Index Advisor 034
5/14/2007 7:49:30 AM

Recommended Trades:

There are none at this time.

Open Positions:

There are no open positions at this time.

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 markets reached their highs on Wednesday...

Earnings season is nearing its end with 29 out of 30 stocks in the Dow Industrials having reported. With a large percentage of companies having reported, it appears that Q1 will be limited to single digit earnings gains of perhaps 9 percent year over year. Still, earnings have been stronger than analyst expectations and the market has rallied.

Before digging deeper, let's review economic reports and other events that transpired during the week.

Monday: There were no substantial economic reports released today. There was a hostile bid made by Alcoa to take over Alcan. This helped to make Aluminum the industry leader for the day and the materials sector also a leader. This move was primarily responsible for the Dow's advance.

Tuesday: Wholesale inventories rose by 0.3% in March, compared to an expectation for a rise of 0.4%. February was revised down to 0.4% from 0.5%. This report suggests that wholesale inventories are where they should be in a healthy economy.

Wednesday: Wednesday was all about a continuation of bullish sentiment and the Fed policy statement didn't dampen that. There was no change in the Fed Funds rate and the only language change was minor. Essentially, the economy is still growing but slowly, and inflation remains the primary concern of the Fed, although they expect it to ease going forward.

Thursday: Thursday saw investors take profits due to a number of economic releases, including:

• A rising trade deficit reported at -$63.9B versus an expected -$60B
• Jobless claims were reported under the expected 315K at 297K
• Export prices rose 0.3% (4.9% yoy (year over year))
• Export prices (ex-food) rose by 0.4% in April (3.9% yoy) March saw a 0.5% rise.
• Import prices rose 1.3% (1.9% yoy)
• Import prices (ex-oil) rose by 0.2% (2.9% yoy) March saw a 0.3% rise.
• The Treasury tax receipts exceed spending in April by $177.1B versus an expected $143B.

The negative note was kicked off by large retailers reporting the worst April on record. Much of this was expected as retailers had warned earlier that an early (March) Easter holiday and cold weather would hurt April sales. 85% of the 51 stores reporting missed their earnings expectations, which set the tone for profit taking.

Friday: Friday's economic reports included:

• Retail sales fell by 0.2% versus an expected rise of 0.4%.
• Retail sales ex-autos were flat (0.0%) versus the consensus 0.5% rise expected.
• The Producer Price Index (PPI) shows inflation rose 0.7% versus an expected 0.6% rise
• Core PPI was unchanged (0.0%) versus an expected rise of 0.2%
• Business Inventories dropped 0.1% versus an expected rise of 0.2%.

The price of oil moved higher week over week to close at $62.37. While this is only forty-four cents higher than a week ago, it belies the dip seen early in the week before fighting back above the week ago closing price. Price is now around the 50-day moving average and above the 200-day moving average. The price of natural gas is almost unchanged, down four cents from a week ago closing at $7.90.

Once again, there is an expectation by the bulls that the Fed will drop rates soon. From our perspective, unless the housing market has a more profound negative effect on the economy than expected, the Fed has made it clear they are concerned about seeing inflation ease. The Friday PPI showed inflation rising (due to energy and food costs, but flat from March's report for core inflation. The important number to watch is for prices to consumers. The CPI report will be released before the market opens on Tuesday in the coming week.

With a benign CPI report, we would suggest that the Fed could move closer to easing interest rates. However, the CPI report is expected to show a monthly rise of 0.5% for April with the core rate expected to rise by 0.2%. Obviously, the effects of high energy and food costs are the major contributors to inflation at this time, but even taking them out, the current inflation rate is still above the Fed's comfort zone. A report that shows core CPI below expectations may fuel a rally, as more bulls will believe the Fed is more likely to lower rates. However, we believe the Fed will still be concerned with the inflation rates of energy and food. Obviously, a higher than expected CPI number would likely send the markets into a sell-off.

The markets remain oversold at this time. We are concerned that the fundamentals do not support a continued advance at this time, and that anything but a limited advance at this time would be a liquidity fueled rally that could just as well be reversed at any time and we would use caution in choosing to enter new long positions at this time.

Market Climate

The markets were mixed for the week, with the Dow powering to a new closing high on Wednesday and finishing higher for the week. The S&P-500 is about flat to last week's close, while the NASDAQ and Russell-2000 are down week over week.

While the Dow continues to rise, the other major indexes are all struggling to rise above the resistance noted last week.

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.

Taking a longer term perspective, the DIAmonds have traded within an uptrend channel since November 05. They are currently testing the upper boundary of that channel. We believe the DIAmonds need to digest recent gains and perhaps pull back a bit here.

It should be noted that the Dow was the most undervalued index of all that we track. This has been the case, however, for years. Even with the solid move up since last summer, the Dow could continue to rise disproportionately to the other indexes for quite a while before it become fairly valued compared to other indexes.

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

There are any number of uptrend lines converging just above current trading levels suggesting the SPYders will have trouble moving higher in the short term. A break of the short term uptrend line is possible in the coming week, which could lead to a more significant sell off. A move below $149 would indicate the short term uptrend had been broken.

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

While the long term resistance allows the QQQQs to move slightly higher, the upper boundary of a short term channel is now being tested by the QQQQs. A break below the $46 level would indicate a break of the short term uptrend line, while allowing the QQQQs to move all the way down to $44 without breaking below the lower channel boundary. We believe this sort of move is actually more likely than a dramatic move higher in the short term.

Finally, we continue to monitor the semiconductor index. The chart appears below:

The uptrend channel has limited moves for the semiconductor index with upside moves likely to be limited until a move lower can set-up a break out.

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

The IWMs are struggling to overtake horizontal resistance. The short term uptrend line is coming into play where the IWMs will have to break above resistance or succumb to moving below the short term uptrend line. Which will occur first? We'll have to watch trading in the coming week, but we believe that there is currently more downside risk that upside benefit possible in the short term.

Conclusion:

The wild cards are really how much does the housing market take down the overall economy and how long can markets stay awash in the liquidity we have been seeing? We continue to see central banks raising interest rates around the globe. When the Bank of Japan raises their rate by the middle of this year, it will begin to reduce global liquidity and we should see a fundamental change in the behavior of the markets.

We would adopt a cautious stance going forward for long investments, not necessarily ceasing to add new positions, nor closing your existing ones, but perhaps allocating less capital to these investments, and begin to accumulate cash or place funds in safer investments for a time.

Regards and Good Trading,