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April 30, 2007

Index Advisor
by Mark McMillan

Index Advisor 032
4/30/2007 9:20:14 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:

Dow 13,000...

The Dow Jones Industrial Average surpassed 13,000 on Wednesday, a new all time high. It took the Dow six months to move up from 12,000 to reach the 13,000 level (Friday's close was at 13,121). This rise was fueled by companies continuing to exceed earnings expectations while the economy continues to show signs of slowing and inflation continues to rise.

Reiterating last week's statement, "The markets seem immune to negative news... Since last summer, the markets have been in rally mode, which makes more sense on a fundamental basis for last year than this year." The one thing that is clear is that analysts continue to underestimate the earnings potential of companies and that the economy continues to weaken while U.S. dollar based inflation continues to rise.

We have seen the fourteen consecutive quarters of double digit growth finally slow to the single digits, but it is still better than analysts predicted. Q107 consensus estimates for year-over-year growth for the S&P-500 companies are, on average, around 3.5% to 4%. Companies are indeed beating these expectations (as we expected) but they are surpassing them by a greater degree than expected, probably around 4% higher than the analyst expectations, which is enough to stimulate buying interest.

Last week we reported the economists continue to ratchet down Q1 GDP expectations, which were around 2% annual growth for Q107. Friday's advance GDP report showed an annual growth rate of 1.3%, which wasn't enough to derail the market but should cause investors some concern.

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

Monday: Even though some M&A activity was confirmed on Monday, the deals had been rumored for weeks and follow a large up day on Friday. Profit taking was the underlying theme of the day, with the only sector advancing was confined to utilities, which is defensive in nature.

Tuesday: Consumer confidence was reported at 104 versus a consensus expectation of 105. Existing home sales were reported at 6.12M versus an expectation of 6.45M in March. February was revised down slightly from 6.69M to 6.68M. Both of these negative reports failed to deter investors who have applauded the better than expected earnings results being reported.

Wednesday: Wednesday's trading was all about optimism, with company earnings continuing to beat analyst expectations and the Dow roaring upward to break the 13,000 mark, closing at 13,089.89. The optimism in the market is impossible to ignore, and is reminiscent of the second half of 2006, when price moved relentlessly upward no matter what the news to contrary, powered by unexpected double digit earnings growth.

Wednesday saw new home sales reported for March at 858K versus and expectation of 890K. Of note, February's number was revised down from 848K to 836K. This may be the reason that all homebuilder CEOs have continued to be sanguine about earnings prospects for 2007. Durable goods orders beat expectations for March, as the 3.4% growth beat the consensus expectation of 2.5%. In addition, February's number was revised upward from 1.7% growth to 2.4% growth. This was an indication of more business investment than has previously been indicated.

Thursday: Thursday's economic reports were about jobs. Initial jobless claims for last week dropped to 321K versus an expected 330K. However, the previous week's number was revised upward to 341K from 339K. The Help Wanted index was reported at 30 for March versus an expected 31. Reported earnings continue to be impressive as well.

Friday: Friday's economic reports included:

• GDP (Advance), which showed an annual rate of growth in Q1 of 1.3% versus an expected 1.8% rate. This number gets revised twice more in the short term, one time in a month, known as Preliminary GDP, and once more a month later known as Final GDP.
• Chain Deflator (Advance), which showed inflation rising at 4.0% annually versus an expected rate of 3.2%. This number gets revised twice more in the short term, one time in a month, known as Preliminary GDP, and once more a month later known as Final GDP.
• Q1 Employment Cost Index was reported at 0.8% versus an expected 0.9%. This is a 3.5% rise year-over-year (yoy). More importantly, benefits didn't rise much in Q1, about 0.1% (3.1% yoy) while wages rose about 1.1% (3.6% yoy).
• Michigan Consumer Sentiment was reported at 87.1 versus expected 85.5.

So, looking at the week as a whole, we did see some sign of business investment with the Durable Goods orders being higher than expected. This was reported the same day as the Dow surged up over 13,000. We think there is a high degree of correlation to that piece of good economic news and the market's ability to rally on Wednesday.

However, most of the other economic reports through the week were neutral to negative, with the GDP and Price Deflator reports on Friday causing some serious concern.

What is important is to note that the market rallied on good news and stayed flat on negative news. The bullish optimism is hard to ignore, but the market is now overbought and ripe for a pullback or sideways trading action.

The price of oil rose nearly three dollars to close at $66.46, the highest closing price since September 2006. Natural gas rose a modest three cents for the week.

The major concern we noted last week was the lack of business investment coupled with the rapid rise in consumer prices for food and energy. Wednesday's durable goods report shows that businesses are, in fact, making some investments. We will need to see follow-through here for the economy to continue to grow. In addition, we have seen things actually get worse on the inflation front for consumers, as food and energy prices continue to swell. This will likely cause a decline in consumer spending at some point in the future, and has already caused a drop in consumer sentiment.

Market Climate

The bulls continue to hold the upper hand as the bears have slinked away unable to wrest control. The Dow surpassed 13,000 for the first time ever and earnings continue to be impressive when compared to expectations of 3.5 - 4.0% growth in earnings.

By Friday, market internals were negative with decliners leading advancers by 3:2 on the NASDAQ and just under that on the NYSE. Down volume led up volume by a similar margin, indicating more than 3:2 on the NYSE but less drastically than that on the NASDAQ. The Index put/call ratio doubled to 2.88 while the equities put/call ratio fell modestly to 0.57.

While the advance/decline ratios indicate some negativity, and down volume led up volume, accumulation has continued now since summer 2006. There really isn't yet a sign of distribution, with the entire month of April showing continued accumulation. In fact, the market has entirely recovered from Black Tuesday (February 27th) when the market sold off in reaction to a fall of nearly 10% in the Shanghai index.

Probably the most astounding number we have seen last week was the Index Put/Call ratio essentially doubling from Thursday to Friday to reach 2.88. While this level is not a rarity, it is a level that isn't maintained for any length of time, and we have noted a pattern of heavy index put buying just before a downward move in the market. These positions are often closed the day of the move, so if we see a sharp downward move in the market in the coming week, and the Index Put/Call ratio drops on that day, then the markets are repeating this same pattern.

The Dow reached a record closing level, while the S&P-500, the NASDAQ, and the Russell-2000 all reached six and a half year highs. The Russell-2000 appears to be having difficulty moving higher, as it fell back to important horizontal support/resistance on Friday after achieving its six and a half year high on Thursday.

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 are at resistance, and moving higher will likely prove difficult in the short term.

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

The daily chart for the SPYders is similar to that for the DIAmonds. In fact, the charts for all the major indexes show a similar pattern, with all indexes achieving new highs on Thursday and testing resistance.

Note that we are monitoring price action to close below the short term uptrend line, which would set-up a juicy short opportunity.

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

The daily chart shows similarities to the other major indexes. The QQQQs have a wider range in their ascending triangle than the other indexes, so have to move farther to provide a catalyst for a short trade.

The Fractal (Choppiness) Indicator (not shown on the chart) suggests that this uptrend could run out of steam at any time.

This week's Russell-2000 ETF (Amex:IWM) Daily Chart is below:

The most interesting thing about the daily chart for the IWMs is that there is little room to maneuver within the ascending wedge formation. A close below the $82.30 level would indicate a break of the short term uptrend line, and suggests more downside action.

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

The semiconductor index has traded up toward the upper boundary and reversed itself on Friday after achieving a local closing high, not seen since May 2006. There has been a fair amount of optimism for this sector with analyst upgrades and earnings announcements providing a lift.

Let's take a quick look at the charts for implied volatility, i.e. the VIX and the VXN, which map to the S&P-500 and NASDAQ-100 specifically.

This week's VIX Daily Chart is below:

Here we see that the VIX has been moving down since Black Tuesday as complacency once again sets in with investors. Note that support is just below and that the VIX has an inverse relationship to the S&P-500.

This week's VXN Daily Chart is below:

Here we see that the VXN has been moving down in a steep narrow channel for the entire month of April. There is little room to maneuver, as horizontal support lies just below and a short term uptrend line indicates the VXN is currently at support. In addition, the VXN can't move much higher or it will violate its narrow downtrend channel. With the NASDAQ-100 moving inversely to the VXN, this suggests we are at an important juncture where the market is likely to move lower or will move to new highs against a backdrop of more and more complacency on the part of investors. This suggests that risk is rising and a correction could be more potent than normal.

Conclusion:

We continue to see optimism in the US Equities markets. We believe that investors are taking on more risk, without perhaps being fully aware of them. This is similar to the late 1990s when the bull ran rampant until a correction finally began in 2000. We are not suggesting that the market is overvalued to the extent it was during the dot com era, but we do note that complacency is high at this time as positive news is embraced and negative news is discarded.

Given that private equity deals have removed supply, and that liquidity has increased demand, it makes sense that prices have moved higher. However, when liquidity is reduced by tighter lending standards and/or increased interest rates, then demand will drop suggesting a drop in the price of equities.

We are clearly in a new era where global liquidity is very high. Some market pundits suggest this new era will not see liquidity withdrawn and there is no cause for concern. We believe a more realistic approach is called for, as we heard similar claims being made during the dot com era and the resulting correction was quite severe.

We are looking for specific signs of an imminent reversal, and will enter short trades on confirmation we have an indication of a tradable reversal. We will just have to wait to see what the market brings and we will enter and exit trades at the turning points.

Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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