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Market Wrap

U.S. Stocks End 2006 With Best Gains in Three Years

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That's the headline that's splashed all over the news and it has in fact been a remarkable year for the stock market. Other than a quick sell off at the end of the day on Friday, those gains were held right to the very end of the year. The year has literally finished at the top of its game.

The big number in the news is of course the DOW. With a 16% annual gain that's a very impressive number for the public to see. As we enter the new year everyone feels good about the stock market and as they make their new year's resolutions and make their financial plans there will be many who pour money into the stock market so that they can capture this great bull market of ours. We know the market needs a rest but it was important for smart money to hold the market up into the end of the year for multiple reasons.

From a tax standpoint it was very important to fund managers that they didn't have to sell this year's gains and have to deal with the capital gains tax issues. It's much better to sell in 2007 and worry about capital gains a year from now. Keeping the public bullish is also very important, especially right now. Many fund managers, and I include hedge funds here, would probably like to see an early sell off in the stock market. By selling off early in the year, taking their profits, tucking some away in money market reserve accounts for next year's tax payment and then buying stocks after they've pulled back, they'll have a better chance of capturing additional gains in 2007.

The easiest and most profitable way to unload so much stock is to do it gradually so as not to spook the public. Smart money needs the public to stay excited about the stock market so that Joe Retailer continues to express interest in buying. Holding the market's gains into the end of the year was a critical part of that process. A controlled bleed off of the helium out of this balloon now becomes job #1 for many money managers. Hand off the inventory to the public without scaring them away. Once the public gets scared by a sell off then we run the risk of a no-bid situation where the selling gets carried away because the buyers step back and wait.

So this is what we're probably facing as we head into January. New money (retirement and other funds that typically come in at the beginning of the month) and more people deciding they want to invest more in the stock market this coming year could give us an early lift in January (the January effect) but smart money will probably be using the beginning of January to unload their inventory.

If you look at the price pattern in the techs it appears that that distribution effort has been going on for weeks. Money has been rotating into big caps which is a defensive move as it's a lot easier to sell fast from a big cap than a small cap (without hammering the price lower). But again, if we don't have enough buyers coming in then we could see selling get out of hand, even if for only short periods of time. That's the risk I see as we enter January.


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Projections for 2007

There are of course some longer term risks that the market faces but that's been true for a while now. I've discussed much of this before but I'll lay out why I think 2007 will be a very challenging year for the stock market. The market has actually been rallying in the face of some developing bad economic news. This too will probably not last long and smart money knows it's time to get out of Dodge with their stolen money before the sheriff catches them. Helping them escape will be the Fed--as long as they keep creating money at the furious pace of the recent past then the market will continue to benefit from that prop. This is the latest chart of calculated M3 money supply:

M3 Money Supply, calculated, courtesy nowandfutures.com

This chart is updated as of Friday so it's current for the latest week. The light blue line is the annualized rate of change and it tipped over slightly in the past week. M3 remained flat for the week. The dark black line is calculated M3 whereas the green line is confirmed M3 from actual figures received later. It's way too early to tell what the Fed will do here but if they start to pause in their money creation efforts then we could see the stock market lose another leg of it's stool.

While the Fed continues to worry about inflation, and may hold interest rates steady at least through the summer (if not raise them), they are clearly worried about a slowing economy which has a lot to do with the slowing in the housing market. As discussed many times before, the housing market has a huge influence in our economy, probably more now than ever before. With one out of every three jobs that have been created in the past 5-6 years associated with the housing market (from real estate agents to home builders to furniture and appliance employees), any hit to the housing market will automatically cause pain in the job market.

Any hit to home values will cause more people to feel poorer than any hit to the stock market (due to more people owning homes than stocks and homes being a bigger part of a person's feeling of wealth). And of course if home values are no longer increasing, or worse decreasing, then there will be less money available for home equity withdrawals. Spending would have to slow down in that case. With $600-700B extracted each year from home equity, that's a huge shot in the economic arm of our country. Take that money away and retailers won't be the only ones squealing about poor business.

If people become worried about their finances, especially if they start seeing their friends and family members losing their jobs, and knowing credit is harder to come by, then they'll start saving more. If we get our savings rate out of negative territory, where it's been for almost two years, it would be good for individuals but bad for our economy. If demand for products dries up then businesses slow down, layoffs increase and people become more fearful.

Fearful people are not bullish people and that's why the stock market will take a hit in such a scenario. The bond market, with the inverted yield curve, has been pointing to a likely slowdown, if not recession, for quite some time now. We've received a slew of economic reports in the past month that point to a slowing economy and the Fed is making money at a furious rate to keep the economic pump primed. And while we've seen the housing market getting a little bounce it's not clear it's anything more than a dead cat bounce after a fast decline.

Bubbles don't land softly and I continue to believe the housing bubble will suffer the same fate as all other bubbles. I don't have a copy in front of me but I saw a chart of the decline in the Nasdaq in 2000-2002 with a chart of the home builders laid on top of it, matching the peak in home builders in July 2005 with the Nasdaq peak in March 2000. It's uncanny how similar the charts are and of course this just points out the similarities of post-bubble moves. That pattern calls for another year of declines in the home builders.

The stock market has remained out of touch and has its blinders on. People have been feeling bullish, with the help of an overzealous Fed, and that creates a bullish market. If housing turns back down then it's not a stretch of the imagination to believe people will become less bullish and more defensive. Adding to my belief that the housing market is not finished correcting (not by a long shot) is what the bond market did this week. This 30-year yield chart shows an important break out:

TYX.X chart, 30-year yield, Daily

By breaking its downtrend line from July (the same time the stock market started its rally) the jump in yields is potentially telling us the bond market is now worried the Fed will not lower rates and may in fact be forced to raise rates. I've felt for quite some time the Fed has painted itself into the inflation corner (due to the amount of liquidity and excessive credit available) and now can't get out. The drop in the value of the dollar is inflationary and with more countries talking about "diversifying" into euros, including oil money, which will only add to the downward pressure for our greenback and cause more inflationary pressure. If the bond market is getting a whiff of this then we could see much higher rates coming. Higher bond yields will start to attract money out of higher risk stocks into the safety of a guaranteed, and decent, return.

Higher interest rates will cause several problems not the least of which is a credit contraction. While the Fed has been creating money to beat the band and creating a credit expansion (banks can lend out more than 90% of their assets and when you ripple that through several layers of banks and lending institutions credit expands at a parabolic rate), the market may force a credit contraction, regardless of what the Fed is trying to do. A credit contraction is bad for the economy because less available money means less company growth, more layoffs, etc. etc.

Speaking of credit contraction and the housing market, Paul Kasriel, Sr. V.P. and Director of Economic Research at Northern Trust, wrote an article titled "Festivus Flow-of-Funds Stocking Stuffers" in his weekly commentary, "The Econtrarian", which was reprinted in John Mauldin's December 18, 2006 weekly newsletter. He discussed household mortgage debt and it was an eye-opener. This chart shows mortgage-related debt as a percent of disposable personal income (DPI):

Household Mortgage-Related Borrowing, courtesy Paul Kasriel

The light brown line is mortgage-related borrowing as a percent of DPI and shows the huge run-up since 1995 into 2005 and a steep drop in 2006 (coinciding with the peak in the home builders)). The dark blue line shows the year-over-year change and shows a huge drop in 2006, much larger than we've seen in the past. First, the large run up was unsustainable, its own bubble. It shows people getting out of whack with the amount of debt they were taking on. But more importantly is the very sharp decline. This is the kind of credit contraction I'm talking about and it represents the very fast correction that's in progress.

Not shown but going along with the chart Paul Kasriel discussed household liquidity--how much money is available for emergencies in savings accounts and money market funds. That measure dropped to a post-WWII low in Q3, 2006. Many feel that home equity replaced the need for liquid funds but as Kasriel pointed out, with home values now contracting, and home equity availability drying up, people are now more vulnerable than ever to financial shocks. As Kasriel stated, "In sum, households have never been as highly levered as they are now or as illiquid as they are now, and their single largest asset is in danger of actually falling in value. If the Fed had to resume raising interest rates in this environment, it would be 'Katy, bar the door' for household finances!"

Back to the chart above, the significant drop in borrowing means less money available for consumer spending. This Christmas season may have been the last "fling" and now with credit cards maxed out and home equity drained, it'll be time to pay the piper and spending could come to a screeching halt. Two more charts that Kasriel showed that I think are worth passing along:

Household deposits as a percent of liabilities, and liabilities as a percent of assets, courtesy Paul Kasriel

The first chart graphically portrays what Kasriel was talking about when he mentioned household liquidity is a post-WWII lows. The second chart graphically shows how vulnerable we are to any financial shock. With record high levels of debt would it be safe to assume we can just keep borrowing more? Higher interest rates would be very difficult to absorb in this climate.

Higher interest rates would all obviously kill any budding bounce we have in the housing market. We've all heard the stories of how painful it has become for people who have refinanced with aggressive and unscrupulous lenders only to find they have increasing payments and can no longer afford their homes. Sub-prime lenders are going out of business at an alarming rate. Foreclosures are increasing all over the country.

This is not a localized problem--it's on a national scale which we haven't seen in over a hundred years. Almost half of the mortgages in the last couple of years, especially in high-cost areas, have been "creative" loans designed to get people into homes who can't afford those homes. The number of houses that will come onto the market due to foreclosures will put tremendous downward pressure on the home market. Banks which own foreclosed homes are truly motivated sellers since homes on their books gets them a less favorable review by the Fed.

If you're in a home that's your home and you don't intend to move and you don't have an oversized ARM mortgage then you really have nothing to worry about. If your house value drops so does your neighbor's. Yes you lose equity but it was all fluffed up paper money anyway. But if you're forced to sell your home in the above environment (loss of job, divorce, etc.) then you become just another motivated seller who will drop his price in order to sell.

If this housing scenario plays out, and we could see bigger cracks in the foundation if this spring's sales don't meet expectations, then it's not difficult to understand the depressing effect that will have on peoples' psyches. Fearful people are not bullish people and the stock market will suffer.

OK, enough about what my crystal ball is showing for 2007. We ended a very bullish 2006 and those who have been long the stock market deserve a big pat on the back for hanging on for the ride. You rode the momentum wave and you participated in the gains. Unless you were in the DIA or DOW futures you didn't do quite as well as the DOW's 16% since the rest of the market, and individual DOW stocks, did not see those kinds of gains, but nevertheless you did well. So congratulate yourself, throw a party and now do yourself a favor and SELL! :-)

DOW chart, Daily

Not much has changed from yesterday's update so I won't rehash a lot on these charts. For additional info on what I expect to see you can reread Thursday's Wrap. I have an ascending wedge that I'm following and today's pullback is so far just a pullback within the wedge, a pullback I was hoping to see. If I've got the internal Elliott Wave (EW) count correct, we should get another leg up to finish the wedge. A drop below Tuesday's 12337 low negates the wedge pattern and would be a strong indication we've already seen the high for the market. Until that happens watch for another push higher to a Fib projection at 12626, 160 points higher. Whether it gets there, or stops there, who knows but that's what I'll be watching for.

DOW chart, 120-min

This 120-min chart is an update to the one I showed Thursday where I'm watching the development of the ascending wedge. Because this wedge pattern calls for an a-b-c move up for the 5th wave I was looking for a pullback against this week's rally to then be followed by another leg up to finish off the whole thing. I'm not sure if we'll see a little more pullback when the market opens on Wednesday or if we're now set up for the next leg up. My guess is that we're ready for the next leg up (based more on SPX).

SPX chart, Daily

SPX dropped to its 20-dma, 30-min 100-pma (often support and resistance) and near its uptrend line from July (which is at 1416). This should be good support to launch another leg higher and that's what I'm expecting to see on Wednesday. If the DOW pushes up to an upside target of 12626 then we should see SPX make it up to 1434. The big caution for bulls is the continuing bearish divergences on daily charts across the board. This can not be ignored and will result in a top very soon if it hasn't already occurred. If SPX drops below Tuesday's 1410 low then there's a good chance the top is in.

Nasdaq chart, Daily

As I mentioned Thursday, I'm just waiting for the COMP to do something. It's currently in the middle of a very busy 4-lane highway wondering which way to run.

SOX semiconductor index, Daily chart

Ditto my comment on the COMP.

BIX banking index, Daily chart

Of all the charts I reviewed for the weekend, this is one of the more bearish as far as the sell signal I'm getting from this one. After running up to the top of its parallel up-channel, in a clean 5-wave up from November, it sold off sharply and RSI has taken a dump. It dropped straight through its 10-dma which has supported the month-long rally. On an intraday basis it looks ready for a bounce but I'm thinking the banks have already topped out. If the broader market averages manage to push to a new high next week but are unaccompanied by the banks to a new high then I'd say the bearish non-confirmation is the kind of signal a bear wants to see and I'd be adding to my longer term short position.

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

The home builders currently leave me wondering what's next for the short term. It looks ready for another bounce but I can't be sure enough of that to feel bullish here. But it's not looking bearish either. I'm holding off short term judgment for the moment even though longer term I fully expect to see this roll over and head for new lows.

Oil chart, January contract, Daily

Oil continues to pound $60 support. It should start its bounce higher now, and higher oil might be one of the contributing factors behind a topping stock market. A drop in the US dollar may also contribute to rising commodity prices, including oil and gold. Higher commodity prices will only add to inflationary problems which I should have mentioned above as far as what I'm expecting to see in 2007. If oil bounces a little here and then breaks below $60 I still see the high $50's as support but it might consolidate at this level for quite a bit longer before making a move.

Oil Index chart, Daily

Oil stocks rallied a little this week but were rejected at the 20-dma (green MA) and as long as that continues then this will likely roll back over towards new lows. If stochastics flattens out here (indicating a downtrend in progress) then RSI has a ways to go before it reaches oversold.

Transportation Index chart, TRAN, Daily

Stochastics flattening out in oversold (downtrend in progress), RSI turning back down and price rejected at its retest of the broken 200-dma. Looks like a recipe for a continuation lower.

U.S. Dollar chart, Daily

The US dollar looks ready to continue lower.

Gold chart, February contract, Daily

Gold has made it up through resistance from its moving averages and should be able to continue higher. Next resistance level is at its November high near 655.

Next week's economic reports include the following:

There are no pre-market reports so we'll get to see how the cash market reacts to some potentially market-moving reports at 10:00 on Wednesday. Construction spending and ISM will be scrutinized carefully for signs of growth or slowing. How the market reacts to that news is always a guess since we don't know if bad economic news will still be bullish (hoping for a Fed rate decrease) but I suspect most participants are starting to give up on the idea of a rate reduction soon.

Therefore bad numbers here could jolt the market to the downside. Watch the head fake move though--it could be an opportunity for the market to get jammed to the upside in order to get that bear fuel (short covering) to launch the next leg up. Then in the afternoon the FOMC minutes could move the market if there are any surprises (or rate reduction disappointments).

There are many people expecting a sell off in January to take profits and the bears are probably already positioned for it. If it doesn't happen right away, like it did in 2005 after rallying in December 2004 (a pattern the bears are hoping to see repeated) then I suspect many will jump out of their short positions and wait yet again for the next top. Any early sell off though could accelerate as people take profits/short the market in preparation for another January like 2005.

But we know what happens when too many expect something so beware any early selling that gets a quick reversal--it could carry quite a bit to the upside. The reverse is also true of course. Using January 2005 as an example, the day started bullishly and rallied nearly 90 points to match the December high before selling off sharply to end the day down -54 points. If nothing else, watch for potential volatility.

The SPX weekly chart, with the closing candle, shows price just hanging near its high with the threat of the oscillators rolling over. There's nothing bearish yet but by the same token I sure wouldn't want to buy this chart no matter what the time frame.

SPX chart, Weekly, More Immediately Bearish

And that's it. That wraps up a great year for the stock market and I wish I could say I see the same possibility for 2007. It's so much easier being bullish than bearish. I'm an optimistic person by nature and being bearish this market has me tagged as being a pessimist. Nothing could be further from the truth. I try to read the tea leaves and trade unemotionally and without a care as to which way the market goes. I can trade the short side as easily as the long side.

I've been way off on my call for a market top but I know I'm in good (bad?) company when I read a lot of market analysts I've come to respect over the years for calling it as they see it. One look at that shot up on the weekly chart from July says "blow-off top". And we know blow-off moves are irrational--lasting far longer than we can remain solvent trying to fight the move. It was a pure momentum play for those who stuck with the long side, helped by the Fed and their rapid increase in the money supply.

The question for 2007 is what happens next and I laid out as best I can why I think the bears will rule 2007. Trading the short side is more difficult than the long side because the buying spikes are much more difficult to deal with than selling spikes in a bull market. Volatility increases (with a higher VIX) and stop management becomes disproportionately more difficult. But we'll do the best we can here to help guide you through the mine fields. I hope you stick with us in 2007 as I see some very good money-making opportunities.

Happy New Year to everyone. Enjoy friends and family, don't drink and drive and we'll see you here next week. I'll see some of you on the Market Monitor on Wednesday where we'll try to catch the next move, and back here on Thursday when we'll hopefully be a step closer to identifying where that top might be. Have a great weekend.

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