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Market Wrap

Not So Fast on the Rate Increase Pause

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The market reacted negatively this afternoon to a comment on CNBC that Bernanke felt the market misinterpreted his statements last week before Congress. When he inferred that the Fed might, perhaps, maybe, possibly, could pause after the next rate increase in order to watch how the market adjusts to the spate of increases so far, the market took that to mean the Fed is done. Well, fortunately we have Maria Bartiromo to set us straight. In a conversation with Bernanke at a Saturday night dinner, she asked Bernanke if the market misunderstand his comments. He then informed Bartiromo that the Fed merely wants flexibility and might pause or they might not, and if they pause it doesn't mean they won't raise rates next time.

It seems to me that's what we heard last week. Why Bartiromo decided to inform the market of this huge and important find of hers is beyond me. She's a waste of air time as far as I'm concerned and I'm trying to be kind. Bernanke was simply reiterating that he remains hawkish (not dovish) on inflation, and the major indices pulled a hissy fit and sold off hard this afternoon. After holding still for practically the whole day it looked like all it would take was a "boo" to get the market to make a fast move in one direction or the other. Thanks to Maria we got a move down.

Until late this afternoon the market had been holding up reasonably well but was unable to proceed higher after making an early morning attempt at new highs. The consolidation was beginning to look a little bullish by hanging near the highs. But that all changed quickly once the sell programs hit and the major indices immediately dove for the lows of the day. The intraday swing was not extreme and it remains to be seen whether this afternoon was just a knee-jerk reaction (sell first, ask questions later) or the start of something a little bigger to the downside. We'll see what the charts are telling us but my sense is that we should be finishing up a sideways/down correction from last week and getting ready to make a run for new highs (sorry bears, I call them as I see them).

It was quiet on the earnings front with no influential companies reporting this morning. Wal-Mart (WMT 45.96 +0.93) pleased the market this morning with a report of a preliminary +6.8% increase in April same-store sales, which was above prior forecasts for 4-6% growth. The retail sector did well today and is based on hopes other retailers will see similar results. Also helping the DOW today was Home Depot (HD 40.54 +0.61).

Personal income and spending numbers were released before the bell and they were somewhat encouraging because income, +0.8%, was up more than the +0.4% expected, and up from the previous +0.3%, and spending was also up but less than income. Personal consumption expenditures, excluding food and energy, rose +0.6% and was higher than expectations for +0.4% and was an increase from the previous +0.2%. Unfortunately, looking behind the numbers, the personal income was up largely due to the increased payments under the new Medicare drug program. It would have been nice if it was actually due to higher wages. The Fed watches PCE carefully for a sign of excessive inflation and with the rise in PCE at 2% for the past year, it was right on the edge of the Fed's comfort level.

At 10:00 AM we got the Construction Spending and ISM Index. Construction spending jumped up +0.9% which was more than double the expected +0.4% but slightly less than the previous reading of +1.0%. In real dollar terms it was up to another record high of nearly $1.2 trillion. Private and public construction spending hit new highs as did private residential construction.

The ISM Manufacturing Index was up to 57.3 from 55.2 in March and was higher than the 55.0 expected. This made for the 35th straight month of growth and the number was the highest since November. If the number for April (57.3%) is annualized, it corresponds to a 5.3% increase in real GDP growth. The Price Index was also up--71.5 vs. 66.5 in March. The Employment Index was up to 55.8 from 52.5 and Production Index was up to 60.4 vs. 57.5. The two numbers going in the "wrong" direction were New Orders, down to 57.6 from 58.4 in March and Inventories were up to 51.3 vs. 48.7 in March. Those last two items is not something we want to see in a developing trend. But for now these numbers show healthy growth in our economy.

Last week I read about a Wall Street Journal/NBC News poll that showed Americans are not feeling particularly good at the moment. Our collective mood seems to be doubtful and fearful. The poll's purpose was to show how it could affect midterm elections but I look at the results with an eye towards our markets. And what caught my eye was the statement that there's a "striking gap between Americans' mood and the nation's economic performance. Fully 77% call themselves uneasy about the state of the economy rather than confident...There's almost nothing that the public is satisfied with," says Democratic pollster Peter Hart, who conducts the Journal/NBC poll with Republican counterpart Bill McInturff. "What they're telling you is, they want change on every front."

This backs up the most recent numbers we saw from the consumer sentiment numbers for April, especially the expectations index falling to 73.4 from 76.0. This is what EW analysis measures--the cyclical swings in investor mood and when it turns fearful, as it appears to be doing, that's when the stock market is in danger of falling as investors get more protective and pull money out of the market instead of chasing it higher and higher. In a little bit I'll finish up my discussion on the stability/instability question by showing how investors have chased after higher risk stocks in the past couple of years and especially this year. This appetite for risk is called greed. Once greed turns to fear it will have a negative impact on our markets.

But the late-day spike down in the market's major indices is a good setup for the Fed to come to the rescue tomorrow, something a few billion dollars injected into the system should be able to take care of. I wouldn't be surprised if the banks engineered that sell off so that they could suck in some more shorts. This way they'll have the fuel they need to launch a new rally leg with a few big buy programs. Bernanke probably hates shorts as much as Greenspan did and I'm sure he wouldn't mind seeing a few bears' butts get roasted. But that's just speculation. Let's see what the charts are telling us.

DOW chart, Daily

The DOW is stalling and consolidating in the middle of its ascending wedge and near its highs. This appears bullish for now but it could pull back further before setting up its final leg to new highs, which is what I continue to believe we'll see. This could pull all the way back to its uptrend line though, currently near 11200 and not spoil the bullish possibility here. It's a risky spot for new trades.

SPX chart, Daily

SPX could also pull back before heading higher and I would expect this to find support at its 50-dma, just above 1296, or its October uptrend line near 1291. It could just consolidate sideways to chew up more time. Regardless, until the support levels are broken, this should press to new highs.

Nasdaq chart, Daily

The techs are starting to worry me from a bullish perspective. The COMP broke through support today on that spike down this afternoon. It broke both its 50-dma and October uptrend line. In mid April when the DOW and SPX were threatening to break these support levels it was the COMP that was holding up better. It barely tested its 50-dma at the time. Now these support levels have been broken. Therefore, like the DOW and SPX before it, the COMP must turn back to the upside quickly otherwise it could be a quick trip back down to 2250.

QQQQ chart, 240-min

I can't quite figure out if the Q's are pulling back in a bull flag or if this is getting ready to let go to the downside. If this continues to chop its way lower and finds support around 41 (there's a Fib projection to 41.16) then I would buy it for another leg higher. If it drops strongly below 41 then I'll switch over to shorting the rallies.

SOX index, Daily chart

The SOX appears stuck at the moment and I can't quite figure out which direction it's going. As long as it holds the bottom of a potential sideways coil pattern, currently near 503, this can still resolve to the upside. A break below its April 17th low at 498 would be bearish but then there will support close by at the 200-dma nearing 490.

I had mentioned on Thursday that investors have increased their appetite for risky investments. This goes along with the notion that the market is less risky due to its long term stability. Other than owners of most of the tech stocks, many people have now forgotten the 2000-2002 debacle in the stock market, especially with the DOW back up near its previous high of 11750. This expectation for the market to remain stable is actually what sets it up for a harder fall because once it starts to crack, the surprise will shock many investors and scare them more than normal. Riskier investment vehicles will likely experience a more negative reaction to any bad news in the market. This will scare investors who were thinking they were safe into moving even faster out of those investments and this is what starts to unravel the system and create panic sell offs.


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There was an article written by James Montier titled "The Dash to Trash" and it is highly informative when you see what investors have been doing lately. It ties in perfectly with this whole notion of investors taking on much more risk at a higher price for lower returns. It's exactly opposite to what we're supposed to be doing in the market. Investors feel they have a roll cage built around them with front, side and rear air bags to protect them. Unfortunately it only provides a false sense of security as the Mack truck comes barreling down the road which is capable of flattening this little trading vehicle investors are in.

Montier points out that the QQQQ, typically a gauge for investor aggressiveness, barely has any short interest--only about 1-1/2 days based on its 30-day average volume. Investors must feel that it can't go any lower and therefore presents very little risk. But after a P/E ratio of 13 in 1995-96 the Nasdaq has a current P/E ratio of 40 today, clearly overvalued. It shows that investors are willing to pay top dollar for riskier stocks that have not been doing terribly well lately. The willingness to buy these riskier stocks in the hopes of getting better returns is indicative of the willingness to look the other way when it comes to risk.

Standard and Poors has a quality ranking for equities (known as the earnings and dividends ranking) in the S&P 500 and bases their ratings on the track record for the stocks over the past 10 years. Scores are adjusted for rate of growth, the stability within the long-term trend and cyclicality. The grades are ranked from 'A+' (best quality) to 'C' (lowest quality). Obviously they are behaving like the schools nowadays--we don't want to hurt the feelings of these poor companies by giving them something less than a 'C' for fear of hurting their feelings and damaging their self confidence. Actually there is a grade of 'D' which means they're in reorganization and then 'LIQ' which is for companies in liquidation.

As shown in this chart, the junk stocks (er, excuse me, the 'C' stocks) have been getting all the attention:

Stock performance by quality rating, courtesy DrKW Macro research

As can be seen in the chart, the highest quality stocks have been shunned as too boring. The highest risk stocks, those with the lowest quality rating, have clearly outperformed. Investors are flocking to this junk in hopes of finding better returns. In the S&P 500, of the top ten performing stocks so far this year, none are rated as anything higher than B+ (which S&P refers to as "average"), 9 of the 10 are rated below average (B) and 6 have the lowest quality rating (C). While investors have been rewarded for choosing these riskier stocks so far, the problem will occur when these stocks disappoint (which they will since they're rated a 'C' for a reason). The stability that we currently see in the market will suddenly destabilize and the dislocation will catch most investors off guard.

To show how this year is out of whack with recent history, this chart shows the performance by quality rating in the previous 20 years:

Stock performance by quality rating, courtesy DrKW Macro research

As you can see, recent history shows that the higher quality stocks have been lower risk and higher performing than their junky cousins.
The other thing about the lowest quality stocks is that they are also carrying, by far, the highest P/E ratios. Investors seem to be happy to buy junk even at the out-of-whack high prices that they're currently sporting. Again, this just shows how investors have become overly comfortable with risk today and that is what sets up a vulnerable market.

Not surprisingly the highest quality stocks tend to be the large caps. The tech companies, and higher beta stocks (the ones with greater volatility) tend to be your smaller caps. For the past 2 years we've seen the small caps outperforming the large caps as investors have rushed into these riskier stocks. I thought the following chart was interesting because it shows a long history (the past 30 years) of the comparison between large caps and small caps.

Large and small cap comparison, courtesy DrKW Macro research

The above chart shows the Graham and Dodd PE (based on 5 year moving average earnings) for US large and small caps. With small caps trading at a 31 P/E, which is a record high, it's not hard to identify this group as riskier than the other groups, and the willingness of investors to pay top dollar for this risk.

What really amazed me was a chart showing the volume going into what I call "super junk", the OTC BB (over-the-counter bulletin board), or "pink sheet", stocks. Generally speaking, these are the lowest quality stocks, and highest risk. These are the stocks we keep getting spammed about which suggest we're fools to ignore the wonderful investment opportunity for which we've been specially selected in order to participate in the company's expected explosive growth. I delete these without even reading them but apparently others are not only reading those emails but they're also buying the stocks.

Average daily volume of OTC BB stocks, courtesy DrKW Macro research

Here's what's amazing, and scary--see that little blip in early 2000? As we headed into 2000, that was a huge spike and it indicated an excessive move into high-risk stocks at the time, which was an indication of irrational exuberance. The stock market had a significant correction shortly thereafter. The current parabolic climb in volume that is going into these super junk stocks is not encouraging for the health of the bull market. This is more like the sign of the end of it in a blow-off top.

This is of course the view of the market from 30,000 feet--the big picture. It doesn't tell us when the market could make a turn back down but it does tell us to be very careful. I continue to believe we're probably not far from the time we'll see surprises that occur to the downside instead of upside. Short term though, I see the possibility that bearish traders could get a nasty surprise in May, perhaps even into the summer. The banks have been very strong the past week two weeks and the last time the banks broke out to the upside (October 2005) the rest of the market followed. Don't bet against the banks.

And speaking of the banks, they corrected today as profit taking too hold. JP Morgan Chase and Citigroup were two of the influential leaders to the downside today as the banks gave up a bit of their strong gains from last week.

BKX banking index, Daily chart

After thrusting higher out of its 2-month consolidation price stopped at an internal parallel line to the October uptrend line. This tells me it made a measured move and is now ready to correct that move. I would expect the December 31, 2004 high to act as support now. I also expect the banks to continue higher once the last spike up corrects. And as the banks go, so goes the market. The big fly in the ointment for me is the Securities Broker index which looks bearish. This is the index that also is a good market proxy.

Securities Broker Dealer index, Daily chart

The Securities Broker Dealer index doesn't inspire bullish feelings in me. By breaking sharply through its October uptrend line and then its 50-dma it looks like a breakdown in the making. It has also dropped back inside an old parallel up-channel. In order for this to maintain a bullish possibility here, it needs to get turned around quickly and head back up. If this spends more than couple of days floundering around below the 50-dma, or continues to break down hard, the broader market could be in trouble.

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

The home builders look like they're going to continue to drop lower. At any time we could see a bounce back up to test the broken uptrend line or H&S neckline but those trend lines should now act as resistance.

Oil chart, June contract, Daily

Oil got a nice bounce back up today and that may have been helped by both the continuing geopolitical risks as well as the drop in the US dollar. But I expect the price of oil to continue to pull back and it's just a guess as to what kind of pullback we'll see but I'll continue to watch against the pattern depicted on the chart.

Oil Index chart, Daily

The oil stocks keep following oil so no divergences yet. After today's bounce, which may not be over, this index should continue lower. Whether the 50-dma provides support or further down at the 200-dma and uptrend line, once we get a deeper pullback here it should then turn around and head back up.

Transportation Index chart, Daily

The Transports are holding at the October uptrend line and continue to work their way up in a tight parallel up-channel. The pullback over the past 1-1/2 weeks looks corrective with overlapping highs and lows. It looks like a bull flag. This suggests we're going to get yet again another new high in the Transports. But if the Trannies break below 4565, that could be a look out below signal.

U.S. Dollar chart, Daily

While I don't see much in the way of bullish divergences to suggest a bottom is forming for the dollar, I wouldn't be surprised to see a bounce from here. The combination of the uptrend line from January 2005 and the low in September 2005 should provide some support. But the dollar looks to be in trouble and a corrective bounce should lead to a further breakdown. That should be bullish for the metals and many other commodities.

Gold chart, June contract, Daily

Gold ran up to the trend line across the highs since December and may stall here. Short term we could see gold chop a little higher but this one could be close to topping for now and we'll get a deeper pullback. If the dollar bounces it might be ready for a pullback based on that as well. I certainly would not chase gold higher here but instead wait for a pullback. If we're finishing up a 5-wave move from last July, we'll get a much deeper pullback, perhaps back down to the mid-500's.

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

Tomorrow is light on economic reports with only auto and truck sales to be reported. Neither one should have much of an impact on early trading. Beyond tomorrow the more influential reports should be Factory Orders, ISM Services, Productivity and Nonfarm Payrolls.

Today's late-day sell off but a negative tone to the day and sector action also showed a tilt towards the negative side. The green sectors were led by the energy indices, retail (thanks to Wal-Mart's strong retails report this morning), gold and silver and cyclicals. The red sectors were led by the securities broker index, biotechs, utilities, SOX and other techs.

From a short term perspective, and countering the potentially negative news for the market that we got at this afternoon about Bernanke's hawkish position, we have a growing number of CBOE equity put options. About two weeks ago I showed a chart that was labeled "PPT intervention risk indicator" and it essentially showed a graphical representation of the 10-dma as a percentage of the 30-dma of the CBOE put options. In the past whenever the 10-dma climbed above 18% of the 30-dma we had some significant short covering rallies. When too many people start leaning towards the short side of the market, it's relatively easy for the mega-banks' trading teams, with the help of the Fed's new money, to hit the market hard with buy programs and get a strong rally started, aided by short covering. As of Friday this PPT intervention risk number was above 24%. We don't know if the same thing will happen as has happened in the past but it should put the bears on alert here.

They have typically looked for a new driven event that drops the market and then they come in and start the relentless buy programs. Was this afternoon's sell off enough to get them interested in hitting it here? Or do they want to see another 100 DOW points lower? It's hard to say and in fact it's hard to say whether or not we'll even get the same kind of program buying event. But the fact that they come out of the blue without any warning from the charts, it's a difficult thing to guess about.

If I go with my interpretation of the EW pattern I see more upside as necessary before the market is ready for any kind of significant sell off. But it's too hard to tell whether or not the market is ready to bounce now or from 100 DOW points lower. The choppiness that we're experiencing could continue much longer, including in a push higher into the summer. For an example of what we could see, check out the summer of 2000 to see how it unfolded. We could be set up for a similar summer. That's just speculation but I see that as a possibility and it will be an ugly market to trade. Be careful of any early spikes to the downside tomorrow morning since it could be the head fake to pull in shorts before the buy programs hit. This is a very difficult market to trade. Trade light, trade quick and be careful. See you on the Monitor.

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