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May 07, 2007

Index Advisor
by Mark McMillan

Index Advisor 033
5/7/2007 9:14:38 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 market continues to make new highs...

In general, earnings season tends to provide the markets with a lift, unless companies are missing their earnings expectations. This season has been no different, and the end of earnings season often sees flat trading or the beginning of a downtrend.

In addition, there is an old adage, which is "Sell in May and Go Away". This is a relatively simple strategy that recognizes that the great majority of gains in the U.S. stock markets are seen in the months from November through April, and that May to October often are challenging for investors.

Separate from all of that, companies have exceeded analyst expectations significantly, although it is easy to argue that the bar was set too low by analysts. It is generally the case the companies, on average, exceed analyst expectations by some two to three percent. In this case, that would have allowed for increases in earnings of around six percent year over year for the S&P-500 companies. It appears that companies have vaulted well above those returns with current expectations that returns will be nearer double digits. Therefore, stocks have caught a bid.

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

Monday: Monday's economic reports included:

• Personal Income was reported at 0.7% versus the consensus 0.5%.
• Personal Spending was reported at 0.3% versus the consensus 0.5%.
• Core PCE inflation was reported at 0.0% versus an expected 0.1% rise.
• Chicago PMI for April came in at 52.9 versus an expected 55.0.
• Construction Spending in March rose 0.2% versus the consensus 0.3%. February's rate was raised to 1.5% from 0.3%.

Tuesday: Tuesday's economic reports were mixed:

• The ISM Index was reported at 54.7, well above the expected 51.0 consensus indicating strength in manufacturing.
• Pending home sales dropped by 4.7% versus the expected increase of 0.4% indicating continued weakness in housing.
• Auto sales (April) were reported at 5.0M versus an expected 5.1M
• Truck sales (April) were reported at 7.5M versus an expected 7.2M

Wednesday: March factory orders rose by 3.1% versus an expected 2.1%. February's factory orders were revised upward from 1.0% to 1.4%.

Thursday: Economic reports were positive:

• Initial jobless claims for last week were reported at 305K versus an expected 325K.
• Preliminary Q1 Productivity was reported at 1.7% versus an expected 0.8%. Q406 Productivity was revised to 2.1% from 1.6%.
• April ISM Services index came in at 56.0 versus an expected 53.0.

In particular, the Productivity report helped propel the indexes to another positive close as the unit labor costs rose only 0.6% in the details of that report, easing some wage related inflation concerns.

Friday: Friday's payroll's report came in close to expectations:

• Non-farm payrolls grew by 88K in April versus the expectation of 100K. In addition, March payrolls were adjusted to 177K from 180K
• Unemployment matched expectations at 4.5%
• Hourly earnings rose 0.2% versus an expectation of 0.3%
• The average work week declined to 33.8 hours matching expectations.

Clearly, job creation is slowing from the pace of the last few months but this can ease concerns about wage induced inflation. That appears to be how investors are interpreting the report, especially with the lower than expected rise in hourly earnings.

The price of oil has now fallen below $62.00, closing at $61.93. The price of natural gas is staying near the eight dollar per MBTU level closing at $7.94.

The past week saw a continuation of companies reporting earnings that beat analyst expectations and a bevy of positive economic reports helped ensure that the Dow put in a rise in 23 out of the past 26 sessions, a feat not seen the late 1920's, just prior to the crash of 1929 and the beginning of the Great Depression.

With the exception of continued weakness in the housing sector, it appears the U.S. economy is continuing to expand, showing recent signs of expansion across the board. With the U.S. Consumer's income growing, while wage pressures appear to be mitigating, the Fed may indeed have threaded the needle with a brake put on inflation, while the economy slowed but didn't stop.

With this backdrop, many market bulls are now suggesting the Fed will ease rates this year (they have been saying this for a long time now) to ease housing woes. If this occurs, this will provide a further lift to the markets but it is premature to assume this at this time.

What are the negatives at this time? The markets are looking a bit overextended and there is a sense that many non-U.S. markets have been running a bit ahead of themselves, including the speculative Chinese markets, and some international real estate markets have moved up so much that recently some of Spain's largest developers have see their stock prices as much as halved in anticipation of a correction.

Market Climate

The markets continue to show strength recording another positive week with the Dow, S&P-500, and NASDAQ all moving to all-time or six and a half year highs. The Dow is at an all time high while the S&P-500 is nearing its high of 1527 set in March 2000. The NASDAQ is at 2572, about halfway to it's all time high set in March 2000 above 5,048. Even the small caps, represented by the Russell-2000 continue to hit new highs, although they continue to retreat slight each time they hit new highs as well.

All of the major indexes have broken upward above horizontal resistance, which may now serve as support before any downtrend could get started.

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 show that they had been trading in a clear channel prior to the breakdown on February 27th. They are back in that channel and this may prove to be a reliable gauge of where turns in market will take place. At this time, they are at the top of that channel and are just under the Fibonacci 161.8% level. We would expect some trouble moving up strongly from here, but until that channel is broken, a gradual rise is likely for the DIAmonds.

With a confluence of resistance a the current price level, downside action may occur, or it may be a sideways motion, but support should hold at the bottom of the uptrend channel, as well as at the last swing low, a bit above 130. Also, note that the short term uptrend line would be violate until price broke below 129 or so. The bulls will continue to run until that occurs.

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, although the DIAmonds continue to break to new highs, and the S&P-500 hasn't quite reached the uptrend line resistance boundary yet. The $151.70 may prove to be significant resistance which would likely put the SPYders into a sideways trading action.

Several key support levels could be broken, with the short term uptrend line just below the $149 level, the swing low just below the $148 level, and horizontal support around $146.50. We still see support for the SPYders holding until a close below the $146 level is recorded. At this time, a break down could provide a tradable short, but it wouldn't be prudent to let the short run until these support levels are taken out as a bounce is more likely than continued downside action.

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

The QQQQs have hit their 161.8% Fibonacci projection level on Friday and then retreated, still registering a six an half year closing high, closing six cents higher than last week. Even though a local high may have been reached intraday on Friday, we don't look for much downside action to get started until support is taken out around $45.67. The short term uptrend line is currently around $45.50 and will rise to around $46 by the end of the week. A break below this will see support just below by the 50-day and 100-day moving averages, so we don't see a lot of downside action until these levels are taken out, currently above the $44 range.

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

The IWMs are the most interesting of the four charts in that they are not moving strongly up an uninterrupted short term uptrend line. Rather, they continue to violate trend lines modestly then reverse after testing just outside these boundaries. Friday saw a close above resistance. Thursday a week ago also saw this occur and was reversed. The beginning of the coming week should be interesting to see whether the IWMs can hold this level or if they will, once again, succumb to more profit taking.

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

Unless the swing low around 488 is violated, we see the semiconductors continueing to move higher over time. A move that breaks the support of the intermediate term uptrend line that has served as the bottom channel boundary would suggest a downside action in earnest but sideways action could see continued support for more than a month at this time.

Conclusion:

U.S. equities have risen at a good rate all year and the underlying fundamentals support a continued rise over time. The housing market is the largest easily identified negative, but geopolitical risks are always a wildcard and the continued rise in energy and food prices will continue to undermine the consumer's ability to continue spending.

Give the seasonality and the overextended nature of the major indexes, we would see sideways trading at this time, but we are yet looking for major downside to get started as investors continue to adjust their expectations upward, based on the latest earnings news and economic data.

The Fed meets in the coming week and a policy change would certainly affect the markets. As always, the statement will be carefully parsed for a clue as to a change in the stance of the Fed, to try to gauge whether they will raise or lower rates in the near future. No change is expected at the coming meeting.

The liquidity is also a factor in the continued rise and while the Fed may not take steps on their end to reduce the U.S. money supply, most other economies are expanding more rapidly than the U.S. and central banks in those countries are likely to take action, over time, to quell inflation in their economies, which may act to remove some of the liquidity that all the cheap money has provide in the past. In particular, the Japanese central bank is expected to remove some of the attractiveness of the carry trade in the near future.

If liquidity is reduced, this will adversely affect the market. At the same time, there are less shares to chase with the current supply of money. While a reduction in the supply of funds will depress prices, this has to be looked at in balance with the supply of shares. Unless there is more IPO activity or companies discontinue buying back their shares and private equity stops the trend of taking public companies private, the supply of shares could be reduced less than the supply of funds to buy them caused by a liquidity crunch. If that happens, prices could easily continue to rise.

Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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