Option Investor
Market Wrap

Continuing to Churn

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The market got a little lift today so now we're left to wonder if the Santa Claus rally began or not. Typically the rally starts tomorrow so perhaps there were a few people trying to get in early and gave the market a little boost, especially towards the end of the day after the market had been running pretty flat for most of the day. But the rally was less than inspiring as it was a bit too choppy to indicate it was the start of something bigger to the upside. Instead if felt like just a bounce in the continuing sideways consolidation we've been in for the past month. If that interpretation is correct we can expect a pullback tomorrow morning at least and then maybe get the rally started, or not. Once this consolidation is complete we should get another rally leg started but it's been a challenge trying to figure out where and when it will start.

We had only a few economic reports this morning, none of them market moving. Jobless claims number were released and showed initial claims fell -13K to 318K (consensus was 325K). The prior week's number was revised up to 331K. Continuing jobless claims rose 41K to 2.6M while the 4-week average fell to 324K. The hurricane-related claims now total 571,200. For employers, the insured unemployment rate rose to 2.1%.

Consumer spending was up 0.3% which was in line with expectations and higher than November's unrevised 0.2%. Wages and salaries were up 0.2% (down from October's 0.6%) and disposable income (income after taxes) was up 0.3% (up from October's revised 0.2%). Personal income was up 0.3% vs. 0.4% as expected, which was a drop from October's revised 0.5% (revised up from 0.4%). Therefore consumer spending was slightly higher than income and the savings rate stayed the same as October's at a negative -0.2% rate.

Core inflation rate was up 0.1% for the month and up 1.8% year-over-year versus 1.9% annual rate in October. The inflation number was the lowest seen since the spring of 2004 so it was Fed friendly.

The Leading Economic Indicators came out at 10:00 and again was a non-event as far as the market was concerned. November's LEI was up 0.5% and 7 out of 10 US Leading Indicators rose. All in all it was positive but not Fed scary.

Speaking of the Fed, I need to pick on Fed Governor Lacker. He came out this afternoon with some talk about rates (too soon to tell if they're consistent with growth), the impact of energy (he feels the risk of inflation from higher energy prices is still present), and then he discussed the personal savings rate and the yield curve. He stated that he's not worried about the low US personal savings rate and that the yield curve is not useful anymore as an economic predictor. Which planet do they get these guys from?


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As for the personal savings rate, it's a question as to whether it is better to keep consuming or to save for a rainy day (like retirement). To say that a negative savings rate is OK is questionable to me, to put it mildly.

As for the inverted yield curve, what he's really saying is that it's different this time. I know there are a lot of people arguing that it really is different this time but until proven otherwise I think that's a risky proposition. A steep yield curve (low short term rates steadily increasing as you get to the higher long term rates) is stimulative because it encourages investment in anything other than short term bonds. That helps put capital investment into our businesses and economy. As the yield curve inverts, the short term rates increase above mid term rates and get up close to long term rates. The curve becomes more like a bowl. Investors flock to the short term bonds for a guaranteed return versus risking it in the market place.

Banks have trouble making money when the yield curve inverts since they're paying out more as compared to what they're taking in. This tends to tighten their lending practices and they lend out less money. This then chokes off growth in the economy as it discourages capital creation. This is a complicated field and is why there are so many different opinions on the subject but generally speaking the risk is there for a recession to occur if the yield curve inverts. But Fed Governor Lacker (and Greenspan) discounts the yield curve now saying it's different this time. Time will tell.

Most of the daily charts look like larger versions of today--they appear to be on hold, consolidating and waiting for something to spark the next round of buying. Let's see what the charts are telling us.

DOW chart, Daily

The DOW continues to chop around its long term downtrend line. Even the daily stochastics seems confused as to which way to go. There's an expectation for a Santa Claus rally but so far there hasn't been any real interest in buying. It could be most of the buyers are already in and now it'll just be a choppy battle between bulls and bears for the rest of the month. Ideally we'll get one more pullback that sets up a stronger rally.

SPX chart, Daily

Like the DOW, this index is just consolidating. The longer it consolidates near the highs though, the more bullish it becomes. As long as a pullback stays above about 1253 I'm expecting to see another rally leg out of this and then 1285 becomes the first upside target.

SPX chart, 120-min

This 120-min chart zooms in on the consolidation since November 23rd. These sideways patterns are hard to judge when they're about to end but a pullback to 1253-1255 would a good ending to this pattern and would set up the next rally leg. But if it drops below 1250 it would say this consolidation pattern may not be bullish.

Nasdaq chart, Daily

The COMP recovered back above the trend line along the highs from January 2004 so that was a good recovery from a potentially bearish break. Whether it's ready to rally higher or will also consolidate a little longer is hard to say but like the others, this should rally to a new high with an upside target in the 2250 area.

SOX index, Daily chart

The SOX may have finished a simple 3-wave pullback and is now ready to rumble to the upside. If money starts rotating back into techs we could see this index start its next rally leg from here.

BKX banking index, Daily chart

After pulling back into the December low, the banks look like they're into their next leg higher. But this looks like it could be the last leg up and in fact the negative divergences at this retest of the high says it will fail. If the banks roll back over any new rally in the major indices will be suspect so keep an eye on this sector.

I had mentioned in Tuesday's Wrap that we Americans, taking our civic duty seriously, have been spending like there's tomorrow and thereby absorbing the world's excess manufacturing capacity. We've been doing this by spending more than we make, which has been greatly assisted over the past couple of years by the housing bubble and the equity we've been taking out of our homes. Before that we took the equity out of our overly inflated stock portfolios. Everyone is starting to look around for the next free-money source since the tree in our back yard has done been plucked clean.

The Fed has been more than a willing participant in providing essentially free money. By keeping interest rates below the inflation rate for a few years, it was cheaper to borrow more money than to wait while you saved for that new car or trip to the Caribbean. But it's all beginning to catch up with us and we now need to be prepared for the consequences of a long period of easy money. There was an interesting article in a Hong Kong paper that discussed the indebtedness of the US and the potential danger to those countries who are buying up US debt.

Japan is the largest creditor of the US Government (they hold a little less than $1 trillion of our paper), and the Chinese mainland has been a fervent buyer for the last few years. As for Hong Kong, most if not all of its reserves are in US dollar denominated assets, principally US Treasury Bonds. One of the reasons for Greenspan's "conundrum" about Treasury yields fighting his effort to raise rates is due to the buying pressure to purchase our treasuries, thus keeping prices high, yields low. The foreign investment in US assets finances as much as 90 per cent of the federal deficit. As I had mentioned before, this has been a symbiotic relationship as both parties have benefited from this arrangement.

There are many arguments at the present time about whether the US's outsourcing of manufacturing and servicing jobs is long term healthy or not. History shows that many countries have seen their currencies take a steep fall when they stop producing and become consumers instead. The argument is whether or not the US and its dollar will suffer the same demise. That's an argument for another time and I'll try to address the pros and cons in the argument and whether or not it's different this time.

The Hong Kong article expressed concern about the consequences when foreign central banks stop buying up so much US debt. The fear expressed in the article is testament to the fact that many central bankers are probably very leery about their exposure to the US dollar. They may start to divest as part of their own diversification program or they might do it out of necessity if Americans stop their profligate spending. Less spending on foreign goods will mean less money in the coffers of foreign countries which will mean less money coming back to the US. If these central banks start lightening up on their exposure to US dollars and Treasuries we could see a drop in the value of the dollar and bonds which will jack up yields.

A drop in the value of the dollar will create inflationary pressures at home and that would cause the Fed to increase their rates. These events would only exacerbate the problem of Americans tightening their spending habits and forcing them to save more. Less spending by Americans means less money received by foreign countries means less investment in US assets and you can see how a vicious cycle could ensue. A slowdown in the US could quickly turn into a slowdown on a global scale.

A long term solution will come of all this and it's a necessary cleansing of the "system". Once Americans stop becoming the primary consumer for the world, the producing countries will need to start stimulating internal consumption. This will continue to strengthen these countries as they develop a more balanced production-consumption program. But the interim period could be a little painful.

The big question of course is what is going to slow down the almighty American consumer. I've already mentioned the fact that the free money source (first the stock market bubble and then the housing bubble) is drying up. So there will simply be less money to throw around (even with a Fed that's turning electrons into money at a furious rate). Americans will be forced to live within their means. The trouble is costs are now on the rise so the more limited dollars will now be going to more expensive needs and leaving even less for our wants. There are four primary areas where we'll be seeing higher costs.

One, energy prices are still high even after a strong pullback since the summer. As a percent of Disposable Personal Income (DPI), total energy costs in the winter of 2004-2005 ran about 4.5%. By early summer 2005 that had climbed to 5.5%. For the next year, projections for post-Katrina energy costs will rise over 6% of DPI. With total DPI estimated to be about $9 trillion, a 1.5% shift in spending towards energy equates to about $130B removed from other areas. And that may be a conservative estimate.

Two, mortgage interest rates have been on the rise. A 2% increase on about $1 trillion of adjustable mortgage debt will trigger $20B of additional mortgage payments on about 5 million households.

Three, the temporary AMT adjustments from the Bush tax cutting will expire Dec 31st. The number of individuals and families that will be hit with the alternative minimum tax liability starting January 1, 2006 is projected to jump from roughly 3.5 million this year to nearly 19 million next year. The total impact will be approximately $30B or about $2000 per household. So $30B out of the consumers' pockets and into the government's pocket.

Four, post-Katrina rebuild efforts will take many years and a lot of borrowed money. This will continue to be a drain on local, state and Federal budgets. Individuals and businesses will be spending what they can locally in order to get back to some semblance of normal life there.

These all add up to a significant reduction in consumer spending for the next several years. On top of that, without housing prices, consumers will feel poorer and are likely to spend less. As housing prices cool off Consumer Sentiment will likely take a dip. It's always hard to predict what will happen in housing but the current 11% year-on-year gain in real house prices compares to a 50 year average of only 2%. The current growth is three standard deviations above its mean, and historically, this has broadly been a mean reverting series. The odds are high that the growth in real house prices will fall below zero in the next few years. The experience of the UK and Australia suggests that even a leveling off in prices will be sufficient to cause a pullback in consumer spending growth.

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

The housing market continues to struggle in its bounce. Even the positive build numbers haven't helped it much. Interest rates have dropped a little since the November high but that hasn't helped it much. Watch the reaction to tomorrow's report on New Home Sales. The bounce off the October low in this index continues to look like a bear flag. It could chop a little higher to 1000, maybe a little more, but I would use any additional rally to look for shorting candidates. But like the banks chart, the retest of the last high has been met with negative divergences so the current bounce should fail. This one should correct hard in the next leg down.

Oil chart, December contract, Daily

Oil continues to look bearish to me. The bounce failed to hold the 50 and 200-dma's. In the new parallel down-channel, based on the last bounce high (which only achieved a 38% retracement), the bottom of the channel crosses the longer term uptrend near $54. I've drawn in a potential H&S neckline that currently crosses through $56.30 so any break of that neckline could suggest significant downside for oil. Many will scoff at the idea that oil could drop back down into the $40's and I will admit it's hard to believe. The only thing it would be telling me is that we have a significant slowdown in the economy, on a global scale, on the way.

The latest numbers for natural gas showed a decrease of 162 bcf in storage for the latest week but the price of natural gas plunged today, down $1.28 closing at $13.02.

Oil Index chart, Daily

The oil index also looks bearish to me and it might be forecasting lower oil prices if this index breaks down. It's right on the edge here--it needs to break down soon otherwise it could rally back up to new highs for the bounce. The larger bounce pattern still would remain bearish but we could get a higher bounce before it rolls back over. In the meantime I'm expecting this index to break down and start breaking support, first at its 50-dma, then 200-dma and uptrend lines.

Transportation Index chart, TRAN, Daily

Someone lit the fuse under the Trannies the past two days and the index is making new all-time highs. It's doing this without the DOW again so the non-confirmation continues and is glaring. The rally in the Transports is not to be trusted. Ideally, as depicted on the chart, we'll get a small pullback and then a final high, with a target for the high in the 4275-4300 range. I've got some Fib projections lined up there, ideally 4282, and the previous triangle pattern from earlier in the year gives us an upside projection of about 4300.

U.S. Dollar chart, Daily

The US dollar bounced back up to the line where it has been finding support and resistance, just under $91. If it manages to hold above it should continue its rally to new highs. Otherwise watch for a pullback to its uptrend line near $89.50.

Gold chart, August contract, Daily

Gold is getting a bounce a little earlier than I thought it would. I was expecting a bounce off its 50-dma and October high, both in the 485-488 range. Whether the current bounce is a dead cat bounce or will lead to the one that takes it back up to around 520 is hard to say. If the current bounce develops legs, watch the 520-524 area for resistance.

Results of today's economic reports and tomorrow's reports include the following:

We have some potential market moving economic reports tomorrow morning so watch for a reaction in the futures to gauge how the market might open.

Sector action was generally positive today. Almost everyone was in the green. The lonely red sectors included the retailers, natural gas, oil and oil service but these were only marginally red. Strength today came from gold and silver, biotechs, healthcare, airlines, the SOX and disk drive index.

The gold and silver index wasn't much affected by the news that Barrick Gold (ABX 27.14 -0.08) sweetened its bid for Placer Dome (PDG 22.35 -0.30). In the deal ABX upped its offer to $10.4B, from the previous offer of $9.2B. Under the deal, PDG shareholders can choose to receive either $22.50 in cash or 0.8269 of one ABX share plus 5 cents a share in cash. The revised offer includes a $259.7M breakup fee, but PDG has the right to consider other proposals until January 19th. It was interesting that both companies dropped hard on the news and then both rallied back up to just under breakeven for the day.

Healthcare got a boost from Humana which hit an all-time high after it reaffirmed FY06 EPS guidance and said it expects enrollment in its Medicare plans to more than triple by January 1st.

The lackluster performance by the market today could have been the result of low volume due to the holiday weekend and the NYC transit worker strike. With the strikers returning to work tonight we should have a full crew in tomorrow at the exchanges. Whether or not that will make a difference we'll have to see. But the bounce today lacked the oomph to give me the feeling it's starting something bigger to the upside. It looks like it's ready for a pullback tomorrow and the larger corrective pattern that we've been in for the past 4 weeks makes it very difficult to figure out if it's finished or has a little more downside work to do. My preference would be to see it pull back a little further, to about SPX 1254/DOW 10750 but I guess that will depend on how many buyers show up for the Santa Claus rally.

If the majority of buyers are already in, in anticipation of the year-end rally, we may not have enough fuel to get this thing going. We could instead just chop up and down as the bulls and bears fight for control. Because of all the choppiness, it's hard to line up a price level and say "Ha, above here and we're breaking resistance and will continue to rally." That level is a new all-time high and that doesn't do us much good if we want to participate in the rally up to there. The other possibility of course is that we're done rallying and we've been in a topping formation. I'm not ready to believe that yet and I'm still on the side of the fence that expects a rally into the end of the year, possibly into early January. It's after that rally that I will turn very bearish.

So tomorrow could be tricky to trade and I'll be watching to see what sets up before I trade it. If you're following us on the Monitor I'll be trying to get you into the rally while always keeping in mind priority #1--capital preservation. Good luck and I'll see you tomorrow.

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