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7/07/01 Technical Traders Report
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TONIGHT:
- Earnings warnings and slower employment report sparks selloff.
- S&P slices through gap up point as Dow and Nasdaq try to hold on.
- Very gloomy commentary on the short term situation makes some lose sight of the economic improvement that is occurring.
- Looking for buying opportunities wherever they are.
- Subscriber Questions

Market gets off to a bad start and gets worse.

AMD and EMC were slaughtered, and they took down the techs with them. Those warnings had already set the stage for the selling, but then the employment report notched a much larger drop in non-farm payrolls than expected, and that spooked investors. The selling lasted the entire day and volume edged higher though it was still below average. That shows that there is still no major share dumping, but as we have seen on other rounds of selling, that does not help when it is your stock that is falling in price.

It does, however, mean that the market can recover and move higher faster than if there was heavy dumping. We have seen the market make solid, higher volume rallies after these rounds of fairly steep (if not high-volume) selling. If there is no heavy share dumping, the market retains that ability to rebound from what appears to be a final cleansing before it is ready to continue to move up off the bottoms set earlier this year.

S&P and Dow break below some important levels.

On April 18 the S&P 500 gapped higher and was off and running on a new rally even before the Fed cut rates in a surprise move that day. It gapped up to 1200 that session, and the 1200 level has been the bottom of the range since that time. Friday, however, the index fell below not only the 1200 level, but also completely filled the gap that started at 1191.53. That knocks out the gap higher as a support level and opens the door to further downside. We were looking for 1200 to hold, but that is not the case. Why? As we will discuss, a narrow view of the short term in the form of last quarter's earnings and lagging employment versus what is actually happening now.

In any event, the S&P dropped hard through support and now has room to fall. The first point of interest is 1182.17, the level of the 'hump' in the double bottom pattern (the breakout point and a natural support level) and also the point where the head and shoulders pattern that formed in May and early June would reach its likely consummation (the fall is usually equals the distance from the top of the head to the neckline). That is a mere 8 points away from Friday's close.

As for the Dow, it broke through 10,400, a level it tested after its double bottom breakout and the level that represented the 'normal' drop after its somewhat head and shoulders pattern that formed in May and June. 10,250 has acted as support in the past, but there is not a lot keeping the index from testing the 10,000 level if the selling continues. It only takes another day such as Friday and it is there.

Nasdaq still hanging on for now.

Even though the techs took the worst thumping on Friday from a percentage basis, they still managed to close above the recent support level that is roughly the gap up point in April. As with the other indexes, volume was higher but still well below average. There were many big name tech stocks that were dumped on higher volume, but the high volume damage was pretty much limited to those stocks. We are not saying all is well on the Nasdaq, but as with the other indexes, if it cannot hold here at the gap up point, we feel it is still near its low as it makes a final test of the April low.

Good news shoved to the back burner Friday in favor of short term gloom.

AMD and EMC did not help the market, nor did the employment numbers. But even as the market focuses on past events, we cannot lose our focus. Sure we don't want to go wading in front of big name tech stocks when the overall market is still trying to get its arms around the fact that earnings are still not going to be anything looking remotely positive in Q2 or is sulking over employment figures that are already a quarter old. But we have to keep our eyes on what is the next move.

The jobs report was not that bad, and forward-looking economic numbers still look good.

Friday the focus was on the drop in non-farm payrolls; seems the Q2 numbers are not catching up with the recent upturn in the other economic numbers (factory orders, durable goods, building permits, NAPM, Chicago PMI, Philly PMI, NAPM services). It was wishful thinking on our part to think they would.

But look closer at the number. First, employment is lagging; the economy has often made its turn higher even as employment numbers continue to decline. We have already discussed the relationship in the previous two weeks of reports, and that was repeated by many economists on Friday. Second, take a look at the REVISIONS in the number once again. The May number was revised from a 19,000 job LOSS to an 8,000 GAIN. Originally it was -29,000, then -19,000, and now +8,000. That is a 37,000 job positive swing brought about by simply getting the numbers right. Remember, in April the number came in at minus 228,000 before being revised to a loss of 182,000 (a 19% swing). Third, big layoffs as we have seen over the past three months are planned well before they are announced or implemented. This is another reason they tend to lag the economic turn. Fourth, over the last three months the length of time it is taking to find a new jobs is falling. For a while the length of time to find a replacement job was edging higher and higher. Now it seems that trend is reversing as the job search time is falling once again.

Thus, in review, even the lagging employment indicator is not looking so bad, and is indeed even looking a bit better. Again, we cannot let this take our eye off the ball of, despite the very negative mood that some were voicing Friday, positive economic news. Indeed, we were surprised to hear Larry Kudlow so adamant that the employment number was recessionary. As things weakened last year, Kudlow was quick to point out that those citing strong employment as a reason for their belief in a continuing strong economy that employment was a lagging indicator. Of late he seems to have overlooked the more leading indicators (the LEI's themselves, NAPM, housing, permits, factory orders, durable goods, etc.) and is focusing on the one area that is still weak or at least is not showing improvement. His comic relief on the CNBC point/counterpoint segment Friday was also very gloomy and preaching that the Fed should really lower rates from here and that there will be no recovery in 2001 and maybe not in 2002. Of course, this is the same man who last year was saying the economy was still too strong and defending the Fed rate hikes and lack of rate cuts even when it was obvious that things were weakening. To us he is more of a contrary indicator; now that he is converted to the negative side, things are probably ready to continue to improve.

When do the market and the economy bottom?

There is an old line of economic thought that the stock market bottoms three to four months before the economy. In other words, the stock market anticipates the move higher in the economy just as it anticipated the moved down in the economy back in 2000. From our view of the market and the history of the market, it appears that the Nasdaq bottomed on April 4 and the S&P 500 and Dow bottomed on March 22. About three weeks ago we started to see improving economic numbers in the form of a rise in home starts and sales, rising building permits, rising LEI's, improving NAPM, Chicago and Philly PMI, factory orders, durable goods, weekly jobless claims). That is right at three months, and that would put things right on historical schedule. You have to look at leading indicators, not lagging indicators, to understand this.

Moving out of warnings season.

One of the drags on the market: worries about Q2 earnings being even worse than expected. With AMD and EMC, we see those worries come home. Again, however, our analysis shows us that we are seeing the worst right now (historically when things seem the worst and the preoccupation is with how bad things have become, the bottom is here) as far as lagging indicators just as we see the leading indicators start to pick back up. Thus, while warnings were bad and worse than expected, we also think that we have seen the worst of it.

This week earnings announcements start. We will still get warnings, but we feel that the majority have already hit the wire as companies were looking for the last numbers from June to come in before making the announcement. Remember, companies want to avoid the lawsuits that accompany failure to warn prior to the earnings release. If they were going to miss big or by more than anticipated on the street, they would warn. Warnings will now slow down.

Actual earnings will take precedence, and the key will be future guidance. We anticipate some positive guidance, but with the AMD and EMC-like news, we may also see continued caution looking forward. CEO's tend to be overly cautious just as the economy turns, and we saw AMD have to come out and warn even worse than before. We may not get as many positive statements, but we will get to the point where there has been enough selling and investors start looking again toward the future. Kind of like the PMCS warning: it was a warning, but it was not as bad as most thought it would be. There will be earnings that are poor, but we feel that before it is over there will be the start of another move higher.

THE MARKET

All three major indexes fell on rising though below average volume, and the S&P 500 put in a very weak performance as it crashed back down through its April gap higher. There were very few winners on Friday as the market had to deal with the much worse than expected earnings warnings and the weaker than expected employment report. There were not many sectors on the positive side even in the recent stronger groups. Whether this was a one-day event given the news or the indication of more selling this week remains to be seen.

Markets always tend to give reflex bounces after several down sessions. If the Nasdaq and the Dow cannot hold at the current levels, we would prefer to see some serious selling to form the right side of a longer double bottom than the short 9-day one on the Dow and S&P back in March and April. Right now we are watching patiently as the Dow and Nasdaq test support, and we are going to watch for a high volume reversal while being wary of any reversal that does not occur on high volume. The market is pricing in bad news for past events and possible disappointment over the next two weeks with earnings. If earnings for the most part are not worse than expected (at least by much) and there are a few positive outlooks as economic data continues to improve, we are looking for this selling to be a buying opportunity.

Overall market stats:

VIX: 24.97; +2.25. Volatility started to pick up speed as the fear started to rise on Friday. It is now in the 'middle' range with 20 being considered low and 30 considered high.

VXN: 51.99; +2.55. Fear is edging back up on the Nasdaq as well, but the numbers are still not at levels considered high.

Put/Call ratio (CBOE): 0.93; +0.27. Big spike higher as option players started jumping onto the downside. Still did not close over 1.0 which can indicate a turn, but it was the highest level since it spiked over 1.0 in April. That was the point the market bottomed. We would like to see another strong selling day that closes it above 1.0, but we will probably get a weak rally that will take the edge off of the fear.

NASDAQ: More really negative sentiment out there on Friday, and there were simply no buyers willing to step in ahead of the official start of earnings season. There will have to be a reason for buyers to step in, and massive warnings were not the reason on Friday.

Stats: Down 75.95 points (-3.7%) to close at 2004.16.
Volume: 1.441 billion (+11.9%). Higher on the selling, the first distribution day since the Nasdaq bounced up from the 1990 level over two weeks ago. 1.311 billion shares to the downside and just 107 million to the upside. More sellers and no buyers.
A/D and Hi/Lo: Decliners extended their dominance at 2.19 to 1 (1.72 to 1 Thursday). There were not many areas of relief on Friday. New highs fell to 55 (-9) as new lows jumped to 108 (+34).

The Chart: http://www.investmenthouse.com/cd/$compq.html

The Nasdaq started lower and finished just off the session low (2001.82). The Nasdaq traded as low as 1973.70 on June 20 before it started the last move up to 2180. It is the last index to hold above its recent trading range, but will it succeed with its test at this point and turn? The Nasdaq has been a couple of days ahead of the Dow and S&P the past three weeks; it has been selling for four sessions while the others have sold for just two. A test down to 1990, maybe down to 1970, and then a strong high volume reversal is what we are watching for. Still, if it does not happen, we are going to be patient and play some of the downside plays that are properly set up (not chasing a bus that has left the stop) while we wait for this test to end. We still believe that the lows have been put in, and we expect the stocks that have been leading to continue their moves higher when this bout of selling is over.

Dow/NYSE: 10,400 did not hold as the Dow tests 10,200 and looks to try 10,000.

Stats: Down 227.18 points (-2.2%) to close at 10,252.68.
NYSE Volume: 1.043 billion shares (+11.7%). Down volume was 837 million shares to just 200 million to the upside. Still below average, but rising and the second distribution day in the last 5 sessions. A/D and Hi/Lo: NYSE decliners jumped to 2 to 1 (1.23 to 1 Thursday). New highs fell to 67 (-32) as new lows rose to 78 (+27).

The Chart: http://www.investmenthouse.com/cd/$dja.html

Smashed through 10,400, unable to hold the recent support. We are looking for a test of 10,000 to 9,992 if 10,200 is broken. That represents the 'hump' in the prior double bottom pattern. In 1974 the Dow completely retested the prior low. That would take it down to 9100, another thousand points. At this point we don't think that will happen, but we have to be patient and let it unfold at this point. We believe the low has been put in, and now we are waiting for it to test and start its recovery.

S&P 500: As previously discussed, the S&P filled the April 18 gap higher, breaking below what was trying to form up as solid support. It can now test 1182 with ease, the level of the hump in the prior double bottom pattern that formed in late March and early April. We are not getting the test of those lows as it makes a second double bottom pattern, one that should prove to be much stronger than the original shorter pattern. The question now is where it stops. Again we wait patiently for the investors to get the short term worries sold out of the market so we can start moving higher again in anticipation of better earnings brought about by the improving economy, signs of which we are already seeing.

Stats: Down 28.65 points (-2.3%) to close at 1190.59.
Volume: NYSE volume rose to 1.043 billion shares (+11.7%), the second distribution day in 5 sessions.

The Chart: http://www.investmenthouse.com/cd/$spx.html

Summary: Volume on the recent selling remains below the volume on the recent rise. Maybe that was a factor of the holiday week, so we need to be careful concluding the selling was not really strong. We have to see what happens this week as earnings start coming home. The breaks below support are not good and usually lead to more downside testing as opposed to the move up from here. Be wary of a move higher on continued low volume. What we need is another sharp drop that then leads to a reversal on higher volume. We should also not get too upset and remember that stocks are pricing in worst-case scenarios after AMD and EMC, and that we most likely will not see the same type of pitiful earnings reports from other stocks that have not already warned. With continuing improving economic numbers and earnings reports that are not as bad as originally anticipated, the market will most likely find its footing before it completely retests the prior lows.

End Part 1 of 3

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