Semiconductor Stocks Look Dangerous 10-24-06

Good Evening.

Despite all of the praying and wishing from the Bears, the Market refuses to roll over. Most observers would say that this is a positive indication that bodes well for future strength. However, the market has marched higher with lousy internals in a very narrow manner. Largely a function of lower rates and energy prices, the rally is now also being held up by performance anxiety from lagging money managers.

Importantly, most Bears have now capitulated which eliminates the natural buyers underneath the market that would provide bids during short covering. This lack of natural buyers makes the current situation very vulnerable for a sharp correction. Evidence that we are late in the game is the extreme complacency on the Put/Call ratio and Vix. Furthermore, corporate bad news and geopolitical concerns continue to be ignored and is unfortunately mounting. The Technology sector has also decoupled from the Semiconductor stocks which is a phenomenon that usually self adjusts over time. The most likely scenario is that the NASDAQ will be dragged down by the Semiconductor complex. In our entire careers, we have yet to see a sustainable rally in technology land in which Semiconductors weren't participating.

The other forces that have driven this market such as the geopolitical environment, dovish Fed, and other attributes that we have listed in prior posts have indeed started their unwinding process with a negative bias. Does the market even care? No, but they will at some point in time and few players will have the ammunition to add buying support.

Clearly we have been too cautions and underestimated the stamina of the dip buyers over the past several weeks. However, the piper must be paid and usually the last remaining Bears that capitulate are the ones that have to shell out the moola. If you have underperformed during this run by being too bearish or underinvested as we have been; this is not the time to throw caution to the wind further compounding the error. Remember that the market is a never ending game of opportunities. Patience will prevail as long as coherent arguments can be made to justify your posture.

In the present situation, most participants agree that a sharp pullback is inevitable. In fact, the pullback might become a self fulfilling prophecy. Regardless, it is important not to bet too aggressively on the long side or the short side at this point in time. There will be plenty of opportunities to play the inevitable downside when it materializes. More importantly, we expect enormous opportunities to play the long side over the next couple of years, so please do not be in such a rush at this juncture. We believe it is okay to be slightly net short and add to those positions when it is clear that the market has cracked.

Remember, underperforming the averages is quite frustrating for many players and it leads to emotional decisions. Mature Money Managers and Individual Investors have learned to stay cool when everyone else seems to be cheerleading. Often the Bears who did not like the market when it was levitating on fumes prevail in their wisdom, but are slightly off on their timing, thus depriving them of any profits when the Market finally cracks to the downside. Remember stocks fall three times faster than they go up and underperformance can quickly be repaired with a few well placed shorts.

After the bell, ADI preannounced negative guidance. KLAC was essentially in line on revenues although they guided higher. The Semiconductor stocks are still suffering with inventory issues as most of them have had less than stellar reports including last nights TXN. Other companies that disappointed after today's close were GLW, CKFR, FLR, and FLEX. On the other hand, AMZN had a decent report which is already attracting the 'momo' players after hours. Whether or not AMZN will spill over into other stocks is in question, considering the host of other bad news reports and the big bad Fed tomorrow afternoon.


If You Held A Taser To Our Head:
The Semiconductor stocks are in a critical state. They have been severely lagging due to poor fundamentals. The SOX is in danger of breaking below the 442ish level which would provide a major technical breakdown of the group. Should that happen, we would not be surprised to see the SOX head abruptly lower by 8% - 10% most likely taking the NASDAQ with it. In addition, there seems to be a rotation taking place out of Semiconductors back into the Energy complex. A few more days of this action bodes very negative for the NASDAQ indeed. Perhaps tomorrow's Fed announcement will coincide at a critical moment for the Market…we shall see.

Still playing defense.

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