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Market Wrap

From Bad Santa to Late Santa

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Santa obviously had a little too much egg nog before the holidays and was too hung over to fly after Christmas. He was a no-show in the last week of December but he made up for it in spades today. Today's price action left a bullish engulfing candlestick and looks like a key reversal day. Now we'll have to see if we get some bullish follow-through.

As I'm sure many of you will remind me, my forecast for a rally on Friday was off the mark. I had thought surely the fund managers wouldn't let the DOW close in the red for the year but in fact that's what happened. The next day I opened up the business section of the paper and what was the only headline I saw? "DOW finishes in the red for 2005". I had to dig deep into the article before there was even mention about all the other indices that had an up year.

The reason I have been expecting a rally is because of the consolidating price action since November 23rd. From an EW perspective, it was a pretty strong corrective pattern and calls for another rally leg to new highs. We'll find out soon enough if today's rally was the start of it or just another bounce in a longer consolidation pattern. My feeling is that today's low was it the end of the 5-week consolidation and we should now look higher. If true, my call for a rally on Friday was a day off.

Briefly reviewing 2005, since I mentioned the DOW was down but not the other indices, it wasn't a barn-burner of year but it wasn't bad. The DOW finished down about 69 points, for a miniscule -0.6% decline. The S&P 500 finished the year 3.0%, the Nasdaq was 1.4%, the NDX was 1.5% and the small caps (RUT) was 3.3%. Fair to middling numbers. Compare those numbers to the Nikkei which was 40.2%, the FTSE at
16.7% and Australia's ORD 16.2%. And that was after the Fed pumped in a huge quantity of money as measured by M-3 ( about $750B) and the buying pressure we saw from foreigners. If 2005 was the best we could do with all that money coming in, things might not look so good for 2006.

There were some indices though that did very well. The NYSE did well, up 6.9%, and the Trannies had a very good year, up 10.5%. The NYSE, TRAN and RUT all made new all-time highs in 2005 (and the NYSE pressed to a new all-time high today). As discussed for the TRAN chart below, we have to wonder what is going on between the Transports and the DOW since they have not been confirming each other's moves and that's negative as per the Dow Theory. TRAN closed marginally in the red today, this after a strong up day in the market. The editors at Dow Jones replaced some dawg stocks in the TRAN and replaced them with some high flyers back in the fall of 2005 so instead of letting the index represent the actual market they seem intent on just making it look good by having the index go up. That's not helping the Dow Theory comparison and in fact has made the TRAN rally suspect since October.

We had about half the major averages make new all-time highs in 2005 and the other half have failed to make new highs. These kinds of intermarket divergences is not a healthy sign for the market which is another reason I think we should be looking for a major top soon rather than the start of another major bull market leg. Whether that top occurs this week, this month or this spring can't be known yet but my guess is that we're close to one. I think we'll top out this month, perhaps as early as mid-month. Interestingly the DOW topped on January 14, 2000. Maybe we'll have a repeating pattern there.

Economic reports today were light. Construction spending came in at 0.2% vs. 0.7% expected, down from the prior revised 0.8% (revised from 0.7%). ISM was 54.2 vs. 57.5, which was down from the prior 58.1. This was the lowest level in 4 months so while it still reflects growth (anything over 50), it looks like growth is slowing. These were disappointing numbers and the market continued selling into its 10:30 bottom. But after that morning bottom it was all up hill from there.

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The overnight futures had set the tone for an early bullish morning but that was sold off almost from the start. The economic reports just pushed it further down. But in hindsight it was probably a move to get a lower entry for the Boyz, and to suck in some shorts to provide more rocket fuel. GM and WMT set an early negative tone to market. GM was hurt by cut in its target price by Bank of America. WMT announced their sales would be at the low end of their 2-4% growth forecast, coming in at 2.2%. Because of the run up in crude prices, which closed up $3.20 at $63.15 and that gave the energy stocks a real boost. Because of those stocks, the S&P 500 soon started to outperform the DOW to the upside. But the higher cost of oil was likely a contributor to the relatively poor performance of the Transports today.

The Fed's FOMC minutes from its last meeting in December were released at 2:00 and the market had been pretty much on hold after an initial bounce off the 10:30 low. Once the minutes were released it was like letting go of a wound up spring. All kinds of buying came in and it was probably a combination of shorts covering and real buying hitting. Once the Fed's minutes were out of the way, people felt free to buy.

The FOMC December minutes showed the members' views differed on how many more rate hikes there would need to be, with some believing rates were already in the neutral zone. Some members wanted to drop the wording "measured pace". There seemed to be general agreement in the belief that there wouldn't need to be that many more rate hikes as concerns over near-term inflation had eased. The staff forecast slower but "solid" economic growth for 2006 and the members discussed the fact that they must be mindful of their policy's lagged economic impact. They felt their policy outlook was less certain and more data dependent. They're very likely aware that the data is largely rearview mirror analysis and may not necessarily reflect what's directly ahead.

Clues from the Fed that we could be nearing an end to its current monetary tightening cycle helped the Treasury market as it was bid up, dropping the yields. The yield curve's slight steepening, following last week's inversion, helped the rate-sensitive stocks as well. The minutes certainly didn't instill fear in the bulls and once they started buying, the bears ran for cover. The trick for this market is follow through since it's something that's been sorely missing for the past couple of months. The daily charts look bullish after today's move so let's see what they're telling us.

DOW chart, Daily

The daily candlestick is a bullish engulfing one and it looks like a key reversal day. Think of the pattern since Nov 23rd as a bull flag. Follow through is the key but this should continue higher. But watch out for a large pullback once the current leg up is finished. Once the pullback is finished we should be set up for a strong rally again.

SPX chart, Daily

SPX got a stronger lift today than the DOW, thanks to oil stocks. As with the DOW, we should get a stronger pullback which should then set up the next rally leg. Upside potential is a Fib target zone of 1281.55-1303.68. A small throw-over of the trend line along the highs since January 2004, currently at 1285, would be a typical end to this rally.

Nasdaq chart, Daily

The COMP also looks like it pulled back in a bull flag pattern from the end of November. Upside Fib target zone is 2280-2356. This is a little wide right now which I'm hoping to narrow down once the rally leg develops a little further.

SOX index, Daily chart

The SOX didn't quite pull back to its 50-dma and now looks ready to join the crowd and rally to a new high. The upside target is not as easy to identify on this index but a guess is the 520 area.

Much of the weekend reading was not surprisingly about the inverted yield curve, what it means, the fact that it's different this time (or not), its predictive value, etc. I thought it might be worth discussing this tonight and boil it down to something that might make some sense for most of us. In previous Wraps I've discussed this yield curve and Linda did a nice job with last weekend's Traders Corner article explaining what it means. The challenge for investors is how to take this information and use it as part of their longer term investment plans. The challenge for traders (being more short term oriented) is how to understand the potential volatility that might result from market participants' understanding (and misunderstanding) of what this all means. Even today's volatile price action was "blamed" on the bullish action in the treasuries that saw the yield curve steepen just enough to take away the inversion. As this yield curve inverts and then "un"inverts, we will likely see whippy price action around it.

Last weekend when the yield curve briefly inverted there was much hand wringing and gnashing of teeth. Surely the sky would fall next. Then the yield curve reverted briefly back to flat and the market rejoiced. Then it swung back to inverted on Friday and the market closed down. We have our new short term trading indicator! If only. It did show the volatility we're going to deal with as the market argues whether the inverted yield curve is significant or not. So I thought I'd review a little history.

First of all, the yield curve inversion has shown itself to be a reliable predictor of a coming recession. But the true measure is the comparison of the 90-day T-bill and the 10-year note, not between the 2 and 10-year. We hear about the comparison between the 2 and the 10 but the more reliable predictor comes from the comparison between the 90-day and 10-year. Secondly, it's the 90-day average of the yield spread that is important, not the first sign of an inversion. Last week was the first sign of an inversion but it could just as easily have been a result of fickle bond players, especially in light of the low volume because to so many of the large bond players were on vacation. Let's see how things settle out this week.

Any inversion that doesn't last at least 90 days loses its effectiveness as a forecasting tool. That means we would have to have a yield curve inversion between the 3-month and 10-year that stays in inverted through the end of March 2006 before it has a chance for making a more reliable forecast for a coming recession. The forecast is for a recession to occur with 4-6 quarters which puts a recession into 2007. The problem of course is that we'll have many arguments in the interim about how effective the signal will be. And that will cause volatility in the market. Plus the market will be way ahead of an actual recession as far as reacting to it (by dropping). Usually, by the time a recession is recognized, the market is bottoming and it's time to buy again.

If the yield curve inverts and stays there, reliably predicting a slow down if not a recession, the stock market will react negatively to this. On average the stock market drops 43% before and during a recession. I've been saying for quite some time that the longer term EW pattern calls for the 2nd leg down in the larger bear market and based on this pattern I would say we have a recession coming. Chopping the DOW nearly in half would take it below 6000. There are some other cycle studies that suggest the end of 2006/beginning of 2007 could see a large sell off in the market that bottoms the bear market cycle. It seems a lot of pieces are coming into place to make that prediction more believable.

Normally the yield curve rises from the lower left to the upper right where the maturities increase from left to right and yields increase from bottom to top. There have been times when the yield curve completely reverses and has the highest yield at the shortest maturity and drops to the lowest yields at the longest maturity, so the yield curve drops from the upper left corner down to the bottom right corner. How far the yield curve inverts gives us a percentage probability of the likelihood of a recession within 4-6 quarters. Therefore, what the studies of the past have shown is that the accuracy of the forecast depends on how long the inverted yield spread is in place and how much of a spread exists.

Some initial studies back in the mid-1980's, confirmed with studies up through 2000 show that the inverted yield curve, with qualifiers, is the most reliable predictor we have of future recessions. It's better than all other financial and macroeconomic indictors including the Leading Economic Indictors. What is particularly interesting, in light of hearing so many people, including the Fed and Greenspan, talk about how it's different this time is that in every case where the inverted yield curve accurately predicted a coming recession, many economists wrote volumes about how it was different that time. And in every case they were proven wrong. Up until a few months prior to the 2001 recession some 50 out 50 Blue Chip economists were saying we would not have a recession. So when the so-called experts get up and say this and that about what this all means, it's not worth much more than the paper it's written on. You can bet we'll hear again how it's different this time.

The historical average for the 10-year bond since 1982 is 7.31% while the average for the 90-day T-bill is 5.49% for a 1.82% spread. Today's values are 4.37% for the 10-year and 4.15% for the 3-month, for a 0.22% spread. But more importantly than today's reading is the 90-day average yield spread and obviously it's still positive. The fact that the yield spread between the 2-year and 10-year inverted last week may be somewhat meaningless. What it of course could mean is that we have a steeper inversion on the way and the 2/10-year spread is the heads up that it could be coming. But in and of itself, it is not a predictor of a coming recession.

With the Fed likely to raise short term rates again in January, there's a good chance we'll see the yield curve invert if it hasn't already inverted and stayed inverted before then. Then we would need to see if the inversion between the 90-day and 10-year yields stays inverted for 90 days in order to give us the official recession signal. In the meantime of course the market would be on recession alert and likely not doing that well. The 90-day average yield curve spread got to -0.71% at the end of 2000 and -0.95% on January 2, 2001. It then reversed into positive territory within a month after that. But the damage had been done.

Is it time to head for the hills yet on your index funds? Not really. The yield curve is not really telling us anything other than to pay attention at this time. So we will. I should note that many indices other than the internet bubble NASDAQ were not that far from their highs in July of 2000 when the yield curve started to show serious problems. In fact, the markets went up for a month or so following that negative inversion. In the meantime, expect some volatility in the banks as well.

BKX banking index, Daily chart

With the yield curve going back to a more normal one today, the financials got a boost. But there's something ugly about this pattern and I don't trust the upside. If the broader market can continue to rally, the banks should as well. But I wouldn't be surprised to see a new high in some of the major indices that are not matched in the banks. We'll see.

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

The pullback found support at its 200-dma and bottom of its up-channel and now looks ready to rally higher. There's the 62% retracement at 1001 and the top of the up-channel at 1025. There is an internal Fib projection at 1007 so if and when this index rallies up to there I'll be watching closely for evidence of topping out.

Oil chart, February contract, Daily

Jim had noted to me that he read on Friday that oil shorts increased by 50% last week. Seeing the gush higher from near $57 I would say that short covering had a part in it. If the bounce from the low in November (3-wave bounce so far) is to be just a correction to the Aug-Nov decline, then I like to watch for where we'd have two equal legs up in the bounce. That was hit today at $63.30 so that Fib projection was tagged (and then some) before closing lower. Short term it looks like oil is ready for a pullback. Longer term we may have finished the bounce and oil might now start heading for new lows. I'll have a better feel for this after it pulls back some. First support would be the broken downtrend line near $61.

Oil Index chart, Daily

So pullback got stopped dead in its tracks with the bounce in crude. We got a strong bounce back up to its previous high and it's looking bullish here. I would expect to see a push higher but the larger pattern from the October low looks very corrective. That leads me to believe any rally should be an opportunity to simply short this at a higher level.

Oil Index chart, 120-min

We're looking at a little closer view of the down-channel that the oil index was in, and the breakout today. After respecting the downtrend line several times, that breakout was a clean buy signal to get long. If this is headed higher, we should get a small corrective pullback followed by another thrust higher.

Transportation Index chart, TRAN, Daily

Like the banks, the Trannies leave me with the impression that new highs in the major indices may not be matched by the Transports. After reaching Fib targets and the projection out its sideways triangle, we got a steep pullback, indicating that the last high was significant. And if we do get a new high in the DOW in the next several days/weeks that is not confirmed by the TRAN, we'll be hearing lots more about Dow Theory non-confirmation.

U.S. Dollar chart, Daily

The US dollar got slapped silly today and it may have been a contributor to the rally we saw in commodities like oil and gold. The uptrend line is at $89.55 so watch for support there. If it breaks, we have 200-dma support just above $88.

Gold chart, February contract, Daily

The bounce in gold has gone higher than I thought it would, easily surpassing the 62% retracement of the drop at $523.60. But the size of the bounce is relatively unimportant, and can even make a minor new high without changing the slightly larger pattern which calls for a deeper pullback. I expect to see gold roll back over, perhaps as early as tomorrow.

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

Tomorrow's economic reports include auto sales, truck sales and factory orders. None of these are expected to be market moving.

Not surprisingly, sector action was almost entirely green today. The only red sector was airlines which was likely due to the large bounce in the price of crude. Lagging sectors, but green, were the Transports and healthcare. Leaders to the upside were the gold and silver, energy, SOX and other technology indices, drugs and pharmaceuticals.

Last week rewarded the bears who were betting Santa would be a no-show. If you held onto your short positions into today, Santa took back your present and gave it to the bulls. This market has been full of give-backs. Anyone trying to trade the market in all of 2005 as a swing trader found it difficult to have a trade last more than a couple of days if you were lucky. Position trades were far less successful. Just about the time your position was in the money and you felt you could move your stop, the market came flying back in your face and took your position away from you. I would dare say far more money was given back to the market than was made last year.

We're still in that environment which is why I continually suggest taking money off the table when you have it to put in the bank. While it's true that successful traders let their winners run, that's when the market has established a trend. In a trendless market, successful traders are the ones who are constantly pruning their fruit tress and putting the fruit in their baskets before the birds come to eat it all.

My guess for tomorrow is that we should get a relatively shallow sideways/down kind of day. It will look like a consolidation of today's rally. If we see a lazy corrective pullback with overlapping highs and lows, it will be a good sign to buy it for another leg up. After a relatively small leg up we should get a steeper pullback, perhaps into the 38-62% retracement zone of the bounce from today's low. I would also look at that pullback to get long. I'll be looking for the upside targets noted for the DOW and SPX above and then I'll be getting antsy about getting longer term short but it's too early for that. Hopefully you can follow us on the Market and Futures Monitor where we'll do our best to identify the turns and support and resistance. See you there and good luck with your trading tomorrow.
 

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