Stock Market Giving the October Surprise

SUMMARY:

- CAT gives up on the US economy, raising further mortgage & credit fears and fueling expiration Friday selling.
- Oil runs to $90 but energy balks: too high for its own good?
- Lots of recession talk, and after 5 upside years that is normal. What the market is telling us about it.
- Market giving the October surprise we discussed last weekend.
- Looking for some leaders to hold up and others to recover from some fear-driven expiration selling.

Market gets some CAT-scratch fever on fears of a slowing economy.

GOOG, AMD and indeed most all techs have posted some good numbers thus far, but on Friday that did not really matter as some industrial stocks undermined the good work put in by tech. CAT, MMM, and HON failed to impress though their numbers were not bad. What was bad was the commentary, the words that accompanied the results. CAT said the recovery in the first half of 2007 would fade in the second half of the year. More than that, it could threaten the rest of the world economy, in effect dragging everyone with us. With some anecdotal evidence that Europe was slowing (and it was purely anecdotal; the UK reported a 3.3% GDP growth rate), the impact was devastating on a market that was already in pullback mode, trying to find some footing to continue its breakout move.

Instead it was more of a breakdown. Stocks started lower, tried the traditional (of late) midmorning bounce, but failed the attempt. It failed it horribly. There were many negatives on the session, at least there were many that were repeated all day on CNBC and other financial stations. On top of the CAT comments there were calls that the US economy was going into a 'doozy' of a recession. It was the 20th anniversary of Black Friday and the comparisons during the day were ad nauseam. There was the weak dollar with the dollar index hitting a new low and again, comparisons to 1987 when the dollar was weak as well.

All of this led to a snowball selling effect, and in the afternoon when there was no rebound as in the prior sessions there was the definite smell of panic as shares were dumped and the indices went straight down to the close without even trying to bounce or otherwise come up for air. Oh there was a 3 minute or so blip in the last 15 minutes once the sell on close orders cleared out and there were no buy or sell imbalances on the NYSE board, but that was washed over in a last wave of selling.

Technically the action was about as weak as you can get it. A low open that only got worse as the day progressed, knifing lower in the afternoon right into the bell. The indices all lost more than 2.5% with the small caps pushing 3% (-2.98%). Nothing like economic and recession worries to skewer the smaller issues that are so economically, and specifically US economically, dependent. The internals were commensurately weak with surging volume on the selling (3 out of 7 distribution sessions on NYSE, 4 out of 7 on NASDAQ). A sad fact is that the only really strong volume outside the Fed rate cut day has occurred on the downside, just as in the July and August sell off. Breadth was -5:1; weak anyway you cut it.

The charts also told a weak story as SP500 and DJ30 dove through their 50 day EMA and into the May and June trading ranges just before the July and August breakdown. NASDAQ is still hanging in there above its July high and thus holding its breakout, but it is a very tenuous save. Now 200 of the Dows downside was due to just 7 stocks, and more than half of that was attributed to just three. That, however, does not change the outcome and it certainly doesn't explain the massive weakness in SP500 and the small caps.

Leadership was mixed. Energy was just coming to life the past week once more and then Friday it suffered a blowout. SLB reported great earnings but it was torched. There were calls oil would reverse sharply, and along with the recession talk (recession means less demand for oil) the energy stocks got hit as well. Industrials were slaughtered after CAT spoke its mind about the economy. Financials were of course lower with the renewed worries regarding the economy and CAT's comments about the housing industry.

On the other hand techs were remarkably solid. Of course, tech earnings have been solid, indeed strong (e.g. GOOG, NOK, INTC, YHOO). Amazing what some solid earnings can do for a stock and a sector. Interestingly, techs led the move higher and looking over many of those same stocks on Friday, they held up very well, holding their uptrends and just making normal tests. Metals were also quite strong. Yes they were lower, but they were just testing, setting up nicely for a new break higher. It remains to be seen whether they continue their normal tests or succumb to the selling in the other sectors, but on Friday when investors were throwing everything out the window, these stocks were holding the line. That is a nice plus, and we are looking at these areas for when the selling winds down.

Friday was a classic example of why we take gains on the way up, i.e. after the strong runs in stocks when they start the moves we anticipated. Even though the move looks strong, when a stock makes a strong surge over a few sessions it is prudent to lock in some gain, particularly with options. In a market where the economics still look good and the Fed is on investors' side, the market can still react adversely. After all, the Fed tends to lead the economy, selling off before there are many hints of an economic decline. That is why you have to look at what the market does as opposed to relying on your own conclusions and emotions. Friday smelled of panic, especially in the afternoon when no rebound transpired. With the very heavy negative technical indications, however, you cannot just write it off to panic and assume things will be back up next week. The market was consolidating nicely until Friday when it was clocked and the breakouts in the NYSE were given up. This may just be a new buying opportunity in the making, but we have to see how this coming week pans out, particularly watching how the remaining leaders hold up.

THE ECONOMY

Oil blitzkrieg balks at $90/bbl.

Energy broke higher in September after a good base, and after a three week test of that initial run, it started to break higher again this past week. As oil moved toward $90/bbl that started to pull some of the major integrated companies along with the service and independents that had already broken higher. The high prices also got the tar sands and other alternative energy plays moving again.

As oil hit 90, however, if immediately came back. That did not kill the energy stock advance, not until SLB announced some solid results and got slammed. The results were better than expected but nonetheless SLB blew up. It took the other service stocks with it, the particular sector that really led energy higher. Now on the positive it did not take down the rest of the energy sectors. There was some selling in the independents as they are considered a bit riskier, but they did not fold up their patterns. The majors sold some as well, but they also held up. The tar sands and other alternative energy stocks held up just fine. It was not a washout, but the leading sector took a hammering.

What is the deeper story here? Is there a deeper story? The first thing that you think of is oil approaching $100/bbl. Boone Pickens said that might be the choke point but he quickly followed with a general denial of just at what point the economy would seize up. Good reason too as he believed it was a lower point last year. Not criticizing him; he has made billions for himself and his investors. Just pointing out that the economy has changed such that quantifying oil's impact on its output is very difficult.

Thus you look at how everything reacts when it reaches certain points. It hit 90 the past week and it immediately pulled back. The service stocks, despite strong earnings, gapped lower. The stock market struggled all week and then went into a tailspin Friday. There is a point where oil becomes too expensive and the economy stalls as a result. Call it the 1970's syndrome when it surged due to the embargo and western economies seized up into recession. Again in the early 1980's when price hit its all-time high (and that is still the champ in inflation adjusted dollars even with this spike higher) the economy recessed. Price just got too high and the economy couldn't handle it.

When you have $90/bbl oil and then add a housing bust, a credit crunch, a tanking dollar, protectionism, and talk of ending the economic policies that brought about the prosperity, it is tough to keep things going. When you think about it, that is a harsh laundry list of negatives for any economy to withstand. It is easy to fall into the trance many are in that recession is inevitable. It doesn't look great, but it hasn't for a couple of years. The acid test is what the stock market does. This last week was a nice pullback until Friday. Now it is a question mark as to whether the market will recover or will roll over and end the expansion. The latter seems improbable, but lets look at the issues at hand.

What is the market saying about the economy.

Lots of talk Friday about a market crash and a doozy of a recession. As noted, that helped fan the selling frenzy. Up until Friday the market was running higher and making rather orderly pullbacks with strong leaders plowing the road ahead. Definitely positive action. Even with Friday and the sharp sell off there is no reason to panic based on that event alone. Sharp sell offs are rather normal in continuing runs higher, though Friday, for just one session, was a bit extreme with all indices down more than 2.5%. That was a spanking. Nonetheless, even after Friday with SP500 and DJ30 plunging, it was not a breakdown. NASDAQ still holds its breakout, and as noted, some good solid leadership basically ignored the selling.

But market, and thus the economy, has some issues. In July and early August we discussed how the VIX was rising even as the indices made new highs. The last time that happened was in late 1999 and early 2000 and the market topped in March. Volatility did fall as the market rallied out of the August selling, but it held above the average level for the past 3.5 years and has rebounded close to 23 with the Friday selling. That is a sign to be watching for events such as Friday to develop into something worse.

There was heavy distribution in the summer selloff. Massive volume at record levels never seen on NASDAQ or NYSE. The recovery lacked any volume and indeed volume remained below average on over 90% of the recovery. To be fair average volume surged thanks to that record volume, but the point is the selling volume far surpassed the trade as the market recovered. That has been the major weakness of this recovery. Without a doubt much of the July and August volume was panic selling over the credit crisis, but it shows investors are ready to sell en masse if the conditions are right. After 5 years of economic expansion, investors are a bit more skittish.

There is also a big divergence among sectors in the market. Retail, housing, and other consumption related stocks are in the tank, declining even as the overall market rises. Energy, materials, metals, technology, agriculture, etc. are hitting highs. Divergences never go on forever. Remember in the 1990's the large cap techs were leading and no small caps were following? It took a nasty yet quick bear market in 1998 to get everything working together in harmony.

These current divergences have a huge difference, however, to those in the 1990's. Back then the US was THE game in town. The world was producing goods and selling them to us. Japan was in its depression after the 1980's when we were phobic about Japan buying up all of the US. It did, then those assets went down the tubes and we had the money and the property. Sweet deal. Makes you kind of wonder why we are all bent out of shape now about foreign purchases. It always tends to work out when the economy turns over and the house keeps everything. In the current situation the foreign countries are expanding sucking up all of the materials, thus driving prices, and those of the stocks dealing with these materials, higher. The consumer and retail sectors are languishing because of a slower US economy vis- -vis the rest of the world. After a 5 year run that is hardly unexpected. Thus the divergence is not the big issue that some make it out to be.

Okay, so the divergence is not anything to fret, but the rising VIX on the new highs and the heavy selling volume versus the rebound volume are significant market issues. Still, even with those the market is not breaking down. This pullback is thus far similar to others. It is the fact that it comes after a long expansion that makes each pullback worrisome to many pundits. How it responds to this selling given that there are some important issues is the key to how it moves going forward. Thus we want to see how this expiration sell off pans out in the week ahead. The market dug itself into a hole with that move and now we see how it responds.

MONDAY

Mercifully next week the economic data dies down somewhat, leaving earnings as the main focus. They would be the focus in any event given this is the heaviest week of the season for S&P results, but there won't be the distraction of a lot of economic data.

Thus far S&P earnings are running at a -1% clip versus last quarter. Outside of technology the picture is just not looking that promising. Indeed even with all of the positives from tech the industrial earnings are overrunning the good news. The fear has to be that the foreign economies will start to slow either due to getting just too hot, because oil has moved too high, or some combination of both. Coupled with the grim expectations recently expressed about the US and its economic future, there was some selling that, combined with expiration Friday, became some panic selling.

Looks as if this is the October surprise we talked about in last weekend's report. No weakness in September and a run right up into earnings. Earnings at first did not live up to the run, but then they almost pulled it off when tech started coming in and giving credence to the run higher. When industrials, the shoe-ins for strong results given the world economic expansion, did not serve up results topping expectations, the pullback started, and Friday it started to have the look of a correction.

This is, however, somewhat typical action for an October. There can be selling in September that continues in October until it bottoms, or there can be a run to October that then turns into selling as we have here. We are looking for some more selling after this recent turn to the downside, but when DJ30 gets to its trendline (which won't take long at this rate) and SP500 tests the 1490ish range we will look for some kind of upside answer. That is not much further at all and we could see some undercutting of those levels, but a hold generally near those would be the start of a recovery to take the markets higher to the end of the year.

The question is what will leadership look like when this is over. Will the same guard take up the point or will a new crop rotate in? Tech held up well Friday as did metals and ag, and both of those led the move higher thus far. We keep looking for the move to spread out and it tried to do so, but it never really caught on. Now with the small caps getting clubbed the logical choice is tech along with those other leading sectors that are holding up (and that does not rule out energy despite SLB's collapse Friday).

Of course we have to see how this week pans out. Given expiration Friday and the more emotional reaction to the CAT comments you would surmise that the Friday selling was overdone. Indeed the market tends to always overshoot in the short run. Thus we could see stocks try to start back up early in the week given expiration is over. Whether they try to bounce or fade a bit further, the key is to be patient. When casting a fly you have to be patient and let the line move through its pattern after your arm movement lest you rush it and pop your flow off your tippet. Same with pullbacks; you have to let them run their course as a harsh sell off is often met with a relief bounce that does not last. You can get caught moving in too early, and then when it fades back again you are susceptible to second guessing and doubt that pushes you into bad decisions even as you look at the charts and see things are going as you would expect. It is one thing to look at a chart without money at risk versus looking at one when you are significantly invested. The goal is to always look at a chart with the mindset of the former, but it is a constant battle to do so.

That is one good reason why it is a good practice during these times to move in piecemeal, i.e. if you see a move you like, don't go all in on the first bounce. Put some money to work, and see how it pans out. If it moves on up then add when there is a test. If it moves lower you are not killed, and when the bottom does come again you can add to your position and get a better overall price. If it does not bottom you can sell and not be hit as bad.

In short, adjust to the times. Back in September when the energy and metal stocks set up beautiful bases and tests we were going all in on the plays and we made a ton of money. That was a situation where everything was perfect. Now things are jumbled at best, and it is prudent to move slowly and cautiously, taking advantage of moves when they show up, but realizing the set ups are not as sure. Remember, these are the times that are not going to make you rich but they can hurt you. In other words, during this kind of action the risk/reward ratio is not as good. It behooves us to recognize that and to be patient and let the plays come to us whether upside or downside. Everyone was running to go short Friday and more will be doing so to start the week. It is best not to rush after it but let it test; if it fails the test then you move in. Otherwise you are chasing the bus and just after you catch it, it slams on the brakes.

We still see some great stocks in good position, and if they continue to show nice, easy pullbacks to test their last moves we are going to be ready to move in. Indeed we have some for this week that we are looking to do just that. If they show the moves, great. If they are not ready we will wait on them and adjust the buy points based upon their moves. There are a lot of earnings coming this week, and right now the market is going through the initial phase of the season where it makes its first strong move based on the results. This one is down. It will have to run that course, and if say tech earnings continue to come in strong the selling will wind down and then the second phase will take control. If tech remains solid then those earnings will propel that sector and start the move toward year end. What we will do is be ready to move into the leaders that are holding the line and setting up new bases for the upside, and if there is a weak bounce in the market overall or in certain sectors, we can use the bounce to bird dog some downside plays. Again, it is a time to be patient and let the move mature, then be ready to move as it concludes and the next phase begins.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at InvestmentHouse.com

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