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Bad Santa

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When Santa fails to call, there will be trouble at Broad and Wall. It goes something like that and it refers to January. So without a rally this week there are many traders now worried about January. It was a quiet day today. OK, it was a downright boring day, with only an occasional sell program that hit, especially at the end of the day and in the DOW and SPX futures right after the 16:00 close. It looked like some people pulled the plug out of fear of a nasty reaction to the failure of Santa to show up this week.

But despite that nasty little decline at the end of the day I'm actually thinking we might have bottomed. I could be way off base on that but we should know early since a rally has to start very quickly tomorrow morning (we could see a brief drop at the open but nothing sustained). If we see a further drop, with SPX getting much below 1253 and DOW below 10760, then we'll likely have a down morning, if not the whole day. I'll lay out in the charts below why I'm thinking we've bottomed.

But first we had some economic reports this morning, which ended up having little to no impact on the market. Weekly jobless claims numbers showed new claims up 3K to 322K, which was in line with expectations. The 4-week average was up 250 to 325K and continuing claims were up 85K to 2.72M. The Help-Wanted ad index came in at 39 vs. November's 38. The relatively good unemployment numbers leaves the market looking for a strong 200K rise in December nonfarm payrolls.

Existing home sales numbers were also released and showed sales fell -1.7% to 6.97M units, which was below expectations of a -1.3% drop and is the lowest level since March. Existing home inventory stands at a 19-year high so obviously homes are now taking longer to sell. There may be more people trying to sell also, fearful of getting caught by the bubble or rising interest rates. The good news is that home prices are up 13.2% year-over-year. Now if that could only hold but I'm guessing 2006 will not be kind to the housing market.

The Chicago PMI for December came out at 10:00 and was 61.5 vs. 60.0 expected. This was virtually even from November's 61.7 and bodes well for the upcoming read on national manufacturing activity.

Lastly, crude inventory numbers were released at 10:30 and showed crude stocks up 100K barrels in the latest week. Gasoline stocks were down -1.2M barrels and distillate stocks were down -900K barrels. According to EIA, "U.S. crude oil inventories are well above the upper end of the average range for this time of year. Total motor gasoline inventories...[are] in the lower half of the average range. Distillate fuel inventories...are just above the lower end of the average range for this time of year. Total commercial petroleum inventories dropped by 7.4 million barrels last week, but remain above the upper end of the average range for this time of year." The price of oil barely reacted to the news but did climb higher throughout most of day before pulling back into the close, finishing up 0.45 at $60.25.

We've been consolidating for a very long time so let's see if the charts offer any hope of ending this choppy pattern we've been in for over a month now.

DOW chart, Daily

The DOW has been consolidating around the downtrend line from January 2000 and the level where it started the year (10783). While it's entirely possible the DOW will pull back further before we see another rally leg I would be very surprised to see the DOW close below 10783 tomorrow. The large funds have a vested interest in keeping the DOW positive for the year. So many people have heard about years ending in '5' being up years and they'll be upset if this year is different. Even though there are some qualifiers on that statistic, most people don't want to know the details--they just hear the headline statistic and that's what they go with. If fund managers can avoid having to answer a bunch of concerned investors about what it mean that 2005 was a down year, they'll do everything they can to ensure the DOW closes in the green. We'll just have to see if they're successful tomorrow or not.

SPX chart, Daily

SPX could find support at 1253 which is the 62% retracement of the 2000-2002 decline. The internal pattern of the consolidation since Novemer 23rd can be called complete at today's low and based on that we should get a rally started tomorrow. If instead 1253 does not hold then I see the possibility for a drop to 1246, the July high. But if a rally does get started, and takes us into early January, based on a projection off the pullback low, I'm currently looking for an upside target of about 1290 to finish off the bull market rally. That would take the DOW up to about 11,100-11,200.

SPX chart, 120-min

A little closer view of the consolidation pattern shows price dropped below the bottom of a parallel channel and if price rallies back up into the channel tomorrow, today's end-of-day price action will look like a classic ending to a consolidation with a throw-under. But this is why the rally must get started early tomorrow morning. If price hangs below 1257 then it will look like a confirmed breakdown.

Nasdaq chart, Daily

The COMP looks like it could pull back a little further relative to the DOW and SPX but it too looks close to support in a possible bull flag pattern. Assuming we'll get another rally leg going, the upside projection is just above 2300 to as high as 2355. If it pulls back further then I would look to the 50-dma at 2200 for support.

SOX index, Daily chart

The pullback pattern in the SOX looks like a small descending wedge, which is typically bullish. The daily oscillators look like they would support a turn back up any day now so the combination of the consolidation pattern and oscillators leads me to believe the SOX is ready to rally.

BKX banking index, Daily chart

The ongoing hype about an inverted yield curve may have prompted some consolidation in the financials and the banking index has pulled back the past three days. If I look at its pattern exclusive of the others I would say the banks have topped. But if the broader market rallies then I would expect the banks to rally as well (if they didn't rally with the broader market it would be that much better confirmation that the whole market is about ready to top out). So this one bears close scrutiny as we head into January.

In last Thursday's Wrap I discussed the inverted yield curve and why it's considered bearish for the economy. On Tuesday the curve hit the flat point after U.S. two-year Treasury yields drew even and then slightly higher than 10-year yields for the first time in almost five years, producing a so-called flat and then inverted yield curve. This comes after the Federal Reserve raised interest rates 13 straight times since June 2004. The difference in the yields has shrunk from 2.82 percentage points in June 2004, the day before the Fed starting lifting its interest-rate target for overnight loans between banks. Over that time, the 2-year note's yield has risen from 2.8% to a recent range of a little more than 4.3% to 4.5%. The 10-year note's yield has fallen from 4.69% to 4.34% on Tuesday and Wednesday which is when people were yada yading about the inverted yield curve and how the sky was going to fall. Then when the 10-year yield climbed up to 4.38% by the end of the day Wednesday, it was credited for the stock market rally (of a few points). I guess all of a sudden things were remarkably better in the market because the 10-year yield got a bump back up. We play with some very strange people in our profession. The yield curve inverted again today and it was blamed for the negative day. It always amazes me how they have to design a reason for why the market does what it does.

Banks will react to the yield curve because of their dependence on profitability from the spread. Without the spread (in a steeper yield curve) they are not as profitable. In fact I was surprised to see banks rally so strongly off their October low--as the yield curve was flattening, banks were rallying and I thought that strange. They pulled back the past three days but it was all part of the broader market pullback. It remains to be seen now how they'll react further to this inverted yield curve discussion.

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

The housing index is struggling to stay on top of a recently broken downtrend line and may get a bounce off this line and the bottom of its bear flag pattern. It's currently also being supported by its 200-dma at 927.40. If this index drops much below 917, and certainly below its 50-dma at 908, then it's in trouble. But it looks like it's setting up for another bounce in which case it could be targeting its 62% retracement at 1001, maybe even all the way back up to the top of its flag pattern around 1020. Whether it's now or it's later, this index appears headed lower once the upward correction is finished.

Oil chart, February contract, Daily

Oil got a nice little bounce off its previously broken downtrend line near $57. It's battling its 50-dma at $60.20 and if able to get back up to its new downtrend line at $61.40 it will likely find resistance there. Short term though oil is looking ready for a pullback and if it just keeps dropping then I'll be looking for $54-55 for support.

Oil Index chart, Daily

Oil stocks were doing OK today until they gave it all back and then some into the close. This sector got the blame for the relatively poor performance of SPX as compared to DOW (the DOW was also helped by GM of all companies). This index was not able to hold its 50-dma at 523.67 today and that is bearish. After giving its recent uptrend line (the bottom of its ascending triangle that formed in Oct-Dec) a kiss goodbye, this index continues to look lower. Any turn around back to the upside needs to get through 540 to turn the chart more bullish.

Oil Index chart, 120-min

Looking a little closer at price action since the top of the bounce on Dec 14th shows a parallel down-channel that can be used to guide your trades in stocks in this index. Price bumped its head against the downtrend line today and pulled back sharply. A continued drop in this index portends a continued drop in oil as well. The bottom of the channel is near 507 which matches the daily chart showing support at its 200-dma and uptrend line.

Transportation Index chart, TRAN, Daily

Railroad stocks hit historic highs today following a report on rail freight carload traffic. The Association of American Railroads reported much stronger than expected weekly volume data, and this caused an early morning rally in the Transports before selling off in the afternoon. Even though today's high in the Trannies wasn't higher than Tuesday's high, it may have been the end of its rally from the October low. It's a little early to call that but the EW count inside the pattern can now be called complete. There are some internal Fib projections for the wave count, starting back at the bottom in 2003 up until the final leg up from October 2005 which line up just shy of 4300. A projection out of the sideways triangle pattern that formed for the greater part of 2005 was just above 4300. The Trannies have so far hit a high of 4306 and they're leaving clear negative divergences at the most recent highs. Like the discussion about the banks above, watch the Trannies carefully. If the broader market rallies into next week without the Trannies that would not be a healthy sign for the rally. If the broader market manages to rally to new highs without both the banks and Trannies on board I'd start backing up the truck to get long term short.

Looking at the broader market, specifically the NYSE, there are some proprietary signals that were developed by Peter Eliades (stockmarketcycles.com), based on earlier work done by Jim Miekka and Kennedy Gammage who wrote the Sudbury Report. They've dubbed the name of this signal the "Hindenburg Omen" and it means what it sounds like. It's an infrequent sell signal generated by certain parameters and it's a heads up that the market is vulnerable to a crash. The market generated the most recent signal on Dec 21st and I'm watching to see if we get a cluster of signals over the next week or so. The last cluster of signals was back in September but it didn't result in any crash (just a large drop into October followed by a miraculous recovery). Before September there was a signal in April 2004, which also saw a big drop and then a miraculous recovery into May. June 2002 was the previous signal before April so you can see it doesn't happen often. No market crash has happened without the warning of a Hindenburg Omen signal but not every signal results in a market crash (it only warns of the vulnerability to one). The signal is also not a market timing tool since a large sell-off can occur within a week to a month or more.


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Interestingly, each time we've seen the market generate this Hindenburg signal, the Fed has injected massive amounts of money into the system. Maybe they're watching the same signals and when they get worried, they hand all their dealers huge quantities of money and tell them to get ready to buy. They did it in April 2004, again in October 2005 and they started again last week. For example, in April 2004 the Fed pumped in $155B in liquidity in a 4-week span of time in April-May. Starting in September 2005 they pumped in $148B over a 6-week span of time in September-October. These rates were 2-3 times the rate of GDP growth and at a time when the Fed was warning the market about the dangers of inflation. In the meantime they pumped up liquidity at hyperinflationary rates. Why? Could the miraculous recoveries from the market sell-offs be a result of that money? Makes one wonder, especially knowing the PPT does in fact exist. What we don't know is exactly how much they step into the market. It is generally believed at this point that they have become much more active in our "free" markets. Hence they phrase "Greenspan put" and is why so many participants are not afraid of a market crash. This is the perfect setup for a "major dislocation" as some like to call a market crash.

So here we are into December and as reported by Jonathan last week on the Monitor, the Fed injected large quantities of money into the system through their repos, to the tune of $18B on Thursday Dec 22nd and another $20B on Friday. Could this be the start of another $150B add over the next 4 weeks? Time will tell. And if they are doing this, it means they're worried about something in the market. The increase in M-3 money supply may end up being our market vulnerability signal. One of these days they won't be able to stop the natural market forces and in fact are likely making things worse by not allowing larger corrections to flush out the wastes.

Here's the kicker about M-3 though--the Fed will stop reporting M-3 beginning in March 2006. This was announced more as a "oh by the way" right after Bernanke was appointed to replace Greenspan. I guess this is how old Ben will be more transparent than Greenspan. I'm going to lay out a scenario that sounds a bit worrisome and I don't do it to just scare people but instead as an effort to educate and inform. We may not head down this path but I offer it as a heads up as to a possible scenario that could have some negative repercussions down the road.

Without the reporting of M-3 the Fed will be freer to jack money supply around without the knowledge of the market. Interestingly, the date that M-3 will start to be hidden is the same month that Iran declares economic war against the US Dollar by trading its oil in Euros on its new bourse. Right now of course, all oil transactions are conducted in US Dollars. Iran's decision has the potential to have a huge negative impact on our currency as well as our market. Do you suppose the Fed will be busy cranking electrons into dollars around that time? But we won't know because the Fed will stop reporting it.

The Fed's shenanigans are having an impact on its ability to find good people. The Federal Reserve currently has three vacancies within the 19 top Regional Bank and Board of Governor spots. They appear to be dropping like flies and resignations are increasing--6 of the 12 Regional head spots have resigned in the past few years. This is a highly coveted job where Fed Presidents are treated like kings with enormous power and prestige. Yet people are dumping these jobs and unfilled slots remain unfilled. Two of the seven Board of Governor positions remain unfilled and have been open for quite a while. Do the people who have resigned (or aren't taking the job) know something the public doesn't and are unwilling to be participants in the Fed's scheme? If so, bully for them and thank God we have some people with real moral values. For the remaining I'll be kind and just say they're misguided.

The net result of this is that we will likely have a batch of largely inexperienced individuals at the helm of our banking system. And now they decide to hide key money figures from the public. That's real confidence inspiring. If a substantial amount of oil transactions will suddenly be conducted in euros instead of dollars, the dollar will likely take a hit as people exchange dollars for euros. This might even cause concern about the dollar's status as the world's reserve currency. That in turn would make it more difficult for the Fed to mass produce all the dollars they want without driving the dollar into the ground. If the dollar drops then foreign central banks will start to liquidate their US assets for euro-based assets. Treasuries would take a hit (yields would increase) and kiss housing values goodbye. You can see how it all relates. This won't necessarily happen but the threat is there and it's like dominoes--once the first one falls it may be hard to stop the chain reaction.

Which brings us back to the Fed and M-3. If the dollar tanks, and we lose the interest of foreign central banks in buying up our debt, is it possible the Fed may be considering monetizing the Federal debt by buying US Treasuries themselves in order to support the dollar and Treasuries? Scary thought. It would require huge quantities of new money and none of it would be reported since M-3 would be hidden. Possibly there are people who simply don't want to be part of what might be about ready to go down. As for current M-3, the past 6 weeks have seen an increase of $193B, a 17% annualized rate. This is a lot more than current GDP and CPI and one must wonder what the Fed is worried about that they feel the need to crank out that many dollars. It's what makes shorting the market very difficult--there's just too much money coming into the market to support it. Greenspan worries about the "conundrum" about why the bond market seems to be fighting him and not letting yields increase. Greenspan IS the conundrum as he buys up bonds (keeping prices high, yields low). It's a strange world out there so tread and trade carefully. It could be an interesting trip we take together in 2006.

U.S. Dollar chart, Daily

After bouncing back above support/resistance just under $91, the dollar is holding up. If it drops back down it should find support at its uptrend line near $89.50. A continuation of its rally should take it up into the mid-90's. The interesting thing about its longer term pattern is that the bounce from the low back in December 2004 is a corrective one. This means that once the correction against the decline from 2001-2002 is finished, the dollar will proceed to new lows, below December 2004 ($80.39). The current year-long bounce looks like it should continue for at least another month or two before it tops out. And this takes us potentially into March. As per the discussion above about the potential weakening in the dollar, even the long term EW pattern suggests something bad is about to happen to the dollar once this bounce is finished. It could make the leg down from 2001-2002 ($120 down to $80)) look small by comparison.

Gold chart, February contract, Daily

Future trouble with the US dollar may have been one of the reasons gold spiked so high (also the demand from oil producing countries turning oil into gold). But it went too far too fast and the hard drop back down was a typical reaction. Now we're getting a hard spike back up, also a typical reaction but the pullback is likely not finished. The current bounce should be peaking soon and we'll get another leg down. When we get back down to $460-470 I'd be interested in buying gold again, especially if the dollar looks like it may be finishing its correction. If the current bounce is finished, two equal legs down from its peak would be at $469.50.

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

The Chicago PMI is the only economic report of significance tomorrow morning, coming out at 10:00. It should not be a big market mover. If we have anyone awake tomorrow they have a chance of moving the market better than an economic report.

Sector action today was mostly red but relatively mild. The leaders to the downside were the oil service, SOX, networkers, computer hardware and disk drive makers and the energy sectors. The oil service sector was the only one down more than 1%, at -1.6% for the day. The green sectors were gold and silver, up 1.7%, airlines, Trannies and then healthcare squeaked out a positive 0.28%.

The game we play is a difficult one. We try to be contrarians so that we're not going with the crowd. We know what happens to lemmings when they start following the crowd. But often times when we think we're being a contrarian we're actually still following the crowd. But here's a suggestion for the next couple of weeks which I think is contrarian. Santa was a no-show, this after most expected him to show up and sprinkle fairy dust on the market. Instead he sprinkled coal dust. Now there's been great hand-wringing going on about January. I would say most are beginning to expect a down month, and the put-call positions support this. Therefore from a contrarian perspective we should be thinking long into January. The hard part of course is where do you dip your toe in the water without too much worry the sharks are going to bite them off.

I use EW analysis to help me identify where we might be in a pattern but unfortunately in a corrective pattern it's not much better than many other technical analysis tools. But the combination of EW, trend lines, channels and the myriad of other tools at our disposal (moving averages, oscillators, envelopes, etc.), I can more confidently form an opinion about where the market is and therefore where it's going next. This is of course in the end all guess work and that's why we use stops. I think it was Bill Fleckenstein who said something like "I will confidently make predictions and most of them will be wrong". But he keeps trying because when he's right he's often very right.

So, what does my crystal ball tell me? I think we're bottoming, if not bottomed today. We could get a little lower tomorrow but it can't be by much, otherwise I'm wrong. If we've bottomed then I think the consolidation from November 23rd is finished and we're ready to rally to new market highs over the next couple of weeks. And if we're about to rally to new market highs then January, at least the beginning of it, will be up. That will blow away those who are bearish the market as we head into January and from a contrarian perspective I like that.

And if I'm wrong and we continue to drop lower tomorrow I'll simply stop myself out of my long position (I went long a small futures position at the close) and reevaluate and get myself ready to confidently issue another forecast. It's all part of the game we play. See you in the Futures Monitor tomorrow and good luck in your trading. Only one more slow day until we get back to something more normal next week.

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