Index Advisor 021
3/19/2007 8:45:34 AM

Recommended Trades:

We are going to wait for Monday's trading action before recommending trades here. At this time, the QQQQs and IWMs are showing bullish leadership versus the DIAs and the SPYs which are looking more bearish. We would like the markets to tip their hand before entering new positions.

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 big bounce...

The tone of the last week was defense. The primary evidence of this was the massive buying on Wednesday when the markets retested their lows (or made new ones) and bounced on huge volume.

The markets continue to mimic weakness of the Japanese Yen. When the Yen has weakened versus the U.S. dollar, the market rallied. When the Yen strengthens versus the dollar, the market sells off. This has to do with the Yen carry trade and fear that the carry trade may have to be unwound all at once if the Yen strengthens beyond about 114 to the dollar.

The market is clearly still somewhat fearful of another leg of the downward move initiated three weeks ago. To that effect, premiums have been charged to buy downside insurance, which is manifested in relatively high VIX and VXN prices, showing implied volatility continues to be elevated.

Examining both those charts below, we note that when the VIX and VXN hit high enough levels, bottoms are put in, but these bottoms get tested. Let's examine the weekly chart for the VIX:

The VIX has moved back up to close not far below 17 on Friday, after it bounced from around 14 the previous week. Intraweek values saw the VIX hit it highest intraday value (21.25 on Wednesday) seen since the market bottom in July 2006. While the close is elevated, it hasn't yet reached a level where the market has consistently bottomed.

In addition, when the VIX reaches weekly closes above 18, it seems that the bottom is always retested. When the VIX tops out at lower levels, the bottom is often a clean V without a retest.

Examining the weekly chart for the VXN:

The VXN recently rose to close above 25 twice in the last two and a half weeks. Last Wednesday, implied volatility for the NASDAQ-100 reached only 23.5 before subsiding to close the week at 19.60. There is less fear about a collapse of the NASDAQ-100 than the S&P-500.

The VXN chart shows that when high level reversals are achieved for the VXN, the market bottom are often retested. Lower highs on the VXN however doesn't show the same V bottoms for the NASDAQ-100 ETF (NASDAQ:QQQQ).

We suggested a retest lower was likely and we saw that last week. The peculiar nature of the extreme volume defense exhibited on Wednesday argues that tests of this level are not yet over, and we may in fact see a challenge lower yet.

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

Monday: The only economic report released Monday was the budget deficit, reported at a level of -120B dollars, which was 3 billion dollars better than the expected -123B dollars. This report itself doesn't move the market in the short term. M&A activity does move the market and Shering Plough's (NYSE:SGP) acquisition of Akzo Nobel's drug unit for $14.4B in cash bolstered sentiment. Sub prime lender worries continue as Countrywide Financial (NYSE:CFC) announced it was writing less loans due to tightened credit guidelines due to rising defaults reported. It was only the interest in tech that allowed the market to shake off the lower open and to move modestly higher.

Tuesday: The economic report that drew the most concern was on consumer spending. Both retail sales and retail sales excluding automobiles were expected to be reported with growth of 0.3%. Instead, retail sales were reported with a rise of only 0.1% and retail sales ex-autos actually fell by 0.1%, a miss of 0.4% in expected growth! Business inventories grew by 0.2% as expected.

Wednesday: The current account deficit dropped to $195.8B from $229.4B. This was versus an expectation of a deficit of $203.4B. Going along with that, export prices increased by 0.6%, while import prices dropped by 0.1%.The economic report that drew the most concern was on consumer spending. Both retail sales and retail sales excluding automobiles were expected to be reported with growth of 0.3%. Instead, retail sales were reported with a rise of only 0.1% and retail sales ex-autos actually fell by 0.1%, a miss of 0.4% in expected growth! Business inventories grew by 0.2% as expected.

Thursday: Merger news kept a floor under the markets as economic reports today were mostly bearish.

• The Producer Price Index (PPI) was reported increasing 1.3% for the month, versus an expected 0.5%.
• Core PPI was reported with a 0.4% increase versus an expected 0.2%.
• Initial unemployment claims were reported at 318K versus an expected 325K.
• The NY Empire State Index was reported at 1.9, versus an expected 17.0 (above zero indicates growth).
• Net Foreign Purchases of long term US debt instruments in January was $97.4B versus an expected $60.0B
• Philadelphia Fed reported 0.2 versus an expected 3.5.

Friday: The Futures market was trading significantly below fair value until the CPI report was released at 8:30am EDT.

• CPI was reported as growing by 0.4% versus the expected 0.3% growth
• Core CPI (excluding food and energy) was reported at 0.2%, as expected
• Industrial production reported 1.0% growth versus an expected 0.3%
• Capacity utilization came in at 82% versus the 81.3% expectation
• Michigan consumer sentiment issued at 88.8, inline with the 89.0 expectation

The strong industrial production was much needed good news. The CPI numbers came in mostly as expected, but it seems clear the Fed will have to keep a close eye on inflation for a bit longer, and no rate decrease can be expected for awhile.

Oil fell nearly three dollars to close at $57.11. Support was around $57.40, and that level was just broken. Natural gas fell three and a half cents to close at $6.924. This is just below support and we could be looking at oil and natural gas making bearish moves starting next week if support isn't seen early in the week.

Overall, the economic reports last week were quite negative. Friday's report should have actually provided some good news for a change, but the market sold off on Friday anyway. The core CPI coming in as expected and the industrial production showing 1% growth versus the expected 0.3% should have been enough to cause a rally, but there is more wariness and pessimism in the markets now than we have seen in months.

The bulls have likely given up on hopes that the Fed will lower rates anytime soon, but there is a Fed meeting next week so investors will be searching the language of the statements released after the meeting to see if the Fed is communicating any change in their somewhat hawkish outlook on inflation.

Last week, the sub prime market worries continued as New Century Financial (NYSE:NEW) to steps to protect itself from bankruptcy. The major brokerage firms are looking at this as an opportunity to pick up sub prime lenders at fire sale prices. This can assure that some of these companies will weather the current storm but others are almost certain to collapse. It is still an unknown how much the problems in the sub prime segment will affect the rest of the financial community but some more details have come out.

Some 20% of loans written in 2006 were sub prime, compared to 5% in 2005. These sub prime loans have been packaged and sold with other loans and the risk has therefore been transferred to investors that bought these packages of loans, or have bought into funds that purchased them, etc.

Homeowners may lose their homes, and a flood of homes on the market that must be liquidated to repay the banks could further depress home prices. It is still too early to gauge the overall effect, but no less than former Fed Chairman Alan Greenspan has commented that the effects from the sub prime debacle could impact the overall economy.

Clearly the economy continues to slow, and investors seem to being paying some heed to risk out there. The sub prime market concerns, the Yen carry trade concerns, and concerns over declining consumer sentiment are all weighing on the minds of investors.

Market Climate

The market began the week with a continuation of its move higher on Monday and then selling off on heavy volume on Tuesday. Wednesday saw continued selling to retest and surpass lows before a dramatic reversal to the upside was put in. Thursday saw some follow through to the upside before Friday saw further weakening yet again. The common saying in the markets is that weak Fridays lead to weak Mondays.

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

Even though Wednesday's retest of the low was repulsed, the market did make a new intraday low. The chart shows that the gains from the week before have been lost and the weekly close on Friday left price about the same as for two weeks earlier.

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 daily chart shows a new bearish cross of the 20-day moving average through the 100-day moving average. We had suggested a failure to rally above the 100-day moving average would see a test of the recent low, which occurred and was repulsed, but not until after a new intraday low was formed. The key to a further decline is if the DIAmonds move further down, breaking the uptrend line support dating back to summer '06. If that support holds, then the more likely move is upward.

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

The weekly chart of the SPYders shows that price is at an even lower level than two weeks ago, after the dramatic sell-off. All of the prior weeks gains have been erased. The SPYders are also just above the lower Bollinger Band, so it will be interesting to see if they bounce from it, or begin to walk the band in the coming week. Volume has clearly been markedly heavier to the downside.

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

The daily chart of the SPYders shows the SPYders are trending just above the uptrend line drawn from summer '06. A break below that line would likely lead to further downside. Aslo, the Fibonacci projection suggests there is further downside in store toward the 200-day moving average. The imminent bearish cross of the 20-day moving average below the 100-day moving average also argues for further downside.

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

The chart for the QQQQs shows a different story than the charts for the other major index ETFs. The retreat this past week was quite modest and the QQQQs are clearly trying move higher. This could be the leadership required for the other indexes to reverse course to move higher as well, so it bears watching. The lower Bollinger Band is just below current price range, and it will be interesting to watch whether price will trade down to it, and then begin to walk the band or reverse off of it.

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

The chart for the QQQQs shows a bearish cross of the 20-day moving average crossing below the 100-day moving average. The key to a move upward would be a close above $43.33, while a close below the $42.50 level would suggest another retest and perhaps a challenge of the 200-day moving average.

This week's RUSSELL-2000 ETF (AMEX:IWM) Weekly Chart is below:

The weekly chart suggests that the sharp downward move that began three weeks ago would continue downward, but thus far, there is a lot of momentum continuing to the upside, with the uptrend line and the lower Bollinger Band clearly moving higher and both are, as yet, untested. The Fibonacci retracement level at around $74 has not yet been touched, so a suggestion of a test lower is still there.

This week's RUSSELL-2000 ETF (AMEX:IWM) Daily Chart is below:

The chart for the daily IWMs suggests that significant resistance lies overhead with the 20-day, 50-day, and 100-day moving average just above. The 20-day moving average just made a bearish cross of the 50-day moving average on Friday.

A failure to retake the major moving averages and to close above $79.00 would likely signal a retest lower is once again in the cards. A retest lower that bounces off of the uptrend line before the lows are tested would be bullish.

We will examine the advancers and decliners on the NYSE and the NASDAQ. In the charts, you will find 5-day moving averages and 8-day moving averages which illustrate when activity moves out of its normal range.

Note that both charts show the 5-day moving average and the 8-day moving averages recently started moving in the same direction, downward. We don't know how much further these averages will continue, but they tend to move in the same direction for a few days at a time before reversing. The market moves strongly in their direction during this alignment, so we are looking for the markets to continue moving down in the short term.

Will the ADV/DEC line break out below the normal range as the market continues to decline? The rapidity of these two averages to reverse will suggest a lot about whether the markets can stage a meaningful rally, or whether more downside will follow what has been started recently.

As we identified last week, a failure to attain and hold above the 100-day moving averages on all the major indexes would result in another move lower, which is just what occurred. At this time, we would look for a continued move downward so the Advance/Decline moving averages can reach the bottom of their "normal" channel, which would allow them to align in a strong move upward.

Conclusion:

Last week we suggested that a retest lower was likely to happen early in the coming week. We would suggest Tuesday's massive sell-off and then Wednesday's move lower qualifies as that retest.

In the coming week, we would look for weakness on Monday. After that, it is unclear if support will hold on this third retest, or whether the test will continue all the way to the 200-day moving averages. If we had to bet, we think that the eventual test to the 200-day moving average is inevitable. The question is whether it will occur next week or further into the future.

With oil breaking below $60 and, in fact, below support at $57.40, a continued move to the downside should bolster the markets, generally, but will adversely affect the oil related companies, which are a large part of the S&P-500. This will provide mixed results for the markets, allowing the NASDAQ to outperform the NYSE. We'll have to watch this carefully.

We think it is important to watch Monday's trading to gauge whether the markets will move higher or lower from here. There are clear areas that suggest a break out will gather momentum, and trading would yield a high probability of success. The markets are, by many measures, oversold, and may look to move higher here. The question remains, how far will this move carry them and is there move immediate downside before a sustainable rally can take place?

Stay tuned for more.

Regards and Good Trading,