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IN THIS WEEK'S ISSUE:

1.  MARKET SUMMARY  
2.  WEEKLY ETF PERFORMANCE  
3.  ETF RELATIVE STRENGTH MONITOR  
4.  MODEL ETF PORTFOLIO   
5.  TRADE OF THE WEEK  
6.  CONTINUED GUIDANCE ON PREVIOUS TRADES  
7.  ETF SPOTLIGHT  
8.  WEEKLY EDUCATIONAL BONUS  

We urge all readers to print out this newsletter each week for maximum benefit...
           

(1.)  MARKET SUMMARY

Stocks rose last week, led by the biotechnology sector and other technology-oriented stocks. The broad market did not miss a new high by much. Meanwhile, the technology sector managed to attain new rally peaks, and the pattern higher does not look complete there. On the trading front, our attempt to purchase the Semiconductor HOLDR (SMH, $31.18) to capitalize on this rally did not get triggered last week. The fund missed our entry target by about $0.30 as prices dipped, but not by enough to allow us to enter into a solid long position.

The State of the State
The stock market refuses to die. Prices have been stuck in a trading range ever since peaking on June 17th, and the market has worked off its "overbought" state. (Overbought is a technical term that essentially means prices may have risen too far, too fast.) However, when an overbought market stays at or near overbought levels for an extended period of time, it means we're in a strong uptrend. Typically, you measure overbought via momentum indicators such as the Relative Strength Index (RSI). I spoke about momentum in some detail in my educational bonus on divergences last month.

I believe that we are still working off the overbought condition from July. One typical pattern that prices will often trace out is that of a "triangle." A triangle means that prices trade in a continuously narrowing price range. The S&P 500 may be tracing out just such a pattern (see chart below). I would expect the ultimate break to be to higher levels, but we might see another week or two of sideways price action before that next move occurs.

More Technicals
The S&P 500 briefly traded below its 20-day moving average last week and bounced off Bollinger Band support on July 2nd. (Bollinger Bands are volatility-based measures that often contain price movements. I've shown them on the chart -- you can spot them as the envelopes around the price action.) Since that time, the S&P has rallied, but has failed to reach Bollinger Band resistance. However, falling volume tells me that we should not be terribly concerned, as it likely means prices will stay in this range a little bit longer before resuming their current trend, which is higher.

Option Expiry
July options run out of time next week. The market typically sees increased volatility around options expiration time, and in several instances over the past few years prices have made major turns around the time of the July expiration. The most obvious two took place at the 1998 high, as the Russian debt crisis became known, and at last year's low.

With prices so near their recent highs, there is substantial risk for a turn lower. That said, options expiry is not a good enough reason to get short, but it is a good reason to be cautious about buying breakouts (moves into new high price territory).

The Bottom Line
The trend, at least for the short-term, remains sideways. I'm a bit concerned about the S&P's recent breaks below its 20-day moving average, but as of now, I still expect the market to post one more new high, at least into the 1,030's on the S&P 500, and possibly into the 1,080's. Those of you who have been reading this newsletter for awhile know that beyond that near-term high, however, I expect prices to ultimately fall below the 2002 nadir. Of course, we have not yet received that sell signal. Though there is a small chance that the July options expiration could push us over the edge, the markets will more likely make their highs in the middle to latter part of August.

THE WEEK IN REVIEW
Up, down, left, right. In the end, the broad market went nowhere last week. Looking at specific sectors, however, technology stocks managed pretty decent gains, with the Nasdaq Composite setting a new high at 1,758 on Wednesday.

There is an interesting dichotomy going on here from a behavioral perspective. Short-term analysts and traders seem to be losing their nerve, as prices have now trended sideways (without making a new high) for the longest period of time we've seen since the market bottomed in March. Meanwhile, we are starting to see economists raise their expectations for economic growth. Both of these behaviors cannot coexist for an extended period of time. Ultimately, I expect the short-term game will first hurt the naysayers (stocks should rally), and after that to clobber the economists (after rallying, stocks should tumble to new lows). Remember -- the market often acts as a pain maximizer, and if it does what I expect it to do in the coming months, then it will likely cost investors a significant amount of money.

ECONOMIC ANALYSIS
The economic front was quiet last week. Weekly unemployment claims jumped to 439,000 (439,000 new people filed for unemployment claims across the country last week), which showed that there is absolutely no sign of an improvement on the labor front. Wholesale inventories rose unexpectedly. Nobody's selling anything, as confirmed by chain store sales in June (and despite the continuing gains in retail stocks). The Producer Price Index (PPI, a measure of price inflation as seen by wholesalers and manufacturers) rose +0.5%, though if you exclude food (+0.4%) and energy (+3.4%), prices actually fell -0.1%. Of minor concern is the fact that crude goods (early stage of processing) ramped higher for the second consecutive month.

Next week will bring a slew of data. The Empire State Index, which measures economic activity in New York State, is due on Tuesday. That index gave quite a stir last month when it unexpectedly jumped to 26.8. The forecast for this month is near 17.0, but the actual figure could be worse. However, keep in mind that this index is quite new and is not widely followed. Retail sales are far more important, and this data is due out on July 15th as well. Forecasts are for a gain of between +0.1% and +0.3% with vehicle sales seen at a similar number. The way retail stocks have traded recently, somebody is expecting strength there, and with much higher energy prices last month, the risk is to a stronger-than-expected gain in retail sales.

Why, you ask, should a jump in energy prices help retail sales? I'm glad you asked. One segment of retail sales comes from gas stations. If prices rise at the pump, then that pushes total sales higher (unless, of course, the number of gallons bought falls). Retail sales are not adjusted for inflation, so if prices rise, then so do retail sales (all other things being equal, as the economists say).

Wednesday begets the Consumer Price Index (CPI). I don't foresee any problems there, as both the core CPI and total CPI are expected to come in between flat and +0.1%. The core CPI jumped +0.3% last month, so another similar gain will get the inflationists roaring. I doubt that will be a problem.

Capacity Utilization and Industrial Production are forecast to be barely changed (due out on July 16th at 9:15 PM ET). These proxies for Gross Domestic Product remain moribund.

The only place where there is joy in Mudville comes from the housing sector. Forecasts for building permits and housing starts (due out on July 17th) are for 1.83 million (annual rate) and up. However, given the recent spike in interest rates, we could see these levels moderate from last month's 1.803 million and 1.732 million, respectively.

The 17th also sees the Philadelphia Fed Index (cousin to the Empire State Index). Forecasts are for a drop to 4.0, but a negative reading here isn't out of the question. And finally, consumer sentiment (University of Michigan) should drop when it is released on July 18th (Friday).

WHERE DO WE GO FROM HERE?
I expect to see the market dip early in the week, likely below last week's nadir. For those following the broad market, I'd recommend purchases there. This should be followed by a rally to new highs, possibly attainable this week, and almost certainly within the next month. My line in the sand is around 962 in the S&P 500. A fall below that level would open us up to a decline to 909 and a chance that we will have begun my long-forecast fall to new lows.

The most likely outcome is that prices will continue to trend sideways this week (meaning the options expiration will not have a major impact), and that the market will break higher later this month, only to turn down between mid-August and mid-September. For now, however, I'm going to buy on the dips.

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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.)  ETF RELATIVE STRENGTH MONITOR

(Note:  If you're a first-time reader or you are otherwise unfamiliar with our proprietary ETF Relative Strength Monitor, then please click here for a brief description.)

It was a good week in ETF land. Only four funds fell last week, with Oil Service HOLDRS (OIH, $58.50) taking over last place in our Relative Strength Monitor after falling -2.74%. We purchased OIH on Monday at $58.50 for our Model ETF Portfolio, so we now hold a long position in this security. If this fund does not start to move up quickly, then we will jettison it.

Last week's worst performer among the ETFs we track, however, was the Canadian WEBS (EWC, $11.56), which sank -2.94% as the Canadian dollar fell sharply (see last week's discussion of the Japan WEBS to get an example of how of the currency market can affect your foreign stock market holdings).

Also losing ground last week were the Pharmaceutical HOLDRS (PPH, $80.84). I have had a short recommendation outstanding on that ETF for a couple of weeks, but PPH has not been able to rally up to my sell level. I have now decided to cancel that recommendation, as there are better plays in the market right now.

The top performer among the ETFs we track was the Semiconductor HOLDR (SMH, $31.18), which gained 6.6% for the week. SMH was the subject of our two News Flashes last week, as I sought to buy this fund on a pullback. Although prices did dip, they did not fall far enough to give us a good entry price.

The Nasdaq Biotech iShares (IBB, $72.85) ranked second on last week's list of winners, jumping +6.51%. We are long IBB in our model portfolio, and those strong gains helped us to just about keep pace with the S&P 500 even though we are holding more than 60% of our portfolio in cash right now.

Here is this week's ETF Relative Strength Monitor...

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(4.)  MODEL ETF PORTFOLIO

                    S&P 500  Model Portfolio 
Last Week            +1.29%      +1.25%    
Since Inception      +5.94%      +7.13%      

We just about kept pace with the S&P 500 last week, despite getting stopped on our Japan WEBS trade (EWJ, $7.84). The fund's high was $8.12 and it had gapped higher at the open on Monday (where we shorted it). I set our stop loss very tight on this trade, as I had not really expected it to move that high. By the end of the week, EWJ had declined more than 2% below our original sell level.

We also bought the Oil Service HOLDRS (OIH, $58.50) last week. As you saw in our Relative Strength Monitor section above, OIH is ranked last in our Monitor. In addition, its meager +4.07% gain over the past 13 weeks puts it last among the equity-based funds we track. OIH is also down -7.66% over four weeks, which also ranks it as the worst performer among all ETFs we track for that period.

Although OIH is not oversold, it appears to have completed its period of underperforming the S&P 500. The chart below shows the price of OIH divided by the price of the S&P 500 (a falling line means OIH is underperforming the S&P 500). As you can see in the lower panel below, stochastics have been making higher lows, indicating that OIH's underperformance is running out of steam. This may not bode well for the overall market either, as OIH has often performed well during recent market downturns.

In other trading action, we were stopped out of our Japan WEBS trade (EWJ, $7.84) last week, but this fund remains poised for a near-term selloff. We're going to short 500 shares of EWJ at the open on Monday, and will set our initial stop loss at $8.20. Since this will also be our trade of the week as well, I will discuss EWJ in greater detail below.

This week's instructions are:

• Sell short 500 shares EWJ at the open on Monday. Set your initial stop loss at $8.20.
• Raise stop on OIH to $57.20.
• Raise stop on IBB to $70.20.

MODEL ETF PORTFOLIO

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(5.)  TRADE OF THE WEEK

SELL SHORT 500 SHARES JAPAN iSHARES MSCI WEBS (EWJ, $7.84)
I have decided to short this fund once again. Many of my reasons for selling last week remain. We got stopped out of our short position in EWJ last week for a -0.6% loss, as the fund gapped higher -- much higher than expected -- and then a brief short squeeze likely pushed EWJ through our stop level before it reversed course and moved lower. (We set our stop at $8.10, and EWJ hit a weekly high at $8.12. We sold at the open on Monday at $8.05.) Here is an updated list of reasons to short EWJ:

• RSI hit 80 last week. That usually means a decent correction is upon us. I do not see the recent top as a final high, mind you, but this fund has gained about +30% in about two months and is due for a substantial correction.
• In Elliott Wave Theory, a five-wave rally is followed by a three-wave decline. Prices rose in a very clear five-wave pattern (see chart) from their lows in late April. A typical correction would be a minimum of 38%, which targets $7.38. My target to take profits is the 50% retracement at $7.16. (See our educational section below for information on my new book, which will teach you how to use the Elliott Wave Theory.)
• The Average Directional Index (ADX) is extended and is now falling. This implies at least a temporary trend change. (See our educational supplement in our June 16th issue for more information on this technical indicator.)
• Slow stochastics crossed (a momentum indicator) negatively from extremely overbought levels (the bottom panel on the chart, with the blue line crossing below the red line).

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RECOMMENDATION:

SELL SHORT 500 SHARES OF EWJ AT THE OPEN ON MONDAY, JULY 7TH, LIMIT $7.67. YOU MAY SHORT THIS FUND ON A MOVE BACK ABOVE $7.67.

TARGET:  $7.16
STOP:  $8.20

Assuming a sale at Friday's $7.84 close and a purchase at our $7.16 target, you would make $340 from this trade, or +8.7%.

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(6.)  CONTINUED GUIDANCE ON PREVIOUS TRADES

SELL SHORT 100 SHARES PHARMACEUTICAL HOLDR (PPH, $80.84) ON A BOUNCE, AND AT THE SAME TIME BUY 20 SHARES OF ELI LILLY (LLY, $69.27)

I have decided to CANCEL this trade. Although PPH continues to underperform the market, I do not want to have two short trades on at the same time until stocks start to fall. PPH often outperforms in a weak market, so if stocks turn, then I'd rather short an overbought ETF.

RECOMMENDATION:
SELL SHORT 100 SHARES OF PPH AT $83.78, LIMIT $84.15.
BUY 20 SHARES OF LLY AT THE SAME TIME
TARGET (PPH):  $79.18
STOP (PPH):  $86.00

THIS TRADING IDEA IS NOW CANCELLED.

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(7.)  ETF SPOTLIGHT

RETAIL HOLDRS (RTH, $83.95)

HOLDRS, which are managed by brokerage giant Merrill Lynch, are a bit different from traditional ETFs in the way they trade and in their expense ratios. (There are some other technical issues that you might want to discuss with your tax advisor as well, after you've read the prospectus.) For example, you cannot buy or sell less than 100 shares of a HOLDR in any transaction. However, they are still exempt from the uptick rule (the uptick rule says that you cannot short a stock unless the last price change in the stock was to a higher price).

Unlike most other types of funds, which track broad-based indices that contain hundreds (or some cases even thousands) of stocks, HOLDRS consist of just a handful of stocks and are designed to track particular industry groups. Because they only track a few companies, HOLDRS are very inexpensive to manage. However, because they aren't highly diversified, HOLDRS tend to be much more volatile than the average ETF.

This lack of diversification is worth discussing further. Many HOLDRS are very heavily weighted in just one or two individual stocks. When it comes to the Retail HOLDRS (RTH, $83.95), for example, Wal-Mart (WMT, $56.53) accounts for more than 24% of the value of the fund. Meanwhile, Home Depot (HD, $33.17) contributes another 16%, meaning that these two stocks comprise more than 40% of the value of the fund!

In my special report -- What Every ETF Trader Needs to Know: How to Protect Your Trade When Everything Looks Right -- which I've reserved only for one- and two-year ETF Authority subscribers, I discuss the importance of knowing what the charts of the main holdings in a particular HOLDR look like. With earnings season upon us (earnings surprises often cause individual stocks to move strongly in one direction or the other), it will become even more important for investors to analyze the specific holdings within these highly concentrated securities.

In my special report I also show you how to hedge these funds against moves in stocks that make up a large percentage of a particular HOLDR. (You can view the exact makeup of each HOLDR at Merrill Lynch's dedicated HOLDRS web site -- http://www.holdrs.com.) Each HOLDR consists of 100 shares of stock, and these shares are divided unevenly among the companies within the HOLDR. The Retail HOLDRS, for example, contain 36 shares of Wal-Mart. If you were bullish on the retail sector but were nervous about Wal-Mart's prospects, then you could buy 100 shares of RTH and at the same time short 36 shares of Wal-Mart. After doing so, you'd essentially own RTH without Wal-Mart in it.

The Retail HOLDRS invest in stocks of companies that are in the retail business -- stores that sell directly to consumers. I've listed the fund's top 10 holdings in the table below. These make up more than 70% of the value of the fund, and there are only 21 stocks in the whole trust. Despite taking it on the chin in 2002 and early 2003, retail stocks have performed well as of late, and a number of major retail companies are now approaching their 2000 highs. For example, electronics retailer Best Buy (BBY, $45.40) has nearly tripled from its October 2002 low of $16.99, but it is still below its March 2002 high of $53.75 and its April 2000 peak of $59.25.

HOW TO MAKE MONEY IN RTH THIS YEAR
The pattern in RTH itself is actually quite sloppy. There have been several stellar performers, as noted above, in the fund, and a few real dogs as well (check out KSS, WAG and MAY). The overriding story is that the fund has room to rally further from today's levels. However, I doubt that the fund will rally much further than the 61.8% retracement to its 2002 high ($87.32). We had a clear breakout last week, but another 3% or so gain should just about do it. After that, there is risk of a drop to a new low.

However, the more likely scenario is that RTH will not actually take out its March 2003 nadir. After all, the charts of some of this HOLDRS' constituents (not shown here) look fairly strong. For example, Home Depot (HD) has been in a nice uptrend, and I do not have any real reason to expect it to tumble to new lows (there is a short-term double top there that bears watching). Meanwhile, Wal-Mart (WMT) is in a triangle formation, as is another of the fund's components -- Best Buy. Barring major negative developments elsewhere, new lows appear a bit far fetched for RTH, but a 15-20% fall from the highs is likely to start within the next couple of weeks. RTH may turn before the overall market.

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(8.)  WEEKLY EDUCATIONAL BONUS -- WHAT IS A TREND AND HOW DO I IDENTIFY ONE?

I am always talking about the market's trend, but what is a trend? In layman's terms, a trend can be defined as the market's overall direction, which means it can take three possible paths: Up, Down and Sideways. An uptrend is defined as a series of higher highs and higher lows. A downtrend is identified by lower highs and lower lows. A sideways trend is identified by a lack of market direction (and traders pulling large clumps of hair out of their heads).

Timeframe
That's not so hard, right? So, let's take a look at a chart. Tell me, what is the trend in the iShares Nasdaq Biotech Index (IBB -- see below)?

The correct answer is: up and sideways.

Although that might seem like an unusual answer, it is actually the correct one. The gap higher that started last week allowed prices to rise above the big red candlestick from late June. That gave IBB a new high with an interim low above the prior low. So, the short-term trend is a positive one.

However, IBB has yet to exceed its early-June high, so this fund's medium-term trend is actually sideways. If prices break out above the early-June peak, then we will be able to say that the medium-term trend is also up. However, if prices first drop below IBB's low from the latter part of June, then we'd say the medium-term trend is down.

I have not shown a longer-term chart here. As an exercise, I generally look at a monthly chart to determine that trend.

Of course, this analysis is all too simple, and I have not yet burned enough trees with this week's report, so I will now complicate things a bit more for you.

Moving Averages
There is more than one way to identify a trend. Another method uses moving averages. If prices remain above a moving average, then the trend is up. If a stock or fund falls below its moving average, then the trend is down. But which moving averages should we examine when analyzing a chart? Usually, short-term trends are identified by moving averages in the 5-day to 20-day range. A medium-term trend would be identified by a 50-day moving average. And finally, the classic long-term trend is identified via a 200-day moving average.

Many trading systems are built off moving averages. A simple one is to buy when price crosses above the 20-day moving average and sell when it falls below the 20-day moving average. This works well when the market is trending nicely in one direction, but if the market is trending sideways, then look out! In this particular case, you could lose giant sums of money as a stock's price crosses back and forth over its moving average, earning your broker a nice living while lowering your net worth at the same time.

Look at the sample chart above. Assuming you sold the morning after IBB closed below its 20-day moving average in June, you would have been stopped for a pretty good-sized loss. Late February into early March, and part of April also, would have resulted in losses. However, the huge gain from mid-April into June would have more than made up for those losses.

To help out with trendless markets, you can filter your moving average system with an indicator that helps identify whether the market is trending strongly or not (such as the Average Directional Index, or ADX, which I wrote about in our June 16th ETF Authority issue).

Trendlines and Channels
Technical analysts have a number of other tools at their disposal that they can use to identify trends, including momentum and volatility breakouts, as well as trendlines and channels. We'll discuss these and other topics in the coming weeks, so please stay tuned!

Summary
I hope this brief primer helped you to better understand what I mean by "trend". I use all of the tools noted above in helping me to determine what direction the overall market (or a particular stock) is trending. I also use the Elliott Wave Theory very heavily (for those of you familiar with Elliott Wave, remember that the trend is the direction of the impulse moves). That is beyond the scope of this lesson, although I do give a brief overview of Elliott Wave Theory in my free five-part trading course -- The ETF Money Machine -- which you received when you subscribed (click here to view this course on our web site). I have also written a book on the subject, Applying Elliott Wave Theory Profitably, which is set for publication by John Wiley and Sons later this summer. For a limited time, you can save 30% when you preorder this book today.  CLICK HERE TO LEARN MORE.

Thanks again for reading this week's issue, and good trading in the week ahead!

Steven Poser
Editor
The ETF Authority
New York, NY

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