Like a scene out of an old Abbott & Costello movie with the monster creeping slowly up on the unsuspecting victim, usually Costello, the Dow and S&P edged ever so closer to recent resistance. The Dow might have soared above the 10635 level from last week had it not been for Merck. The drug maker killed the opening rally on positive economic news by announcing it was pulling its new arthritis drug request from the FDA. The stock closed down -$3.69 on the news, which equates to something in the area of -25 Dow points. This was the major drag since there were only five other Dow stocks in negative territory for a total loss of only $1.59.
The economic news just keeps pointing the way to better times and the markets are showing every tendency to want to believe it. The Industrial Production numbers soared in February to +0.4%, about twice the consensus estimates, and with the upward revision to the January number it has now been positive for two months in a row. It is clear that the economy is coming out of the depths reached in September. The chart below, courtesy of Economy.com, shows the progress of the new trend.
Capacity utilization also rose but there is plenty of room for the manufacturing process to grow before bottlenecks or price pressures could impact inflation. The Fed has no worries here! The low interest rates have encouraged expansion and that expansion is growing. Fourteen of the twenty industries contributing to the report showed growth in production in February. Without a pickup in the business environment continued growth will be slow due to lack of demand but it is rising.
The Producer Price Index (PPI) also showed a slight increase in the price of finished goods but the gain was negligible. The lack of strong demand is keeping prices flat. The only major gains were due to a rise in energy prices but those are likely to be cyclical and are not expected to increase.
The Weekly Leading Index of the ECRI showed another slight gain which was fueled by a drop in jobless claims and a rise in financial stocks. The index is seen as a leading indicator of economic activity and it is now at its highest level since early-2000. It is suggesting the chances for an overall recovery in 2002 are very good.
Consumers must feel good about the future because the Michigan Sentiment for March (preliminary) showed a gain of nearly five points to 95 from 90.7 in February. The expectations component showed the largest gain from 87.2 to 92.3 while the current conditions component gained only 3.1 for the period. This is also the highest reading for the survey since December 2000. Whether the recession is really over or not it appears the consumer has already forgotten it happened. Consumer spending remains high despite weaker then expected Retail Sales this week. Much of this spending has been fueled by the low interest rates and the flood of refinancings. What will happen as the interest rates begin to rise is a source of concern.
Speaking of interest rates rising, the next FOMC meeting is Tuesday. Nobody expects a rate hike so soon but almost everyone expects a change in the bias to neutral. After nearly sending the economy into shock by raising rates to the choking point two years ago it is inconceivable that Greenspan will act rashly this time. He is approaching retirement and would like to go out with the economy on a high. Most analysts do not expect any actual rate hikes until fall although the Fed funds futures are factoring in a 50 point hike by July. According to anybody willing to go on record that is unrealistic based on the tenuous nature of the economic recovery. We are showing gains in almost every area but it takes a microscope to see many of them. Most feel this meeting will see a change to a neutral bias and a change to tightening will not happen until the June-25th meeting. Why the futures are factoring in a 50 point hike before then is unknown. Still, the uncertainty surrounding the FOMC meeting on Tuesday is likely to impact any rally hopes until after the closing statement is read.
If consumers could vote with their cash for an economic recovery it would have looked like last week. For the week ended Wednesday there was a whopping inflow of cash to the tune of $7 billion into equity funds according to Trimtabs.com. Considering that there was also a record number of debt offerings, $11 billion from GE, $8 billion from AXP, to name a couple, it was amazing to see that much cash move into the stock market. The large number of debt offerings has undoubtedly impacted the stock and bond markets over the last two weeks. You can't take $30 billion, by some estimates, out of the markets without a ripple. Much of that ripple was absorbed by cash flowing out of the bond markets attracted to higher yields from these high grade corporate borrowers. Still, we can attribute some of the weakness in stocks to this as well.
Despite the mixed results for the week, Dow +35, Nasdaq -61, S&P flat, it was a very good week. Not as good as the prior week which saw strong rallies across the board, but very good in my opinion. There was a very good chance for profit taking and a change in direction. Instead only minor consolidation occurred and the major averages are ready to test the high ground again. The Nasdaq bounced off 1850 support and while it continues to lag the blue chips it did behave well. Chalk up the weakness to multiple chip downgrades, computer maker downgrades, Oracle earnings weakness and continuing telecom problems. Still, if you look at AMAT, KLAC and NVLS, the leaders in the .09 micron manufacturing process to be used in the next generation of processors, they held support and were up strongly on Friday. Intelligent investors know where the leaders will be WHEN the recovery finally catches fire.
The triple witching options expiration week ended with a whimper and most highly visible stocks ended pinned to critical strikes. There was simply not enough conviction to break free from overhead option resistance. Our turn will come, be patient.
Impacting the oil markets was the OPEC meeting this week. Oil prices have risen to over $24 on fears they would cut production or we would attack Iraq. Neither has happened and the short squeeze from futures traders has now passed. OPEC said they would not cut production and that clears the air until the next meeting in June. The administration is getting no support for attacking Iraq so oil should continue to flow from there. I bring all this up because I think the stage is set for a drop in oil prices and a corresponding drop in oil stocks as money moves out of this hot sector. Most stocks like the ones we have been playing, SII, TDW, etc, have huge gains and traders will likely rotate out of oil now that the pressure is off and into something else. The hot sectors on Friday were biotech, health care and banking to name a few. The transports should firm again as oil cheapens and support the next leg up for the Dow.
That leg could come as early as Monday. All of my indicators were bearish prior to the close on Thursday but turning up. After the economic reports on Friday they firmed even more. Had it not been for MRK losing -3.69 and being an huge morning drag on the Dow the close on Friday could have been significantly stronger. Make no mistake, we are not out of the woods yet. Close but not yet. The Dow did close over 10600 again and the S&P eased back to within nine points of resistance at 1175. These are critical levels. Once over 10635 and 1175 there should be another round of short covering.
Also, we are entering the end of the quarter. Fund managers sitting on cash and seeing the Dow and S&P breaking out of resistance could start chasing stocks in order to dress up their portfolios for quarter end. They are paid to produce results not sit on cash. They will want their statements to be chock full of premium names to encourage investors that they are on the job.
If it were not for the FOMC meeting on Tuesday I would be much more bullish on the coming week. Once over that hurdle the CPI and FOMC minutes will loom in our path on Thursday but neither are expected to be earth shaking. Greenspan has repeatedly said bullish things about the recovery so minutes of the Jan-30th meeting will not be relative. My exit levels for last week were 10450/1865/1145 respectively. The only one breeched was the Nasdaq, which traded down to 1850 on Thursday, and 1845 on Friday. It rallied to close back above 1865 but only barely. I still believe bullish investors should be in the markets until the current trend changes. When it does we should exit gracefully and wait patiently for a new entry point. I am revising my exit points for this week to Dow 10475, Nasdaq 1850 and S&P 1150. Should any of those levels be broken I would consider closing any long plays in danger.
That last comment will bring a flood of email so let me explain. If you are invested in a Dow stock and the Dow fails then you should probably close the play. Same with a tech stock during a Nasdaq failure. However, in many circumstances you could be in a stock that is gaining $1 a day, regardless of market direction, like UNH last week. There is no reason to close those plays unless they show weakness. You must use your judgment. The exit levels I give you are general guidelines. We all know that 85% of a stocks movement is related to the market/sector movement. If the sector is hot due to rotation out of the general market then by all means enjoy it. Just be aware that a prolonged market dip will eventually impact all sectors and all long plays. In times of market weakness snug up those stops on the winners before they become losers.
One last note. While I am leaning to the bullish side in the comments above, I am still expecting another sell off in the next several weeks. This may seem like a contradiction but we need to always be conscious of historical trends. I mentioned that my indicators were turning bullish on Friday but one is definitely going bearish. The VIX closed at a low on Friday of 20.77 and a level not seen since last July. The challenge here is a combination of events. The bullish sentiment is swelling for reasons stated above but that same sentiment can change in a heartbeat as we all know. I have written about this several times in the last month but we need to always remember that the period between April-15th and May-15th usually brings a drop in the markets. This is the start of the summer doldrums and is usually prompted by weak earnings in the coming cycle. As evidenced by the Oracle earnings this week the economy has yet to recover to the point where earnings will exceed expectations for the 1Q. We have not had many warnings this cycle but the season is still young. Expect positive events but be prepared for negative surprises. Eric is going to go more in-depth on the VIX correlation in the Market Sentiment this weekend. Be sure to check it out.
Sell Too Soon!
We have had many rewarding plays in the "Watch List" section of the newsletter recently. For those not familiar with this section Eric chooses several stocks, which appear ready to make a move and suggests entering a play only when the action point is met. For those new to this section you can visit it here: