The breakout over S&P 1297 came with a bang on Wednesday and while Friday's gain of +1.92 to 1307.25 may not have been exciting but it marked the sixth straight day of gains and a new 4.5-year high. The Dow added +26.41 to close at 11279 and the highest level since May 2001. The bulls charged out of the gate on Tuesday and right up to Friday's close they never looked back. Friday's gains may have been lackluster but it was a bullish confirmation that the indexes shook off a quadruple witching event and added to their gains.
Chart - Daily
Dow Chart - Weekly
Dow Chart - Monthly
The last two weeks were interesting for stock watchers with the typical early March weakness limited to a drop of only -29 S&P points and that drop completely erased beginning on Monday. The negativity and caution from various economic reports translated into a wall of worry for the bulls. They scaled that wall with ease and even after a week of gains the bullish sentiment is still running rampant. The retail investor is back and funds are having trouble spending the money. Some small cap funds are closing because they have more money than they can spend. Individual investors are also adding funds to their accounts. Charles Schwab reported that it received $10.6 billion in new cash in February alone. Average daily trades at Schwab rose to 319,600 in February compared to 210,900 in February 2005. While this is still significantly lower than their high of 420,100 in 2000 it is still a huge improvement over just last year. If you have been trading long you probably realize that retail traders are normally the last into the market and this suggests trouble ahead. Not necessarily next week but in the long-term outlook.
This bull market is already very old in relative terms, 36 months as of March 12th. The S&P has risen +529 points or +65%, +3863 Dow points or +52%. Those numbers pale in comparison to the small caps and transports. The Russell rose from 343 to Friday's 746 close or +117% over the same period. The Transports exploded from their March 2003 low of 1918 to Friday's close of 4563 for a gain of +2645 points or +137%. By any measure of the market these are huge gains. Everyone knows that smart investing requires buying stocks when nobody else wants them such as in March of 2003 at the market lows. Using the Schwab numbers for comparisons they averaged only 153,400 daily trades for that period in 2003 and accounts were being closed by the thousands. Today with the markets breaking out to new 4.5-year highs and monster gains already in place those same traders are reopening accounts and putting hard earned money back into stocks at the highs.
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The current bull market at 36 months of age is right at the peak for an average bull, which lasts an average of 37 months using market data going back to 1942. There were 15 bull markets in that period with seven beating the averages with a length of more than 37 months. The longest was 60 months from 1982 to the crash in 1987. The second longest was the 52 month bull from April 1994 to July 1998 for a +170% gain. However, we know that the bear market that hit in July 1998 was news related and only lasted one month for a -20% drop. The dip was met with a rebound of monumental proportions to the March 2000 high of 1527 on the S&P and a +60% gain from the 1998 bottom. In retrospective it was really a 71-month bull and the longest on record with a monster event driven correction in the middle. That bull would have added +1089 S&P points for a +248% gain from the 438 low in April 1994 if you disregard that -20% correction in the middle.
What prompted that monster bull was a rising economy and the expectation that the Fed was going to stop raising interest rates soon. The Fed raised rates six times in 1994 and ended their hike cycle with a 7th hike in Feb-1995. The last four hikes were for +50 basis points or more with the Nov-1994 hike a whopping +75 basis points. The total for the seven hikes was +3.0% taking the Fed funds rate from 3.00% to 6.0%. This was to slow inflation and return to a neutral rate after 18 consecutive rate cuts starting in July 1990. The Fed cut rates from 8.0% to 3.0% over that period. The economy finally caught fire and the Fed had to push rates higher very quickly to offset the suddenly exploding economy. That produced the seven hikes in rapid succession starting in early 1994, which returned rates to neutral at 6.0%. It also created an environment where the economy could prosper and set the stage for the Y2K Internet bubble. Life was good and money was flowing.
That brings us back to today and the current market. The Fed lowered rates to 1.0% over 2001-2003 to counteract the devastation from the market bubble and the 9/11 attacks. For one year, June 2003 to June 2004 there were no changes as the economy built a base using that nominal 1.0% rate. Beginning in June 2004 the Fed began its "measured pace" removal of their economic stimulus program. When they meet on March 28th they will hike rates for the 15th consecutive time to 4.75%. Because of the slowdown in housing, autos and some of the recent economic reports most Fed watchers now expect only one more rate hike in May to bring the Fed rate to 5.0% and hopefully a neutral bias. The equity markets are focusing on the May meeting as the end of rate hikes and the all clear signal for the economy. There are some who believe there will be another hike at the June meeting but they are currently in the minority.
Fed watchers are hoping to get a clue on Monday night when Bernanke will give a speech at the Economic Club of New York. While everyone will be on pins and needles almost nobody expects any specific news. Deutsche Bank expects Bernanke to remain neutral to prevent a bias to the FOMC mindset ahead of the coming meeting. Lehman Brothers expects a balanced speech that reaffirms a March hike is likely but that subsequent moves are data dependent. Those are the keywords, data dependent. If Bernanke does use the data dependent phrase it will be seen as a potential halt to rate hikes in May. After a full week of economic reports the coming week is devoid of any material input for the Fed. They will make their decision on the basis of data already released. One exception could be the existing home sales on Thursday and the new home sales on Friday. We saw a firming of construction numbers on last Thursday signifying perhaps that the decline in housing may have found a bottom. If next weeks sales numbers confirm this then the Fed should be convinced to move again for added insurance. The Fed wants the housing bubble to cool but not burst. If sales fell sharply then the Fed could be convinced to quit with the March hike depending on the data.
I know I spent a lot of time on this today but it is really the key to the market focus for the next two weeks. Traders are looking back at the 1995-2000 rally and wishing hard for a repeat in some form. Since we do not have Y2K and the creation of the Internet to fuel the fires the expectations are much lower but still include a scenario where the Dow could retest its highs at 11750. That would be a stretch given the age of the current rally but entirely possible. Just keep in mind that only four times in the last 63 years has a bull market made it to its fourth birthday. Thomson financial believes we may have another year left on the bull despite 2006 being what they believe is the last year of double-digit earnings in this economic cycle. Q4 earnings are over except for a few stragglers, Oracle and Morgan Stanley report next week, and the Thomson estimate is +14.1% growth for Q4. That will be the 10th consecutive quarter of double-digit growth for the S&P according to Thomson. S&P, which calculates operating earnings differently than Thomson claims this will be the 15th straight quarter of double-digit growth and an all time record. However you calculate it the recent numbers have been strongly influenced by the massive gains in the energy sector. According to Thomson Q4 earnings ex-energy were only +8.5% AND are expected to fall to +6.0% in Q1. For comparison Q1 earnings in 2005 ex-energy was +11.2%. Overall earnings in Q1 are expected to be only +10.3% and the smallest gain since Q2-2003.
The farther you go in an economic expansion the harder it is to post earnings growth. You may remember for most of 2003-2004 earnings were rising more than +20% per quarter. This was due to the depressed earnings results post 9/11 that provided easy comparisons as the economy began to recover. Strong cost cutting measures during the 2001-2002 recession provided a strong base for a rebound as companies streamlined operations after the bubble burst. Since oil prices broke over $25 a bbl in early 2003 companies have seen costs pushing steadily higher but their ability to raise prices at the consumer level has been hampered by slow wage growth. With expectations for consumer spending to slow in 2006 the ability to raise prices will continue to be nearly nonexistent. For example earnings growth in the healthcare sector is expected to be only +3%. This has been a strong performer but they have priced themselves out of the market until consumer incomes catch up. The consumer staples sector is expected to grow by only +4% due to slower consumer spending. The basic materials sector including chemical manufacturers are actually expected to drop -7% due to higher raw material costs. Copper hit a new all time high on Friday at $2.36 due to rising demand and rising transportation expenses. Copper is a key component in nearly every manufactured item other than clothing and plastics. Industrials are expected to drop to +12% growth from +17% in Q4 with tech companies posting +15% growth down from +17%. Thomson is projecting overall earnings growth to be +14.9% in Q3 and +12.8% in Q4 driven mostly by the energy sector and financials. Q4-2006 should be the end of the double-digit streak and the beginning of a period of flat growth.
The current market gains appear to show that investors are pinning their hopes that those earnings will continue through Q4-2006 and the hopes that the Fed halts their hike cycle in May. The question for traders is simply how much longer do they expect this bull market to last? Investors typically look six months into the future and that takes us to September. Given the still decent earnings expectations for Q4 we could stretch the market gains for another couple months under optimum conditions. The end of Fed hikes would provide fuel for that continued move. However that only gets us to May just in time for a sell the news event after the May 10th Fed meeting. Remember the adage "sell in May and go away." While that six month trading strategy has not been especially accurate the last couple years we have been in a bull market. While we don't see any evidence of crutches today the bull is in the twilight of its life and will eventually die. Can it make it to four years and March of 2007? I would bet against it but we could easily have a couple more months before the pallbearers begin to appear.
Consumer spending is going to be the key. I read last week that there is $2 trillion of adjustable rate consumer mortgages which will reset to current rates over the next 18 months. Because of the extremely low short term interest rates we saw back in 2003 some of those mortgage payments could rise as much as +50%. Citigroup estimated as many as one million of the 1.4 million loans affected would have to be terminated either by sale or foreclosure. Mortgage delinquencies rose last month to 4.70% from 4.44% with adjustable rate and sub prime loans driving the increase. That may not sound like much but it represents 1,936,400 loans more than 60 days overdue. Since the majority of borrowers opting for the risky adjustable rate mortgages were trying to qualify for more house than they could afford the tidal wave of foreclosures could be huge. If they live in a market where housing prices have not fallen they could get out alive by flipping the property and downsizing to a more affordable home. However, many areas of the country have seen prices decline and homeowners may end up taking a hit to escape the pain. The bottom line to this scenario is a depression in consumer spending. Those staying in their mortgage will have a significantly higher payment and less discretionary income. Those bailing out for a loss will be tagged with a different type of payment but the piper will still have to be paid. Those unable to escape the debt and opting for bankruptcy or foreclosure will also have less cash and less credit. Another funds drain is the lack of home equity financing due to tighter credit standards and falling home prices. Those with a habit of borrowing against their equity will find the well drying up and less able to borrow for new consumer purchases.
In addition to the home equity ATM running out of cash we have the new restrictions on credit card bills. The new minimum payment rules are going into effect forcing borrowers to pay a minimum of 1% of their principal plus interest every month. Some banks, Citibank, Bank of America and MBNA for example, are raising the minimums from 2% to 4% per month. The rules were announced in January of 2003 and gave lenders/borrowers two years to make the transition. Of course most waited until the last minute to take advantage of collecting the most interest possible from John Q. Public. Many lenders fear that this will be the tipping point for many consumers where just getting by will be a real challenge. The average consumer has eight major bank cards and twice that amount if you add in department stores and gas cards. Average family credit card debt is reported to be around $10,000. That average must take into account anyone warm and breathing from newborns to age 100 because I don't know anybody with less than $10K in card debt. Most are well over that level. You would not believe the number of credit card rejections we get for subscriptions every month. It always boggles my mind that we have so many subscribers to an investment newsletter whose cards will not authorize for a monthly subscription fee. I believe the new payment rules will take enough cash out of consumer pockets that it will be readily observable in the economy. It does not take any stretch of the imagination to predict what a doubling of all the monthly credit card payments in the U.S. will do to a population used to spending more than they make.
Adding to the consumer problems this summer will be higher gasoline prices. New rules for gasoline formulation are going into effect that will make gasoline and diesel more expensive to refine and reduce the number of refiners capable of producing those products. That price increase will be passed on to the driving public. This is in addition to whatever price oil is trading at due to geopolitical concerns. Oil rebounded from last week's drop to $59.25 and appears comfortable in the $63 range just under resistance. Once the refineries finish their maintenance cycle and begin drawing down crude supplies again that resistance at $63.75 could easily be broken. In a discussion of the oil scenario on Friday several analysts predicted $60 would be the new floor due to increased geopolitical risks. Nigeria was at the top of the list due to the increasing amount of rebel activity. Damaged installations are being repaired slowly and the rebels are still making threats about future attacks. The new civil war in Iraq is threatening to disrupt the flow of the 1.5 mbpd currently trickling out of that country. Saudi Arabia is under increased terrorist alert after the failed bombing a couple weeks ago. It is only a matter of time before an attack is successful. Saudi can prevent 99 out of 100 but the terrorist only needs one success to create a major disruption. The Iran problem is in diplomatic limbo and there is not likely to be a positive resolution. The tone of commentary coming out of Iran is becoming harsher with each passing day. Last but not least is Venezuela. It now appears the threat to oil production from VZ is not going to be from VZ but from the U.S. side. Chavez is running for reelection and there are rumors making the rounds that the U.S. may put some sanctions in place to apply pressure in hopes of having him defeated. If the U.S. does start applying pressure to Venezuela then Chavez will likely fight back with his oil card. Chavez has also pledged to support Iran with like cuts if Iran plays its oil card. Either way there is a growing risk that future shipments from Venezuela could be in jeopardy.
The top five oil exporters in the world in order are Saudi Arabia, Russia, Norway, Iran and Venezuela. I was originally going to say that exports from four of the five could be disrupted at any time due their political instability but Norway also falls into that group as well. Elections in Norway in Sept 2005 ended a nearly 20-year reign by a conservative coalition. In September the Labor party, headed by Jens Stoltenberg, seized control of 60 of the 169 seats in Parliament. In order to strengthen his hold on the government he reached out to the far left "Socialist Left" party and the agrarian "Center" party to form a coalition controlling a majority of the seats in Parliament. Because of the substantial differences between the three groups there has been dissention and there are threats of strikes in the energy sector. That makes it official that oil output from all of the top five exporters is in daily danger of disruption. Achieving a stable flow and a stable price under these conditions will be virtually impossible. Count on higher prices as the summer driving season progresses.
Crude Oil Chart - Daily
I am not trying to paint a negative picture of the markets or the economy but every once in awhile we do need to step back and take a look at the longer term view. Currently the economy appears to be thriving. GDP for Q1 is widely expected to be over +5% growth. Jobs are improving and inflation while at the high end of the acceptable range but apparently cooling. Banks and financials are soaring on the possibility of an end to the rate hikes. Homebuilders have also rebounded strongly with six days of strong gains after the homebuilder index ($HGX.x) hit a four month low last week. The transportation sector is on fire despite the price of oil hovering just under $64. The Dow Transport index jumped nearly +250 points from the 4352 low on the 8th to Thursday's high of 4597. That is a +5.6% jump in just one week and a new historic high. The railroads are powering the sector due to the higher cost of diesel and the lack of truck drivers. Union Pacific raised its estimates on Tuesday from 80-90 cents to $1.00-$1.10 for Q1. Analysts had expected 89 cents. UNP jumped +$7 on the news and provided a lift for the entire sector. In later interviews with various transportation executives the outlook for the sector was always very strong. The railroads appear limited only by a lack of rail cars. Manufacturers of cars, Greenbrier (GBX), Trinity (TRN) and FreightCar America (RAIL), all have substantial backlogs with no slowdown in orders. UPS and FDX are battling it out in the global package-shipping arena and both continue to gain share in a market that is far from saturated. The FDX chart has been nearly vertical since Feb-3rd on the strength of strong earnings. Even the airlines have found favor with investors as they remove in-flight services and pack travelers even closer together. The post 9/11 fears have evaporated and American traveler is on the move again.
From the viewpoint of a casual investor the road ahead appears paved with gold and profits are falling from the sky. Memories are returning of the late 90s bull market where buying any stock on any dip produces a profit. Those same investors have forgotten the pain inflicted when that scenario changes suddenly. Let's keep that memory at the front of our subconscious as 2006 progresses. Every craps shooter eventually sevens out and the streak comes to an end. The points I outlined above are just signposts along the way. When this bull finally dies we can look back and see the roadmap clearly. Until then most retail investors will don the rose colored glasses that filter out the road signs with only the lure of dollar signs to lead them ahead. I will continue to remind you periodically to remove those glasses and adjust your vision.
The market action last week was very bullish. The Dow rallied within 10 points of 11300 and managed to hold that level on Friday despite a quadruple witching. This is very bullish in my view since investors have not shown much conviction over the last few months. December and January were volatile but remained in a relative narrow trading range as the gains from the October rebound were consolidated. In late February the Dow broke out of its range to test 11150 but the historical early March weakness blunted that effort and knocked us back for consolidation of those gains. Once it was evident that investors were not going to let 10950 break the bulls rushed in and a +300 point gain appeared. The complete lack of profit taking on Friday convinced me that this breakout is for real. We are only a week away from a Fed meeting and a little more than two weeks from the start of Q1 earnings. Investors appear confident that the news will be good in both cases and the sudden appearance of conviction was surprising. Stocks making new 52-week highs soared to 721 on Thursday and 534 still managed to make new highs on Friday. These are the strongest numbers in many months.
The S&P finally broke the 1297 barrier and sprinted another +13 points to top out at 1310 on both Thursday and Friday. Still, there was no selling and it closed at 1307. This is very bullish but the index is moving into a area of heavy congestion from the 1999/2000 period. 1300 to 1500 is going to be a game of inches rather than long yardage days. The S&P traded in that 200-point range for nearly two years so don't expect it to be a cakewalk ahead.
SPX Chart - Monthly
The biggest challenge of the week was the Nasdaq. It continued its rally off last weeks lows at 2240 and topped out once again at 2323 and the same level that held it back in early March and mid January. This is no coincidence since 2328 was also the resistance high back in May 2001 and support turned resistance from mid 1999 as well. Getting over 2330 will be a challenge and a very big accomplishment when it happens. I mentioned on Tuesday that the biggest problem for the Nasdaq was the SOX and its two-week decline to support at 500. We saw a rebound off that support on Tuesday but it was short lived and eventually broke on Thursday. That 500 level is now resistance and it could be formidable. Intel broke below $19.50 on Friday to make a new two-year low but that was not the incentive for the SOX break. The real anchor on the SOX turned out to be a warning by Kulicke and Soffa (KLIC) that knocked them from $11.27 on Wednesday to a close at $8.81 on Friday. Their warning was seen as an indictment of the entire semi sector with diverse stocks like AMAT, BRCM and TXN all taking a substantial hit. Even the better than expected semi book-to-bill number at 1.01 failed to provide any lift. This was the first time since August 2004 that orders surpassed billings. The SOX closed at 496 with next support in the 480-485 level. The drop in the SOX weakened the Nasdaq just as it approached that 2328 level and sapped the momentum it needed to make a decent breakout attempt.
Nasdaq Chart - Weekly
Nasdaq Chart - Daily
Semiconductor Index Chart - Weekly
Meanwhile the Russell shook off the chip dip and rebounded to close at a new historic high at 746. This is phenomenal given the -30 point drop, which started on March 5th. It appeared somebody wanted out of small caps in a hurry and that three-day dive was painful. However, it corresponds almost exactly with the drop in oil prices and makes a compelling argument on how much the Russell is impacted by energy stocks. The chip dip was barely noticeable in comparison. Note the charts below.
Russell and Oil chart - 30 min
The NYSE Composite also closed at a new high and only a handful of points off its intraday peak. The chart correlation between the NYA.x and oil is also amazing. The Wilshire 5000 also clawed its way to a new high and as the broadest index of market strength it is painting a bullish picture. The Wilshire does not have a lengthy chart pattern in terms of time and as such has no prior resistance to chart. It does however mirror the S&P 500 very closely only ten times the index value. This suggests the same 13000-15000 level is going to be tough hiking. The Wilshire 5000 closed at 13174 on Friday and right at the top of its historical channel.
5000 Chart - Weekly
As we enter next week the potholes could start with Bernanke's speech on Monday
night and continue with the PPI on Tuesday. Most analysts expect the PPI to be
tame and the more important bit of economic news to be the home sales numbers on
Thr/Fri. Here is a clue about the homebuilder sector. On Friday the CEO of
Lyons Homes (WLS) offered $93 a share to buy the company. The stock was
trading at $75 at the time. If the homebuilding sector was in real trouble would
you offer to buy the company now or wait for the expected hard times ahead? I
know, dumb question. The offer by the CEO tells me that orders and projections
are still strong and the current weakness is temporary. The market is telling us
the same thing since the price of the stock zoomed to more than $100 after his
$93 offer. Evidently
the market believes there are better times ahead as well.
WLS was trading at a PE of 5 based on 2007 projected earnings before the offer.
We have heard a lot about the bursting housing bubble. If this is proof of
anything in the market it suggests the economy is strong and homebuilders are
about to post another amazing recovery. If the housing numbers next week are
positive it may push the Fed to hike again in May but it will also confirm to
investors that the bull is not ready for
the slaughterhouse just yet. Heck,
another week or two of gains and I will have to resurrect my signature close of
"Sell Too Soon."