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Market Wrap

Long Live the Consumer

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The consumer is doing his and her job of consuming and by doing so is keeping our economy humming. There are signs of a slowdown coming, but the consumers are showing a brave face in light of high energy costs and they're keeping those wallets open. The retailers came out in force today and were providing some solid same-store sales numbers for May--up 4.2% vs. an expected +3.5% increase.

But Wal-Mart (WMT 48.37 -0.06) almost spoiled the party by reporting only +2.3% in May which was at the low end of their previous guidance of 2% to 4%. They said they were expecting growth to be in the 1% to 3% area for June. They commented that their customers are citing fuel prices as their top concern. An interesting observation by WMT was that they're seeing reduced customer traffic but then large volume bursts twice a month, coinciding with pay days. This tells them that their customers are living paycheck to paycheck even more than before.

Wal-Mart, General Motors (GM 26.90 -0.03) and Coca Cola (KO 43.92 -0.11) were the only DOW stocks in the red today. GM got hit after they reported auto sales dropped 16% vs. an expected drop of 11%. As usual the Japanese manufacturers and their small gas-stingy automobiles sold much better and their sales were up. All three US manufacturers continue to lose market share. The rest of DOW components were in the green today, AT&T (T 26.91 +0.85) strongly so (+3.3%) after getting an upgrade from CIBC World Markets. As the numbers in the above table show, the internals were strong.

Price action has become a lot more volatile as of late and the nearly 100-point move for the DOW is starting to become the norm again. Today's move up keeps price within a possible correction of the May decline and we'll review in the charts why it may not be anything more than a bounce that will lead to lower lows. But for the time being we should expect more upside.

There were a few economic reports this morning, none of which had much of an impact on the market. Equity futures got a nice pre-market pop off the productivity numbers but the market opened up flat to slightly higher but then proceeded to chug higher for most of the day with only a brief consolidation during mid-day.

Initial jobless claims were up 7K to 336K which was higher than expected. Excluding the one week when government offices in Puerto Rico shut down this is the highest number since last October. The 4-week average was up by 2,750 to 333,500, also the highest since last October. Continuing claims jumped up by 19K to 2.43M, the 3rd increase in a row now. But the 4-week average of continuing claims fell by 2K to 2.40M.

US productivity rose 3.7% for the 1st quarter, up from 3.2% reported previously. Economists were expecting this to be revised up to 4.0% so while it was a good number it was a disappointment against expectations. But labor costs came is less than the 1.8% expected as the number had been revised lower to 1.6% from the previously reported 2.5%. The 4th quarter was also revised lower from +3% to -0.6%. The combination of the increase in productivity and drop in labor costs is what is helping companies absorb the cost of higher costs in other areas, namely energy, and not pass them along to their customers. Real hourly compensation is down 0.9% year-over-year which is good for costs but bad for consumer strength. It will all catch up to us soon probably. Unit labor costs are up only 0.3% year-over-year.

These numbers show that inflation has been contained. So the numbers today were Fed-friendly and the reason for the pre-market pop in the equity futures. The futures had been driven down overnight but got a boost back up to the flat line by the open. There is speculation that the Fed will be able to take a pass at raising interest rates in June. But interestingly, Bank of America raised its year-end 2006 target for fed funds to 5.74% from 5.25%. Their reasoning is that the core inflation rate is running slightly above the upper limit that the Fed wants to see.

Construction spending numbers were a little disappointing in that outlays fell -0.1% in April vs. +0.9% in March. This surprised most of the economists who were expecting a +0.2% increase. A drop in home construction, to the lowest level since January 2004, got most of the blame.


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The May ISM manufacturing index fell more than expected to 54.4% from 57.3% in April. This is the lowest reading since August. Anything above 50 shows growth but this combined with pending home sales falling for the 3rd straight month and a slowdown in construction spending for the first time since last June shows the economy is likely slowing down. The bond market rose on the news (yields dropped) as rate increase fears subsided some.

Before we get to the charts, I just need to make a comment on President Bush's nomination earlier this week of Henry Paulson, the CEO of Goldman Sachs to be Treasury secretary, replacing John Snow. I don't mean to sound cynical or like a conspiracy theorist, but this appointment fits too nicely into the scheme I've discussed before about the cozy relationship between the major banks (the Fed's primary dealers), the SEC, the Treasury and the Chairman of the Federal Reserve Bank. There's already lots of speculation as to what the trading teams in the mega-banks are up to and why they're able to make a bazillion dollars per quarter and why "risk has been removed" from their trading operations. Now we have the CEO of GS becoming the Secretary of Treasury. As the Church Lady would say, well isn't that special.

DOW chart, Daily

The DOW has been attempting to bounce back up to what was support and is now resistance. Its 50-dma at 11273 is acting as resistance the last two times its been tested, including today. If it can get a little higher, there's resistance at its broken October uptrend line near 11320. There are some Fib levels close to 11350 (see chart at the bottom of this report) that price could be gunning for. But at this point, the current bounce should lead to another decline, like the May decline, and I would be looking for the setup that you like to get short once this bounce completes.

SPX chart, Daily

There are Fibs and the 50-dma that line up in the 1296-1300 level that I like for a place to look to get short. A new low below the May low is needed to confirm whether or not the market has topped, but that's the way it looks from here. If true then the current bounce is just a correction to the initial decline and the next leg down should be fast and steep.

Nasdaq chart, Daily

I have a slightly different pattern, or wave count, for the techs than I do for the blue chips. My best guess for the COMP is that it needs a minor new low before it sets up a larger bounce. Support at the August 2002-April 2004 uptrend line, near 2110, could be the place where we see a bigger upside correction. Its 200-dma, broken April-October 2005 uptrend line and some Fibs all line up in the 2230-2240 area which is where I'd watch for a short play to set up. And then depending on what the broader market is doing, and assuming we get another drop, watch that 2110 area for potential support.

QQQQ chart, Daily chart

Like the COMP, the current bounce should be close to completing. Two equal legs up in its bounce is at 39.83 which is close to a 38% retracement of its 3rd wave down (typical) at 39.78. But if it manages to punch through this resistance zone and can get above $40 as we head into opex, the Q's could make their way up to the 200-dma at $40.61 which also close to a Fib projection for the current leg up at $40.63.

SOX index, Daily chart

The SOX found support at an old downtrend line from May 2002. If it can get a decent bounce going it could drive back up to the 500 area where it will find tough resistance by its 50 and 200-dma's. If it takes a little while to get there then the 50-dma could be meeting the 200-dma closer to 492. A cross of the 50 down through the 200 would clearly be bearish for this index.

Liquidity Contraction
Recently I've written about the higher levels of risk that investors are taking in order to achieve higher returns. As the equity market volatility has driven to near record lows, and equities have stagnated for the past couple of years, investors have looked far and wide, literally, for better returns. Overseas markets have enjoyed a large influx of money, especially in the past year as more and more people hype up the smaller developing markets. More money from U.S. investors has flowed to overseas markets than our own.

They're also investing in areas that have typically been traded by the commercial players--commodities. With the introduction of hundreds of ETFs, such as oil (USO), gold (GLD) and silver (SLV), people are now able to trade commodities along with the big boys. Junk bonds are enjoying a bull market. Even the debt of some countries whose stability is uncertain has been purchased by return-hungry investors.

This all ties in with what I've discussed in the past about the long-running stability that we've been experiencing. It lulls investors into a sense of complacency and it gets them looking into riskier investments because they feel the stability will just continue. It sets up a dangerous time because the longer the stability continues the more massive the disruption will be. The fact that our market hasn't had a 10% correction in almost 3 years, close to a record, actually sets us up for a harder fall.

And now we may be starting to see some leaks in the dam as the ground underneath starts shaking. What looked so stable for so long may become unstable in a hurry. We're seeing a global asset market correction and it has hit the smaller markets particularly hard, the same ones that investors have been flocking to for the higher returns. Many of the foreign markets have experienced a 10% correction. Equity markets in Korea, Thailand and the Philippines dropped by 10% and those in India and Indonesia by 15% in May. Stocks in Mexico and Brazil have lost an average 12% of their value, while losses in Russia and Turkey are near 20%. These small markets can't handle a rush of sell orders from the many fund managers who have been investing in these foreign markets.

Global bond markets have not been immune from the selling and that's why this correction seems due to a global contraction in liquidity. The falling equity and bond prices has only contributed to the contracting liquidity. Japan has been in the news lately about its plan to begin raising interest rates. China is planning on curtailing their growth and both of these actions will cut the amount of money available for investing inside and outside their countries. The US and EU have been on a campaign to raise rates and in so doing are contributing to the credit squeeze.

But the big factor here is Japan and the Japanese yen. Many savvy investors have borrowed Japanese yen, at 0% interest, and invested it outside of the country, and much of that in these emerging markets. These funds have been lent by Japanese banks to foreign investors in the form of interest and currency swaps. As Japan talks about raising their interest rates, the borrowers of the yen will want to pay it back and hence their desire to sell the assets in order to get their money out and back to Japan. This will cause a major contraction in global liquidity. This could be the grain of sand that causes a major dislocation in the market, the one that causes the avalanche in what was a stable looking pile of sand.

By draining liquidity from the banking system, the Bank of Japan has made it increasingly expensive for investors to roll over their yen loans. Since the majority of these loans are for one year investors will be forced to replace their existing loans with more expensive ones. When you combine emerging market asset value depreciation with yen appreciation it forces investors to liquidate their investments that were funded with ultra-cheap yen loans. This is one of those situations that clearly was not forecast as a possibility as many funds who were pounding the table about what a great buying opportunity there was overseas have been suspiciously quiet lately.

With increased concerns about inflation creeping into the core rate (we've already seen higher CPI numbers) the Fed could be forced to continue raising rates, hence Bank of America's raising of their fed funds forecast to 5.75% by the end of this year. That's 3 more rate increases if the Fed continues at +0.25 each time. They might even be forced to raise it by 0.50 one time to "shock" the system. This would further exacerbate the credit crunch and any selling of US assets by foreign holders could the further exacerbate the global asset contraction. With the increase in interest rates we'll see a sell off in the bonds as well. A decline in bonds and rise in yields would further choke off credit. You can see how it could spiral down quickly.

So are we seeing the start of this with the sell off in May? This May was the worst May the market has seen in years. "Sell in May and go away" was taken seriously this time. From a price pattern standpoint, the sell off in May appears to be just the start of what will end up as a bad year for the stock market. And the emerging stock markets would in turn have their worst year in a decade. If you participated in the foreign emerging markets, I'd be very careful and establish a stop loss level for yourself.

Back to the short term price action, with today's bounce it looks like we have a little more upside to go and then the selling will probably kick in again. The banks and securities brokers have been a good barometer so we'll continue to watch them for some clues.

BKX banking index, Daily chart

The banks held on to the short term uptrend line along the lows since January, and even managed to climb back above the 50-dma at 377.89 (although it's only been cycling around that average lately). Price stopped dead against its 20-dma today. The 383 area still holds the potential to be tough resistance. If the banks can keep rallying I suspect the broader market will follow so keep your eye on these. Any drop to a new low from here should be confirmation the broader market is in trouble.

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

The housing index hasn't been able to get much of a bounce going. It has now dropped to the level where I would expect to see a bigger bounce. If it's not able to muster anything and continues to drop lower, and drop out of the down-channels in the process, it will be very bearish since it will likely mean it's in a waterfall decline (crash-like) and headed for a lower target near 500.

The Energy Department said crude inventories rose 1.6M barrels for the week ended May 26th to a total of 345.5M, 4% above the year-ago level. Gasoline stocks rose 800K barrels to 209.3M barrels, 2.7% below the year-ago level. Distillate supplies rose 1.8M barrels to 118.9M, 8.4% above the year-ago level.

Oil chart, July contract, Daily

It's been a choppy ride as expected, and oil should drop down to support in the $66-67 area. That should then set up another rally to new highs to finish off the rally in oil before we see a much larger pullback into the end of the year.

Oil Index chart, Daily

If oil gives us another drop, the oil stocks should follow and that would mean at least a retest of the lows in these stocks. I'm still not sure how the oil stocks will rally if the broader market is sinking, as I think it will, but I'm leaving the depiction as is until price tells me that's not going to happen (with a break below 530). Who knows, maybe I have the price pattern on the broader market wrong and the pattern on the oil stocks is telling us we're going to see a summer rally in the broader market as well.

Transportation Index chart, Daily

The Trannies are getting a nice bounce now but watch resistance between its 20-dma at 4769, a 62% retracement at 4830 and then its broken October uptrend line near 4850. It's possible that today's rally has finished the upward correction and any drop to new lows should be an indication that another large decline has started.

U.S. Dollar chart, Daily

As expected, the US dollar is getting a little bounce but is pretty much going sideways. This consolidation should lead to another new low and the $83 area holds the potential to be a good support level from which the dollar should get a much bigger bounce. A new low should be met with bullish divergences to support that idea.

Gold chart, August contract, Daily

Gold looks like it will head for uptrend support near $600. It gave up its 50-dma today. If it can make it down to $600 relatively quickly I would say it could be worth a buy there if support holds.

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

We've got some potential market movers before the open tomorrow. The nonfarm payrolls number could cause a reaction if it's significantly different than the expected 170K. If it's below 100K, indicating a real slow down in the economy, the market wouldn't like that. If it's over 300K indicating an overheating economy (doubtful) the market wouldn't like that either (too much worry about the Fed stepping on the brakes with further rate increases). The Hourly Earnings could have the same impact as far as how the Fed could react to the number.

Factory orders at 10:00 AM are expected to drop from last month so that's priced in. If that were to drop more than that we'll probably see a negative market reaction. Anything over zero and we'll probably see a jump higher in the market.

As mentioned in the beginning of this report, the internals backed the bullish day we saw in prices. We had strong up volume and advancing issues vs. down volume and declining issues. But the high number of new lows vs. new highs is still worrisome. Not everyone is participating in the rally. And that fits the scenario of a corrective bounce here that will lead to new lows for the decline that started in May.

As for sector action today, just about everyone was in the green. The only red sectors on my list were gold and silver and disk drives. Near the bottom of the green pile were the energy indexes. The commodity index was in the red. Leaders to the upside today were healthcare, telecoms (thanks to AT&T), the SOX, internet, high tech, airlines and retailers. The banks were in the middle of the pack but were strong as well.

For the next couple of days we could see the market work its way higher. A correction to the May decline, which looks like an impulsive move, is typically a 3-wave affair--an A-B-C bounce. The way it's looking, we're into the c-wave as shown on this chart:

DOW chart, 60-min

This shows a potential parallel up-channel, a bear flag, for the current correction to the May decline. Two equal legs up (wave-A = wave-C) is at 11344. A 50% retracement of the May decline is at 11355. So the 11350 level is where I'd look to initiate a longer term short position.

SPX has some good correlation around 1296, its 50-dma, for strong resistance there. Two equal legs up from its May 24th low is at 1294.46. It's broken Feb-Apr uptrend line will be up near 1300 by Monday. Therefore I'm thinking 1296-1300 could be tough resistance for the SPX.

There is a possibility that instead of two equal legs up, as depicted in the above chart, that we'll motor sideways for the next week. If we get a negative reaction to any of tomorrow's numbers, we could see a drop back down to recent lows and then bounce up and down for a little bit. That would also be a bearish setup but possibly not until after next week.

This monthly chart of the COMP shows why I want to get short the market, since I think May marked the top of the bull market run:

COMP chart, Monthly

If this were a daily or 60-min chart of a stock you were reviewing would you want to buy this stock or sell it? I think most would agree this is a good setup for a sell. This pattern is set up for the next big decline and I would not want to own any stock for the rest of this year. This could certainly rally higher but I think the risk, based on this chart, is on the bulls' side.

Therefore I think we have a short term bullish opportunity but it's such a short term that I think it's not worth the risk unless you can watch the market intraday. Setting some sell stops to enter on a breakdown could be a good way to both protect long positions as well as enter short positions. A drop below last week's low would be that trigger.

But here's what worries me about thinking short the market. I show this to keep you on your toes and from going overboard if thinking about shorting this market.

CBOE Put/Call Ratio, chart courtesy of Dr. Robert McHugh, technicalindictorindex.com

If you look at the previous times when this ratio spiked down to 1.0 or below, it marked the bottom of price declines. The spike down in this chart (as of last weekend) was an extreme and it was after only a relatively minor decline (albeit one that was more severe than we've seen since 2004). This chart says we might have found a significant low instead of just an intermediate one. Be very careful here and always have an exit strategy in mind if you get short the market and it keeps rallying. Will it take one more time to new market highs to get the bears to completely and totally give up on shorting this market? Maybe.

Good luck in your trading and I'll see you on the Monitor.

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