(1.)  MARKET SUMMARY

It was a tough week to be long the stock market. After grinding higher for several weeks, equities finally gave up the ghost. However, it could have been a whole lot worse, as stocks steadied at lower levels on Thursday, despite the fact that Japan's Nikkei-225 got pummeled for a -5% loss on that day. That said, reactions to good earnings have been problematic, suggesting that stocks are already priced for perfection.

Earnings season will continue in full force next week. Unless we see major outperformance, equity prices are likely to remain under pressure. While I do not expect a collapse in stocks from here, there is far more downside risk than upside potential right now. I still think the market has a chance to hit one more 52-week high, but outside of a swing trading perspective, this small gain is probably not worth the risk if you're a long-term investor. For the next several months, upside potential will most likely be limited to the 1068-1125 range on the S&P 500 (with the lower end more likely and a 25% chance that the markets have already seen their highs). Downside potential is to the low-900s, with a 10% shot of new lows before we move higher again.

WILL THE FED COME TO THE RESCUE THIS WEEK?
Recent speeches by Fed members over the past couple of weeks have been getting the markets prepared for the idea of rate hikes in the future. However, the probability of such a move at Tuesday's FOMC (Federal Open Market Committee) meeting is near zero.

More important than the actual rate action will be what the Fed has to say in their statement. Given everything we've heard from the Fed over the past few weeks, many economists were beginning to expect the Fed to imply that the economic outlook had brightened. However, an article in the Washington Post last week -- in the unofficial Fed mouthpiece's John Berry column -- pointed to the probability that the Fed would continue to point to two-sided risk and would not upgrade their view on the economy.

To be honest, at this juncture, the Fed should be more positive on the economy. If the Fed continues to harp on concern over the economy, it might cause investors to raise the risk factor in their portfolio decisions, hurting equities. My expectation is for no rate hike, and a very slightly more positive tilt to the statement. This should allow stocks to stabilize around recent levels, and will probably hurt the bond market.

THE FED LONGER TERM
Previously, I have suggested that I thought the next move by the Fed would be a rate cut and not a rate hike. That was predicated on the idea that stocks would move concertedly lower soon. This is now a bit less likely. At this juncture, if the markets continue to follow the track that Japanese stocks took in the early 1990s, the probability favors a 10-20% drop soon, followed by another rally. This will permit the Fed to raise rates next year sometime. The markets will find that a 1.00% hike in the Federal funds rate (the rate that the Fed targets in its money market operations) is probably too much, and that once the Fed hikes, it will be the nail in the stock market's coffin.

THEY ARE ALREADY TIGHTENING!
The Fed has been withdrawing liquidity from the market. They obviously are concerned that the market has gone too far, too fast. Although they are not prepared to hike rates, the Fed is attempting to slow things down via a tighter money supply. However, you can be very confident that this market-psychology-oriented central bank will attempt to ensure that the market's losses do not get out of hand. Ultimately, the Fed will find that it cannot control things completely. For now though, with the economy crawling back from recession, they should be able to put a floor on the market in the short- to medium-term.

THE WEEK AHEAD
Given that we saw very little in the way of economic data last week, I suspect some folks were quite surprised at how much the market moved. In some sense, in an overbought market that has been propped up by decent economic numbers, the lack of news allowed stocks to fall on their own. However, the high volume as prices fell is a major concern.

The big news this week will come from two camps: Tuesday's Fed announcement (which I've already covered) and the first estimate of third-quarter Gross Domestic Product (GDP). This is the broadest measure of the economy's health (as of the end of September). Expectations have been ratcheting higher for that figure, and the consensus estimate now calls for economic growth of around 6.0%. I have heard some economists even talk about 8.0%, which is a bit scary. With expectations for stellar growth running extremely high, I think the actual third-quarter GDP data could turn out to be a slight disappointment.

There are other data items out next week as well: New and existing home sales on Monday, durable goods on Tuesday, and Chicago's purchasing managers survey on Friday. All of these could rile the market. Data are expected to be strong, and I do not expect to see any real disappointments there.

TACTICS FOR NEXT WEEK
Friday's strong close implies follow through early this week. However, I think the market's gains will be limited to around 1040 on the S&P 500. From there, I expect the markets to fall towards wedge support, which currently sits near 1005 on the S&P and is rising less than one point per day. In other words, this correction is not yet over. We should run towards support either late this week or early next week. Only at that time will purchases be safe. An eventual rally to new highs is likely from near the aforementioned support level.

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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...

(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.)

When looking at our relative strength rankings, it's important to remember that they are not based exclusively on the most recent week's results. For example, take a look at the Nasdaq-100 Index Trust (QQQ, $34.20). Its -1.2% decline last week ranked it towards the bottom of all funds I track. However, its strength in prior weeks actually helped it rise in our rankings.

Last week's top performers were the fixed-income funds. Meanwhile, the Utilities SPDR (XLU, $21.90), which rose +0.2%, was the only equity-linked fund to eke out a gain. The worst performer was the Japan MSCI (EWJ, $9.05), which sank -5.2%. However, it is still ahead nearly +3.0% over the past four weeks and is up +45.0% in the most recent six-month period. Only the Hong Kong MSCI (EWH, $9.79, +49.0%), the Broadband HOLDR (BDH, $12.43, +60.0%) and the Semiconductor HOLDR (SMH, $38.55, +49.0%) have delivered better returns over that same period.

Despite their gains last week, the fixed-income funds remain locked near the bottom of our relative strength rankings. Only the Oil Service HOLDR (OIH, $55.39) and the Pharmaceutical HOLDR (PPH, $73.60) rank lower according to my proprietary formula.

It is worth noting that if the stock market remains weak, then the Pharmaceutical HOLDR (PPH, $73.60), the Nasdaq Biotech iShares (IBB, $70.78) and the Biotech HOLDR (BBH, $128.17) may outperform, at least based on their recent price action. Of course, bond market-based funds will lead the way, but defensive sectors such as the above noted, along with the utilities (XLU) and energy-oriented funds such as the Oil Service HOLDR (OIH, $55.39) and the Energy SPDR (XLE, $24.32), are likely to outperform as well.

As of now, there is no reason to believe that stocks have peaked. However, if defensive funds start to outperform the broader market, then I would stand up and take notice. I do see far more downside risk than upside risk for the next several months.

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

(4.)  MODEL ETF PORTFOLIO

Summary:  (began trading on September 29, 2003)

The dollar stabilized versus the yen, and the Japanese stock market nose-dived last week as well. Although we remain ahead of the benchmark S&P 500, this hurt our portfolio's performance last week due to our substantial position in EWJ. There are no changes to the portfolio this week.

Our holdings are:

--  415 shares of iShares MSCI Hong Kong (EWH, $9.79)
--  455 shares of iShares MSCI Japan (EWJ, $9.05)
--  34 shares of iShares MSCI EAFE (EFA, $123.49)
--  325 shares of iShares MSCI Canada (EWC, $13.14)
--  179 shares of iShares Materials (XLB, $22.87)

Replacement Watch:
Japan's sharp losses last week nearly pushed EWJ out of the top third of all funds based on our relative strength rankings, but its incredible gains over the past three months and six months allowed it to hang on in our portfolio. However, it is the most likely to be replaced right now. The Mid-Cap SPDR (MDY, $97.50) is the most likely replacement fund based on current rankings.

MODEL ETF PORTFOLIO

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(5.)  TRADE OF THE WEEK

BUY 100 SHARES DOW DIAMONDS (DIA, $96.18) AT $93.50 OR LOWER
To be honest, with the market as volatile as it has been, it was difficult to find any spectacular trading ideas this week. My expectation is that we are nearing a short-term low in the market, and we might even begin a run to new highs. With this in mind, this week's trading idea is to buy DIA right near its 100-day moving average and just above a possible trendline support. DIA might bounce higher to start the week, towards the upper-$96 handles. From there, prices should fall toward my projected entry point. At that time, I expect to see short-term momentum divergences. Additionally, we will have a corrective three-wave drop (based on Elliott Wave Theory, which I use heavily in my analysis). From there, we can complete the topping pattern still in force.

Bigger picture says that the trend in force is still higher. Yes, we have momentum divergences, but I expect DIA to move higher one last time before prices turn down. In addition, with strong support seen near the September low at $92.42, there is certainly room for a several percentage point rally and possibly a new high in the next few weeks. However, if momentum confirms another new low, then I will cancel this trade.

Reasons to buy DIA include:

• Underlying uptrend.
• Expected momentum divergence at next low.
• Support from September low and 100-day moving average.

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RECOMMENDATION:

BUY 100 SHARES DIA AT $93.50 OR LOWER
TARGET:  $99.25
STOP:  $92.40

Assuming a purchase at $93.50 and a sale at $99.25, the profit potential from this trading idea is $575, or +6.1%.

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(6.)  CONTINUED GUIDANCE ON PREVIOUS TRADES

SOLD SHORT 200 SHARES QQQ ($34.20) AT $35.14
QQQ continued its move lower last week. However, a spinning top and close well off its lows suggests risk for at least a small rebound. I am going to trail our stop loss down to $34.51 to protect profits.

RECOMMENDATION:
DATE RECOMMENDED:  OCTOBER 13, 2003
DATE ENTERED:  OCTOBER 13, 2003
SOLD SHORT 200 SHARES QQQ AT $35.14
TARGET:  $32.40
STOP:  TRAIL STOP LOWER TO $34.51
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SOLD SHORT 100 SHARES BBH ($128.17) AT $130.00
The relative strength seen in BBH in the latter part of the week strongly suggests that shorts here are no longer preferred. In a declining market, BBH showed a strong gain on Friday, closing at its high. I've therefore decided to close this position at the open on Monday.

RECOMMENDATION:
DATE RECOMMENDED:  OCTOBER 20, 2003
DATE ENTERED:  OCTOBER 21, 2003
SOLD SHORT 100 SHARES BBH AT $130.00
TARGET:  $122.00
STOP:  CLOSE TRADE AT OPEN ON MONDAY, OCTOBER 27

(7.)  ETF SPOTLIGHT -- iSHARES GOLDMAN SACHS CORPORATE BOND FUND (LQD, $110.60)

Most exchange-traded funds (ETFs) track various stock market indices -- broad market indices such as the S&P 500 or Russell 2000, subdivisions of those indices (such as the Russell 2000 Growth Index), international market indices (such as the MSCI Japan Index), or individual industries or sectors (Biotechnology companies, for example). Some ETFs also track various other asset classes. For example, although they are not heavily traded enough for us to follow in this newsletter, two different funds symbols ICF and IYR) track real estate (REIT) companies. We also will soon see a fund that tracks the gold market, and there are already several funds that track the bond market. I previously wrote an "ETF Spotlight" article that discussed the three U.S. government bond funds (please see our July 28, 2003 issue).

In this week's "ETF Spotlight" I'm going to cover the iShares Goldman Sachs InvesTop Corporate Bond Fund (LQD), which is designed to track the index of the same name. The index is meant to provide a representative sampling of very liquid investment-grade corporate bonds issued in U.S. dollars by firms domiciled in the United States, Canada, Japan or Western Europe. The bonds must be rated investment grade by both Moody's and Standard and Poor's (S&P) and must have at least $500 million outstanding (at face value). The debentures in the index must also have at least three years remaining time to maturity and they cannot be more than five years old. Finally, the bonds must be registered with the SEC (they cannot be "Eurobonds," which are debt securities that might be issued in U.S. dollars, but generally cannot be easily bought or sold by U.S. investors).

The index, which is updated monthly, has other rules that eliminate certain bonds that might have very high price volatility or whose spreads to Treasuries are too wide. The spread to Treasuries (bonds issued by the United States Government) is seen as a proxy for how safe the coupon payments are expected to be from the bond. If the spread is wider than other bonds in its rating class, then the market is essentially assuming that the ratings agencies may downgrade the debt's repayment rating.

If all of this sounds a bit too complicated for you, then please stay with us here! Below you will find definitions of several key fixed-income terms that should assist you in your analysis of LQD:

Ratings agencies -- These companies provide a grade to each individual debenture issued by a company or government. The grade rates the likelihood that the bond will be paid off in full, with all of its coupon payments paid on time. There is a cutoff rating below which a bond is not considered investment grade, meaning there is a high risk that the company might default in its payments. When it comes to the grades given by ratings agency Standard & Poor's, bonds rated below BBB are not considered investment grade.

Time to maturity -- A bond's maturity is the date on which the company must pay back the face value of the bond. Depending upon how the bond's payments are structured, this face value might be more or less than what you initially paid for the bond.

Coupon rate -- This is the annual coupon rate based on an issuance price of $100. If you hold a bond with a 7% coupon, then for every $100 face value of the bond, you will receive $7 per year in interest. (FYI -- It is very unlikely that you will ever pay exactly $100 for an outstanding bond, as prices fluctuate from moment to moment based on the current interest rate environment.)

Most corporate bonds pay a coupon twice per year, so the coupon rate is double the semi-annual payment. The term "coupon" is a historical one that derives its name from the time in which investors had to cut little coupons off the bottom of their bond and bring them to their local bank for redemption. In this day and age, this is now all done electronically.

Yield to maturity -- This is the mathematically computed yield you would receive if you held the bond to maturity. The calculation assumes you could reinvest your coupon payments at this same rate and that interest rates will not change between now and maturity.

Spread -- This is usually short for "spread to government-issued treasury bonds." It is a measure of how much higher the yield is for a given bond when compared to a like-maturity U.S. government issue. It is usually quoted in "basis points," with one basis point being equivalent to 0.01%. For example, if a U.S. Treasury with five years to maturity has a yield to maturity (YTM) of 3.22% and a five-year bond issued by ExxonMobil sports a YTM of 4.96%, then the spread is said to be 174 basis points (100 times 4.96 – 3.22). Yields are almost always higher for corporate bonds due to default risk. It is assumed that the U.S. government will not default on their U.S. dollar-based obligations. This is reasonable, since the Treasury can always print dollars to pay off its debt if need be.

The iShares Goldman Sachs InvesTop Corporate Bond Fund (LQD) invests a large proportion of its holdings in long-dated securities. In other words, the fund holds many bonds that do not mature for ten years or longer. In fact, the average time to maturity for the fund's holdings is roughly 10.5 years. This makes the price volatility fairly high (all other things being equal, the longer a bond's time to maturity, the more volatile its price will be) and similar to that of a 10-year Treasury note. Therefore, LQD is moderately more volatile than the 7-10 Year Lehman Treasury Bond Fund (IEF, $84.99), but is less volatile than the 20+ Year Lehman Treasury Bond Fund (TLT, $85.27).

Recall that prices of debt securities tend to move in the opposite direction of equities. This is not always true, but in recent years we've seen this negative correlation hold in a fairly consistent manner. This means that during periods of falling stock prices, investors will often rotate money out of stocks and into bonds. Typically, corporate bond funds underperform Treasury funds during such periods. This is because stocks usually fall during times of a weak economy. Although yields fall during such difficult periods, the default risk also rises, so spreads to Treasuries tend to widen. When spreads widen, corporate bonds underperform like-maturity Treasuries.

In 2002-2003, yields fell very sharply. There was a huge search for higher yields. This allowed yield spreads to narrow despite concerns regarding the economy's health. But if interest rates rise from here, then spreads may widen as well. Therefore, the current risk in corporate bond funds is much higher than normal. It also means that if the economy unexpectedly slows, spreads could also widen by a greater margin than in the past.

HOW TO MAKE MONEY IN LQD THIS YEAR
The bond market executed a major reversal last June, and I seriously doubt that the low price of this reversal has been achieved yet. While there is potential for LQD to trade up to $113, the main risk is for a fall towards $101-$105 (we're not likely to see a decline beyond that). I expect LQD to hit a new 52-week low before the year is out. After that, I would look at accumulating new long positions in this security, as a large rally is then likely. However, if you're looking to go long the bond market, then the Treasury sector will be a preferable place to invest the fixed-income portion of your portfolio, as yield spreads will probably widen. This change in yield spreads will probably hurt LQD's returns more than the higher corporate bond yields will help.

Please do not forget that when you short a bond fund, you will have to pay the dividends accrued when they are paid out. Although dividends aren't shown in the chart above, they have generally been about $0.45-$0.55 per month since the fund's inception in July 2002.

(8.)  WEEKLY EDUCATIONAL BONUS -- RETRACEMENTS

Markets do not trade in just one direction. They zig up and zag down. They often trade in ranges for long periods of time, then explode higher or lower. Technical analysts look for likely resting points to act as support or resistance when trends pause and consolidate. These areas of likely support or resistance usually congregate around certain percentage retracements between historical highs and lows.

A QUICK EXAMPLE
To give you a better feel for exactly what I mean, here's a quick example. Let's say shares of fictional trading company XYZ Inc. have just risen from $100 to $200 per share on news that its founder just was named "Technician of the Century." Unfortunately, the stock closed the day at $195 and has signaled a correction due to a bearish engulfing pattern on the Candlestick chart. One possible retracement would be 25% of the gains from $100. You can compute this by first determining what that 25% figure would represent in dollar terms: 0.25*($200-$100) = $25. Next, subtract $25 from $200 to give a retracement target of $175.

HOW DO I KNOW WHAT PRICES TO USE FOR THE RETRACEMENT CALCULATION?
I could write a book about this. In fact, I did! My method for determining where and when you should be looking for retracements is the Elliott Wave Theory. I cannot go into a detailed explanation of Elliott here (if you're unfamiliar with this type of analysis, then you'll want to refer to Lesson #5 in my ETF trading course, which focuses on Elliott Wave Theory, before continuing any further). However, in short, you should look for retracements following completed three-wave and five-wave Elliott patterns. (If you aren't familiar with Elliott Wave, then don't worry -- I'll take care of that analysis for you in this newsletter. However, if you'd like to learn more about Elliott Wave, then you may want to review my newest book -- Applying Elliott Wave Theory Profitably.)

In addition to Elliott patterns, many traders and investors will look at non-Elliott moves and will compute retracement levels off of these price actions. While I would be less inclined to expect those levels to be important outside of an Elliott Wave framework, if many people are looking at a similar price move, then those retracement levels may very well hold.

DO YOU FAVOR ANY PARTICULAR RETRACEMENT PERCENTAGES?
My hidden agenda comes in right here and now! In addition to the 50% retracement level, which occurs halfway between the high and low of a given move, the retracements that I find most reliable are those related to so-called Fibonacci ratios. Other commonly-followed retracement ratios include 1/4, 1/2, and 3/4.

As many of you know, Leonardo of Pisa, who went by the name Fibonacci, was one of the great mathematicians of his time. He lived around 1175 AD. Fibonacci developed a number series (he did not name the series after himself -- that came hundreds of years later) that answered the following problem: A pair of rabbits are put in a field and, if rabbits take a month to become mature and then produce a new pair every month after that, how many pairs will there be in twelve months time?

The series is computed by summing the two prior numbers in the series to get the next. If we start at 0 and 1, the next number is 1 (0+1) followed by 2, 3, 5, 8, 13, 21, 34 and so on to infinity. As you approach infinity, the ratio of the nth number divided by the next number in the series approaches 0.618, or 61.8%. If you divide number n by number n+2, you get 0.382. Meanwhile, n divided by n+3 begets 0.236. I also look at 0.764, which is merely 1-0.236, for retracement levels. Many people use the square root of 0.618, which is 0.786. That is very close to 0.764, so feel free to use one or the other.

The number 0.618 is also known as the "Golden Ratio," or phi (a Greek letter). It is supposed to have special properties. The pyramids and many items in nature apparently have properties related to this ratio. However, that is beyond the scope of this article.

Steven Poser
Editor
The ETF Authority
New Yo