End In Sight
As U.S. troops neared Baghdad, the markets reflected renewed optimism about a coming end to the war in Iraq. The move was confirmed by action across a number of sectors, including oil, gold and treasuries. For a day, at least, recent disappointing economic reports were forgotten and the technical signals we got Tuesday that a bounce may be in the works proved reliable. Traders will recall the last time the war appeared on the verge of ending we were trading as high as Dow 8500. That was just a couple of days after it started and U.S. troops had seen almost no opposition. Investors were expecting a repeat of the 1991 action that lasted only days and market euphoria was topping out ahead of that first weekend. Some of the rally was likely due to short covering ahead of a possible surrender and we may be seeing some of that same activity now.
The (end of) war-rally theory gets support from the gold market, where April Gold Futures (GC03J) dropped $4.60 per ounce and tested relative lows at 326.1, trading down to 327.5 before catching a bounce. Gold was the safety net investment that investors turned to as the build up to war got more serious and it is also one of the hardest hit sectors since the war began. It did hold up over the past week, creeping higher as questions about just how long the war would last persisted. However, this morning's rollover suggested that now that troops have moved within spitting distance of Baghdad, traders are once again setting a timetable.
The action in gold is also reflective of the move in the U.S. dollar. The dollar has also fluctuated with the progress in Iraq and today it rallied strongly. The dollar index moved back over 100 for the first time since March 26, showing a flow of investment back into U.S. dollar denominated assets that include stocks. By the end of the day it sat at 100.05.
The bond market, although denominated in U.S. dollars, is also seen as a safe haven investment and has given reliable signals on a technical basis, as well. I generally follow the ten-year note, as it splits the difference (actually weighted more heavily toward short-term) between the short-term and long-term treasury and seems to give reliable signals that can be extrapolated to equities. The Ten-Year yield traded down to its early November and late December lows over the past couple of days. That level has led to big bounces on two of the last three tests (the third test in January failed along with the broader markets, but triggered a reversal at the October low). The yield reflects the return on the bond - as bond prices rise, yields drop (mirroring equities) and it is a reflection of asset allocation between the two markets. After finding support yet again at 3.8%, the TNX started its rebound yesterday and exploded higher again this morning, prior to the equity market open, as cash shifted back from bonds into equity futures and stocks. The TNX broke through its 50-dma and also above the 61.8% retracement of its Oct-Dec lo-hi range that drove it back on Tuesday. However, it topped out for much of the afternoon at 3.94% and signaled an end to the equity rally as the asset allocation took a breather.
Chart of the Ten-Year Yield
Intraday Chart of the Ten-Year Yield
Much of the rally was news driven, as the U.S. said that the Baghdad division of the Iraqi Republican Guard - supposedly the cream of the crop of the Iraqi military - had been destroyed. Troops are within 20 miles of Baghdad and it appears the U.S. will lead an assault on the city soon. While the fighting has been more severe than many traders were betting, the latest advances by U.S. troops, including the capture of an important bridge over the Euphrates River, had been easier than it appeared it would be after the delays of the last week, fueling speculation that the end is in sight.
The oil market, which has been a good contra-indicator for stocks, also reflected several events that drove the price of oil lower and helped fuel the equity rally. The U.S. advancement was one of the factors in driving down oil futures, which ticked back below $30 per barrel on Tuesday. I have heard it estimated that a drop from $31 to $24 per barrel would lead to a 1% increase in U.S. GDP. One of the other factors that have contributed to the drop in prices is the apparent over-production of oil by Saudi Arabia, which has pledged to make up for any shortfall in world supply that the war might create. That overproduction led to a rise in imports to their highest level on record, averaging nearly 10.4 million barrels a day over the last week. Crude oil inventories rose by 6.8 million barrels, which was higher than the expectation of 4-5 million barrels. The American Petroleum Institute posted an increase of 9 million barrels. The fact that oil supplies have continued to increase, in spite of the war, pushed prices down, with May Light, Sweet, Crude (CL03K) dropping $1.19 per barrel on the day. I've posted the chart of oil futures versus the Dow several times and today's action only underscored the relationship once again.
Chart of the Dow versus the May Oil Contract
For those traders who follow Dow Theory and looking for confirmation of the rally from the Dow Transports (TRAN), the drop in oil prices also pushed this sector much higher, right up through resistance at 2200. The $3 billion+ airline aid packages added on Tuesday by Congressional and Senate appropriations committees to the war spending request by the White House didn't hurt either, although the White House considers it excessive. That 2200 level has been tough to hold ever since it broke down in late January and has also acted as support in the past. It broke above that level on a closing basis for the first time since March 21. The boost was impressive in light of the new scare from the SARS virus that has begun to affect international travel. The predicted drop in tourism and business travel to Asia has already led analysts to lower their GDP forecasts for Hong Kong, which derives a good portion of its revenue from tourism. Yesterday's quarantine of a U.S. flight landing in California due to several passengers reporting SARS - like symptoms should only heighten the fear of flying, as travelers must now worry about being locked up in a confined space with anyone on a plane with symptoms. It could continue to weigh on airline stocks, as could further bankruptcies and those stocks make up a significant part of the TRAN. Today the index did give bullish signals however, so traders just need to be careful about the mid-term prospects if they jump into these stocks for a short ride.
There is also concern that SARS will interrupt exports from Asia and affect tech production. Several companies have already begun asking workers to stay home and since so many tech fabricators are located in that part of the world, we could see production interrupted. While it may be an overreaction to an illness that is something new, as of this time there is not a cure and the hysteria may grow before it fades. It is actually a derivation of the virus that is part of the family of viruses that cause the common cold. However, it is a new strain that humans have not seen and therefore the immune system is not built up for it. Since it is a version of a virus that no one has yet developed a cure for, it may be a while before an effective treatment is created and therefore we may see a continued effect on these industries.
While it may have been an afterthought in today's action, we did get some more economic news that continued to paint a glum economic picture after yesterday's disappointing ISM report. Factory orders fell -1.5%, in February, which was more than twice the expected drop of -0.6%. This was a reversal from the 1.7% gain in January and the biggest drop in orders since September. The only area to show any strength was the demand for defense goods, which rose 27.1%. Orders for core capital goods, which exclude defense and aircraft, dropped 3.1% and shipments of all factory goods fell 1.5%. The inventory-to-sales ratio also rose from 1.32 to 1.34. Durable goods orders dropped 1.6% and shipments of durables fell 1.7%. Computer shipments fell 4.2%. These numbers are consistent with the worse than expected ISM report and show little improvement in the economy, calling into question the ability of the recent rally to hold its gains.
The indicators that told us we might be seeing a rally yesterday could be found in the point and figure charts. While we had seen some bouncing around last week after the pullback from recent highs, none of those bounces were significant enough to reverse these charts higher from their sinking columns of "O" until the action of the last two days. The bounce from Monday's lows made it high enough to register reversals in the Dow/SPX/OEX on Tuesday afternoon and those reversals were added to today. The other signal from the world of Xs and Os that gave us a sign that bounce was in the cards was the bullish percents in the major indices. These percents, which measure the number of stocks in an index currently giving PnF buy signals, had reversed out of oversold territory below 30% and headed into the low 40s. They don't reach oversold territory until the 70% range, so there is still room to run. More importantly though, is the fact that a 500 point pullback in the Dow (and similar pullbacks in the OEX and SPX) were not enough to reverse enough of those new buy signals to lower the bullish percents. While some did reverse, there were enough others registering new buy signals to make up for it. The last two rebounds have been good for a run in the Dow bullish percent (which sat at 40% throughout the pullback) to 60% and 72% and the reluctance to weaken on the drop signaled at least one more good pop.
Point and Figure Chart of the Dow
Dow Bullish Percent
Does that mean that the pop will last? Certainly the economic picture is anything but rosy. It is hard to imagine a real rally continuing on back to December highs over 9000 as we head into an earnings season that comes on the heels of a sick economy. However, we saw similar action last fall, when disappointing third quarter earnings reports that often missed expectations led to rallies. The only explanation was that things weren't as bad as we thought. We then saw many companies beat expectations that had been dialed down for the fourth quarter, but the market rolled over on disappointing future guidance for 2003 that was mostly blamed on the uncertainty of the geo-political environment. The theory was that companies were holding off on spending until the Iraq situation cleared up. We now have the wild card of a war in progress and its effect on fuel prices and business spending. If businesses begin to see spending pick up after the conclusion of the war, then we may see improved guidance for future quarters. However, one byproduct of the war lasting longer than many investors were hoping for is that any post-war pickup in spending will also be put off. Of course, that may also buy many companies another excuse during the upcoming earnings releases in the next couple of months. After all, if the war had ended in just a few days and there was no effect on spending, then what reason would they have to predict an improvement?
The bottom line is that we have a sick, but hopeful economy. We are pinning hopes on companies suddenly increasing hiring and spending after the war. I think this is a tenuous expectation, at best. We may continue to see a short-term rally over the next few days, as the U.S. progresses toward an end to the current conflict. The bullish percents and point and figure charts indicate there is still some life left. However, the mid-term and long-term outlook still appears questionable, so traders jumping on the runaway train should keep their stops tight, as a train off its tracks often crashes.