1. MARKET SUMMARY

My trade recommendation last week to purchase the S&P 500 SPDRs (SPY) in the StreetAuthority Market Advisor proved to be quite profitable, although I did leave some money on the table as equities continued to power higher for the remainder of the week. The continued strength in the stock market and the U.S. dollar has propelled stock market sentiment to one of its best levels in recent memory. This also has sent the U.S. bond market down to challenge the lows it recorded back in late October.

While I am loathe to lean into the wind here, as I will discuss below, risks are growing that this rally may run into some strong headwinds in the near future. Even if the U.S. economy has turned the corner, I believe that the equity markets are due for something more than the consolidation we went through for the better part of November. My bigger picture belief remains markedly bearish, as bear markets do not normally end with a huge surge (and with the whole world looking for a bottom, as it was in October).

THE WEEK IN REVIEW
There is little doubt that last week’s rally was impressive. U.S. equities surged, breaking out of a four-week trading range to reach their highest levels since last August. Although volume remained low early in the week, market breadth had been warning for more than a week that there was plenty of buying going on. Turnover exploded on Thursday, confirming the gains. Friday certainly did little to alter the picture, as blue chips took only minor losses and even the overheated Nasdaq managed to hold its own.

There were breakouts all over the place. Many of the ETFs that we track moved to their best levels since August, along with the broad indices. Most notably, the iShares Nasdaq Biotechnology Fund (IBB, $56.14), Technology Sector SPDRs (XLK, $16.77) and the Software HOLDRs (SWH, $30.34) all exceeded their August peaks. Meanwhile, the Nasdaq-100 SPDRs (QQQ, $27.72) and the Pharmaceutical HOLDRs (PPH, $79.06) extended new highs recorded in the prior two weeks.

Only the bond-market-oriented funds showed any real signs of technical weakness, although Retail HOLDRs (RTH, $74.27) have not traded as well as most other equity-linked ETFs.

ECONOMIC ANALYSIS
On the economic front, last week’s data were largely friendly to the market, as consumer prices remained tame and weekly unemployment claims fell. The Philadelphia Fed’s diffusion index of manufacturing activity in that bank’s district flipped back to positive, reaching its best level since July. On the negative side, housing starts tumbled by more than 11%. However, with mortgage rates well above their lowest levels, the still strong annualized 1.60 million per year rate recorded in October is historically high. In addition, a drop in starts might actually ameliorate risks associated with a perceived bubble in the residential sector, as it would prevent supply from burgeoning even further.

As I will discuss below, next week should provide us with plenty of fodder for armchair economists and technicians, with the release of further consumer confidence data, revised 3Q 2002 GDP, existing and new home sales, personal income and spending, durable goods orders, the Chicago Purchasing Managers Index and possibly most important of all, the Fed’s Beige Book.

WHERE DO WE GO FROM HERE?
As I alluded to in the prior section, I am concerned that the stock market has risen too far too fast. However, it is not my style to attempt and pick tops and bottoms for trades (as an analyst, I will often try to identify where and when I expect a market to turn, but when it comes to actually putting a trade on, discretion is the better part of valor).

Although prices have broken out to new highs since the lows we reached in early October, most sectors remain below their August peaks. The economy remains at risk, and the relative weakness in the Retail HOLDRs warns of concern over a weak holiday selling season. Sales data will be difficult to interpret this year as well. Last year’s numbers were not as weak as feared, as consumers emerged from the September 11th-induced hangover to buy more than was expected at the time. Also making for a difficult comparison is the fact that Thanksgiving is late this year. On the other hand, Hanukah is early, which will help this week’s numbers.

The Beige Book may be key, as we will see our first detailed explanation regarding how the Fed really feels about the economy. The outsized 50-basis-point rate cut, coupled with recent discussions regarding deflation, should certainly make you stand up and take notice. While I personally do not expect deflation to succeed in latching its icy grip onto us, the risk of that is far greater than inflation right now. Fed Governor Ben Bernanke’s missive regarding deflation, which you can view at the following link:

http://www.federalreserve.gov/BoardDocs/speeches/2002/20021121/default.htm

leaves me more than a little nervous that the nation’s central bank is not prepared for falling prices. (Please remember: deflation means generally falling prices. This means the GDP deflator, or CPI, should be down. A drop in computer prices, or even producer or commodity prices, does not qualify. Falling commodity prices are often a boost to the economy as they are inputs to manufacturers and may help improve margins.)

What should we be looking for next week? Higher stock market and lower bond market prices remain forecast, at least early on. However, I have day counts that suggest that U.S. stocks should turn lower before the week is out. The preferred cycle date is Wednesday, but 24 hours on either side of that day is close enough. This week’s recommendations will therefore focus on defensive stock market strategies.

2.  THIS WEEK'S TRADES

As I warned above, I am more than a little bit nervous that equity prices will turn lower on either Tuesday, Wednesday or Friday (the markets will be closed on Thursday for the Thanksgiving holiday). My preferred forecast is that the S&P 500 and most likely the Nasdaq Composite and Dow Jones Industrials will tumble to new bear market lows. In case you think that a 20% rally means that we are in a bull market, note that the July/August 2002 and September/December 2001 bounces have, to date, been larger than the move seen since the October 10th low. In addition, there were no fewer than FOUR 20% or great rallies in the Dow between November 1929 and March 1932.

All three trades that I will recommend this week are bearish stock market trades. Although I expect prices to rise in the early part of the week, we would be cutting it way too close by being long. That said, since I am not a big fan of very risky trades, I have chosen three structures that should limit our losses if we're incorrect, but will be very profitable if prices tumble.

TRADE #1: BUY PUTS ON THE NASDAQ-100 TRUST (QQQ, $27.72)
Trading options is one of the most difficult things to do. You need to combine timing with a knowledge of how the price of an option is determined. Expecting prices to move in a given direction is not nearly enough. You need know how long it is going to take for the price of the underlying security (in this case, QQQ) to get to your target, as well as something known as the implied volatility of the options.

Implied volatility, simply put, is the market's expectation as to how much, in either direction, the security is expected to rise or fall in the year ahead. So, a 20% volatility would mean that options traders expect the underlying stock or bond to move up or down by 20% over the next 12 months. This also means that in three months, the expectation would be for about a 5% move. If you buy an option with three months to expiration -- and you wait until expiration -- and the stock does not move IN THE PROPER DIRECTION (down for puts or up for calls) by AT LEAST the amount forecast by the volatility of the option, then you will lose money on your trade.

The stock market has an interesting bias. As prices rise, volatility usually falls, and as prices fall, volatility usually rises. Following the terrorist attacks in September 2001, volatility on the Nasdaq hit as high as 99.35%! At the bottom in July, it touched 71.51%. It closed on Friday at 46.49%, which was its lowest weekly close since late May. This tells me that investors are starting to believe that the bear market is over. During 1999, when prices were still moving higher, VXN, the Nasdaq Volatility Index, ranged mostly between 35% and 50%.

If prices rally, as I expect they will at the start of the week, VXN could fall towards 40-42%. This would be low even for a bull market! The lower the volatility, the lower the cost of the option.

My recommendation is to purchase put options on the QQQs. A put option is a bet on falling prices. As prices fall, volatility should rise, which will make the option even more valuable. Since I expect the market to tumble to new lows, you can purchase puts that are "out-of-the-money". Out-of-the-money means that the “strike price” of the put we purchase will be below the current price of the QQQs.

I expect the stock market to bottom in January. To provide us with extra time, my recommendation is to buy March 2003 puts with a strike price of $24.00 per share. The ticker symbol here is QAVOX (or QAVOX.X on Yahoo). On Friday, they closed at $1.10, but if prices rise further over the next day or two, then you will probably be able to buy this option for about $1.00 or less.

As of Friday, the QQQs were trading at $27.72. However, if I am correct and the QQQs move to a new low, then that would mean they will trade below $20.00. Under that scenario our put option would then be worth more than $4.00!

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RECOMMENDATION:

Buy QQQ puts with a $24.00 strike price and March 2003 expiration (symbol QAVOX or QAVOX.X) ON WEDNESDAY at the open.

Risk up to one half of the value of your option. In other words, place a sell stop at exactly half of whatever your buy price ends up being (the exact pricing here will depend on where QAVOX opens on Wednesday morning).

Once the option doubles, sell one half of your position. This will lock in your profit. Hold the remainder of your position at least until the Nasdaq reaches a new low, or until we update the strategy.
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TRADE #2: BUY ISHARES LEHMAN 7-10 TREASURY BOND FUND (IEF, $84.34)

The bond market is in a downtrend at the moment, but is approaching support levels. When equities start to tumble, assets will flow back into the Treasury bond market. Recently, government bonds have slipped due to high corporate bond issuance. Issuers hedge these bonds by selling (shorting) U.S. government bond futures. When the stock market falls, that process should slow up as well. And, of course, a weaker stock market usually means a weaker economy, which helps bond prices.

While I am not a big fan of trying to catch a falling knife, bond prices are far less volatile than equities are. As such, even if the bond market keeps falling, then our losses will be relatively small. I expect IEF to fall to, or slightly below, its October low of $83.87. I am therefore recommending purchasing the iShares at prices just above that low. (Also, note that this fund pays dividends every month! The amount varies, but since inception in September, it has not been less than $0.257.)

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RECOMMENDATION:

Buy iShares Lehman 7-10 Year U.S. Treasury Bond Fund (IEF) at $83.90

Initial Target: $86.50

Initial Stop: $83.00

Due to the high dividends paid by this fund, you should lower your stop by the amount of dividends paid each month. The next dividend will affect prices on December 2nd, but has not yet been announced. A capital gains distribution will be made in mid-December as well, which you must adjust for. I will provide an update as soon as this information is made available.
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TRADE # 3: SELL ISHARES MSCI JAPAN (EWJ, $6.91)
The Japanese stock market has been falling for 13 years now. It is probably approaching the end of the downturn, but should make one more new low. An added advantage to being short this fund is that if Japanese stocks rally, it will probably be in conjunction with U.S. equities. The normal relationship is that when U.S. stocks rise, the dollar rises. A strong dollar will hurt the progress of the EWJ. That means that if stocks do rally, the rising dollar will slow the increase in this market’s gains and will thus limit your losses.

The Japanese economy remains in very poor shape and the Bank of Japan just downgraded its economic assessment. Interest rates are already near 0% there, and the government has been ineffectual in getting a grip on the bad bank loan problem. Add to that the fact that the dollar is overbought, and you have added risk for the short-term (as a strong yen often hurts this export-driven economy).

My recommendation is to short EWJ at $7.01 or higher, which is the 62% retracement back to the high on November 6th. You should risk up to the 38% retracement back to the July 2002 high, which comes in at $7.36. My target price is $6.07.

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RECOMMENDATION:

Sell EWJ at $7.01

Initial Target: $6.07

Initial Stop: $7.36
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3. CONTINUED GUIDANCE ON PREVIOUS TRADES

Steven W. Poser
Editor
The ETF Authority
Steven@StreetAuthority.com 
swp@poserglobal.com

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