Market Wrap, Thursday, 07/21/2005
The Year of the Rooster
by OI Staff
HAVING TROUBLE PRINTING?
The Year of the Rooster
China has been making the news a lot this year whether it has to do with their increased pressure on global resources, their fast growth rate or their refusal to float their currency the yuan (pronounced you-an). The big news early this morning, before the nail bombs and bomb scare in London, was the Chinese announcement that they were going to float their currency against a basket of currencies rather than leave it pegged to the U.S. dollar. This was a requirement for China to become a player in the World Trade Organization and there was expectation that they would do this but the timing was earlier than expected and it caught the market by surprise. The U.S. dollar lost ground but the Japanese yen did well since their trade balance with China will benefit.
Some economic numbers were released this morning included unemployment claims. The Labor Department reported new unemployment claims dropped last week by the largest amount in 2-1/2 years to a 3-month low. They attributed this to a slowdown in layoffs in the auto industry. Unfortunately several tech companies have announced recently huge layoffs coming (HPQ) so they'll probably pick up the slack. The 4-week average initial claims dropped 3,250 to 318K. New benefit claims dropped by 34K to a total of 303K giving many the impression that the labor market continues to strengthen. The decrease in new claims was the largest one-week drop since a decline of 35,000 in the week of Dec. 21, 2002 and was more than triple the 10K drop that many analysts had been predicting. The continuing jobless claims dropped by 41K to 2.58M. So it sounds good for the unemployed but those who have given up on searching, and therefore are not counted among the unemployed, would probably disagree.
Some housing numbers were also released and showed housing starts were flat at 2.0M annual rate which is still very healthy. May's housing starts number was revised lower to a 2.0M annual rate so May and June stayed even. Building permits were up 2.4% to a 2.11M annual rate. This industry wants to see permits staying ahead of the start rate. Think of it as the book-to-bill ratio that the semiconductor industry uses. Single-family starts were not as strong though, falling 2.5% to 1.67M annual rate. And the West is feeling it the worst right now where housing starts dropped to a 7-month low.
But not to worry about any slowdown in the housing industry for our fearless Greenspan is here. He said yesterday that "the economy can handle a home price drop". Wheew, I feel better. He mentioned this when he mentioned the Fed must continue to remove the accommodation in its interest rate policy. And then while nobody's watching they pump up the M-3 money supply at a rate faster than inflation (although they did remove some money from the system last week). Greenspan also downplayed what a flat yield curve means (the one that has typically announced a recession is coming). I guess it really is different this time (these kinds of statements were made in the late 1990's and 2000 about it being different this time, it's a new economy, etc.). When will we ever learn...
The July Philly report came in at 9.6 versus -2.2 in June and showed new orders at 5.0 versus 2.5 in June. The Fed employment was 3.4 versus 7.1 in June. Leading Economic Indicators increased 0.9 percent in June to 137.7 and 7 out of 10 leading indicators rose. This follows no change in May and a 0.2 percent increase in April. The June increase was the largest since a 0.9 percent increase in December 2003. It should be noted that the latest results incorporate two revisions to the way the data is calculated. A statistical trend adjustment was made and a new way to account for the yield spread. The yield spread is a component of the index that measures the difference between the yield on the 10-year Treasury note and the federal funds rate. The last time this Indicator had a major revision was in 1996. Without the revisions the index would have shown an increase of 0.5 percent in June, which is what analysts had been expecting, following a dip of 0.2 percent in May.
Greenspan's testimony to the Senate Banking Committee today was full of Greenspan-isms and as usual his statements were subject to interpretation. He commented on the troubled pension plan system. When asked if there would be a negative impact on the economy if more companies were to dump their pension plans on the Pension Benefit Guaranty Corp., Greenspan's response was that an additional pension burden for the PBGC "clearly is negative." Greenspan said "I think it is a worrisome thing for American taxpayers, needless to say." And to think we pay big bucks to hear such words of wisdom. This session for Greenspan may have been his final economic outlook to Congress. He plans to step down early next year after 18 years on the job. I'll try to shed a tear when he leaves.
On the subject of the housing market Greenspan said Congress doesn't need to create new laws to control the risky new mortgages, such as interest-only mortgages or the loans to illegal immigrants discussed last week. We know that he helped abolish many of the banking controls that were put in place after the 1929 market crash so it's no surprise he feels this way. But while he feels the housing market is doing just fine and that the economy will do just fine even if the housing market takes a hit, he has issued several warnings about the potential perils these riskier types of mortgages can pose to homeowners as well as lenders if home prices suddenly fall, or if interest rates were to rapidly escalate. "We don't need any legislative remedy. This is totally under the regulatory authorities of the banking agencies," Greenspan said. I feel much better now. What we do know is that Greenspan is pressuring banks to unload their mortgage backed securities because he thinks they're too risky for the banking industry.
In light of that risk, Greenspan repeated his desire to see Congress put limits on huge portfolio holdings of Fannie Mae and Freddie Mac. He warned again that their huge debt could endanger the U.S. financial markets. He said their holdings should be "significantly below" where they are now". Fannie Mae and Freddie Mac buy mortgages and then bundle them into securities that can be sold to investors worldwide. Therefore the concern is how a problem in the housing market could ripple through the economy. And if home owners maxed out their ability to pay with their no down payment, interest only loans, or maxed out their home equity account, and housing prices should now fall while interest rates rise, many homeowners will be quickly underwater and may just walk away, leaving banks holding the house. That's where the excess supply could come from. So Greenspan is telling us not to worry about a housing market sell off but we should worry about the consequences of it. Huh? A truer politician there never was.
One of the things that Greenspan is highly in favor of, and thinks they've taken out the risk to the banking industry is the use of derivatives. What started out as hedging has turned into a money-making tool for many (think of how we play with options to make money and multiply that to a very large degree). It is guessed that investors are holding credit derivatives with an underlying value of somewhere between $4 trillion and $8 trillion, up from about $1.2 trillion in 2001. Warren Buffet strongly disagrees with Greenspan on the vulnerability of the market to these derivatives, calling them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." I'm thinking I'd rather be Buffett's corner on this one. I'll follow up on this topic in another Wrap.
While the market turned out to be quite volatile, starting with the pre-market futures reaction to the Chinese currency policy (more on that later) and then the London bomb scare, it was an up and down day that ended down but not drastically so. The big question of course was whether or not the huge pre-market jump in the futures was THE market top and now it'll be all down hill from here. I say no, I think there's more upside to go but we are getting so close that quite frankly only the nimble day traders should be looking for long plays. I think we have an upsurge ahead of us but I also think the surprises will be nasty ones to the downside. We'll probably see increased volatility as we go through a topping process where the big guns are distributing stock to the retail crowd who in now convinced beyond a shadow of a doubt that we are going to rally to the moon, that it's different this time. Let's see...
DOW chart, Daily
The DOW pushed up past its price level resistance just over 10600 yesterday and looks to have come back down for a retest of that level from above. As long as 10600 holds on a closing basis I expect the DOW to continue its rally. If it drops below 10600, the line in the sand for the bulls is about 10560.
SPX chart, Daily
SPX is pushing its way higher towards its Fib target zone of 1253-1257. The top of its current up-channel hits the trend line across the highs since January 2004 which defines the top of a large ascending wedge (see RUT weekly chart below for a similar chart of the wedge). These lines coincide with the Fib target zone by next Monday which is a Fib turn date as measured off the DOW's January 2000 high. If SPX were to drop below 1218 before tagging the 1250 area, I would be very tempted to call a market high is in.
Nasdaq chart, Daily
Oh so close. The NAZ continues to push higher and is approaching the top of its ascending wedge pattern (as seen on a weekly chart). The top of this pattern is at about 2216 so watch for a potential throw-over above it and then a collapse back underneath the line. That would be a sell signal. Until then I see no sell signals on this index.
Over the past couple of weeks I've shown SPX charts where Fibs and trend lines point to 1257 as a strong magnet for price before the rally ends. The current rally leg from July 7th should be the last leg of the cyclical bull market we've been in since October 2002 and then we'll start the next leg down in the secular bear market. I haven't shown the RUT chart but feel it's a good one to watch as we near what I believe to be a market top. The RUT is one of the few indices making new all-time highs but it too sports an ending pattern--an ascending wedge as shown on this weekly chart:
RUT chart, Weekly
If you look at a daily chart of this index, price action since the April low has been contained in a very tight parallel up-channel. As long as the uptrend line from April holds (currently near 657 just below previous lows) then we should see the RUT continue to press upward. The top of that parallel up-channel crosses the top of the trend line across the highs at the Fib target of 690 on Monday, the same day the SPX trend lines and Fib target crosses. So watch to see if this plays out.
One thing to note at the present time are the plethora of signals that tell us the market is way overbought, has way too much bullishness in it and the volatility indices are at historic lows. This was to be expected at a market high for indices like the small caps, and at the end of a cyclical bull market within a secular bear market. These are all classic signs and frankly not tradeable since the reading will go to extremes that we've never seen before. The current run is ignoring all negative divergences and is providing nary a pullback. It has all the markings of a capitulating type of run for the roses. I showed this chart recently and pointed to the tight up-channel in place since the April low. This index is on a mission. The whole market has been ignoring oversold indicators, historically low volatility measures, negative divergences, over the top bullish sentiment, you name it. I've been saying the next rally leg to new highs will see these measures exceed anything we've seen in the past and that it won't be tradeable information (the market will remain irrational longer than we can remain solvent trying to fight it). One other red flag though about the current rally--NYSE insiders have been heavy sellers of stock for eleven out of thirteen weeks. This is a set of very smart investors, and when they turn positive or negative, it is just a matter of time before the market follows. This data is released to the public with a two week lag, so it is not useful as a market timing tool, but it's an excellent measurement of what the smart money is doing and we should be following their example.
SOX index, weekly chart
This weekly chart looks at the SOX from before 2002 where it bottomed. After a 3-wave corrective rally to its high in 2004 the SOX dropped off sharply. Since August 2004 it's been in a clear bear flag pattern and is reaching the top of the pattern at the same time the broader market is reaching important resistance levels. This looks like it's confirming the broader market's topping action here.
IBM, daily chart
I showed IBM last week so I wanted to follow up. After its earnings report, IBM shot above its Fib target and gap closure at $83.58 which is where I thought it would meet resistance. Now it's floundering around just above that level and tested yesterday's $85.96 high with a high of $85.95 today. If IBM presses higher still it could reach for its 200-dma at $87.14. I hold no less of a bearish opinion on IBM this week--once this bounce is done I expect IBM to start back down to new lows.
BKX banking index, daily chart
The banks finally pushed out of its consolidation and ran smack into the broken downtrend line where once again it could not get through. I expect this trend line to hold the banks back and I wouldn't be surprised to see them lead us to the downside now.
XBD Securities Broker Dealer index, weekly chart
This weekly chart shows the broker index getting ever so close to the top of its ascending wedge pattern. It achieved an internal Fib projection at 712 yesterday by getting just above 713. It remains to be seen whether or not it will challenge the upper trend line but I wouldn't be surprised if this one, like the banks, starts to lead us to the downside.
In other big news today, and what got the early morning pre-market futures players all in a dither, was the Chinese announcement about their decision to allow their currency to float with a basket of foreign currencies. You would have thought the huge rally in the futures, before the London bomb scare, would have carried over into a bigger rally once the London news was not as bad as first feared. Traders probably had more time to think about the ramifications of the change in policy, such as more expensive goods for us, and the rest of the day was not quite as bullish as the first reaction would have indicated. But the bond market thought it was important. The 30-year Bond dropped almost a point and a half before getting a small bounce at the end of the day. But it still finished down over a point. That equated to a yield increase of 0.1% on each of the 30-year Bond yield and 10-year Note, closing 4.50% and 4.28%, respectively. The 5-year closed at 4.08% also up nearly 0.1 so you can see how flat the yield curve is. But don't worry about the flat yield curve because Mr. Greenspan has assured us that it no longer matters, that it's different this time.
The Chinese announcement stated that they would set the initial exchange rate to 8.11 yuan to the dollar, from 8.277 yuan, where it had been fixed for more than a decade. That raised the value of one yuan by about one-quarter of one U.S. cent to 12.33 cents. China had been under pressure for years from its trading partners to let the value of the yuan float or at least trade at a stronger rate and some U.S. lawmakers had threatened to impose retaliatory tariffs if China didn't change its policy. The U.S. and others have complained that China undervalued the yuan by up to 40 percent, giving Chinese exporters an unfair price advantage.
Beginning Friday, China said the yuan will be limited to moving each day within a 0.3 percent band against a collection of foreign currencies. The official price at the end of each day will become the midpoint of trading for the next day, which could let the yuan edge up incrementally.
The U.S. dollar dropped on the news but it was already in the process of pulling back (see its chart). I find it interesting that Hong Kong, a key Chinese banking center that has its own currency, will keep its currency pegged to the U.S. dollar. But Malaysia simultaneously announced it too was going to allow its currency, the ringgit to float. As Tab Giles mentioned in the Market Monitor, the Chinese change in policy should be positive for the equity markets and a negative for bonds. As Tab stated, "...a fall of the dollar against other currencies generally makes dollar-traded commodities less expensive and encourages funds to seek alternative investment vehicles. If China needs capital to revalue their currency they just might liquidate their US Treasury holdings." That last statement is crucial in my mind. As a heavy investor in our Treasuries, any liguidation on their part will have a negative effect on bond prices which will spike interest rates. Then we go back to the earlier housing market discussion.
The oil market has breathed a sigh of relief as the hurricanes have done less damage and caused less disruption to the oil flow in the gulf than had been feared. Consequently oil prices have continued to slide back but it looks more like a corrective pullback. I'm using the August contract for this week's chart but the new front month contract is September which we'll switch to next week.
Oil chart, August contract, Daily
Oil continues to consolidate its recent gains but it doesn't look ready yet for a deeper pullback. Oil should continue to rally up towards the top of its longer term channel.
Oil Index chart, Daily
The oil index is consolidating just like oil. It too looks like it should proceed higher towards the top of its channel. If and when it gets there then I'd consider trimming some long positions in this index. Until then I don't see anything that makes me nervous here.
Transportation Index chart, TRAN, Daily
I think some shorts felt like they got hit by a Mack truck this week. That was some rally yesterday. Today it didn't even pull back a little. However that daily candle looks like a bearish shooting star at the top of a run. It needs a red candle tomorrow to confirm.
U.S. Home Construction Index chart, DJUSHB, Daily
The housing index gave us the one more new high that I was looking for and the EW pattern now looks complete. It did a little throw-over above the top of the up-channel (drawn different this week) and today fell back below the line. That's an initial sell signal which won't be confirmed until it drops below the steeper up-channel with a drop below 1050.
U.S. Dollar chart, Daily
I mentioned last week that the US dollar is now on a sell signal. It rallied back up for a perfect retest of the broken uptrend line and gave it a kiss goodbye. The Chinese currency news this morning just helped the dollar decline in what was already started. Initially I would look for two equal legs down from its high, so $87.89, as potential support. The next downside target is whre the 2nd leg down equals 162% of the firs leg down and that's at $86.36. This is also close to a 50% retracement of the rally from the March low, at $86.03.
Gold chart, August contract, Daily
Gold got a bounce near the bottom of its descending triangle pattern. If this pattern were in the middle of a longer term decline I would be looking for a break down. But the longer term pattern is up and therefore I'm thinking gold will break out above this pattern. But if it drops below 415, it could see a sizeable pullback.
Sector action was mostly red today, led to the downside by HMO's, airlines, the utilities, computer hardware, the SOX, networkers and the energy sectors. Normally we see energy and airlines on the opposite sides of the page but today they were together. Airlines were down a little over 3% while the oil index was down about 1%. In between, the SOX was down 1.6% and utilities down 1.8%. We had only a couple of green sectors which included the gold and silver index (XAU) leading the pack up 2.3%, followed by the retail index up 0.7% and the TRAN up again today, +0.3%.
The bigger earnings announcements after the close included GOOG which reported record revenues of $1.384B for the quarter, up 98% year over year. And they're reporting revenue consistent with GAAP so no funny stuff in their numbers. GOOG jumped above $320 after the close on their numbers. More shorts toasted. But then a curious thing happened--GOOG sold off to just below $280 and then climbed back up to about $296 as I'm writing this. They had closed the normal session at $313.52.
MSFT's numbers included Q2 revenue of $10.16B versus $9.29B and expects FY06 revenue of $43.78-44.5B and earnings of $1.27-1.32. There Q4 net earnings is expected to be 34 cents versus 25 cents on revenue of $10.17B. Q1 first call is 34 cents on $9.92B revenue. MSFT closed the regular session at $26.44 and sold off after earnings, down to just below $25.60 before rebounding slightly to $25.85 by the after-market close.
Tomorrow's economic reports include the following:
Today's price action suggests we may have more consolidating to do. The sideways consolidation since the July 14th high may need another leg down to finish off the corrective pattern. If true then I would expect SPX to find support around 1218 and the DOW around 10530. But we're in what I believe to be a finishing rally, a capitulation of the remaining shorts and eager but late bulls. The lack of any appreciable pullbacks is one indication of this--they're all chasing it higher. There are also strong Fibonacci targets just above drawing us up like a moth to the light. Price action is getting volatile and therefore makes it challenging to trade. I'm expecting more upside before THE high is in but it could be a very choppy ride. Nimble day traders only. If you're long the market I would suggest relatively tight stops as any drop below SPX 1210/DOW 10,450 would tell me that a market high is very likely in place and it will be time to short all rallies for the next year or two. Good luck this week and be careful.