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Market Wrap

They're Baaack!

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Just like the rallies in the good ol' days in the last half of 2006--we saw the stock market run up with nary a pullback along the way the past two days until this afternoon. Once again this had the footprints of the Boyz all over it. And another all-time high for the DOW. Yawn, what's for dinner? As you can see though, it was a strong day for the market--total volume was a strong 5.8B shares and advancing volume and issues were better than 2:1 over declining volume and issues. New 52-week highs swamped new lows. It certainly looks like the launch of a new rally leg and of course that's what's needed to suck in the new bulls.

As I had mentioned in last week's report, the pullback from the December high appears to be over and now we're getting the move up which should give us new highs across the board, at least for the major indices. The techs finally broke out of their sideways trading range for the past six weeks and pushed to new highs. They've been acting more bullish this month, as opposed to last month, and they gave us a good heads up that we could see an upside breakout.

But I think the bigger story this week is the continuing decline in bonds, which is forcing yields higher, and the crash in commodities. I'll cover those in a little more detail tonight since I think there's a message to the market here. And when I say market I mean stock market since that's what most of us trade. As usual, as evidenced by today's rally, the stock market has a mind of its own and doesn't look twice before crossing in traffic.

Higher interest rates because of higher than desired inflation and crashing commodities because of lack of demand (potentially) due to a slowing global economy is not a healthy combination for the stock market. But we trade what we see and not what we believe. As soon as you try to trade what you believe you will drain your trading account in a heartbeat. Been there, done that, couldn't even afford the t-shirt.

The way the market is progressing here I'm getting the impression we're going to see a market high next week, appropriate for opex week if it happens. I'll discuss why I think that as I review today's charts.

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In the meantime we had only one economic report today which was Initial Claims. The report showed some strong employment numbers with initial claims dropping by 26K to 299K which is the lowest level since July 22nd and much lower than had been expected. The caution here is that this number can jump around quite a bit in December and January due to holiday hiring practices. The 4-week average dropped by 1,750 to 314,750, the lowest since November 11th. Continuing claims fell 3K to 2.43M, which is the lowest level since October 21st, and the 4-week average fell 11,500 to 2.43M, the lowest since December 2nd.

There was a surprise announcement from the Bank of England (BOE) this morning as they raised their benchmark yield +0.25% to 5.25% which follows two rate increases in the last half of 2006. The timing was a surprise and they said it was because of strength in their economy. Meanwhile the European Central Bank (ECB) is holding its key rate at 3.5%. With the BOE now on par with the U.S., and concerns about a Fed forced to stay on the sidelines, U.S. treasuries took a hit today (as recognition hits home that we're probably not going to get a rate cut by the Fed any time soon). There could be a little more competition from England now for investments since they're paying the same as U.S. and some have already expressed an interest in diversifying out of US dollars. That would further depress our Treasury prices.

Both the stock market and the bond market have been under the assumption that the Fed will be lowering rates soon. They've been under this assumption since last summer, even while the Fed has consistently stated it's not going to happen soon. The bond market seems to be getting it now. As for the stock market, well, as I said earlier, they're still in lala land and life is good.

The Fed funds futures are now showing next to no chance for a rate cut in February and only a slightly better than no chance for a rate cut in March. So the expectations for a rate decrease in the 1st quarter of 2007 have essentially evaporated. This has caused yields on US treasuries to jump higher as the bond market sells the news..

10-year Yield (TNX.X) chart, Daily

After breaking its downtrend line from the June high, the 10-year yield came back for a retest and made a new high today. It was also a retest of its broken 50-dma and this successful test of its 50-dma puts it on an intermediate-term buy signal (sell signal for bonds). It has also climbed back above its broken uptrend line from June 2005. The next hurdle on this chart is its previous high of 4.848% in October and its 200-dma at 4.855%. Needless to say, a rise in interest rates will hurt the housing market, and economy, although you wouldn't have known that by the rally in the home builders today. Lala land over there too.

Another thing we've been watching is M3 money supply which is calculated for us by nowandfutures.com since the Fed has stopped reporting it directly.

Calculated M3 Money Supply, Weekly, courtesy nowandfutures.com

Interestingly the rate of growth (light blue line) dropped fairly sharply last week. Without a lot of new money coming in we did see the market sag, which raises the question what happens when the Fed is forced to curtail their money-making operation. They won't be able to continue creating money at a faster and faster pace, which the rate of growth has been showing here, without creating all kinds of hyperinflationary problems. So eventually the rate of growth will slow and the prop that's been under the market will be taken out. I'm anxious to see what this week's numbers look like (this chart is updated at the end of the day each Friday).

With the huge influx of money coming into the monetary system over the past few years we've seen all asset classes benefit as the excess liquidity bought anything that moved. The recent crash in commodities is saying we might have had too many leaning on the long side.

Commodities (CRB Index) chart, CRY, Weekly

The sharp decline in the commodity index, and impulsive move (you can see a clear 5-wave move on this chart), tells me we have a trend change here. This is a weekly chart so that decline is over the past 7 months but still it's relatively fast. I show a parallel down-channel for the move so a drop to the bottom of the channel would be down near 260.

For Elliott Wave (EW) fans I have the wave count on this and show it to be in the 5th wave of the move down from its high in May 2006. The first downside projection was 286.72 which is based on equality between the 1st and 5th waves. But one thing to be aware of with commodities is that the 5th wave often extends and that's where the projection to 264.57 comes in, which happens to be at the bottom of its channel. I don't know if it'll get down there but the shorter term pattern for this 5th wave down suggests it just might. The caution here for bears is that a 5-wave move is ready for a correction so once this decline is finished we should see a multi-month upside correction to this decline.

There's been lots of conjecture about why commodities have been selling off so hard. As I mentioned above, there's been an excessive amount of liquidity in the market, not to mention cheap lending, and commodities have been a hot item for a few years. Many expected the party to continue and what we've been seeing is bulls disgorging themselves of positions before they lose all their profit. Fear is one of the more powerful emotions that drives these markets. Greed of course is right along side fear.

The other reason, one which I believe, is that we're seeing a slowing in the global economy and the slowing demand for raw materials is causing a selling in the commodities. If ever there was a canary in the coal mine, this is it. Many will argue I'm full of donkey dirt and that's fine. It's just my opinion based on a lot of study, and Elliott Wave patterns.

But the stock market is stuck in high gear as it heads for the cliff. What's a shame is that the passengers in this bus are oblivious to the approaching cliff.

Goldman Sachs Commodity index vs. Natural Resources Fund, courtesy Hosington Investment Management Company

This chart, which I dug out of John Mauldin's January 8th report, was from a reprint of "Quarterly Review and Outlook Fourth Quarter 2006" by Van R. Hosington and Lacy H. Hunt, Ph.D., shows the disconnect between the stock market and commodities. The canary has died and yet the miners continue to blast away at rock.

The Goldman Sachs Natural Resources Fund iShares had tracked their Commodity Total Return Index very closely until about October 2005. Since that time the commodity index started to taper off and has been in a nose dive since this past summer. If you look at the stock market, it rallied from its October 2005 low, pulled back in May and June 2006 and then took off like a bat out of hell in July. The Natural Resources Fund rallied with the rest of the stock market even though the underlying fundamentals for this fund were clearly lacking. This is a big correction waiting to happen and I don't think it will be commodities rallying to catch up. Commodities are due a bounce but probably only back up to where they were in November (the last little bounce before dropping to its current low.

DOW chart, Daily

After briefly breaking its uptrend line from July the DOW has made it back up to it (and slightly above). What we'll watch carefully for now is to see if this will be a kiss goodbye or a continuation higher. short term it looks like we'll get a pullback and then another press higher into next week. We know how long this can continue to press up against its broken uptrend line--if you'll remember the break of a slightly steeper line that was broken in November and then it just kept pressing higher underneath it for another month before establishing this latest uptrend line that just broke. Several Fib projections off the wave pattern in the rally June all point to 12630 which adds to my confidence that we'll see this rally top out around there.

SPX chart, Daily

SPX was relatively weaker than the DOW in that its break of the uptrend line from July was a little more significant. It is also showing a clearer failure to get back above the broken uptrend line and may be a clean kiss goodbye if it drops back from here. It's bullish that it bounced off its 50-dma but bearish if it can't get back above its uptrend line. As I mentioned for the DOW, the short term pattern looks like we're due a pullback and then a final high into next week. I show this in the following chart:

SPX chart, 60-min

The corrective pullback from mid-December should be complete, as an A-B-C correction. Price stalled at the top of the bull flag pattern (the downtrend line from December 15th) and its broken uptrend line from July (shown on the daily chart above). I'm expecting a pullback tomorrow but we should get another push higher to finish the final 5th wave of the rally from July. Once this move up completes we should be at THE high for the rally.

At this point we could finish at any time, including today's high so we're at a very risky point for bulls. If the DOW can press higher to 12630, after pulling back first, then SPX should be able to make it up to just shy of 1440. There is a longer term Fib projection to 1451 so that's also a possibility. It depends on the relative strength between the DOW and SPX. But again, we're not far away from some nasty market surprises.

NYSE chart, Daily

NYSE could provide some early clues as well. Its uptrend line from July through the September 11th low was broken January 5th and was retested today. Today's high (9091) was also a test of its broken 20-dma (9096). Its 10-dma (9066) has crossed down through its 20-dma and price closed below it today (9063). It did bounce off its 50-dma (8971) yesterday so it's a battle between the moving averages and trend line. Obviously a drop back below its 50-dma from here would be bearish.

Nasdaq chart, Daily

The sideways consolidation since November turned out to be bullish as expected. Now previous resistance at 2470 should act as support on any pullback. Upside potential is to its broken uptrend line near 2530 if it can get through 2500 which is a Fib projection based on the 1st wave of the move up from July. At this point I'd say a drop below its 50-dma would tell us a high is in and to start looking to short all rallies. For now this is clearly bullish.

The big cap index (Nasdaq-100 or NDX) also broke out of its pullback consolidation but ran into its broken uptrend line from April 2005 through October 2005. This trend line was broken during the May 2006 decline and held back the rallies in November and December. It tagged it at today's high of 1840.88. The last time it did this was in mid-December and led to a very sharp sell off so that's the risk for bulls as I look at that chart. But it also looks like it could use a small pullback and at least a minor high next week.

SMH semiconductor holder (ETF), Daily chart

The choppy pullback from November looked bullish and now we see the breakout. It almost made it back above its broken uptrend line from July but pulled back and closed on the line. If it can push a little higher then it's possible we'll see it press up to $36. A failure here will look like a kiss goodbye.

BIX banking index, Daily chart

Whenever you see the banks not supporting a broader market rally you need to pay attention. The lack of participation here is worrisome. The small bounce over the past few days looks more like a bear flag than anything else and suggests it will continue lower, breaking its 50-dma. That would be a heads up for what the broader market will likely do next.

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

The top of the parallel down-channel and the 50-dma near are providing support just under 700. It looks like this could continue higher. But with price stopping at the 10-dma it bears watching here. If the 10-dma presses this back to a new low we probably have the sign bears need to indicate that the trend has changed back to the downside, especially with a firm break below its 50-dma.

Oil chart, January contract, Daily

Along with the discussion of the commodities above, oil is right there with the rest of them in breaking down here. There have been many oil bulls for various reasons and this collapse in price is a clear case of too many bulls not expecting a sell off. They're jumping out at a furious pace now and this could make it down to the bottom of its new parallel down-channel, currently near $49 and dropping fast.

Oil Index chart, Daily

Unlike the Goldman Sachs Natural Resources iShares Fund discussed above, it looks like investors in the oil stocks are bailing more quickly. The same thing will probably soon happen to the iShares fund. With price slicing right through its 50-dma and now 200-dma it looks like this will make it down to its uptrend line from October 2005. If October 2005 sounds familiar, that's the time the commodities index and the GS iShares fund started diverging. I don't think this uptrend line will hold but it should be good for a big bounce. Short term we should see a minor bounce before this continues lower to the trend line.

Transportation Index chart, TRAN, Daily

The Trannies look bullish here by breaking the downtrend line from November. Just above this is its 50-dma so watch price action around that level (4711). I don't think the Transports are headed for new highs so this bounce should be a good opportunity to pick on your favorite weak transportation stock to short it.

U.S. Dollar chart, Daily

The US dollar is much stronger than I thought it would be and it appears to be catching some dollar bears on the wrong side. The top and bottom trend lines on this chart identify a potential descending wedge for the dollar and I expect the bounce to fail at its 200-dma or that upper trend line (so around $85.50) and then chop its way lower again towards the bottom trend line. Longer term the descending wedge is a more bullish pattern for the dollar which is an interesting development here. In the meantime, if the dollar peaks and starts heading back down it should help all commodities, including oil and gold.

Gold chart, February contract, Daily

Gold looks like it should head a little lower and its uptrend line August 2005 near $600 should be good support to launch the next rally leg. I'd be a buyer at $600 and then we'll watch what happens if and when it reaches its downtrend line from July again.

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

It'll be a little busier Friday morning for economic reports but other than retail sales there may not be much in the way of market moving news. If the retailers disappoint then Thursday's rally could get reversed (which I'm expecting anyway).

SPX chart, Weekly, More Immediately Bearish

With weekly oscillators rolling over and giving sell signals, even with price holding on, it's not looking so good for the bulls here. This can certainly turn back up but is that the way you want to bet your money?

As discussed above I expect to see a pullback against the past 2-day rally but it should only pull back to a 38-62% retracement zone. Then we should get another leg up into next week. I think we're now very close to a market high and it could literally show up at any time, including today's high. The risk is clearly for the bulls in my opinion. Next week, opex week, is setting up to be a volatile one where we could see a new high followed by a sell off. Opex shenanigans could exacerbate any moves so it'll be a time to be extra cautious. If we do in fact top out next week we'll have plenty of evidence and a bounce to position on the short side. You don't need to be a hero and grab the top.

Having said that, I think we're at a point again where I would look at adding some longer term short positions. Go out many months for long put options and look at some February/March bear call spreads. If you buy yourself a lot of time on your long puts you can use short term bottoms to sell front-month puts (create a bull put spread) and cut your cost basis down. There are a lot of ways to skin this cat so start thinking about how you want to play the short side. Don't get aggressive here but start nibbling.

Good luck and I'll see some of you on the Market Monitor and the rest of you back here next Thursday.
 

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