Weekly Trader Alert #96
3/19/2007 10:53:52 PM

Overview

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.

The U.S. stock market composite chart:

The daily chart shows that price is ready to test its 20-day and 50-day moving averages lying just overhead. A successful close above the moving averages that is maintained should lead to a move up along the upper Bollinger Band. A failed test of this resistance will likely lead to a reversal at the upper Bollinger Band and a move lower to once again retest the recent lows.

Monday's rally (a week ago) was on exceptionally light volume, and was powered primarily by buying in tech, and in particular, interest in semiconductor companies. However, the index (as we will explore shortly) hasn't maintained its move upward. Today (Monday), the market moved higher but again on relatively light volume.

We were correct that a retest of the lows was in the cards last week, and we saw the move lower on Tuesday and the dramatic move lower and rebound on Wednesday.

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:

We now have a divergence where the semiconductor companies are selling off as the market is rallying. Monday's close of 469.18 suggests a move down to the 465 level. The question remains if the semiconductors will rally or break lower.

Fundamental Trends

The leaders are little changed from last week, where the only change was in the relative order and a swap of the Steel Alloy industry for the Farm Machinery industry.

As indicated last week, we don't believe that the oil companies are played out, even if oil appears to be moving back toward the fifty dollar range.

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

Amazingly, the Canadian Oil Industry finally left the cellar dwellers as the value investors have stepped up their level of interest. It was replaced by consumer electronic retailers. Mortgage services also entered the cellar dwellers, which is no surprise as they include the sub prime lenders. Mortgage REITs continue over worries about bad loans in their portfolios.

Interestingly, International Specialty Oils continue as the least liked industry out of some 200 industries we track.

We think that there will be value in these laggards but it is premature to count on a bounce in most of them at this time. We are looking for candidates in them and looking for bottoms to be put in for individual stocks, such as the trade recommendation below.

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

Trade Recommendations

We are looking at one of the home builders for a possible long entry. Beazer Homes has sold off significantly, since getting a late start on the other home builders. Many of the home builders are still at double digit PE ratios, even with slowing growth rates. BZH is trading at a PE of 8.

Let's take a look at the daily chart for Beazer Homes (NYSE:BZH):

We don't want to jump in prematurely, but we think it is worth speculating with a stop placed immediately below last Tuesday's low. In fact, if price is able to hold above the $32.27 level on a closing basis, BZH may be hammering out a bottom here.

We will send out an alert when it appears that the latest downtrend is complete. We don't advise jumping into this stock at this time. We would like to see more progress, but have noted that BZH may have finally put in a bottom, and is likely undervalued at this time.

Current Portfolio

Three of four of our positions moved down last week. Bucking the trend was RDY, which moved into positive territory as BPT moved into negative territory. ROG sold off sharply in a jittery industry, but appears to be bottoming here. FDG also sold off dramatically and then rallied. Although it is still down from last week, it should find support around $22.00.

BPT is in a clear trading range, where if it can close above the $61.00 level, it may be able to get a rally going. There may be a narrow downtrend channel that will provide support at $59.40. A close below the $58.50 would bring on more selling.

Examining

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

Currently, our open positions are all fairly close to the entry price we paid for them. We have an opportunity to get a good entry price on the second half of ROG. We will add this second half tomorrow if it trades higher than today's close.

We will add to BPT on a break out upward.

We will add to RDY on weakness, as it appears we may be a pull back below $15.00, which we could 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

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.

We expected weakness today (Monday), but instead saw a higher open and then a further move higher. It appears that equities are poised to move higher, but there are various levels of resistance just above. We aren't sure where the failure will occur, but we still believe that a test of the 200-day moving average is inevitable.

A break out is more than possible, and we could be in for a move higher in the immediate 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. Today (Monday) oil actually move lower to close at $56.59. Surprisingly, energy was the strongest sector today, with the underlying value of the oils outweighing the move lower for the price of crude.

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Regards and Good Trading,