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IN THIS WEEK'S ISSUE:

1. MARKET SUMMARY  
2. WEEKLY ETF PERFORMANCE  
3. THIS WEEK'S TRADES  
4. CONTINUED GUIDANCE ON PREVIOUS TRADES  

1. MARKET SUMMARY

Equity markets tumbled last week under the weight of mixed earnings reports. With stock prices well off their lows, as I had warned in my previous letter, corporate news had to exceed expectations to keep the positive momentum alive. Economic data were mostly in line with expectations and the dollar, Iraq and to a lesser extent North Korea continued to weigh on the market.

Stocks appear to be short-term oversold, along with the U.S. dollar, while the bond market is extended on the upside. Trading this week will be key: There is a chance that prices might accelerate lower. The alternate idea is that we get a small corrective rally. However, my long-sought-after reversal may finally be upon us. Key support in the S&P 500 index is near 869. It closed the week at 901.78.

THE WEEK IN REVIEW

I had been looking for a dip to start the week and then one final new high. Instead, stocks gapped open higher on Monday morning and hemorrhaged the remainder of the week, with the wound exploding on Thursday night after Microsoft warned that its earnings would not meet expectations.

Losses were broad-based, though a weak U.S. dollar helped the two foreign WEBs that we track to post gains. Biotech shares and the energy sector also bucked the trend, finishing the week higher. On the downside, however, three of the ETFs we track turned in losses of at least 8.0%, with the worst performer being the semiconductor holders (SMH, $22.78), which took it on the chin for a 10.8% shellacking.

ECONOMIC ANALYSIS

Retail sales came in with a profile somewhat different from consensus forecasts, but in line with my warning in last week's report. In last week's ETF Authority, I suggested that car and truck sales would surprise on the upside while the ex-autos number could be weaker than expected. As it turned out, the 1.2% increase in total retail sales was about triple forecasts. But as predicted, the gains were due exclusively to new vehicle sales, as the ex-auto number was unchanged.

Underlying market sentiment was revealed as stocks ignored the strong total number, as well as the revision to November's retail sales data (+0.9% vs. originally reported +0.4%), and instead chose to focus exclusively on the ex-auto data, thus sending the stock market lower.

The growing debate over inflation or deflation was certainly not made any clearer by last week's economic releases. An expected sharp increase in energy prices came in softer than expected, while a drop in producer prices in the auto sector led to weaker-than-consensus price data. Although inflation hawks continue to blather on about how accommodative the Fed is, the risk of deflation is finally starting to find its way into the market's psyche. We are already seeing deflation used as an excuse for lower retail sales, and deflation-oriented terminology is starting to enter the investing public's lexicon.

I do see deflation as a far greater risk to the global economy than inflation right now. Japan's economy has been moribund for more than 13 years now, wracked by deflation and the aftereffects of an asset price bubble not terribly different from what the United States saw pop in mid-2000. Although the Japanese experience has American regulators more cognizant of the risks of deflation, and the more open U.S. economy may augur well in the longer term, there is little doubt that neither the government nor the Fed really knows how to deal with this risk effectively. There just aren't enough past experiences from which to mold an effective policy response.

The official inflation data did little to allay the deflation camp's fears. Price pressures were nearly non-existent, as both the CPI and PPI came in lower than expected. About the only place where we are seeing price gains is in the energy and food sectors. Yet those act as taxes on the consumer and can actually be deflationary if companies don't have pricing power elsewhere.

Friday's data built on the negative earnings out of Microsoft, as they guided 2003 forecast earnings lower. And on the economic front, industrial production and capacity utilization fell. I warned last week that outside of utilities, that was a risk. Economists had expected a small uptick.

Also not helping the equity markets were a drop in the University of Michigan Consumer Confidence Index and a much wider-than-expected trade gap. Although the wide trade deficit could have been viewed as a sign of growing demand from the U.S., it was likely viewed as being caused by a slowdown in demand elsewhere. The market may be worried about the negative affect that a big trade deficit can have on the U.S. dollar's exchange rate.

Next week's calendar is bereft of anything of any importance. Weekly claims on Thursday may continue to be swayed by seasonal factors. Last week saw a big drop, which is what I've been warning about since December. The only other numbers on the calendar are December housing starts and December leading indicators.

Remember, Monday is a holiday (Martin Luther King, Jr. Day) and the markets will be closed for the full trading session. Looking further ahead, the earnings parade will continue in full force throughout the week. Some big names getting set to report include 3M (MMM), Mellon Bank (MEL), Ford (F), Motorola (MOT), Wyeth (WYE), Merrill Lynch (MER), Pfizer (PFE), Qualcomm (QCOM), Lucent (LU), Kodak (EK), PeopleSoft (PSFT --they're always good for a surprise), Texas Instruments (TXN), JDS Uniphase (JDSU) and McDonald's (MCD). As you can see, many of the real tech heavyweights have already reported, but we can get plenty of market-moving news from these stocks as well.

WHERE DO WE GO FROM HERE?

The stock market is oversold in the very short term. The S&P 500 index has reached at least one target area and may be able to consolidate and edge higher to start the holiday-shortened week. Unfortunately, I see little if any chance at a major run-up. Gains of 1-3% are possible from here in the broad market and a slightly larger bounce is possible in the more deeply oversold Nasdaq.

What is astounding is that option volatility barely rose last week. The S&P-based VIX index (VIX, 28.68%) remains well below its 20-week moving average (MA), although it sits just beneath its 100-week MA and actually stands above the 200-week number. Recall, however, that the 200-week moving average includes figures dating back to early 1998.

The Nasdaq Volatility Index (VXN) barely rose, ending the week ahead just 0.56% at 42.84%. That marks the first time that VXN has closed below 43% for two consecutive weeks since May 13, 2002. (The Nasdaq fell more than 30% in the subsequent ten weeks!) Of course, I do not necessarily expect Nasdaq vols to rise as much as they have in the past since the Nasdaq-100 index was rebalanced away from technology issues last December, but this apparent complacency is incomprehensible.

We may very well be range-bound for a week or two. Once prices complete their small bounce early in the week, the end of a five-wave drop could complete by the middle or end of the week. A second-wave rally -- possibly back toward whatever highs we make this week -- would be the next logical step. Wave-3 lower, which should begin in 1-2 weeks, will be ugly to everybody but those who are short -- and you will most likely be amongst those few enjoying the drop.

I have to warn you that your friends and family will not find you entertaining as you cheer on the stock market's losses, and you probably will not really be enjoying it much either. After all, such large drops are usually caused by negative events. I am not sure what that event or events will be, but with all the problems in the world at the moment, it is not likely to be pleasant.

I am pretty confident that market analysts are making a big mistake regarding what could happen to the stock market if there is a war with Iraq. Everybody hearkens back to the Gulf War. As soon as the first shots were fired, the stock market roared higher. So the "brilliant" analysts have taken that sample of size equals one to assure us on T.V. that it will be the same this time around. There's a difference though. Now we know that American intelligence has not yet figured out how to infiltrate terrorist organizations. You can be pretty confident that lives will be lost in America and Europe in response to any action in Iraq. And the loss of life in Israel could be staggering if Iraq gets any of its weapons of mass destruction off against its favorite target.

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2.  WEEKLY ETF PERFORMANCE

Below you'll find a table of weekly performance data for all ETFs that I track for this newsletter...

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3.  THIS WEEK'S TRADES

TRADE #1:  SELL SHORT S&P 500 SPDR (SPY, $90.66) ON A RALLY TO $91.80
The stock market may very well have finally begun its fall to new lows. Even if it hasn't, we appear at least set to retest the lows set at the end of 2002. In the case of SPY, that was $87.18. Prices have already taken a hit, but are likely to trade sideways to higher for the next several sessions. I'm going to use these rallies to enter shorts. Even if prices only slip to their end-of-year lows, you will earn nearly 5% on this trade. And, if losses appear to be accelerating lower (as I expect), then I will adjust my target down.

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RECOMMENDATION:

Sell SPY at $91.80

TARGET:  $87.18

STOP:  $92.95

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TRADE #2:  BUY SEMICONDUCTOR HOLDRs (SMH, $22.78) AFTER FURTHER LOSSES
Has he lost his mind? This ETF is down almost 14% since its high last Monday morning and has fallen 10.8% from the prior week's close. However, barring an out-and-out collapse here and now, it is unlikely that SMH will be able to continue apace without at least a 3-5% rally. One target for the end of this fall is $22.20, as shown on the chart below at the 2.618 extension.

I have never been a big fan of catching falling pianos, however. For that reason, we are going to have to do a little bit more work here. I do not want to buy this ETF on a gap open below $22.20. What I DO want to do is wait for a move below $22.20 without a gap. If prices move down there, then buy at $22.00 with stops below the neckline shown on the chart above. That line falls about $0.02-$0.03 per day and opens Monday at $21.65.

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RECOMMENDATION:

Buy SMH at $22.00 as long as SMH does not gap below $22.20. I may revise these parameters early in the week, so keep your eyes peeled for a News Flash.

TARGET:  $22.78, but subject to revision based on our entry point.

STOP:  $0.01 below neckline support. This changes every day. The stop levels are as follows: Tuesday=$21.67, Wednesday=$21.64, Thursday=$21.62, Friday=$21.59

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4. CONTINUED GUIDANCE ON PREVIOUS TRADES

We were stopped out on two trades last week and have one trade that remains open.

TRADE #1:  BUY S&P MIDCAP 400 SPDR (MDY, $79.35) ON PULLBACK TO $80.55
We were stopped out on this trade at $79.35 on Friday.

RECOMMENDATION:
Bought MDY at $80.55
Stopped out at $79.35

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TRADE #2:  TRADE BREAKOUT OF RECENT TRADING RANGE FOR TECHNOLOGY SECTOR SPDR (XLK, $15.22)
XLK gapped open higher on Monday and we were filled at that open of $16.85. Our stop was triggered at $16.24.

RECOMMENDATION:
Bought XLK at $16.85
Stopped out at $16.25

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TRADE #3:  SHORT JAPAN WEBS (EWJ, $7.14) AT $7.08
I remain short EWJ, though we are going to have to sweat it out a bit since EWJ itself does not trade on Monday due to the holiday in the U.S., yet the Japanese stock market will gets two days of trading in before we can take any action. However, this may very well work in our favor. The Japanese stock market might be able to gain a bit more here, but the U.S. dollar is set to reverse higher. That should neutralize the minor gains seen possible in Japan. I remain bearish on EWJ.

RECOMMENDATION:
Shorted EWJ at $7.08
Stop: $7.26
Target: $6.72

Good trading in the week ahead!

Steven W. Poser
Steven Poser
Editor
The ETF Authority
New York, NY

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