SELF INFLICTED WOUND

We've all heard the old line, "history repeats itself". It's a cliché because it has been proven true over time. There's another cliché we've all heard as well, "for every rule, there's an exception". On Friday, traders bet on the first cliché ruling the day. In the end, they found that they were partially right, albeit in a fashion they were betting against, at least prior to the beginning of trading. On a day when almost every major index imploded, traders actually started the day off somewhat bullish. The S&P futures started the day up almost 8.5 points above fair value, indicating a very positive open for the Dow. In all fairness, this was prior to the release of the anticipated GDP and ECI numbers (we will get back to both) at 8:30 a.m. EST. The question you have to ask yourself is WHY? Why would traders bid up the futures in advance of such key reports? In retrospect, you might even call the data released in these reports crucial, which makes the early buying even more puzzling.

The answer to the question posed above is actually quite simple. Traders were looking for history to repeat itself. Of the three rate hikes last year, each sparked a rally. You can review almost every major economic report released in the latter half of the year and see a rally of some sort tied to it. With a track record like that, who wouldn't look for history to repeat itself. Given that mind set, who could blame traders, being the competitive creatures that they are, for wanting to "one up" each other and everyone else in the market and "JUMP THE GUN". Of course the fears about the numbers to be released were overblown, as had been the case time and again. Why wait to hear what everyone fully expected, especially when you could front-run the almost certain mini-rally that would ensue thereafter. Unfortunately, this is where the second cliché came into play; the one about an exception to every rule.

Friday's turn of events point to a few other gems of wisdom we've all had to learn (endure) over our lifetimes; don't jump the gun, don't count your eggs and the ever classic "don't shoot yourself in the foot". That's probably the one that sums up what happened Friday. The markets, and traders, shot themselves in the foot. Oh, one other pearl we have all heard before - "don't cry wolf". Everyone with anything to do with the markets has become conditioned to some sort of doomsday scenario that is going to end this Bull Market. How often do you hear we are overextended? We challenge you to go back and read a market commentary or two from early last year or late 1998. You'll be surprised at how many of them were concerned at how high the market had gone up and how precarious its grip at those "lofty levels". What was it they said? That the economy is growing too fast, that nothing can go straight up...? Guess what? We have all stopped listening to the people and indicators crying wolf. Unfortunately, there may just be a wolf among our midst this time around! Whatever the case, the current pain in the market would indeed seem to be self-inflicted.

In regards to the economic reports that were released Friday morning, both came in negative and both point to increasing inflationary pressures. Starting first with the Gross Domestic Product (GDP) for the fourth quarter of last year, it pointed to an economy that is growing at a pace that is increasingly becoming non-sustainable. Even if you throw out the old models and rules regarding sustainable growth not exceeding 3% annually, the current pace still seems dangerously high. The actual Q-4 number came in indicating growth of 5.8% versus expectations of 5.5%. Even more disturbing was the growth in the GDP Deflator (comparison of prices/value in the current year for given products versus that of a base year. It is a better gauge of actual price inflation over a period of time than current year [also known as real GDP] numbers because it is comparative), which saw growth of 2% versus expectations of 1.5%. The Deflator is a "leading" indicator in forecasting inflation, so Friday's numbers are rightfully disturbing to economists and traders alike.

The second report was the Employment Cost Index (ECI), which measures wages. An increasing number indicates that wages are rising versus a declining number that would indicate that the cost of employing a person has actually decreased. The importance of this number is straightforward. If employers are forced to increase wages and benefits to attract and keep employees, they will eventually have to pass that cost on to consumers in the form of higher prices. Higher prices at the consumer level eventually lead to declining demand, an oversupply of goods, and employees asking for higher wages to combat rising prices in the stores. This is the textbook example of inflation. The number one reason for the ECI to increase is a decrease in the size of the available labor pool. As the labor pool shrinks, employees can demand better salaries and benefits, as their services become more of a commodity to employers. This economic measure is closely watched by both the Fed and Greenspan in particular. Previously, the number had been held in check, due in most part to increasing capacity and productivity. The gains in these areas were made due to the fact that the overall work force has become more productive and efficient as employers have integrated high tech, streamlined operations into their work environments. In part, they were able to do this because of the favorable rate environment that made it to cheap to borrow money for capital spending. The actual number released on Friday indicated that the ECI had increased 1.1% versus the consensus estimate of 0.9%. The actual number for wage increase was inline with expectations, but the Benefits Cost portion of the index came in high at 1.3%, the highest level since 1993. This was due mainly to the increase in the cost of healthcare coverage. Ironically, the healthcare sector was the shining star on Friday, as investors bought up those stocks seeking safe haven in response to an absence of any mention of healthcare reform in Clinton's State of the Union address on Thursday evening. Who said the President can't influence the market? Prior to this release, the trend over the last several years was for this indicator to have been decreasing, from 3.8% in 97' to 3.7% in 98' and 3.5% in 99'. The new number definitely points to a reversal and actual increase for the current year.

So much for the economic lessons (everything we never wanted to learn about economics in school). As for the markets, they were effected in a decidedly negative fashion. The Dow failed to hold the crucial support level of 11,000. Not one to be outdone, the Nasdaq broke though its crucial support level of 4000. Friday's trading remained inline with the trend for the week, DOWN. The Dow did manage 2 up days for the week, but finished down -512 or -4.6%. The Nasdaq composite managed one up day, but was down sharply for the week -348 or -8.2%. Year to date, things don't look much better, with the Dow down -758 or -6.5% and the Nasdaq down -182 or -4.5%. Keep in mind that the Dow finished one of its better years, gaining 25% in 99', while the Nasdaq had its best year ever, gaining almost 86% in 99'. The start this year doesn't bode well for a repeat of the type of returns experienced on either exchange last year!

As for the Dow and NYSE trading, the index fell -289.15 for the day, finishing at 10,738.87. Trading was heavy at just over a billion shares. As would be expected, breadth was very negative, with declining issues outpacing positive issues by over a 2:1 margin. The up/down volume was even more negative, with down volume winning out 4:1. The numbers of new lows was high at 169, while 16 companies managed to somehow or other set new highs. As mentioned previously, the leading sectors were by far healthcare and pharmaceuticals. This makes sense since these have historically been safe havens during times of market trepidation. Throw in a probable lack of healthcare reform on the immediate horizon, and both sectors look to continue their leadership for the time being. The only two Dow components able to finish with gains of over 1 point were JNJ (+4) and MRK (+2.13). More important was who wasn't performing, such as the financials, techs, transports, telecoms, and retail sectors. Leading the blue chips down throughout the day: T -1.50, AXP -4.69, JPM -7.56, C -2.88, GE -7.75, AMR -1.19, HD -2.63, WMT -4, MSFT -0.5 and INTC -3.94. As previously mentioned, the Dow succumbed to the overall negative sentiment in the market and closed below a significant support level, 11,000. This marks the first time the index has closed below 11,000 since January 4th of this year. The loss signifies something more ominous. The Dow is now sitting below its 200-dma for the first time since last October. It also leaves traders scrambling to determine where the next level of sustainable support might be found. Although there is some at 10,750 and again at 10,600, but the real support is sitting back at 10,500 (or 10,550). The current trend is pointing to a test of this level, which would represent a further 238 point decline or -2.2%. The 10,500 level was significant in October's meltdown and will be equally significant if tested this time around. Failure to hold that level if it comes down to it may very well result in talk relating to a return to the 4-digit Dow. That is still a ways off, but when you see the index carve points in the manner it has previously, indeed as it did yesterday, that could actually be a mere matter of days away. One thing to keep in mind regarding yesterday's losses - they could have and probably would have been worse had it not been for the trading curbs being instituted during late morning trading. Despite that, the Dow finished almost at its low, selling off hard in the last half-hour of trading, a fact that does not bode well for trading on Monday.

If you thought it was ugly for the big board, the Nasdaq actually managed to outpace their competitive brethren to the downside on Friday. The index lost -152.83 points, finishing at 3886.63. This represents the second biggest point loss for the Nasdaq, a drop of 3.8% for the day. The three most actively traded stocks in the entire market were traded on the Nasdaq. Dell (-0.31) was once again heavily traded, followed up by QCOM (-9.75) and ORCL (-3.94). All three stocks managed to trade over 40 million shares each. The internals for the index are reflective of a negative day. Volume was heavy at almost 1.6 billion, with the down volume clobbering the up volume by a margin of 12:3. Decliners outpaced advancing issues 29:13. Among the major drags on the Nasdaq: AMZN -5.25, YHOO -24.13, CMRC -7.56, ARBA -6, SUNW -1.88, AMGN -1.69, CSCO -2.75.......In all honesty, the list does truly go on and on. The most important thing to come out of Friday's trading was the failure to hold support at 4000. The Nasdaq hasn't traded below this level since January 13th. The next level of real support lies back at 3800, with the 50-dma sitting just below that at 3780. As is the case with the Dow, trading down to support (in this case the 3800-level) would represent another -2.2% decline. Another commonality between the indexes; the Nasdaq may be sitting over 100 points above support at the 50-dma, but it is more than capable of getting there in a couple sessions, one if we have another day like Friday. Failure to hold the 50-dma would be a good indication that the index might be headed down to 3500, a 10% drop from the current level. One other fact to keep in the back of your head regarding the overall sentiment on the Nasdaq - six of the top ten largest point decreases for the index have occurred in 2000. This is still January, meaning fully one-third of the trading days in this month number themselves among those six days. January has been somewhat humbling to the Nasdaq.

As for the other indices, they were down across the board. The S&P 500 finished down -38.36 at 1360. The Dow transports closed down -33.52, the utilities -4.23, the SOX -29.52 (sitting right at a very crucial level of 750) and the DOT -67.53. The Nasdaq 100 gave up 4.1% on the day. Two indices that have had good years so far, up till Friday, were the S&P 400 mid-cap and the Russell 2000. Both got hit on Friday, losing 2.1% and 2.4% respectively. With Friday's decline, the Russell is now flat for 2000. So much for the small-cap rally.

On to the bond. After the release of the economic numbers, the bond yield actually climbed to 6.61% early on. At that point, the yield looked attractive enough to attract some large hedge funds that were in the process of performing asset allocation within their portfolios. In addition, traders started to consider the fact that the Fed was buying somewhat heavily (to reduce the national debt), thus drying up the supply, in turn triggering more buying. This lead to the bond being bid up 29/32's, finishing with a yield of 6.42%. There are a couple of interesting points regarding the action and bond close on Friday. The yield increased on the heels of the negative reports. Those reports and the coming FOMC meeting, to be held next week (1st and 2nd), scared traders into further selling of the 30-yr bond, which is what initially pushed the yield up early on. When the yield got high enough, combined with the start of the market meltdown, suddenly the bond looked like a safe, attractive alternative to the troubled equities (safe haven). This was due to the NOW ATTRACTIVE yield - the same yield the same traders had been bemoaning. Talk about cyclical reasoning. Another point that seemed to get lost in the shuffle is the fact that with the bidding down of the yield, the 30-yr bond is now yielding less than the 2-yr Treasury note. This situation is known as a yield curve inversion, which is something we haven't seen for quite some time. Generally, these inversions are negative and act as precursors to an economic slowdown. In the present situation, it's an unknown as to whether it may in fact work in the markets favor if in fact it does foretell a slowdown in the economy. For the short-term, it may further unsettle an already skittish bond market. As if those guys aren't worrying about enough already.

There were two significant stories involving individual stocks on Friday. Both have the ability to influence their sectors over the short term. First was the story involving Amazon (AMZN), who announced the pending layoff of 150 employees, or 2% of their workforce. This unsettled analysts and investors alike, who are still waiting to see if their business model can ever succeed in assuming profitability. It also calls into question the viability of many B2C's and in particular the online retailers. For the day, the stock finished down -5.25 at $61.69.

The second story involves Swedish telecom giant, Ericsson AB (ERICY). The Company released their fourth quarter numbers, beating expectations by $0.04. The stock had been in Wall Street's doghouse up until recently, due mainly to earnings disappointments and problems within the management structure. The earnings release would seem to indicate that the Company had righted itself. In addition to the earnings release, they announced a 4:1 stock split and a change in the Par Value (will revert to 1 krona from 4 krona in May). With Nokia set to report earnings on Tuesday, the news could very well help the entire sector. Shares of ERICY managed to buck the down market, adding 4.44 points to finish at $70.06.

Regarding earnings, we once again advise that investors check their favorite earnings calendar for the coming week due to the high number of companies reporting. Although the season would seem to be winding down, we still have roughly one-third of the S&P 500 companies who have yet to report, with many coming this week. As for the Companies that have reported, on average, those companies are beating their estimates by about 5.4%. For the entire index, earnings still appear as if they will come in approximately 21% higher than the year-ago quarter.

On the Economic front, the story is definitely the FOMC meeting set for Tuesday and Wednesday. Those meeting are followed up by a release of the minutes of the FOMC meeting on Thursday and the employment report on Friday. It would be an understatement to say that this is a crucial week for the bond and equity markets. There are other reports due out, but they all pale in comparison to the effect that the much anticipated Fed meetings will have on the market and the economy. At this point, there is widespread talk of a 50 basis point (bp) move on the part of the Fed. Even more worrisome is the talk on the street and among many respected analysts and economists that we may indeed have up to three moves totaling 100 bp by this summer. While focus will be on the meeting themselves and any ensuing rate hike, the release of the meeting's minutes may in fact spook the market more; this is where traders get to hear the actual discussions and arguments put forth by the various Fed Governors in the meetings. The employment numbers may move the markets, but their effect will probably be somewhat muted due to the Fed meetings earlier in the week.

As for trading this week, it looks scary. We previously told you about the February meltdown in the Nasdaq last February 1st (in last Sunday's wrap). In addition, you now have the Nasdaq and the Dow sitting under crucial support, with the next levels of solid support sitting over 2% below each index. Both indexes finished the week in poor fashion on heavy volume, basically at the lows of the day on Friday. This does not bode well for trading on Monday morning. It is hard to imagine that traders will jump the gun either Monday or Tuesday in anticipation of another rally, not on the heels of Friday's disaster. At this point, the most positive thing that may come out of the week is that it will be behind us come this time next week. At that point, we will have at a minimum cleared up some of the uncertainty and can then gauge where to place our bets. It is arguable that in our oversold condition we are due for a relief rally that could last a couple of days. The volatility index (VIX) is showing that we are nearing a market bottom (at least short term) since it rarely trades above 30 and has only done so a few times in the last nine months. For now, we suggest that you closely watch your long positions and set stops on all positions. The only certainty for this week will be a continuation of volatility due to the bond, earnings and the Fed Meeting. Good Luck!

Louis Horkan
-Chief Editor