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Market Wrap

Mixed Market Signals

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The major indices ended up in a pretty good day today. Here's the headline that will catch everyone's attention:

NEW YORK (MarketWatch) -- U.S. stocks ended higher Thursday, with the Nasdaq Composite Index at its best level in four and a half years.

That's an impressive headline and should get some more people off the sidelines to do some Christmas shopping. What everyone fails to mention of course is that the Nasdaq, after suffering a 78% loss in the 2000-2002 decline, has managed to recover only about 28% of that loss. It's still down 56% from its peak. But shhh, don't tell the masses because that will only depress them and they won't buy more stocks. The leaders of the tech world, the NDX, lost 83% and have recovered only 22% of that loss, and are still down 65%. That's just for some perspective of the 3-year rally we've had.

For a while today it looked like we were just going to hug the flat line again, especially the DOW, but then the afternoon saw some buying kick in and the market was driven higher into the close. With SPX options expiring at the opening tick tomorrow morning, there may have been an effort to get that index above 1240 which they managed to do.
This morning it appeared we were headed for the same choppy flat price action but we then got an energy boost into the afternoon. Actually the DOW got a GM-designed rocket boost into the afternoon close, thanks to an upgrade from S&P equity analysts. GM's rating was raised from a strong sell to a hold, citing good valuation at the current price. It reminds me of the days in 2000-2001 when analysts were rating companies like JDSU a buy or a hold all the way down to $2 from $150. Actually, to be fair, I think they started rating JDSU a sell around $2.50. A ratings increase is a great way to goose a stock price so that the institutions can unload to unsuspecting retail buyers. GM ran from their lowest intraday level since 1987, down -3% on the day, to a +6.3% by the close. Today's bounce was very likely a lot of shorts taking some profits, just like last Friday. Helping GM blast higher in the afternoon was a report that GM CEO Rick Wagoner posted a letter on the internal company website saying GM financials are sound and that "talk of bankruptcy is overblown." I didn't see a denial of bankruptcy considerations, just that talk was overblown. Hmm...

While we got a nice rally in the indices today, looking under the hood of the market leads one to believe this rally has not been a healthy one, but ignore that man behind the curtain who keeps pushing the buy button. But the message of the market here is don't fight the Fed and don't fight the tape. While we study all kinds of things to give us a clue as to where the market is going, and form biases based on that analysis, the bottom line is that price rules. Taking multiple small stops is far better than trying to outlast an irrational market. Is it rational that a market should continue to climb when annual new lows regularly exceeds new highs? Is it rational that it should continue to climb in the face of negative divergences on the charts? Silly questions. Follow price as hard as that might be some times, or stay out until it makes more sense. Always remember that flat is a position and often times the best way to make money--i.e., not lose it.

This morning started out relatively quiet with the overnight futures in the green but shortly after the cash open the market quickly pulled back. The DOW was the weakest link and it closed its gap relatively early. But the other indices were relatively stronger and held onto their early gains through the morning and then added to them in the afternoon once it was clear the Bears would not be able to drive the market down. The early morning economic reports included housing numbers, unemployment claims and industrial production.


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Housing starts fell -5.6% to 2.014M units, below 2.07M consensus, and building permits also fell -6.7% to 2.071M. Single-family housing starts were down -3.7% to 1.704M. Housing starts for September were revised slightly higher to 2.134M from 2.108M. The drop in housing starts was across the nation with all 4 regions reporting a drop. This was treated as good news by the home builders who rallied today. Don't ask. But some are expressing concern that the softening in the housing market is reflecting the risk that the Fed is going too far in terms of raising interest rates.

Initial unemployment claims were down 25K to 303K for the past week, the lowest level since April. The 4-week average jobless claims dropped 13.5K to 321.5K but continuing jobless claims were up slightly by 3K to 2.79M.

Industrial production numbers showed a rise of +0.9% as expected, and is the largest rise in 16 months. Some of the rise is attributed to the hurricane-related activities. The drop in unemployment claims and rise in industrial production is one reason many believe the Fed has 3 more rate increases ahead. Manufacturing output climbed +1.4% and capacity utilization rose to 79.5%, also expected. Utilities output fell -1.9% and mine output also fell -0.5%. There was nothing particularly earth shattering or market moving about these numbers.

One other report was the natural gas inventory which was up 53 bcf in the latest week. Natural gas December futures closed down -$0.39 at $11.94 today. The most recent low was $11.03 on Nov 7th and of course the high for the year was $15.25 on Oct 5th. Crude oil took a hit today, down -$1.60 to close at $56.25, its lowest price since June 8th. The pundits will surely be crediting today's rally on lower oil prices even though they have no explanation on the days that stocks rally in the face of rising oil prices.

The Fed's Poole was out later in the morning jawboning the market by saying the Fed will be doing its best to keep core inflation low. He was doing a little self-congratulatory gesturing (someone had to unhook his arm that was stuck back behind his head), saying how wise the Fed was not to overreact to higher energy prices since they believe high energy prices won't have an impact on core inflation. And I know for a fact that the tooth fairy exists. But, always ready to cover both ends, Poole said they're concerned about some underlying inflation trends even though inflation expectations are "well-anchored" and that expectations for core inflation remain "fairly stable". Greenspan has taught them all well how to master double-speak.

Lastly, the Philly Fed survey results came out at noon and showed the manufacturing sector expanded at a slower pace in November (readings over zero indicate expansion). The Philly Fed diffusion index fell to 11.5 in November from 17.3 in October. The new orders index dropped to 12.7 from 18.6, while the shipments index rose to 23.4 from 19.5. While down a little, these numbers are near the average for the year. The prices paid index dropped to 56.8 from 67.6, while the prices received index was just about steady at 32.5, thus easing inflationary concerns.

After this afternoon's burst higher let's see where that leaves us on the charts.

DOW chart, Daily

The DOW was the laggard today but it too got into gear somewhat this afternoon and as the chart shows, ran smack into the price level resistance at the July high near 10720. With overbought daily this would seem a logical place for the market to pull back and gather some energy to bust through resistance. But of course a logical market is an oxymoron and we could instead see the oscillators flatten out which would indicate a strong trend is underway. Watch carefully here since it could be a good place to try a short (at least protect profits on longs) or if we see a break above resistance, get long on any retest of it.

SPX chart, Daily

SPX broke above its resistance line that is the downtrend line from the July high. The July high of 1245.86 would be the next level if this pushes a little higher tomorrow. Any pullback to the broken downtrend line (1237.70) that finds support there would be bullish. Any break above July's high runs into potential resistance at the 62% retracement of the 2000-2002 decline but there are some other Fibs and a Gann number that projects up to 1265-1275. We could get a deeper pullback before launching up to those levels. I'll put it this way, it would be more bullish if we get a deeper pullback first. If we were to rally straight up from here to those higher levels, I'd back up the truck and short it big time.

I've mentioned several times in the recent weeks how unhealthy the current rally appears. When I say that I mean the internals of the market, the market breadth, isn't supporting the increase in prices we're seeing. Everyone watches the major averages and bases many of their investment decisions based on these averages, many times even more so than the individual stock prices. The larger fund managers knows this and they'll often work very hard to keep the major indices up, or drive them up, so that they can unload some of their inventory without anyone noticing. Distribution is the term used in this case. The market internals is a way to measure this.

For example, let's take a look at the NYSE, the granddaddy of the indices. It has been rallying to new highs recently but strangely enough the number of new 52-week highs is not keeping up with it. More disturbingly, the number of new 52-week lows has often times been greater than the new highs, even while the index makes new highs. This is a bearish negative divergence and tells us to be cautious about the rally. First look at the NYSE daily chart:

NYSE chart, Daily

Take note of the new price high in the index back in early September and the new high now in November.

NYSE New Highs-New Lows chart, Daily (courtesy stockcharts.com)

Now look at the measure of new highs minus new lows--there was a lower high at the beginning of September against the new price high at the time. That then led to a significant pullback in Sept-Oct. We've now seen price rally back up to near the September highs but the NH-NL continues to lag price. In fact here we are today with a significant new high in the index (+2%) and another lower high in the NH-NL. In fact the number of new 52-week lows today was higher than the number of new 52-week lows, 163 to 156, and that's after a strong up day when looking at price. This is bearish negative divergence and the risk for longs is that we could see a similarly large pullback into December. Or, if price continues to rally into December, the ultimate correction will be even more severe. The internals of the market during this rally/consolidate/rally looks to me like distribution from the big funds to the little retailers.

Nasdaq chart, Daily

The COMP is ever so close to resistance by its trend line along the highs since January 2004, currently at 2228. Like the other indices, with overbought daily this looks prime for a pullback from resistance. Protect longs, get ready to short this.

SOX index, Daily chart

With the COMP looking like it's ready for a pullback, the SOX should follow suit. The kind of pattern that it's in would look best if we get a pullback that's then followed by one more rally leg, though that's not necessary considering the last wave of the current corrective pattern that it's in. If it were to rally a little higher from here, resistance by its downtrend line is currently near 478.

Hitting the news again recently is talk about the U.S. Pension Benefit Guarantee Corp. (PBGC). On Tuesday the PBGC confirmed to Congress that it is exposed to underfunded pension plans to the tune of $108B, up from $96B. They are currently running a deficit greater than $23B and the future doesn't look like that will improve, in fact quite the opposite. A recent article in the New York Times, by Roger Lowenstein, "The End of Pensions" described the problem ahead. Lowenstein wrote a book about the Long Term Capital fiasco called "When Genius Failed" in which he describes how it happened. Lowenstein makes the case that corporate pensions are underfunded to the tune of $450B. Public (government) pensions are underfunded at LEAST another $300B. If these figures are even close to true, "taxpayers will be hopelessly in hock to the police, firefighters and teachers of the past." (NYT)

Two years ago companies in the S&P 500 which had defined benefit pension plans were underfunded by more than $240B (based on a CSFB study). The CSFB now suggests that these same companies will still be underfunded by $218B at the end of this year--this after a market that has risen almost 20% since then. Corporate profits have significantly increased but liabilities dropped only 10%. Even in a rising market, the companies did not make significant headway in catching up on their underfunded pension plans.

In the last 3 years almost 600 companies have reneged on pension-fund obligations, with 21 plans each totaling $100M or more. United Airlines' pension fund failure at $9.8B tops the list and this one is the biggest since the government began guaranteeing pensions in 1974. In June, Delta Air Lines and Northwest Airlines told Congress their plans would default unless legislators extended the funding deadline. The automakers, short by $55-60B, may not be far behind. The PBGC has reported they are $23B in the red as of the end of 2004. This is expected to rise to $30B when the books for the third quarter are closed.

Here's where the biggest problem lies--most corporate pension funds assume they are going to make 8% compounded returns over the life of their fund. Today, with the P/E ratio of the S&P 500 at 18.91, it is within the most expensive 20% of all times. Research shows that the next 10 years average return, based on this high of a P/E ratio, can be expected to be in the 2% range on a balanced portfolio, at best 5%. That leaves a portfolio about $500M short over 10 years on a $1B portfolio. Multiply that by the billions of dollars in pension funds and we face a shortage in the trillions of dollars in the next 10 years. Compounding this problem is the longevity of retirees--well beyond the life expectancies that were part of the original actuarial tables.

If instead of even a 2% return on assets we enter another bear market decline that is more severe than the first decline (2000-2002), well, we won't even speculate what will happen then. Suffice it to say, the problem will get far worse before it gets better, even in the best of times, and the taxpayer will be saddled with a huge debt just from this problem. When we add this to the already debt-laden government, concerns about the ability of the U.S. government to honor its debt will come to the forefront. To counter the perceived higher risk in U.S. debt, we will see a concurrent rise in interest rates in order to attract investors, primarily foreign. The higher interest rates will only exacerbate the problem for the government to pay its debt. When this becomes more mainstream knowledge it will become quite depressing and depressed people don't make for good bull markets, which will only exacerbate the underfunded pension plans problem. You can see where all this is leading.

But the bulls are eating alfalfa and are singing "Don't Worry, Be Happy." The bull market continues; just ignore those people sawing away at the limb you happen to be on. The banks had an extremely strong rally over the past month and the steepness of the climb is simply unsustainable.

BKX banking index, Daily chart

Rallies are much healthier with a shallower angle and more significant corrections. This looks more like short covering or over-anxious buyers. Regardless, you tend to run out of buyers faster this way. It too looks like the broader indices now--overbought and ready for a pullback.

BKX banking index, 120-min chart

Because of the steepness of the climb on the daily chart, it's obviously easier to zoom in a little closer to see what's going on. As seen on this 120-min chart, the banks have broken the steep uptrend line and are currently trying to bounce back up to it. Watch for the kiss goodbye, especially if it looks like a double-top with negative divergence.

U.S. Home Construction Index chart, DJUSHB, Daily

Slowing housing starts, pass me the alfalfa. The home buyers will be back, not to worry. Well, let's see what happens again at 200-dma resistance since a break above it could carry this index back above 1000. Another failure at its 200-dma will likely spell trouble for this index and have it head immediately for longer term support down near 800.

Oil chart, December contract, Daily

Oil may finally be ready for a bigger bounce now that it's hitting the bottom of its down-channel. Its 200-dma has held back all bounces once it was broken so it would be telling if it can bounce back above it. Otherwise this could just continue sliding down this channel. Good for consumers if it does, bad for the stock market since I believe it would indicate oil traders are sniffing out a slowing economy.

Oil Index chart, Daily

The oil index held up well today, despite the significant drop in oil. It may have had as much to do with a rising tide in the broader market as anything else. In fact this index was the only negative sector (although only marginally so). If this index bounces back up to its 50-dma, watch the reaction. Above it, bullish; below it, bearish. Simple, no? Actually a break of either the 50-dma or the 200-dma should set the next directional trade. My guess at the moment is that it will stay trapped between these averages and narrow down in its consolidation before breaking lower.

Transportation Index chart, TRAN, Daily

The Trannies rocketed higher over the past 3 weeks and have run smack into the trend line across the highs from March 2002. The daily is overbought and the weekly is nearing overbought at the same time. I'm not confident that the rally will continue higher from here and if it were to roll back over, and the DOW doesn't rally at least to a new annual high, the DOW theorists will be all over that one. The non-confirmation by the DOW would be very bearish, and it's a reliable signal even if not good for day trading.

U.S. Dollar chart, Daily

The U.S. dollar and gold appear to be disconnected as both have been rallying. The dollar did pull back some today and it appears to be finding resistance at an internal uptrend line. Any pullback should find support at its previous resistance at 90.77, the previous high back in July.

Gold chart, August contract, Daily

Gold got a major boost after a close call to the downside. The surge in gold prices today sent it to an 18-year high. Gold bulls will be all over this one. It should be ready for some consolidation but I don't think the rally is done and I'm guessing the $500 level will get tagged. Once this leg up finishes, it may be finishing a much larger pattern to the upside and therefore it's a time to chase stops up and be ready to take profits here. Don't get caught up in the bullish hype that this is headed for $800 and that you should own a bunch. The more bullish everyone becomes, the more cautious you should become.

There are no major economic reports tomorrow.

In today's sector action it was almost universally green. The only red sectors on my list were the oil index, down a marginal 0.13%. Leaders to the upside were the airlines (liked the drop in oil price to a new 5-month low) and networkers who were helped by positive guidance from Network Appliances (NTAP). The securities broker index, internet stocks and the Trannies were all amongst the stronger performers today. Computer hardware also did well with the expectation the Hewlett-Packard would please the market with its after-hours earnings announcement HPQ did not disappoint--their stock was up +$0.79 on the day, closing at $28.99, and then bounced in after hours to $30.60. If they hold that into tomorrow that should help give the market a little boost. Other than GM'S Phoenix performance today, HPQ was the 2nd best performing stock in the DOW.

The fact that 75% of the S&P 500 companies reporting quarterly results so far have either beaten or met analysts' expectations, this suggests a 14th consecutive quarter of double-digit (about 15%) year/year EPS growth. Many are attributing this growth performance as the reason we'll see a year-end rally.

After the bell, as mentioned above, Hewlett-Packard reported a Q4 profit of $400M, or 14 cents a share, on $22.9B in revenue. During the same period a year ago, H-P earned $1.1B, or 37 cents a share, on $21.4B in revenue. While that looks like lower performance HPQ explained that excluding $1.57B in restructuring charges, they earned $1.5B, or 51 cents a share, and this beat the estimates of a profit of 46 cents a share on $22.8B in revenue. So it was a solid quarter for them.

HH&R Block (HBR) also reported and they cut their 2006 profit target after blaming competition and lower performance in the mortgage market business due to rising rates. They said fiscal 2006 earnings are now likely to be between $1.90 and $2.15 a share, down from a range of $2.12 to $2.32 a share that HBR had forecast back in June. The company also reported a fiscal second-quarter loss of $72.2M, or 22 cents a share, vs. a loss of $49.9M, or 15 cents a share, in the same period a year earlier.

For you coffee snobs (I can say that because I'm one), Starbucks reported a profit increase of 21%. They earned $124M, or 16 cents a share, in its fiscal fourth quarter, up from the $103M, or 13 cents a share, it earned in the year-ago period and a penny ahead of the average estimate of analysts. Revenue came in at $1.7B, up 23%, and also ahead of Wall Street expectations. For fiscal 2006, the company said it is targeting revenue growth of about 20% and said it expects same-store sales to rise 3% to 7%.

Tomorrow could be a little tricky. We have obvious resistance levels and everyone sees them. Watch for head fake moves which might only be aggravated by opex shenanigans. I would expect to see a pullback but we might instead see a day that is trapped in a tight range to finish out the week. Next week could be the price the market pays for climbing too quickly without much of a pullback. But as I mentioned above, if the market simply continues its relentless march higher, it will actually be more bearish in that the fall could be harder and faster.

We're closer to some very significant resistance levels and a pullback first to gather some energy could help the market. Without that we may simply run out of buyers, including short sellers. So be careful about a larger pullback coming, either now or a harder one later. My best guess is that we will get a little deeper pullback before a last hoorah of a rally into December as Santa shows up and spreads cheer amongst all the good little traders. That way the fund managers will reap hundreds of millions of dollars in bonuses. You can bet your account that they will fight hard to protect those bonuses. Good luck tomorrow, expect a quiet day and don't feel the need to trade. See you on the Monitor.

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