Index Advisor 025
3/26/2007 9:38:42 AM

Recommended Trades:

We are monitoring the market for an expected pull back.

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 market closed with the Dow posting five up days in a row. The other major indexes weren't able to post such a string of gains, but overall finished the week significantly stronger than last week. Monday's M&A news seemed to allow investors to ignore some negative economic news, which was mostly the tone for the week. The market surged on Wednesday when the Fed softened its policy statement, removing the "additional firming may be required" statement in favor of another statement that higher inflation posed the most serious threat. They also added a statement about the adjustment in the housing market.

The equities markets interpreted this as the Fed will ease rates to alleviate a slowing economy due to the housing bubble bursting and the meltdown of the sub-prime lenders. We are still concerned about how many investors are choosing to ignore the sub prime issue, as we read about how small a percentage of the market the sub prime loans represent. In point of fact, they represent twenty percent of loans made in 2006, up from five percent of loans in 2005. While they amount to less than twenty percent of the mortgage dollars (each sub prime loan is generally less than the average loan size), it is still sizable.

The markets continue to mimic weakness of the Japanese Yen as they did a week ago. The Yen has reached nearly 118 to the dollar, so the collapse of the carry trade is certainly not imminent at this time.

Fear, as measured by implied volatility, and exemplified by the VIX and VXN has moved down. The put/call ratios also moved down after the Fed released their policy statement, so investors are currently complacent about downside risk.

Last week, we were looking for trading action on Monday to set-up the week. We expected it to be downward, but significant M&A news caused the markets to move higher.

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 of significance Monday was the release of the NAHB/Wells Fargo housing market index. The index was reported at 36, from a downwardly revised February 39. This marks the first decline in the index since September, and means that about a third of the homebuilders believe the housing market is healthy. This news was ignored, so is presumably priced into the market. There was also significant M&A news that powered the markets higher.

Tuesday: Economic reports were focused on housing. New home starts surprised to the upside with an annual rate of 1.525M new homes started in February, versus the expected 1.46M. Of course this follows January's disastrous 1.399M number, so suggests that homebuilding isn't completely in the tank. Building permits, which are less volatile were reported at an annual rate of 1.532M versus expectations of around 1.57M homes.

Wednesday: The Fed policy statement gave equities investors what they wanted, which was a removal of some hawkish language and recognition of an adjustment in the housing market. It was like a bottle full of bees was shaken then uncorked. The markets surged on a very large one day move.

Thursday: Jobless claims came in roughly as expected reporting 316K versus an expected 325K. The big "miss" was really the leading economic indicators reported by the conference board. Consensus was that this number would be down 0.3%, but instead was reported at -0.5% and January's number was revised sharply down from a positive number to -0.3%. In addition to the economic reports, Motorola (NYSE:MOT) guided lower and announced changes in executive management.

Friday: The only economic report released Friday was existing home sales, which rose an unexpected 3.9% to 6.69M homes. However, inventories of new homes rose to a 6.7 month supply, and median prices are down 2.3% from a year ago. The National Association of Realtors (NAR) predicts a bottom for existing home sales in Q207. Monday, new home sales will be released and the NAR have predicted a bottom for those sales in Q307. Note: The NAR are notoriously optimistic and have a track record of calling the top late and the bottom early.

Oil rose back above sixty dollars to close at $62.28. Natural gas rose nearly fifty cents during the same period to close at $7.406.

Overall, the economic reports last week were mixed, but the three primary market supporters were the M&A activity, the Fed's removal of a hawkish inflation bias, and the continued weakening of the Japanese Yen.

By the end of the week, Iran came back into focus, as Iran captured 15 British naval personnel. Iran was supposed to address the United Nations on Saturday, but chose not to do so. They were responding to their continuing progress on enriching uranium, in defiance of the UN. This seems to have caught the main stream media's attention, but hasn't really done much to investor sentiment in US markets.

The bulls once again have rekindled hopes that the Fed will lower rates, even in the face of higher inflation. We are not so sure, as food and energy prices continue to climb. The relationship between food and energy costs have recently been the subject of discussion, as ethanol production uses a large percentage of US corn, drives the prices up to produce food products for humans and their pets, as well as to feed livestock, which increases the prices for meats and dairy products. The farmers are soundly defending the ethanol production subsidies by the government, as they are seeing outsized profits across the board.

Market Climate

The market began the week with a move higher on M&A news and continued this move through the week, with some weakness toward the end of the week, particularly in the NASDAQ. The dramatic move up on Wednesday after the Fed's policy statement was released broke through resistance and the market consolidated those gains on Thursday and Friday.

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

The weekly shows that the moves up have been on lower volume than the moves down. This is reflected in accumulation, which has a long ways to go to catch up with its pre- Black Tuesday level.

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 the DIAmonds approaching the level of their recent swing low and the close was on the 50-day moving average. They are also approaching their upper Bollinger Band, which may cause a reversal.

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 the sell-off was suggested by a weakening OBV and the MACD, which was coincident with its signal line. The currently gains haven't seen much of a move up on OBV but the MACD looks like it wants to cross up and over its signal line.

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 testing toward their most recent swing low, but have been able to move above the previous swing low. They are approaching the upper Bollinger Band, with 50-day and the 100-day moving averages just below.

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

The chart for the QQQQs shows a past divergence that the most recent sell-off has realigned. We will look for a further divergence to provide an edge. In the mean time, we will watch price and volume action, as price has been moving up on lower volume than downward price moves, signaling distribution.

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

The chart for the QQQQs shows a reversal at resistance from the most recent swing low. If the bulls are able to cause a close above this level, the $44.76 level is key, as it is the opposite side of the gap, which would close the window. Note that gap is a western term, while the Japanese use the term window.

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

The weekly chart shows a test to the underside of the intermediate term uptrend line. A further refusal here would suggest another test downward.

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

The chart for the daily IWMs shows that resistance from the recent swing low has already been surpassed. We are now looking at the other side of the open window at $81.19 to be tested. This is also where the upper Bollinger Band could come into play to cause a reversal lower.

Let's take a look at the Advance decline lines once again, as we used them as an indicator of a likely reversal on Wednesday.

Note that both charts show the 5-day moving average and the 8-day moving averages have moved above their "normal" ranges. They don't stay outside of their norms for any length of time, so we expect some weakness immediately. How that translates to price action is yet to be determined, but we will monitor the charts daily, and in particular look for the relationship between the advance/decline numbers and volume and price action to determine how long we will stay with the current trade.

Conclusion:

The markets moved up strongly on the release of the Fed policy statement. While it was clearly a break from the tightening bias, the Fed was still quite clear that their predominant worry is still inflation. While they acknowledged the "adjustment" in the housing market, we aren't certain that translates to looser monetary policy in the face of rising inflation from food and energy prices, as well as wage pressures.

Stay tuned for more.

Regards and Good Trading,