Index Advisor 036
5/21/2007 12:54:08 PM

Recommended Trades:

We placed conditional orders for trades and only one was filled last week. The others have expired unfilled. We will look to place short orders once again, once a bullish surge passes.

Open Positions:

There is a single open position 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:

Dow 13,500...

The markets end the week with indexes being bought going into the weekend, since Monday's have had a pattern of M&A activity reported and the markets tend to open higher on Mondays.

Earnings season is nearly over and the S&P-500 companies have reported average gains of around 9%, significantly above analyst expectations.

Let's take a look at the week in review:

Monday: There were no economic reports released Monday. Instead, investors continue to focus on earnings and were somewhat skittish today, as analysts raised forecasts for GM, while downgrading the financials sector. This helped the Dow industrials move to a higher close while the broader S&P-500 and other major indexes moved down.

Tuesday: Tuesday's economic reports were somewhat positive:

• CPI for April rose by 0.4% versus an expected rise of 0.5%
• Core CPI rose by 0.2% matching expectations
• NY State Empire Index was reported at 8.0 versus an expected 9.0
• Net Foreign Purchases for March were reported at $67.6B versus an expected $75B
• NAHB survey slips to 30-year low suggesting the new home market may not improve until 2008
• Home Depot missed earnings expectations, guides lower
• Walmart just met expectations, with weak earnings projected for Q2

Wednesday: Wednesday's economic reports were somewhat positive:

• Housing starts in April were reported as 1.528M, exceeding the consensus 1.48M expected
• Building Permits were significantly lower at 1.429M versus an expected 1.52M
• Industrial Production significantly surpassed expectations reported at 0.7% versus an expected 0.3%
• Capacity Utilization was reported at 81.6% versus an expected 81.5%

While the housing starts were higher than expected by some 2.5%, the permits shortfall of around 8.9% is an indicator of future starts and suggests continued weakness in housing (no surprise there). The real mover of the day was the filings by billionaire investors Warren Buffet, George Soros, and Eddie Lampert indicating they have been making significant investments in large cap names.

Thursday: Thursday's economic reports were somewhat positive:

• Initial jobless claims were reported at 293K versus an expected 310K
• Leading Indicators were reported at -0.5% versus an expectation of 0.0%
• Philly Fed reported an index of 4.2 versus an expected 4.0
• Fed Chairman Ben Bernanke in a speech at the Federal Reserve Bank of Chicago said that sub-prime issues should affect the broader economy, although banks have tightened credit to these borrowers, as well as Alt-A and even prime borrowers.

The lower unemployment number is a mixed bag as it will also cause the Fed to worry about labor utilization. The Philly Fed number is somewhat neutral. The leading indicators haven't indicated a recession yet, but a negative number shows signs of a slowing economy.

Friday: The sole economic report issued on Friday was the Preliminary Michigan Sentiment Index which was reported at 88.7, above the consensus 86.5 expectation. This was quite unexpected and may have contributed to the overall bullish sentiment. The real catalyst though was more M&A activity, such as Microsoft's deal to buy Aquantive for an 85% premium over the current trading price.

The price of oil rose significantly in the last week closing at nearly $65.00 ($64.94). Natural gas rose slightly to close just under $8.00 at $7.994.

It seems obvious that the Fed is waiting to see that inflation has cooled sufficiently before they will reduce rates. Still, you regularly see bulls suggesting that a rate cut is just around the corner. It doesn't appear that the market has many believers who are actually betting that way at this time, however.

Looking at the week in review, we continue to see stock buy backs, private equity deals, and public companies bidding to take over other public companies. All of this reduces the supply of available shares to be bought by a market awash in liquidity. While some central banks continue to raise interest rates, they are moderate raises of no more than one quarter of one percent, which is actually serving to keep inflation somewhat under control. Even China is adjusting the range they will allow the Yuan to fluctuate in as they raise interest rates in an effort to cool off their red hot economy. Japan's central bank, however, has decided to keep their key interest rate at 0.5%. When they finally raise that rate, it will signal that the lucrative carry trade is coming to an end and some of the global liquidity is coming to an end.

One thing to note is that the Chinese government is now allowing its banks to purchase foreign stocks now, in addition to foreign bonds. Their purchase of bonds has been an explanation of low long bond yields and China recently announced they may change that. That money still has to go somewhere, so they can continue to use that money to buy US stock shares, which acts as a further increase of global liquidity and drives up US equity markets.

On the economic side of the equation, we see companies continuing to exceed analyst expectations. The consumer seems to be somewhat affected by higher energy and food costs, but remains confident. About the only significant negative is that the housing market continues in the doldrums, but that has been a known for quite awhile.

All of this provides a positive backdrop for stocks, which are not considered overvalued at this time. Recall that when the market peaked in 2000, the S&P-500 had PE ratio of around 35. Today, the PE ratio is around 18 for these large cap stocks. While economic growth has slowed, it is still positive and showing signs of improving, even as the housing market continues to provide a drag on the economy.

The markets remain oversold at this time. While we see positive signs for the economy and stocks, until inflation is brought under control and the economy begins a robust expansion, we believe that investors are complacent to remain stubbornly bullish here.

The real reason that stocks are currently trading as high as they are has been about reduced supply of shares and increased demand for shares as a place to put all that "cheap money". This sort of trend can continue longer than you would expect. In fact, the 2008 Olympics and the US 2008 Presidential election cycles will be in a similar timeframe.

We would suggest that 2009 is unlikely to be a banner year for stocks and, in fact, is likely to see more downside than is regularly seen post-election and could usher in a bear market. While it is too early to tell what will be happening in the global economy then, it is reasonable to assume that China's red hot economy will have cooled somewhat while they work to get inflation under control and allow the Yuan to adjust more naturally to foreign currencies. We would limit any long term investments to a 2008 window until the picture becomes clearer over time.

Market Climate

The markets were mixed for the week, with the Dow powering to a new closing high above 13,500 for the first time. The S&P-500 shadowed the Dow and the NASDAQ and Russell-2000 moved lower before bounding late in the week.

A key chart to look at is the US Composite of over 8,000 stocks:

The chart shows price neatly contained within a rising uptrend and horizontal resistance. Shortly, we expect this containment to be broken, either to new highs or to new lows. However, before that occurs, we note the Bollinger Bands have been collapsing on each other which usually signals the calm before the storm. After a short rise in equities, we would expect a failure to the downside for summer doldrums. However, with global liquidity continuing to provide outsized demand, we would not be surprised at yet another break upward. Until the pattern is broken, we will adopt a wait and see attitude.

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 DIAmonds continue to power higher, and the rate of rise is unsustainable. When it will break is beyond our ability to predict. Clearly some heavy hitters are continuing to buy many Dow components, and they are the most undervalued of all the indexes. We would be hesitant to short the DIAmonds until a clear sign of a break down was observed.

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

The SPYders continue to power higher, and could easily soar all the way to $154 before pulling back. That price is determined by the short term up trend line which has acted as resistance in the up trend. We believe there could yet be one more surge before we see a break below the short term uptrend that has served as support. When that occurs, the bears will pile on. Until then, shorting the SPYders must be done with care. The bulls are still favored at this time, but the SPYders are clearly oversold, so we thing that if the bulls become over optimistic, things could end badly.

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

The QQQQs have, in fact, retraced somewhat like we suggested they might, but they now appear ready to move back up to challenge previous highs. Gains should be limited to the short term resistance line, and a break above this should see follow-through to the upside. We would look at a failure to overtake this resistance and weakness following this, especially in the Dow Industrials, would signal a good short entry.

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

While the chart showed recent weakness, we believe a rally will occur and the extent of the rally will determine the likely course of the NASDAQ in the near term.

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

The IWMs are poised to rally significantly here as the market pushes mildly higher. They tend to be more choppy than their larger cousins and subject to exaggerated moves. However, a move to a new high may not occur, and if such a move fails, a short trade would be indicated.

Conclusion:

Global liquidity continues to power stocks higher. With recent signs of consumer optimism, the markets can see additional interest in retail stocks as well, so the broader market could easily move higher.

We continue to patiently wait for signs of a break down in the ten month old uptrend. The markets are clearly overbought, but liquidity and trend have trumped these thus far.

Regards and Good Trading,