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October 22, 2006

Earnings Season is Strong...
by Mark McMillan

Weekly Trader Alert #75
10/22/2006 6:33:17 PM

Overview

Most companies that are reporting have exceeded analyst expectations. Earnings are stronger than expected, but guidance has been lowered by a number of companies. Former leaders have been hit hard. This has occurred to construction/mining equipment suppliers, petroleum companies, and to finance companies, that are getting squeezed by the inverted yield curve.

In the past week, PPI was reported showing core inflation to producers increasing significantly beyond expectations. Tuesday, before the market opened, PPI was reported as 0.6 for September. On Wednesday, CPI was reported as lower, but core CPI was as expected, around 0.2. This shows the core rate of inflation is 2.9% annually, which is above the Fed's 2.0% rate that they are comfortable with.

Bulls are trumpeting the better than expected earnings from most companies and dismissing the possibility of further rate hikes by the Fed. In fact, many pundits are calling on the Fed to lower rates, to prevent a further slow down in the economy and to get the housing market reinvigorated. Earnings have been nothing less than impressive for Q3, but guidance is of some concern. Companies are flush with cash, so many aren't tremendously affected by interest rates, with the noted interest rate finance and housing markets.

We continue to be guardedly optimistic that the market will continue its uptrend. With that said, the three month uptrend with no real pull back makes the uptrend a bit long in the tooth, and as we have indicated, currently overbought. In essence, we believe that the market is currently priced to perfection.

By that we mean that the market assumes that inflation will be kept under control, the economy will slow mildly, not significantly, the housing market will recover shortly and prices will stop their free fall in the previously hot housing markets, the Fed will stay neutral or will lower rates, no significant geopolitical issue will arise, and the price of energy will not begin to climb again in the immediate future. If even one of these assumptions is proven incorrect, then it is likely that the uptrend will be diverted to one degree or another.

From a geopolitical point of view, North Korea's nuclear test resulted in the UN Security Council denouncing it and financial ramifications where funds are not being allowed to flow through banks to North Korea. A "soft" blockade of North Korea has been instituted, where ships may be boarded that are suspected of carrying weapons or nuclear materials to North Korea. The President of Iran continues to call for the destruction of Israel, and to generally express negative sentiment about the West. Hugo Chavez, the President of Venezuela, continues to take every opportunity to publicly denounce U.S. President, George W. Bush, but this seems to be on the losing side of public opinion in South American countries.

The price of oil is at a yearly low ($56.82), not seen since November 2005. Natural Gas continues to climb, closing Friday at $7.24, a 28% increase in one week! Natural Gas is historically volatile, and the heavy snows in the North East seem to have caused shorts to cover their positions.

Last week we suggested leadership was shaping up to be tech. Well, things are completely different this week, as the semiconductor equipment makers sold off at an average loss of 4.8% on Tuesday of last week, with more downside action through the week. There were bright spots in tech last week, as IBM and Google both exceeded analyst expectations, even as others disappointed. It was Google (NASDAQ:GOOG) that allowed the NASDAQ-100 to achieve a higher close on Friday.

Other than retail, the steel industries, and the air transport industries, leadership is scattered. We would argue that retail is too volatile to be a leader. Finance has abandoned its leadership position. Steel continues to demonstrate leadership, and this may, in fact be the sector that leads the way in an up trending market. Transports have a place in Dow Theory for a bull market. Thus far, they have been leading, based primarily on lower fuel costs. What other leaders will emerge as leader? This remains a concern.

At this time, the NASDAQ continues to look weaker than the NYSE. This is the second week that we are noting this. If the NASDAQ were to turn downward, and the NYSE continues an upward path, we believe this divergence would resolve itself with a downturn in the markets. We aren't there yet, but we are monitor for this event to occur.

We are detecting a trend of the market over looking companies issuing downside guidance for 2007 or even Q4 of 2006. Many of these are the larger established companies that figure prominently in the S&P-500 or the Dow. The market has yet to react to this, but we continue to be guarded.

To understand more about our view on the markets, we will have to look at the charts.

Market Climate

The U.S. market, as represented by its individual major indexes has achieved moved higher early in the week and has since fallen back. The early part of next week will mark a pivotal point, whether we will see a pull-back or a continuation of the move upward.

The U.S. market has broken above its uptrend line marking intraday price highs. The uptrend has been in place for three months, since mid-July. However, the mid-June lows were at a similar level (double bottom). The Dow's close over 12,000 is not really reflected in the US Composite, although the composite is modestly higher from last Friday's close, closing 3/10ths of one percent higher on the week. In fact, the highest closing price for the week was on Monday, but half of those gains have been given back.

A chart of the composite of over 8,000 stocks traded on the U.S. Stock markets continues to be included.

The U.S. stock market composite chart:

Note that MACD had reached its extreme low along with price in mid-June and it didn't follow price back down to its lows. While it did trade lower again, it was a shallow dip and was only in a downtrend for nine sessions, while MACD was only below the signal line for seven sessions. In other words, MACD showed a divergence with price and indicated the retest of the lows would result in the market moving higher.

RSI, on the other hand, hits its peak in early July and bottomed in mid-July, right along with the market. No divergence was evident in RSI at the time.

Let's look at trading action last week. Last week closing price hit a high on Monday traded back near Friday's price on Tuesday and Wednesday, closed near Monday's high, and fell back on Friday. Intraday trading, however, was relatively flat on price highs until Friday, when intraday trading highs spiked up, even as the close moved down.

The important things to focus on in the chart are the divergences during the last week. RSI peaked on Monday and then declined every day since then (well, it moved up slightly on Friday). MACD continued to move up until Friday, but the divergence between MACD and its signal line narrowed. In fact, it is hard to tell on the chart, but MACD actually dropped slightly on Friday. If there is follow through on Monday, with RSI continuing to drop and MACD dropping, then it likely foretells a downturn, which would be confirmed by a cross of MACD and its signal line.

A look at the 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 trend has been up since mid-July. The DIAmonds have been in an ascending wedge pattern for nearly a month. The lines marking the boundaries of that wedge have narrowed, but won't cross for another two weeks. Friday's intraday trading pushed outside of the lower boundary and make indicate a break to the downside shortly.

There is no telling how far a break in the wedge will carry. The uptrend channel continues to be the trend indicator until broken, therefore the longer term forecast is still for a continued uptrend. Short term indicates a likely break down.

Let's take a look at the hourly chart for the DIAmonds to get some insight:

The hourly chart shows the symmetrical wedge pattern being broken to the downside and then price testing back up to the upper boundary again, before being rejected. Unless Monday's trading breaks through that boundary, downside action is likely.

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

The SPYders looks similar to the DIAmonds. However, there is a subtle difference.

They also are in a rising uptrend channel, and are in an ascending wedge pattern. That pattern predicts downside action. However, the hourly chart shows a different short term probability, seen below:

The hourly chart for the SPYders shows a likely break upward. With the daily chart showing indecision, and the hourly showing a likely break upward, we wouldn't be surprised if there is a short term lift to the market, but the ascending wedge should dominate the short term move and result in some downside action shortly.

This week, we will look at the weekly NASDAQ 100 ETF (QQQQ) Chart before the daily. It is below:

This chart reiterates what we have been saying that the trend line across the tops could present resistance to a continued move upward.

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

The QQQQs have fallen back to test the middle Bollinger Band and rebounded from it. With the Bollinger Bands collapsing, the market is likely building energy for its next push. When the Bands begin to widen again, that push will have begun.

With the 20-day moving average sitting just below the middle Bollinger Band, and the lower boundary of the uptrend channel just below that, there is significant support lying just below. The probability is that we will see sideways trading action as energy builds. Things to watch are:

1. The longer price stays below the 3x3, the more likely real downside action might get going
2. If PPO continues downward, even for another trading day, this may add more to bearish sentiment and would likely result in a test of the uptrend channel to follow.
3. A break down in accumulation would signal that this market could be losing support.

We aren't suggesting any of those things as the most likely, but they would confirm a bearish scenario. Rather, it is appropriate to recall that this uptrend has been in place for three months, and is likely to pause here but until the uptrend gets broken, the most likely direction is up.

Examining the hourly chart, indicates a retest upward is likely here.

The hourly chart shows the window that should be closed. Once that occurs, the direction the market takes afterwards could indicate a break out.

Fundamental Trends

Three of the five top industries have been replaced, so we are likely in a transition point. With that said, there are still five retailers in the top screen (31 industries). Both steel industries also enjoy top screen status, so it appears that the steel trade is still working. This is one of the most undervalued industries, so an investment here is something of a value play. In looking at the charts, however, these are only a momentum play at this time, as they are mostly in overbought territory.

Airlines and Air Freight are another couple of related industries in the top screen, which makes some sense, as their costs are dropping rapidly with the lower price for aviation fuel.

Two sectors that are absent from the top screen are finance and health industries. With the exception of foreign banks, there is no participation whatsoever for finance related industries. It appears that the inverted yield curve is catching up with industries sensitive to it. With companies in these industries guiding downward, the best times for these companies are likely to be behind them, and perhaps ahead, after the economy slows sufficiently for the Fed to begin lowering interest rates. Not a single healthcare industry remains in the top screen either.

Let's examine the industries in the top five. Farm machinery is no surprise, as we have been discussing the presence of food industries in the top screen (only two this week) due to the shortages expected in the wheat crop. Desktop software came out of no where so we will have to watch for continuation. We will monitor these companies for a good trade entry.

Leisure continues to show up in the top screen. However, Toy and Game makers have made it to the leader board for the first time this week. This makes sense as investors are looking forward to strong seasonal buying by consumers going into the holiday shopping season. There are two potential shorting candidate here that we are looking into, Marvel Entertainment (NYSE:MVL) and Hasbro Inc (NYSE:HAS). Both of them look to be setting up for corrections, with MVL likely to announce earnings with significant downside possible, or a renewed move upward. More on this is the coming week.

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

The laggards list has two replacements, but no real surprises. Coal is back in the laggards, even though FDG has continued to move up modestly. Remember that FDG supplies coal to steel makers, and steel makers continue to be in the top screen. Soap and Cleaning products makers are back in the laggards as well.

No petroleum industry is in the bottom five as oil hits a new low of the year, but there are seven petroleum industries in the bottom screen.

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

Trade Recommendations

The awaited pull back in the market is imminent. It may take the place of a sideways move. Either way, unless we get a broken uptrend, we will look to enter some long positions shortly.

Current Portfolio

FDG has rallied from $24.95 to $25.27. SPY moved from $136.63 to $136.84. Neither of these moves is significant. Downside action may get started in the markets this week, or we will likely close our SPY position by the end of the week.

Generally, our model uses set stop prices to control risk. Index ETFs, including DIA, SPY, QQQQ, and IWM are managed somewhat differently, in that trades will be reversed to time the market, as opposed to using a set stop limit.

Unlike the majority of position trades in the fundamental trader, our ETF trades may see us exit positions prior to specific profit goals being achieved, as we are more concerned with positioning for the correct direction of the market more than with achieving a specific profit level. The reason for this is the profits come over time with a fair number of exchanges for long and short trades.

* 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 amended our bearish posture, allowing that the uptrend may continue with the emergence of tech as a market leader. This week, tech leadership was abandoned. The exception to this is the narrow leadership of large cap tech, such as IBM, Microsoft, Cisco, Google, and perhaps Intel). Except for Google, these are venerable names in tech, that led the way up in the non-stop rally of the late 1990s.

Perhaps they will be the leaders of a continued uptrend, but they weren't the large caps they are today. Their lead in an uptrend would have to be at a more relaxed pace, but a slow grinding upward trend may be what we are in store for. No one seems to be jumping up and down and adopting significant risk. At least, the last time they did they paid for it heartily with the collapse of the semiconductor equipment makers last week.

We reiterate that it is not time to commit to large bullish or bearish positions at this time, but rather be selective. It appears that the safety of the large caps is being sought out. Taking a different path could be reckless at this time.

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Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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