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Market Wrap

Call in the Dutch Boy

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It might be a little early but it's looking like the dike is starting to spring some leaks. Microsoft (MSFT 26.85 -0.30) dropped the bombshell on the market before yesterday's open saying their new Windows operating system (Vista) would not be available until January 2008, which causes all kinds of grief for a lot of other players from computer box makers to software vendors. Without the hope of the extra sales before year end it was thought there would be a very negative reaction yesterday in the market. But the banks and the Fed's money came to the rescue and jammed the market higher to make sure the bears didn't get any bright ideas. They'll let the dust settle and the market pull back slowly until the worry dissipates. That's how this game is being played now and why you see the market suddenly rally strong on terrible news. It's simply not being allowed to correct normally.

But today we saw a little of yesterday's enthusiastic bounce given back and now we're left with lower highs as the bounce attempts are getting weaker. So it's time to bring in the little Dutch boy and see how many leaks he can plug. It looks like we should get a little larger pullback now but the daily chart patterns suggest to me that after a pullback we could see yet another push to new highs, at least for the DOW and S&P 500, to finish off the rally from October. The bears will get all excited about a decline (what's that?) but watch some important uptrend lines for support and don't load up the truck with put options yet. I think the topping action will take a little longer and get us into April. At least that's my read on this market currently.

The market has been incredibly difficult to trade intraday and for all who are trying, I feel for you. For those who got long back in October or January and are just waiting for some sell signals to prompt you to sell, congratulations since it's been the right play. For those of you who have been trying to short every high since January, it's been a very frustrating experience. All kinds of bearish divergences, trend lines, moving averages, etc. have been failing to hold back new highs. Technical analysis has been made more difficult because the big players (primarily the mega-banks and their buy programs) know these signals and they're purposely catching shorts on the wrong side.

The traders who are covering their shorts on these buy programs is what helps propel the market higher, even if only in intraday spurts, and it enables the bank traders to make their money. How else is a Morgan Stanley going to make $3B in a quarter trading their own capital (and Uncle Ben's money too), while at lower risk! The short side has been the treacherous side. That will change but I don't think we're there yet. I think we're in for a lot of choppy price action for at least another month. Oh joy. And then we'll enter the summer doldrums. Oh double joy.

General Motors (GM 22.00 -0.01) made news this morning with their announcement that had completed a deal to sell a majority interest in its GMAC Commercial Holding Corp to an investor group. GM had announced a few weeks ago that they were looking for a buyer of this business so that they could free up some much needed capital. GM sold 78% of its equity in GMAC Commercial Holding Corp. for more than $1.5B. As part of the closing GMAC Commercial Holding Corp., which provides real estate financing, re-paid GMAC about $7.3B in inter-company loans so GM received about $9B in much needed cash. Interestingly their timing could have been very good if we see a downturn in the economy and a reduction in the loan business, especially for real estate. As I'll discuss below, the commercial real estate business is about to take a hit.

In other stock news, Adobe (ADBE 36.33 -0.29) had depressed prices a little with their better-than-expected earnings report but downside guidance for Q2. Futures had pulled back for most of the overnight session and the market wasn't able to recapture the lost ground. KB Home also reported before the bell and beat estimates and reaffirmed full-year guidance. But they then cautioned that it will likely see a pullback in some of their markets this year. That started the home builders in the hole this morning but they recovered into the end of the day.

A lot of the recovery in home builders had to do with the strong report this morning on home resales. It increased 5.2% to a 6.91M annual rate vs. expectations for a 6.52M rate. The warm January weather was widely credited with the unexpected hike in sales which of course begs the question what will March sales look like since February saw the return of winter in all its glory. The supply of unsold homes also rose the same 5.2% in February to 3.03M which is close to its all-time record high of 3.04M in 1986. This keeps the unsold inventory at the same 5.3 months as it was in January. Median prices for resales were up 10.6% year-over-year to $209K but down slightly from the $210K in January.

The other major economic report was the jobless claims data. Initial claims fell by 11K from last week's upwardly revised 313K to 302K. This was a sharper drop than had been expected and adds to the notion that the job market continues to be strong which will keep the Fed on their rate-tightening course. But the 302K number makes it the 3rd week in a row above the psychologically important 300K level. The 4-week average, up 6K to 303,500, also jumped above the 300K level for the first time in 10 weeks. It's also significantly higher than the low of 276,750 registered in February.

After the minor pullback today, and the appearance of a turn down in progress, let's see what the charts are telling us.

DOW chart, Daily

After springing above trend line resistance the DOW is now finding them to be support. This is the longer term trend line along the highs from January 2004 and the shorter term one from November's high. After that spike above the top of the ascending wedge that's been playing out since October, I'm watching carefully to see if it fails by dropping back below 11200. That would be a sell signal based on an over-throw of the pattern and then a drop back inside. But the larger pattern suggests to me that a pullback could be followed by one more push to a new high next month. But one leg at a time--it looks like we're ready for a deeper pullback and the continued bearish divergence on MACD says it could be a lot more than just a small pullback. There's nothing to say it can't continue to press higher with continuing bearish divergences though so that's why I want to see what kind of pullback we get. At a minimum, longs need to be careful here as a decline could pick up some speed.

SPX chart, Daily

SPX is in a similar pattern and the reason I'm thinking it needs a pullback and another new high is because I'm looking for an overlapping 5-wave move up from the February low (overlapping because it's an ascending wedge or ending diagonal in EW terminology). This is a classic pattern at a major top which is what I believe we're nearing. It takes a break below the March 8th low on the indices to tell us a major top is in so until then I'll be looking for a pullback to get long for one more ride on the northbound train. Support could come in at the October uptrend line at 1291 and an upside projection from there could be 1320-1330. That's speculation at this point which will hopefully become more apparent as this price pattern develops.

Nasdaq chart, Daily

The COMP continues to be very difficult to read. The large flag pattern looks bullish and maybe the declining highs in MACD is simply a "resetting" of MACD to zero in preparation for a big rally leg. If we get a pullback to its October uptrend line at 2262 and it holds, it might be a good place to try a long play. At least your stop is easy to control. It takes a break of its 200-dma, at 2189, to tell us we've got something a lot more bearish going on so that's not much help for protection on any long positions you might have. The techs are risky because they look weak, especially when I look at the QQQQ (next chart) so protecting profits/capital is #1.

QQQQ chart, 120-min

The QQQQ seem to be stuck in a downtrend and they almost broke it this week but dropped back down inside its down-channel. I changed the EW count slightly to reflect the latest high and it's now in a more complex double zigzag which doesn't really change anything but it's for those who follow EW counts. Interestingly there's a correlation between the Fib projections from the two A-B-C patterns down near $39 which is just below the gap fill at $39.35. First Fib support is at its previous low near $40 so be careful there if you're short. This corrective pullback is in agreement with the other indices in my expectation for another leg higher once the pullback is complete.

The SOX got an early lift this morning after AMD (34.75 +0.38) got a big boost on expectations its stock would do well as a result of Dell's announcement that they're purchasing Alienware, a maker of high-end PCs favored by gamers which uses the AMD chips. But the early bounce didn't last as the SOX ran into resistance and dropped back again.

SOX index, Daily chart

I thought the bullish divergences would amount to something for this index and we'd get a stronger bounce than we've seen so far. I'm beginning to think this will settle down to its 200-dma, now at 480, before stronger support will be found. Chasing the semis to the downside is I think a higher-risk game at the moment.

Before getting to the banks I wanted to discuss some developments with the Fed and the impact it will have on bank lending. I want to discuss some thoughts about a coming recession. I'll start this tonight and then wrap it up in my Monday Wrap. This topic is important for lots of reasons but for us traders/investors even more so because of the negative impact on the market if the winds of recession start to make its presence known. On Monday evening, Bernanke gave a talk which included his reiteration that the yield curve inversion does not mean a slowdown in the economy is being forecasted. I wonder if he realizes that each and every time we've seen a yield curve inversion economists have said the exact same thing and it almost always leads to an economic slowing if not a recession. So the speculation has been on what it all means. Is it really different this time, for real? Many cite the recent improvement in many of the economic indicators, especially after the dismal 4th quarter last year, but many are also trying to predict the future based on what happened last quarter. It seems very difficult for economists to gaze into their crystal ball and hazard a guess as to what coming changes will do to future growth.

On a macro scale I've mentioned several times in the past my concern about consumer spending. I've shown charts of real hourly earnings (declining since 1998) and how personal consumption expenditures (PCE) typically tracks right along with wages (which makes sense). That has been disconnected since about 2003 and can be explained by the huge sums of money that have been extracted out of home equity, either by refinancing existing mortgages or through home equity loans. With a slowing of real estate appreciation (at best), home equity extraction will come to a virtual halt. This will slow spending and have a huge negative impact on the consumer psyche. This will begin to show up in declining PCE numbers that more closely aligns itself with declining real hourly wages. And of course a slowing in consumer spending will cause a slowing in our economy.

Rising interest rates in general have a dampening effect on the economy. The Fed wouldn't be raising rates if that weren't so. They're worried about growth that is too much too fast and worry about the inflation monster. We have a pretty good idea that the Fed will raise rates at least one or two more times so that will continue to make it more difficult and expensive for consumers and businesses to borrow. Lending money is a way to expand the money supply as it's a way to leverage fewer dollars. So a contraction in the money supply could also create a situation where the banks will have even less to lend. While the Fed is creating a lot of money (as shown in the M-3 chart last Monday), they can control where that money is spent. When banks lend money the Fed can't control who gets it and spends it. The Fed now appears ready to start controlling the growth of money through bank lending and it is this quiet change that could have the best predictive value as to whether or not we'll head into a recession.


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Earlier this month Fed Chairman Bernanke gave an official warning to bankers about their commercial real estate loans. The tightening in loan requirements is typically a reliable signal that banks will slow their lending thereby slowing the economy which often leads to a recession before anyone recognizes what happened. There are other tools available to the Fed to control economic growth, one being the Fed's discount rate which is changed to stimulate or restrain growth. The Fed has been jawboning the market about inflation concerns and growth rates and making it sound like they have to raise rates to control that. Theoretically, the higher the rate the less money banks will borrow which means they would lend less which in effect reduces the amount of money created in the banking system. Another tool that they use is the open market operations where they add or withdraw money from the money supply, which is what M-3 has measured but will no longer be reported starting today. While they've been raising interest rates out of inflationary fears they've been hyper-inflating the money supply which itself can cause economic inflation. My opinion on the reason they've been so intent on raising interest rates is because they want some maneuvering room to drop rates again during the next cycle. But the tool that is probably one of the most effective, and little discussed, is the Federal Reserve Bank examiner.

The Federal Reserve Bank examiner is the person charged with the responsibility to determine how the bank's loans are rated as to which ones are considered good or bad. If the Fed wants money supply to grow then the examiners would be more lenient about rating loans made with more aggressive lending standards. If the Fed wants to decrease the money supply then the examiners will classify those aggressive loans as riskier and by so doing require the bank to increase their reserve requirements in the event any of those riskier loans goes into default. This evaluation can be somewhat subjective but they get their requirements from the Fed Chairman and Bernanke recently made some changes. Based on the Fed Chairman's edicts, more or less money could be made available for lending and Bernanke's warning earlier this month essentially gave the examiners instructions to be stricter in their interpretation of loan risk and how they rate the loans. This action will result in a reduction in the amount of money available for the bank to lend out.

When Bernanke sounded the alarm about the commercial real estate loans, he started a sequence of events that typically leads to a recession. By getting a downgrade in a rating on what was previously deemed a good income-producing loan to below satisfactory, the bank is then required to set aside 20% of the value of that loan in a reserve account for bad debts. That effectively withdraws that money from the pool of available funds to lend out to other parties. It also sends a signal to the bank that it had better ensure all future loans are to a higher standard so as to avoid seeing it rated as below satisfactory. You can see how this can quickly snowball into a situation where the bank not only has less money to lend but is also less willing to lend. The ramifications to growth can be almost immediate. It will also negatively affect the bank's earnings by reducing the number of income producing loans. This would clearly have a negative effect on its stock price even if they have stellar earnings from their trading department.

I'll wrap up this discussion on Monday where I'll walk through the steps in this process, the psychological effect on the banker and why the change in lending practices can be almost immediate. This change in lending practices can then put an immediate clamp on new loans and even call in other loans that are iffy. The combination can kill commercial real estate quickly which is one of the first areas we see take a hit in an economic slowdown. It's why I'm thinking GM's cashing out of its real estate financing business could have been superb timing on their part. In the meantime the banks have doing very well so we'll continue to watch them for signs of leaks in the dike.

BKX banking index, Daily chart

The large ascending wedge pattern playing out since October is typically bearish and is one of the reasons I'm watching to see if the banks can make additional headway here or not. And now the price action since the February low is forming another smaller ascending wedge. In fact it's a fractal of the larger one. This is key here since fractals usually play out the same way and now we've got a small ascending wedge that appears to be finishing up the larger ascending wedge. Like the DOW and SPX I also think this pattern needs a slight pullback to its uptrend line from February (about 107) and then a final push to a new high, probably giving us an over-throw up to about 109. If it plays out that way, it should be the mark of a major market high.

In KB Home's 10-K filing last month, KB Home said during the first two months of the year, it saw an increase in home-order cancellations and a fall-off in net orders compared to the previous year. They said, "There are signs . . . that consumer demand in the United States for residential housing at current prices is softening." This is one of the things that first depressed prices this morning but they then got a nice recovery bounce

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

The bullish thing I see here is the fact that after breaking its downtrend line from January, the index came down for a retest and gave it a kiss goodbye. That's normally a reliable buy signal in this case. So I'm taking notice of that. In the meantime the bulls needs to prove themselves by getting this index up and over its 50-dma at 906 and then up to its 200-dma at 947. With daily stochastics in overbought that might be difficult. The other possibility, and it's a very bearish one, is that the wave count is set up for a very strong move down as it enters a 3rd wave. The only thing that could cause that at this point is a very negative reaction to tomorrow's housing numbers. If that happens you do not want to buy dips in this index.

Ongoing geopolitical concerns continue to support energy prices, and reports that the Italian company Eni declared a "force majeure" kept the buyers in. We should break the 2-month trading range very soon.

Oil chart, May contract, Daily

Oil has been consolidating on top of its H&S neckline near $61 now for the May contract. After a sharp drop from its January high this looks like a classic consolidation before the next leg down. These consolidations often mark the half way point for the larger move. That measurement, the H&S projection and an EW projection all point to a move down into the low $50s and I haven't seen anything yet to change that expectation. It would take a rally above $66 that sticks to convince me that oil is probably headed back up to test $70. Until then I'm looking for oil to break down.

Oil chart, May contract, 120-min

Looking a little closer at the consolidation since the February low, it's taking the shape of an ascending triangle (flat top, rising bottoms). This is typically a consolidation pattern and looks to be in the final leg of an a-b-c-d-e triangle pattern. This final leg can do anything it wants--stop short of the upper line, over-throw it or anything in between but the next move after the current bounce is finished should be a break below $60.

Oil Index chart, Daily

The index is looking a little stronger than the price of oil and probably a result of stocks being stronger recently. But it too has a similar consolidation pattern and I believe the next large move will be a break below 530 on its way down to the mid 400s.

Transportation Index chart, Daily

Somebody body-slammed the Trannies this morning. They ran down huge out of the gate and then while they were down they got kicked and barely allowed to lift itself off the mat. I'm not sure what happened but it was clearly a large sell order in this index and right on time. I felt the new high it was making should be the last and now with a break of the short term uptrend line from March 8th, that leg up is finished. The mighty TRAN could still bounce off its October uptrend line, near 4450, and make another run to a new high but that would really screw up the EW count. I'm calling the top on this one. Any bounce with a broader market rally after a pullback should not have the full participation of the Trannies and in fact that's one of the things I'll be looking for as evidence of a broader market top if it's made without the Transports.

U.S. Dollar chart, Daily

The US dollar got a strong bounce off its uptrend line and is now attacking its downtrend line from November at about $90.40. If it can't break higher it will probably consolidate further in its sideways triangle pattern and that would say it will likely break down. So we have the test now to see where the dollar is headed over the next month or two. Which way the dollar goes will likely have an effect on which way oil and gold head. And if oil is going to break down that would say the dollar is probably going to break resistance here and head to new highs.

Gold chart, April contract, Daily

Gold is not breaking down like I thought it would. It appears to be consolidating in a bull flag pattern which would suggest we're not going to get much of a pullback before this zooms higher again. The short term pattern suggests we could get another push up to the top of its flag near 566 before getting another pullback to complete the consolidation. It takes a break below 530 to say we've probably got a much deeper retracement in progress that should take gold down closer to $500. Again, the dollar's move might have an influence on which way this goes.

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

Tomorrow has only two major economic reports but they're potentially big ones. The Durable Orders number will show how strong the economy is which will have an impact on how people perceive the Fed's reaction to it. January's number was way down so if February's is way up it could spark concerns that the Fed will have to stay aggressive on their rate-increase campaign well into the year. The New Home Sales number will obviously be important for the housing sector watch their reaction tomorrow since the housing index is nearing an inflection point. And again, depending on how robust, or not, the number is could spark worries, or hope, about what the Fed will do.

As can be seen in the numbers at the top of this report, the day was mixed. The advancers and decliners were evenly mixed. We had a lot of new highs but the new lows were higher than normal. The internals pretty well matched price action so I see no divergences there. Sector action was also mixed. The leaders to the upside were the energy indexes, disk drives and gold and silver. The red sectors were led by the Transports, airlines, drugs, pharms, healthcare and biotechs. Also in the red, and something a little more bearish than we've seen recently were the financials and securities broker index.

The price action suggests to me that we'll see a down day tomorrow to give us a leg down to at least equal the leg down on Tuesday. That sharp drop has been followed by varying degrees of strength in the bounce (with the DOW being the strongest) but it still looks like a correction. The correction could morph into a larger one and give us another leg up tomorrow instead of an immediate drop but it wouldn't take away the likelihood that we're going to get another sharp drop lower like Tuesday's. I like to look for equality in the moves so looking for two equal legs down would give us downside targets (if the bounce is finished) of SPX 1291 and close to 10215 for the DOW. Note that that level for the DOW happens to be near trend line support and one of the reasons I mentioned a break below 10200 could be significant. SPX 1291 is also very close to its uptrend line from October. So if we get that kind of pullback I'd even think about testing the long side. If the DOW is to rally back to an upside target of 10500 that's a nice swing trade. The risk of course is that a decline will just keep going, but what else is new. That's what stops are for. Good luck with your trading and I'll see you on the Monitor.

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