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A Pause That Refreshes

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Or is this the quiet before the storm? After a sharp move up off Tuesday's low, the sideways consolidation since yesterday looks bullish. We've seen time and again during past rallies these spikes up off the bottom followed by minimal pullbacks and then a resumption of the rally. By not pulling back very far, it doesn't allow bears caught on the wrong side to get out, or new bulls to get in. Consequently when a new high gets made after only a minimal pullback, buyers from both sides scramble to buy at any price and we get a stage two light of the rocket. It's obviously too early to tell if that's setting up again but so far it has the markings of it. As I'll discuss later, the techs are actually giving me a little more bearish impression so I want to temper my bullishness.

The market's consolidation today was downright boring. We had a tight little trading range with a lot of choppiness and it's just not conducive to productive trading. We'll have to wait until tomorrow to see if there's another small pullback in the current consolidation pattern or if we're ready to start another leg up.

There were many retailers reporting sales results for December this morning. A majority of the retailers exceeded expectations for sales during the holiday shopping season, which accounts for about a fifth of the industry's annual revenue. It's no wonder the holiday sales are so critical for retailers--it can literally make or break their year. Several retailers reporting positive sales numbers were ARO, AEOS, COST, GYMB, JOSB, MW, JWN, WTSLA. Retailers forecasting below consensus are ANN, BEBE, DG, HOTT, KSS and MW. Wal-Mart (WMT 45.70 -0.63), the world's largest retailer, confirmed the +2.2% increase that it had pre-announced on Tuesday (the smallest sales growth in 5 years). This was at the low end of its guidance and was not a surprise, but its Q4 EPS guidance was given as a range of $0.82-0.86 versus the $0.83 consensus and this disappointed the market. The retail sector closed in the red today.

Economic numbers today included jobless claims, ISM, some home sales data and crude oil inventories. Initial jobless claims fell 35K to 291K which was the lowest number since September 2000. Didn't something bad happen in September 2000? Oh yea, that started a 2-month decline that lopped nearly 1800 points off the DOW. The 4-week average jobless claims fell 9,250 to 316,750 while continuing claims were up 13K to 2.72M. A DOL spokesman mentioned that jobless claims numbers are volatile this time of year, following the holidays.

The December ISM came out at 59.8 vs. 58.5 in November, which was above consensus of 58.9. The December ISM service employment number was 57.1 vs. 57.0 in November. ISM services prices dropped to 69.5 from 74.2 in November.

November pending home sales index fell -2.5% to 120.6, and was down -2.5% Y-O-Y. The National Association of Realtors said pending home sales are slowing.

Crude oil inventory numbers were released at 10:30 which was general bullish oils stocks. The EIA's report showed a lower than expected drawdown in crude along with a better than expected build in distillates, gasoline, and natural gas. This ended up having a depressing effect on the energy stocks which hurt the big caps like the S&P 500.

As reported by EIA, "U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) inched up by 0.1 million barrels from the previous week. At 322.6 million barrels, U.S. crude oil inventories are well above the upper end of the average range for this time of year. Total motor gasoline inventories declined by 1.2 million barrels last week, putting them in the lower half of the average range. Distillate fuel inventories fell by 0.9 million barrels last week, and are just above the lower end of the average range for this time of year. A drop in high-sulfur (heating oil) distillate fuel more than compensated for a slight increase in low-sulfur (diesel fuel) distillate fuel inventories. 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 gyrated quite a bit today, ending the day down -$0.40 at $62.80. Natural gas price got knocked lower today after EIA's report showed that stocks were up 1 bcf at 2,641 bcf as of December 30, 2005, 79 bcf less than the same time a year ago. But it is 168 bcf above the 5-year average. The price of natural gas dropped from yesterday's $10.19 close (February contract), bounced a little and then finished the day at $9.48. This is the lowest price since the big run-up started last August. Price had peaked at $15.78 in December so it's been a precipitous drop since then (not that we're complaining).

Like the drop in crude oil prices (if the drop continues) what has me a little concerned is why it might be dropping so much. For the first time in well over 3 years, natural gas has dropped below its 200-dma. This signifies something potentially more ominous about the economy other than the reason we've been hearing about warmer than usual weather. It looks to me like players are sniffing out a slowing in the economy. But don't worry, our trusted Secretary of Treasury, John Snow, came out today and said we should ignore that inverted yield curve stuff because it's no longer a predictor of economic recessions. Whew, I feel a lot better now.

Today's consolidation continues to look bullish since it's following the strong spike up from Tuesday. The charts of the various indices are giving me different impressions so let's take a look at them.

DOW chart, Daily

With the daily oscillators turning back up, the DOW looks bullish. It's hard to tell in the current consolidation whether or not we should get another pullback tomorrow or if instead it's ready to continue higher from the open. As mentioned above, the rallies have tended not to let shorts out or new longs in and the sudden realization by both sides causes the next flare-up. Regardless of whether we get a little more pullback first or not though, this looks ready to rally higher.

SPX chart, Daily

Same with the SPX as the DOW--even daily MACD came back down to the zero line and now has a full tank of gas for the next ride north. We may get a little more pullback tomorrow before this is ready to continue higher but it doesn't necessarily need to. Speaking of daily MACD though, keep an eye on it as the rally progresses and eventually turns back down. I suspect we will get a bearish divergence with MACD since the current leg up should be the last one and will show negative divergences and waning momentum as compared to the previous high. It will be the mark of a top that I'm looking for.

Nasdaq chart, Daily

Using EW analysis, the current rally leg could be completing the rally from October. The wave count looks good and it's within spitting distance of a common Fib projection where the 5th and 1st waves are equal (at 2280.21). This is the index that has me on guard. If the techs top out and turn lower, it seems the broader market may not have much luck moving much higher, if at all. This makes me challenge my thinking on the big caps. Maybe they too are closer to a top than first impression. Maybe SPX will only make it up to its lower Fib target of 1281, which is close. However, if the DOW and SPX manage to put a relatively strong rally leg together, the techs will surely follow, if not lead. But bulls should be cautious as I see the potential for a major high here.

SOX index, Daily chart

The COMP has a pattern that I could call almost complete and at the same time the SOX is back up to the top of its parallel up-channel (bear flag on the weekly chart). I have felt the SOX could find resistance from here to perhaps the 520 area. So like the COMP, this one makes me nervous about the market. Bulls should think about protecting profits rather than looking for new long plays.

There was a lot of talk today about the reason the SOX was so strong and it had to do with reports out of companies like Xilinx (XLNX 28.45 +1.68) which reported strong chip sales. If it's true there is strong sales growth coming in this area (I have my doubts) then the chip makers should do well. That means many of the countries producing these chips should also do well. Taiwan is certainly one of those countries. China is also going to participate in that business.

During most of 2005 we often discussed China and its relentless growth and resultant commodity pricing pressures. They've placed demands on the global market place for all kinds of commodities and in particular on those commodities required for expansion of their infrastructure, such as buildings, roads, power generation and new manufacturing plants. They've been "accused" of driving prices high for most commodities. So we watch with great interest how this huge country is doing.

Last week Dow Jones had reported an update on China's GDP forecast--"China's Govt. updates 2006 GDP forecast - China's gross domestic product will likely grow 8.5% to 9.0% next year and the consumer price index should rise 2% to 3% if Beijing implements easy fiscal and monetary policies, the top state planning agency's research institute says."


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As 2005 comes to a close and China makes its plans for 2006, it will begin to pursue a slightly different economic model. The model of the last few years has been growth at any price. The problem created was gross inefficiencies. There have been misallocations of capital and a gross over-supply of manufacturing capacity. This has created a double whammy for them as the need for raw materials has driven up their costs and at the same time their over-manufacturing has driven down their selling prices. Their collective losses have been staggering and must change.

What we've been hearing of course is the phenomenal growth rate inside China. The products they produce get cheaper and cheaper and their customers (primarily the US) have been the beneficiary of these lower prices. But China's leaders have not been impressed and the new model they want to see implemented is growth on a more even scale. They want to see growth that adds value to the population and value to their economy (they will try to encourage internal consumption, which I have discussed previously, to compensate for a drop in exports once the American consumer starts spending less). That will likely mean higher prices for the US down the road which may only further dampen demand by the US consumer.

Up until now most of their growth has been in the coastal cities which has created its own problems with so many citizens moving in from the countryside looking for jobs. China's leaders want to see a narrowing of the income divide between the rural and urban sectors and to do this they want to attract industry away from the coasts and into the interior of the mainland. This will help establish a more stable society.

Part of the drive behind this, as mentioned above, is the gross inefficiencies in their manufacturing sector. The National Bureau of Statistics survey of 200,000 companies in the manufacturing sector showed a combined loss of $15.1B in the first seven months of this year, a 55% increase over 2004. That's not a loss they can make up in volume. The easy money policies, including favorable tax treatment, has created excessive growth throughout the manufacturing food chain and the loss of pricing power has resulted in about a 50% price drop in the past 3 years. This is not in electronics where we expect these kinds of price drops but instead is in basic industry.

China's leaders have decided change is good and necessary. It's broken and they've decided to fix it. They will be cutting fixed asset investment by cutting funding through the banks. The banks will receive strong guidance on which sectors they should lend to. As a side note, this could be very important as it relates to the amount of funding these central banks have available to purchase US assets, specifically treasuries. If funding becomes tighter due to Chinese government restrictions, more bank funds may be directed towards internal requirements versus investing outside the country. That would be a negative for our markets.

The result will be two fold: first, fixed asset investment will fall sharply and, second, since construction is an integral component of the former, it will lead to slower growth in this sector's major inputs, namely steel, glass, cement, aluminum, copper and other basic materials. Demand for imported raw materials should slow and prices weaken. Since each of the major inputs to the construction sector is energy intensive, the policy will also slow down the growth of electricity demand. This may in turn slow down the need for oil consumption which may help reduce the demand for oil. A drop in oil's price may even be anticipative of this change

China will likely go through the same kind of gut-wrenching changes we've gone through many times, leading to restructuring, bankruptcies, mergers and bailouts, you know, the usual capitalistic restructuring. The recent bailout of WorldBest, a Shanghai conglomerate, at a cost of about $620M, is probably a forerunner of things to come.

China's government wants to accelerate the growth of consumer spending to balance the slowdown, which will be seen in fixed asset investment and, possibly, exports. Unfortunately, until a solid social security network is introduced, not much change in current growth rates is likely to be seen. Consumers save to pay for medical costs, education and retirements. This is one of the reasons for their high 25% savings rate. Until they save less and spend more (the American way), consumer spending growth will slow significantly in 2006, especially in the manufacturing sector, even without any slowdown in the US.

Dr. Clint Laurent, the founder of Asian Demographics, has made some important observations about birth rates and has found that Chinese statisticians have consistently overstated birth rates, by about 18.4 million births. This has an impact on measurements such as consumer spending and productivity. It also shows that China's labor force will peak in 2008 and fall through 2025. Consumer spending is already declining as the population in the peak spending years of 20-39 declines. So China's internal spending may see a decline which could be exacerbated by a decline in US consumer spending.

The Director of the National Bureau of Statistics had warned not to use the real GDP data the Chinese issue, because the data was flawed, but to use nominal GDP as it was a better reflection of economic development. This shows that the economy has actually decelerated from growing by 17.9% in the 3rd qtr of 2004 to an expected 12.2% in this year's 4th qtr.

Dr. Laurent commented that the improvement in productivity will create improvements in real GDP growth. He concludes that real GDP should rise by 7% in 2006, 6.5% in 2007, 5.9% in 2009 with growth slowing to an average of 2.5% by 2024. Note that these are slower growth rates than what was reported by Dow Jones recently (8.5-9.0%). For the whole period 1994-2024, Dr Laurent sees an average growth of 4.8%, not the 7-9% forecast by so many analysts. The bottom line is that a slowing in the growth rate in China will lessen demand for many commodities which will lower pricing pressure for the rest of the globe, and that will be a welcome change. Now if we can just get through all this slowing down at a reasonable pace, we'll all have time to adjust. Somehow I don't think we'll have that luxury as history is not kind in this respect.

Speaking of slowing down, our banks look bearish to me. Its pattern is a bit muddy looking right now, and it could rally if the broader market does so, but I wouldn't want to go long the banks here. If they're about to sell off, perhaps there's a whiff of economic slowing in this sector as well. The discussions about inverted yield curve are also making the banks nervous.

BKX banking index, Daily chart

With the yield curve inverting and reverting, the banks have been a little whippy lately. It looked to me like banks could have topped at its December high and I would stay short the banks against a new high (since it's close and therefore keeps risk small). But the pattern is ugly and I'm not confident enough about this index to want to initiate a trade here. This one bears close scrutiny since a rally in the broader market without the banks would be suspect.

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

The housing index is struggling to bounce. I had been thinking that it might rally back up to the top of its parallel up-channel, or at least up to its 62% retracement at 1001. I also have an internal Fib projection at 1007. But the flat top near 980 could be marking an ascending triangle which in this case is a continuation pattern, meaning the next move will be down. If this is the right pattern playing out we should get only a minor pop over 980 followed by a close back inside the pattern and that would be a sell signal. A break of the bottom of the pattern (below 915), the uptrend line from October, would be the confirmed sell signal. And if this index can't bounce much higher, it adds to my concern about the broader market's ability to rally much higher. This will be another important index to keep an eye on.

Oil chart, February contract, Daily

Oil has come close to its 50% retracement at $64.125, hitting a high of $63.80 today), the sharp pullback towards the end of the day has me wondering if oil topped out today. A potential pattern playing out calls for another leg up out of the recent consolidation so I'm not ready to call that one yet. But whether it's now or after another push higher, the leg up from December may be completing a 3-wave corrective bounce against the Aug-Nov decline. If true, we'll then get another leg down that will take oil to new lows, perhaps to the low $50's. The sharp drop in natural gas is potentially a heads up that something is slowing down in the economy and oil's decline would therefore follow.

Oil Index chart, Daily

I've redrawn the potential pattern that could be playing out in this index. I had had an ascending triangle but the rally this week says no, something different is playing out. If this new pattern is correct it's a more bearish ascending wedge. One more small push higher could complete the pattern.

Transportation Index chart, TRAN, Daily

This is one of the more bearish indexes I've been reviewing. Upside targets having been met while getting all kinds of negative divergences tells me to short the Trannies. Short with a stop at a new high (relatively small risk here) would be a good play. If we get a new high I suspect the negative divergences will continue so it could be a matter of trying a short again at the new high. I don't like the long side when looking at this one. And if this turns back down and the DOW is unable to reach 11K before it too turns back down, well, we don't want to go there (unless you're massively short).

U.S. Dollar chart, Daily

The daily chart of the US dollar fails to paint some of the daily candles for some reason but they're there and there really isn't that big gap down. The uptrend line is not holding but it's still within close enough proximity that it could bounce back above and it will look like just a small throw-under. But if it can't hold here, I'll be looking for support at its 200-dma at $88.23. I'm looking for a fairly sharp rally in the dollar to finish off its bounce from January 2004.

Gold chart, February contract, Daily

Gold is getting a little whippy here. Moves of $9-10 in a day is not uncommon. The bounce from the first pullback could be over and I'm expecting another leg down. It could be just as steep as the first leg down. I'll be watching for evidence of that gold could build a large-swinging sideways triangle consolidation and then press higher. But until that evidence presents itself, I'm expecting a new low below $490 in the next leg down.

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

Tomorrow's economic reports include unemployment rate, average workweek, earnings and nonfarm payrolls. The only report that has the potential to move the market is the payrolls number but it would have to be significantly different from what's expected.

Sector action was mixed today but matched the tone of the market which was generally positive with up volume greater than down volume and advancing issues and new 52-week highs better than declining issues and 52-week lows. The DOW was helped today by GM (20.52 +1.11) which was up 5.7%. The dawg stock of 2005 is getting a little loving as 2006 starts off. None of the fund managers wanted that one in their portfolio at the end of the year but obviously there are some who feel GM should rebound. We'll see--it bounced up to its 20-dma today which has pushed this stock back down since August. The reason given for GM's bounce was its report that sales in China had grown 35.2% in 2005. That can be misleading though since the growth rate on a relatively small number can still be a small number. WMT was the lagging DOW component today.

Leading the green sectors was the SOX, up 2.4% followed by internet, networking and other technology indices. There were fewer red sectors which included gold and silver, down 2.1%, the energy indices and utilities. Also in the marginally in the red was the TRAN, retail, drugs and pharmaceuticals. Essentially it looked like money was being rotated back into the high flyers today, including the small caps. This is generally bullish so we could be setting up for another rally leg.

As Jane reported in the Monitor this morning, from Dateline WSJ, "many retailers struggled last month, as shoppers appeared to put off their buying until even later than in the past. There were a number of factors at play, including Hanukkah falling particularly late this year, on December 25, and the New York City transit strike, which occurred in the critical final days before Christmas, hurting retailers in Manhattan." And I guess we're supposed to assume that Manhattan's loss of sales over a period of a couple of days is what caused retailers to miss their numbers. Anyone who has lived in or around New York City has seen the poster which shows a cartoonish view looking west over NYC showing NYC as huge, NJ as much less so and the rest of the country as a line. New Yorkers think more highly of themselves than do Texans, and I've lived both places to know.

Tomorrow is a little tricky for me. I'm not sure if I should be looking for a pullback before thinking long, or if I should get long right away. But the bottom line is that I'm thinking long. We should get at least another push higher even if we're close to topping (as per my impression on the more bearish indices). I will probably watch the opening to get a feel for what the initial move will be and then decide to either wait or try the long side early. Hopefully you can follow us on the Monitor where we'll call it as we see it. Good luck with your trading tomorrow.

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