cars and trucks, which we know has been somewhat weak domestically. Rather, there is a tire shortage for all those large mining and construction vehicles giving sustained demand and pricing power to tire makers, such as Goodyear and Cooper tires. We have been watching the charts, and even though there hasn't yet been a sign of their slowing down, the charts look like they are racing to a blow-off top. We will monitor these stocks for a quick blow-off move that would be a shorting opportunity, although not necessarily for a very long period of time, probably after a short covering rally caused them to achieve the blow-off top we are looking for.

The fertilizer makers continue to back in the returns offered by constant demand by the foods industries. Interestingly enough, the most effect inflation is having on consumers is in the price of food. While oil and gasoline prices grab headlines, about twice as much of a consumers budget goes for food. Food prices have been increasing noticeably for more than a year, and the food producers and related industries (fertilizer) have benefited from this trend.

The Dairy and Meat industries are in seventh and twenty-third place respectively. Another Food industry, restaurants is also in the top screen.

The US Integrated Oil industry moved from eighteenth to second place as market pundits continue to say that money is being rotated out of oil and commodity plays. We don't think that this trend has played itself out yet, due to the lag on exploration projects that can begin to produce new supplies of oil.

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

Plastic makers disappeared from the cellar dwellers. One plastics company, Spartech (NYSE:SEH) expanded its earnings range expectations, allowing for more upside and this was greeted with an open about 10% higher on Monday, after the industry left, so things may be looking up for the industry as a whole.

Mobile home makers, and Mortgage REITs are now in the cellar dwellers and International Specialty Oil companies are also in the cellar dwellers. Petroleum industries come and go from the leaders and laggards regularly, depending on how energy is trading, so this may represent a buying opportunity. The only persistent petroleum group is the Canadian Oil companies, which, for whatever reason, have been snubbed for months now.

The mobile home makers and mortgage REITs are likely fall-out of the sub prime lender concerns. Given that people with marginal credit can't afford a more expensive home, the tightening of credit will affect the buyers and sellers of the most accessible housing. Increasing default rates makes holding mortgage REITs less attractive as well. In fact, we have been actively discouraging investments in mortgage REITs and sub prime lenders for more than a year over these concerns, and the problems took that long to make it to the main stream media.

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

Trade Recommendations

Obviously we have been keeping our powder dry, as the expression goes. Tuesday's rally has taken the major indexes up to challenge their 100-day moving averages, and the composite is now challenging its 50-day moving average, We believe that the markets may still retest their bottoms before moving higher, so again, we want to delay entering new positions. With that said, we are bargain hunting and may issue an alert this morning after trading opens.

Current Portfolio

All four of our positions moved up last week.

The three swing trades were all entered as half positions, given the market volatility.

Currently, they are all fairly close to the entry price we paid for them. We are looking to fill the second half of our positions, but we believe we may get a dip here to take advantage of.

FDG sold off hard with the market, but found support around $21 and has since rallied. It closed Tuesday at $22.84. Given that it will continue to pay a healthy dividend, it makes sense that there will be continued buying interest.

* 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

Are we calling a bottom due to the VIX and VXN reversals? We think we did see a bottom on Tuesday, but that much is obvious. Will that bottom hold? We don't know, but we think a retest lower is likely to happen early in the coming week. If it doesn't happen then, we will have to consider opening long positions to benefit from potential bullishness which will likely become the mood.

With oil dipping below $60, it will be discounted by the broad market as they focus on the sub prime lenders and perhaps jump in early to a tech rally.

The short positions on all of our Index Advisor were closed a week ago Tuesday at the open netting better than 16% cumulative returns for short term trades. This week is options expiration, which tends to put a damper on things by the end of the week. However, the markets are looking for a catalyst and if it occurs a large move may still be in the making, so stay tuned.

We are looking to add a couple more positions, long or short, depending on the market action. There haven't been a lot of good looking short prospects of late, which may give heart to the bulls among you.

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Regards and Good Trading,