A True Rally or Another Head Fake?

Rational or not, exuberance returned to the markets Friday. Investors were given a green light to buy with impunity after weaker than expected June employment numbers were reported, easing fears of inflation and further rate hikes. Both the Nasdaq Composite and the Dow Industrials are now on the cusp of a breakout.

In case you missed it, the exciting number in the labor report triune was job growth, which came in at an increase of only 11k. That's far less than estimates of 260K. Much of the decline was due to government census worker layoffs, so July numbers will be closely watched to see if this is a pattern or a fluke. Unemployment came in as expected at 4.0% and wage growth was in line at a 0.4% increase.

Friday's numbers follow weak reports in retail sales, consumer spending, home sales and factory production. It's almost a given that the Fed will leave interest rates untouched at the next FOMC meeting in August. Since interest rate increases can take six months or so to affect economic reports, Alan & Co. will likely sit back and make sure the soft landing they have constructed does not turn into a nosedive. Of course, July's numbers will come in before the August meeting, so I have to temper my argument by saying nothing is set in stone.

Nevertheless, traders are excited because the economy will now take a back seat to earnings over the next two weeks. It could be that Friday's Labor report was the gateway into an extended earnings rally. Most estimates I've seen call for even better income this quarter than last. If that's true, we could see the leaders move the indices into a new trading range, even if it is only temporary before we get back to reality with the Summer doldrums.

With Friday's rally, both the Dow (INDU) and the Nasdaq (COMPX) have moved above their first level of resistance and are within easy striking distance of moving out of their range-bound trading areas.

Of the two indices, the INDU made the most impressive move. A 154-point gain to close at 10636 came on heavy volume at the NYSE exchange of 933 million shares. Breadth was convincingly positive at 18 winners to every 10 losing issues.

The COMPX picked up where Thursday's rally left off and topped out at 4054, just under resistance at 4075. Late profit taking before the weekend saw the index close at 4023, up 63 points on the day. Volume was about average, at 1.47 billion shares. Advancers led decliners in a 21 to 18 ratio.

Measuring across the exchanges, the S&P 500 was solidly positive by gaining 22 points to close at 1479, a 1.6% gain. The Russell 2000 closed at 528, up 4.9 points. That's a 0.93% gain.

Prices rose and yields fell in the treasury markets Friday. The ten year note gained 12/32 to yield an even 6.0% and the 30 year bond gained 3/4 points to yield 5.87 percent.

Among the sectors, Retail was the best performer. A buy signal occurred on June 30th when the Retail index crossed over trendline resistance. Due to continued weakness in the overall market last week, buyers pretty much ignored retail until Friday, when the index scored a huge 6.25% gain. Among the leaders, Wal-Mart (WMT) was up 4.06 points, Target (TGT) gained 2.44 points and Home Depot (HD) was better by 4.25 points.

Any mention of easing inflation will help financials and that was the case Friday. Banks gained 2.63%, Insurance was up 2.0% and brokerages gained 0.55%.

A notable losing sector was Drugs. After topping out at 425 on Wednesday, which was equal to the previous record set in 1999, the sector has turned lower and closed at 418 Friday. This is significant because a spread double top formation is now in place. If the drugs don't find support at least in the 400 area and turn back up, look for heavy selling.

Technology stocks moved higher, led by the usual suspects.

Semiconductors gained 3.69%. The SOX index is still in a downtrend, so a firm buy signal hasn't been scored yet. I get the feeling that Thursday's downgrade of the chip sector by Salomon Smith Barney was a bait and trap. When the leaders were taken out, institutions had the opportunity to buy chip stock at sale prices and Friday Merrill Lynch and Banc of America came out with upgrades to make sure the group moved higher. Some argument can be made to move the group even higher over earnings, but the top is probably within sight (at least over the near term) because the market is aware that increased production is coming on line within the next six to nine months.

Biotechs continue to surge on speculation about the human genome product. The Amex Biotech index gained another 3.3% Friday to close at 724. With a clean break above 700, next resistance comes at 750 then the all time high at 800.

Among the biotechs, the rally is fairly narrow, including Millenium Pharmaceuticals (MLNM) up 5.94 points, Abgenix (ABGX) up 5.54 points and Human Genome Sciences (HGSI) up 9.68 points. Missing from the party were Affymetrix (AFFX) +0.75 and Protein Design Labs (PDLI) +0.31, both of which suffered recent downgrades. Celera Genomics (CRA), the company which mapped the human genome, is still getting punished for doing so and has not participated in the rally. Go figure.

Networking stocks closed at another all time high. The traditional networking companies - Cisco Systems (CSCO) +0.62, Nortel Networks (NT) +1.12 and Lucent (LU) +0.75 are participating but the rally is primarily a fiber optics play. Among that subgroup, SDL Labs (SDLI) gained 10.88 points and Sycamore Networks (SCMR) gained 16.75 points after winning a $420 million contract.

One technology sector continues to put in a poor performance. Internet stocks were punished again Friday with a downgrade of Yahoo (YHOO) -5.88. The CBOE Internet index lost 2.25% to close at 526 and the sector is in a downtrend pointed to support at 500. Gone are the days when Yahoo had an exciting pre-earnings stock price run-up. The company is set to report this week.

Looking forward at the coming week, it's earnings, earnings, earnings. The biggies are YHOO Tuesday, AMCC Wednesday, then JNPR, MERQ and RBAK Thursday. If you are a trader, be sure to check for earnings on the stocks you own. Remember that Splittrader recommends exiting a position before earnings due to the increased risk of selling on the news. If you are a long-term investor, a single earnings report shouldn't matter.

On the economic front, there are some significant reports this week, but I do think that earnings are more important now. The two most important are Retail Sales and PPI, which come Friday.

From a technical perspective, the move outside of the trading range for the INDU is positive. We need to see another close above trendline to get a confirmation. For the INDU to move higher, financials and retail will need to join a rally in technology stocks. Another positive sign for the INDU is last week's strong performance in transports and weakness in the typically defensive drug sector.

The Nasdaq composite looks like it's ready to challenge 4076 again. This time it's even more significant because the 100-dma has moved down to meet the June 22nd high. A first signal for a continued rally will be a move over that level. A second and more affirmative signal is a CLOSE over 4076.

Don't forget the Nasdaq 100 (NDX) chart here. As we pointed out during the worst of the COMPX sell-off in May, the real support levels were found on the NDX chart. I expect the same now. Support and resistance are clearly visible on the 60-minute chart of the NDX below. If the big names can't match the advance of the small cap stocks outside the NDX, then any rally will be short lived and followed by a sharp sell-off, so watch this index next week.

Two notes of caution before I wrap this up. On Friday, June 30th, the markets ended the week solidly bullish, but with the Volatility index at 22.26. By Tuesday and Wednesday we were in another sharp retracement. This week ended on a rally and I think most people are bullish going into earnings. On Friday, the 7th, the VIX was at 21.92. We've seen corrections often at this level so be nimble if you are placing bets.

Also consider that this rally is not one of strong conviction. If a major company should warn of or report an earnings shortfall, we are likely to tank. Unless you can watch the market closely, the safest bet may be to wait for a pullback to support and then go long if the market confirms an upturn.

Good Luck!

Steve Pekarek
Editor

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