US Market Report - week ending 26th January 2007

The US markets have maintained a strong Bullish environment since early 2003. More recently, we have experienced a sharper upwards drive that now finds the major averages trading near long-term high levels.

While this is a positive aspect for investors who had purchased any time since early 2003, the Strategist must air caution towards the recent market activity. Typically, when a sharp inclination in trend occurs, we usually find profit taking resulting in a quick market reversal. The depth of the reversal then needs to be measured depending on the economic conditions, market sentiment at the time, and company stock price activity.

In our last report, we had discussed the potential that the markets were experiencing a “slowing” in buyer activity, in which we suggested this could lead to a market top. Early in the New Year, there was a brief resurgence of buyer activity resulting in the major averages pushing into new long-term highs. However, this has failed to find the support required to continue trending upwards. For example, the S&P500 index, which had broken upwards, is now trading back within the range it had previously held.

Activity in the coming week will determine whether or not the upwards trend is likely to continue, or strengthen the outlook of a market that is topping out. If a return of buyers occurs, then expect new high levels to be attained. Alternatively, a failure of buyers influencing the markets could lead to a potential market correction.

Markets focussing back on Economic data …

The last week of economic activity has been relatively subdued. Only Housing data on Existing and New Home Sales were released, leaving the markets to focus on a plethora of 4th quarter Earnings Announcements.

However, the coming week will be extremely influential. Not only do we still have an extremely large number of companies releasing earnings details, but we also have Advanced GDP (Gross Domestic Product), Consumer Confidence, Chicago PMI, Construction Spending, the FOMC (Federal Open Market Committee) policy statement, Auto Sales, and Unemployment data.

Of these, GDP and Unemployment data are two of the key indicators to evaluate the state of the economy. However, it is the FOMC policy statement on Interest Rates that is likely to have the markets on the edge of their seats in anticipation of the announcement.

Currently, market participants would like to see the FOMC lower Interest Rates by a quarter percent. Economic data in the last couple of weeks, however, has suggested otherwise. We believe there is a very low probability that the FOMC would lower rates, and a higher probability that they would leave Interest Rates steady.

The FOMC had spent 17 straight policy statements raising Interest Rates by a quarter percent, up until midway through last year, with the last 4 FOMC meetings leaving Interest Rates steady.

The desired affect of slowing the economy down by raising rates has been achieved. However, the big question is now whether or not the economy has sufficiently slowed down to warrant an easing in Monetary Policy – lowering of rates.

Recent economic data has suggested that there has still been some growth from in the economy, and from companies in general. Mixed results from earnings reports is also failing to find the desired sentimental direction, so it may be just a little too early to warrant an easing in Monetary Policy just yet.

What will really drive the markets one way or the other will be the accompanying statement from the FOMC. If their wording of the statement results in a consensus that suggests an easing will occur, investors will buy the market up. However, any hint of uncertainty would certainly find profit taking.

Earnings results likely to slow …

We may find that the final results for this quarterly earning season results fails to meet the “double digit” earnings we have come to expect. This might lead investors to profit take as well. We have already seen a slowing in the market trend due to results thus far.

Summing up the broader market activity is a reflection of the NASDAQ and Russell2000 indexes. Both have formed consolidation patterns at the top of long-term upward trends. We have supplied a line chart of the Russell2000 index, which is a broad indication of 2000 of the mid-capitalized stocks.

Clearly these markets have failed to find strong direction. To which direction they will break is indeterminable at this stage, though investors should remain prepared for a break either way.

Strategy Evaluation …

Money Management at this stage would suggest limiting the exposure to Bullish positions, or adopt risk management strategies to new or existing positions.

For investors who already hold stock positions that have realized good capital gains, this is a time where profit taking, or locking in of profits could occur:
· This could be achieved by downsizing the size of your position (that is selling stock).
· Alternatively, Call options could be written, creating a little more income but locking in a sell price (as long as the stock closes above the strike of that written call). We would suggest writing an OTM (Out of The Money) call.
· A Put option could be bought at relatively cheap prices. If it is purchased with several months time until expiration, then you have the right (but not the obligation) to sell stock at that strike price at any time before expiration. It will cost, just like insurance, but if the stock price continues to rise, you will benefit from the capital gain still.

Investors looking for new long-term positions should limit their exposure. The markets have been trending upwards for some time, and we just do not know when the next market top will form. It could be soon, or it could be a while from now. But there is no point purchasing stock when they are at their long-term highs, especially during a period of mild indecision.
· Limit exposure by using less capital to invest on each position
· Limit the number of positions that are entered
· Enter positions that have pre-established risk management, such as using Put protection against purchased stock

The short-term trader should still be adopting Bullish positions because the upwards trend has not been broken. However, if the markets are slowing ahead of a correction, risk management is extremely important. Though, traders of the NASDAQ might suggest we have changed to Neutral conditions in the Technology market. Adopt Bullish risk strategies using options to still benefit from upward market conditions, but to offset any potential change in trend that may occur. Such as:
· Spreads
· Straddles