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Market Wrap

Rates Don't Matter

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We've seen the market rally hard since last July and the reason we were given for the bullishness was because of expectations that the Fed would be close to reducing interest rates. As long as that belief remained true the market kept rallying. For the past month or two we've been hearing that the Fed is not interested in lowering rates and that instead they're more concerned about persistent (albeit it somewhat slowing) inflation rates above their target. Today the Fed came out and said there is no need to lower rates and that if anything they might have to think about raising rates. So what does the market do? Why it rallies of course. Hence the title, rates don't matter.

Well, of course rates matter since they'll have a longer term effect on our economy but you can see how the stock market looks for an excuse to fit what's happening to it. If the stock market could predicts what's coming 6 months down the road, as many believe, then it should have figured out that the Fed wasn't going to be lowering rates. And if lower rates wasn't needed to get the stock market to rally then why all the excitement last summer when we were being told that's the reason the market is rallying (in anticipation of lowered rates). Now the Fed says they continue to worry about inflation and the possible need to increase rates and the market rallies. Where's the logic? A logical market is of course an oxymoron.

I'll get a little more into the FOMC statement after covering the rest of the economic news. Between the economic reports and some other fundamental assessments I thought tonight would be a good time to cover what's happening in the market and why I continue to urge caution on the long side.

Economic Reports
Clearly the focus for the day was on what the reaction might be to the FOMC announcement this afternoon. The early morning economic reports were largely ignored. But there were a few of them.

Chicago PMI (Purchasing Managers Index)
The PMI contracted unexpectedly to 48.1 this month, down from December's 51.6. A number below 50 indicates contraction in the manufacturing sector and obviously not a healthy sign for our economy. It's another sign of slowing. The number had been expected to improve slightly to 52.0 so once again economists were surprised by the slowdown. These are the same economists who don't see a recession on the horizon. The more important number will be for the ISM (Institute for Supply Management) that comes out Thursday morning. The PMI is often a good indication of what the ISM will be and a number below 50 for that (it was 56.7 for December) would be a stronger indication of economic contraction.

Construction Spending
Construction spending fell last month by -0.4% and was again worse than the +0.1% gain that economists were predicting. This number is a little troubling because the warmer weather in December had been expected to boost construction spending. With the colder winter months upon us it means we could see that number worsen over the next couple of months.

GDP
The good news this morning was the upside surprise in GDP for the 4th quarter, growing at +3.5% and a nice jump above the +2% growth rate in the 3rd quarter. After listening to a piece by Paul McCulley at PIMCO I thought he made a few good points worth passing along. He was interviewed yesterday and discussed what he thought GDP would be and where it's likely headed. In short, the point made by McCulley was that we would see a surge in Q4 GDP because of the much warmer than usual weather which greatly helped the construction business and specifically the housing market.

McCulley made two points that are worth mentioning here: one, the warmer weather helped keep the construction business going longer than normal; two, the drop in bond yields from the summer peak helped prime the economic pump. This second point is the more important one and the drop in yields was the bond market anticipating an economic slowdown which would cause the Fed to start easing rates soon. These two factors were cited by McCulley as the single most important factors goosing GDP for the 4th quarter. After bottoming in November the bond yields have retraced about 62% of that drop (in recognition that the Fed will not be easing anytime soon) and in so doing they broke the downtrend line in yields from the June high. Stocks have yet to break their uptrend line and that's where we currently still have a disconnect between the stock and bond market.

Now we enter the 1st quarter with colder weather and higher interest rates. The expected slowdown in construction, particularly the housing market (which will obviously also be hurt by the higher rates), and the tightening in the credit market will likely cause the GDP to contract sharply again. Once the stock market starts to grasp this concept we will (should) see a decline as the reality of slower growth sets in.

Speaking of rates, here's an update to the 10-year yield chart:

10-year Yield (TNX), Daily chart

Both the 10-year and 30-year (TYX) pushed above their respective 200-dma's but pulled back today. Post FOMC we saw a further drop in yields but they both found support at their 10-dma's which have supported the brief pullbacks since the beginning of January. As you can see, TNX has almost retraced 62% of the decline from last summer (TYX has retraced 62%) and therefore the big question here is whether or not yields will now turn back down again in anticipation of an economic slowdown and eventual Fed easing. For the short term it's looking like yields may pop a little higher (McCulley speculated that we could see 5% before they peak at least for the short term, at which point he said he would probably be "writing a lot of buy tickets for bonds").

Consumer Price Index
As part of the GDP report we got some CPI numbers that should be very encouraging for the Fed. Between the higher GDP number and lower CPI I'm sure the Fed governors will be high-fiving each other on what a masterful job they're doing. CPI dropped an annualized -0.8% in the 4th quarter which makes for the first quarterly drop in 45 years (1961) and the biggest drop in 52 years (1955). While that will do wonders for dropping the longer term rate which the Fed wants to see, we don't want to see too much of that otherwise it raises the specter of deflation. For all of 2006 the economy grew +3.4% which was an improvement over the +3.2% in 2005 but a little less than the +3.9% in 2004. All in all, a pretty steady performance by the economy.

The core personal consumption expenditure price index (PCE), which excludes food and energy prices, rose +2.1% which is slightly above the Fed's target rate of 1%-2% so that one still needs to come down a little more. The good news for the Fed is that that rate has been declining slowly over the past several months so again, high fives for the Fed (for now). The core inflation rate is up +2.3% in the past year, down from +2.4% in Q3.

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Consumer Income, Spending and Savings
Disposable personal income (DPI) rose +5.4% annualized and this is good news. With the credit crunch, housing slowdown and lower mortgage equity withdrawals (MEW), consumers need higher "normal" income in order to sustain a spending level that continues to be supportive of the higher GDP numbers. The good news/bad news about the personal savings rate is that it is less negative. It improved from -1.2% to -1.0% from the previous quarter. It has been running negative for two years.

Consumer spending rose at an annualized rate of +4.4% for the 4th quarter, following a +2.8% rate in Q3. Spending on durable goods was up +6% and on non-durable goods it was +6.9%. Spending on services was up only +2.9%. All this spending contributed a little over 3% to the GDP number so you can see the importance of consumer spending. Residential investments did not do as well, down -19.2% which made for the largest drop since 1991. Housing expenditures subtracted 1.2% from GDP. So you can see the double-whammy potential here if consumer spending drops AND housing investment continues to drop.

The only other number to report was the Employment Cost Index which showed costs rose +0.8% in the 4th quarter, a slight increase from the +1.0% in Q3. Employment costs, which includes wages and benefits, are up +3.3% in the past year which is down slightly from +3.5% in 2005. This is helpful for the Fed in their inflation-fighting efforts as it's an indication that we don't have a tight labor market which would cause wage inflation.

The consumer spending and negative savings rate that I mentioned above is worth additional discussion because it is unfortunately a sign of the times for us and our country. The government, businesses and consumers have been binge spending for a number of years now and we're due for a hangover. With the asset bubbles that have been created over the past decade (stocks and real estate) we've seen a significant increase in the wealth effect from these assets, particularly housing, which has spurred lots of spending and accumulation of debt.

As a side note I thought yesterday's story about Carl Icahn and his maneuvering to get himself on the Motorola's board of directors was interesting. I found his comments about cash vs. debt very telling about our current situation. In a nutshell he was saying Motorola is foolish to sit on its $11B cash pile and should instead spend it (acquiring other companies and spending on other investments) and utilize debt more strategically. The message here is that cash is bad and debt is good. Does that strike a familiar ring to what's been going on in our country?

While on the one hand Icahn's point is valid--you can certainly leverage yourself much more with debt than with cash. But that's the trouble, or at least vulnerability, that I see for us currently. With liabilities far in excess of assets we have built ourselves a house of cards (this is true for the government, businesses and consumers). Everything is wonderful as long as no one sneezes. Hurricane Katrina will look like a light breeze compared to the hurricane forces waiting to blow down our house of cards.

The Fed's willingness to inflate asset bubbles with their easy credit and excess liquidity has propped up one asset group after another. The trouble for us now is that after the real estate bubble there's little else to inflate (although they've done a fine job on the equity market again since last July). All this excess liquidity will continue to help keep the house of cards standing as long as there is demand for the easy money. Once demand dries up so will credit. With a credit contraction comes recession (lack of demand for goods results in a drop in production and wages, etc., etc.). As Steven Roach of Morgan Stanley commented, "The Fed, in effect, had become a serial bubble blower."

Speaking of the Fed and their money creation, here's the latest M3 money supply chart:

Calculated M3 money supply, Weekly chart, courtesy nowandfutures.com

The light blue line, annualized rate of change, dropped last week and we saw a market decline. So far this is showing a pretty close correlation between the money created by the Fed and what the stock market does within the same week or a few days later. With the market getting goosed this week, especially post-FOMC it will be interesting to see what the numbers look like at the conclusion of this week.

Back to the discussion on debt, and for a sense of how much debt we're in and why we're more vulnerable than at any other time in our history, one only needs to look at what's been happening since 2001 where overall indebtedness for private households has surged by 66%. Rising home values fully supported this surge (home equity withdrawals) and the surge in home values has been extremely critical to the well being of the private households. Therefore any reduction in the value of homes will have a very deleterious effect. We have no savings to support us in bad times.

With a drop in home values, or even the fear now that home values will not continue to increase as they have, home owners and prospective homeowners have applied the brakes to their borrowing. Mortgage financing peaked in Q3 2005 at an annual rate of $1,224B. That rate dropped to $673B in Q3 2006, for a 45% drop. Without this priming of the economic pump by the home industry the Fed has felt the need to step in, and Helicopter Ben is doing what he promised he would do. The downside to his efforts of course is devaluing the US dollar and creating an inflation problem. Something will have to give soon. And as consumers slow down their spending the Fed will simply not be able to compensate.

Our economy right now has been supported by excess liquidity and credit growth, which is a change from our past when credit growth was tied to economic growth. But since the 1980's we've seen credit growth far outpacing GDP growth. As an example, credit expansion in 2000 was $1.6 trillion while in 2005 it was $3.35 trillion while GDP grew by $0.7 billion. That's a huge discrepancy and says it required $4.50 of new credit to add $1 to GDP. At the same time the national savings rate dropped from $583 billion to $7 billion. We have borrowed ourselves into prosperity, but at what cost? Where's the beef?

History shows that every financial crisis was preceded by excess liquidity as we're seeing in this country now. Whether it was leading up to the 1929 crash or the Japanese crash in the 1980's, the situation was the same as we're seeing currently. History is not kind in this regard. We've seen asset bubbles as a result of excess liquidity and the bursting of the bubbles will lead to liquidity destruction and excess debt (in other words we'll lose the value we think we have in our assets and be left with the debt we've incurred to gather those assets). This is a result of the total disregard for financial risk that we currently see in all markets (such as the extremely low VIX).

FOMC Announcement
The big news today of course, not that it was really big news, was the FOMC announcement. No surprise, rates were left unchanged at 5.25%. The Fed funds futures, at 94.75 through June (100 - 94.75 = 5.25%), continue to support the view that the Fed will stay on the sidelines for the next few meetings. Also not a surprise, considering the number of Fed heads out in the past month jawboning the market about the need to stay vigilant on inflation, the Fed's statement included wording to this effect. They shifted some wording slightly from "growth has slowed" to "firmer economic growth" and from "substantial cooling of the housing market" to "tentative signs of stabilization have appeared in the housing market."

Their vote was unanimous and they repeated further tightening may be needed as core inflation has improved slightly but remains above their target rate. That keeps them cautious about the inflation rate while the economy's growth and improving housing market puts pressure on inflation. As they stated, "...the high level of resource utilization has the potential to sustain inflation pressures."

Market Vulnerability
I wanted to highlight this section because of all the bullish hype we're hearing out there right now and while many of you will think of me as just a permabear who can't see the reality of this bullish market, I can only say that those who chase this market higher do so at a very high risk. I've outlined over the past few months why I'm bearish this market. I highlighted some fundamental reasons for it above and I show in charts why we're very close to topping out.

John Hussman's weekly commentary in mid January highlighted why he believes the market is vulnerable to a nasty correction. He identified four measures to identify an overvalued, overbought, overbullish market that's under yield pressure. He calls it his "Ovoboby" measure. These are his criteria:
Overvalued: S&P 500 price/peak earnings greater than 18
Overbought: S&P 500 at a 4-year high and at least 5% higher than its level 6 months earlier.
Overbullish: Investors Intelligence percentage of bullish advisors above 53%.
Yield pressure: 3-month Treasury yield higher than its level 6 months earlier.

While the 3-month Treasury yield is essentially where it was 6 months ago it is at its high. The other three criteria have been met and therefore we are now at his "ovoboby" point. As he identified in his research, these occasions resulted in rather swift breakdowns in the market. As examples he cited -10.5% in 30 days, -12.3% in 50 days, -36.1% in 38 days, and more examples like that. The first several days of decline typically wiped out weeks and sometimes months of gains.

Hussman also compared our current market to the late 1972-early 1973 market. After declining sharply to a new low in 1971 (looks like the 2000-2002 decline) and then streaking to a marginal new high in 1972 the DOW crashed nearly 50% to a new low in 1974. At the new highs in 1972-1973 there was a Barron's annual investment "roundtable" with the accompanied title "Not a Bear Among Them." The latest roundtable just published by Barron's reflects the exact same sentiment.

Hussman remains defensive on the stock market because of this and says the negative outcome often comes quickly on the heals of an otherwise good looking market that has repeatedly produced marginal new highs. Does that sound familiar? And for the past couple of months now we've been seeing huge disparities between insider selling and buying, with the selling outpacing buying in excess of 100:1. It hasn't been this bad since just before the stock market crash in 1987. Caveat emptor on this market.

With that, and the big rally today, let's see what the charts are telling us.

DOW chart, Daily

Ho hum, a new all-time high for the DOW today. But looking at the potential ascending wedge that's forming, especially with the progressively shallower highs since the end of December and the continuing bearish divergences, it's just a matter of time. This market has been murder on bears trying to short this market as it keeps pressing to "one more new high". It's a very slow top in the making, that's for sure. But when it breaks, and it will, people will look back and wonder how they could have missed the setup. It's so easy in hindsight and I'm still working on perfecting that trading module. It works so well when I back-test it but I can't seem to get it to work in real time.

SPX chart, Daily

Just like the DOW--ascending wedge, bearish divergences, broken uptrend line, retesting from underneath, and just waiting for it to break down. Both the DOW and SPX finished the month of January in the black so now the Boyz can crow about "as January goes, so goes the year" in hopes of pulling the sheeple in to buy their inventory as they prepare for a market swoon into spring.

Nasdaq chart, Daily

The techs rallied as well today but unfortunately there's nothing bullish about this chart yet. The COMP stopped at resistance again at the top of its congestion near 2470. After dropping sharply from its January high we've seen price consolidating in what looks like a continuation pattern for more lows. A break below the January 26th low at 2418 should be followed by some fast selling.

SMH semiconductor holder (ETF), Daily chart

The semis are part of the "beef" problem, as in "where's the beef"? A rally without the semis will always be suspect. The price pattern since last August reminds me of a rolling top and the leg down from this pattern should look like the leg up in July/August.

BIX banking index, Daily chart

Right on cue the banks bounced off the 100-pma and uptrend line from October 2005. That's an important trend line and not at all surprising to see a bounce off it. Assuming the broader market will be able to push a little higher into next week I see the bank index making it up to around 405 for a 50% retracement of the decline from December. The leg down looks impulsive and the bounce appears corrective so far. That's a recipe for a continuation of the decline once the bounce finishes. Watch for a setup to short this index (or your favorite weak bank).

XBD broker index, Daily chart

I often mention Mother Merrill (MER) on the Market Monitor since there are still many floor traders who watch Mother. If MER is not in synch with what the broader market is doing then they fade the indices. For that reason I like to watch the broker index as well since I think it will provide a good heads up for what's coming. Right now it looks like we might have seen a top but if true we should see this index turn around and head for new lows now. It should break the 50-dma quickly. Otherwise a continuation higher to a marginal new high is just as likely from here.

Question: What's another name for a California real estate agent?

Answer: A waiter

OK, that was mean. And to my California realtor friends (Denise), my apologies. But hey, the home builders are doing well lately and everything is fine and rosy. We're going to have a stellar spring selling period and life is wonderful. If you believe I believe that then I have some explaining to do.

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

There's still a lot of hope out there that the improved numbers from December (due to warmer weather) will spill over into the spring selling season. We don't have much more than hope supporting that view but hope is where bear market rallies come from. The current rally in the home builders is not exception (imho). How far the bounce will go is not clear but I have the 779 area and then 838 area as potential upside targets if they can keep this rallying for another few weeks. Otherwise, like the broader market, the risk for bulls is a downside surprise at any time.

There was a report on housing vacancies that came out earlier in the week and it mentioned the number of vacant homes that are waiting to be sold jumped 34% to 2.1M at the end of 2006 as compared to the number at the end of 2005. The vacancy rate for owned homes now stands at 2.7% vs. 2.0% a year ago. This is of course a large number of motivated sellers who are likely holding on in hopes the spring selling season will bail them out. I've been there--two mortgages and a bridge loan and I can tell you what it's like to bleed and be a motivated seller. This vacancy rate has consistently stayed below 2% with a long-term rate of 1.4% from 1965-2000. The jump to 2.7% is very significant and one more sign of the difficulties facing sellers this spring.

One of the effects from all these vacant homes, if they stay on the market longer than the seller can stomach (or afford), is that many will be turned into rental units (been there also). The effect of that is that it could put downward pressure on rental rates (good for renters and good for the Fed's inflation numbers, but bad for the landlords). Consider all these things as you make your own housing plans for the spring. I remain convinced that the housing market will drop precipitously starting in the spring.

Oil chart, January contract, Daily

Oil has bounced stronger off its low near $50 than I had expected. This is somewhat typical of commodities which seems to "suffer" more from emotional trading. I'm still expecting a turn back down to a new low after this bounce completes. The bounce will have two equal legs up at $58.64 so if you like to trade oil keep an eye on that level for a short play to set up. If oil keeps heading higher then it will likely find strong resistance by its 509-dma and downtrend line, both near $60.

Oil Index chart, Daily

After a strong decline off the December high I'm expecting the current bounce to be just a correction of that decline that then lead to a continuation lower. The current bounce, if it can press a little higher, could find resistance at the 62% retracement of the decline, at 646.48. But, like the rest of the market, it's in the Fib resistance zone and could top out at any time.

Transportation Index chart, TRAN, Daily

Nice rally! The Trannies broke above both the January and November highs and could have their sights set on the May high just above 5000. But I also see the possibility for the current move up to finish in a truncated 5th wave in the EW pattern. That would be an end of the rally without a new all-time high. That's a bit of speculation at the moment but it would be fitting and would continue to support the DOW Theory non-confirmation.

U.S. Dollar chart, Daily

The US dollar looks ready to roll back over and should work its way back down towards the bottom of a large descending wedge that's visible on the weekly chart. If that pattern is the correct interpretation of the long term pattern then it suggests we'll see a big rally in the dollar later this year. But for now we've got a bearish setup for a move down towards $81. That should help gold over the next month or two.

Gold chart, February contract, Daily

Gold has broken its downtrend line from July and it found support on a pullback to the line as well as at its 10-dma, both of which are bullish. It looks like we should see gold press higher although the caution here is the overbought oscillators. We could see another slightly deeper pullback before it presses higher again. But I'd rather be long gold than short.

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

Tomorrow's reports could move the market a little bit, especially the ISM number. If it comes in below 50, mirroring today's Chicago PMI number, then the fear of a contracting economy could spark worry about earnings growth. Of course, if that sparks speculation in a Fed rate decrease, well then...

I think it's more likely we'll see some price consolidation on Thursday so I suspect we will not see much of a reaction to the economic reports (if anything it might cause a bit of selling).

The weekly chart shows price sneaking its way higher towards a possible Fib target at 1455.

SPX chart, Weekly, More Immediately Bearish

A shown on the daily chart above, the past several weeks are creating an ascending wedge as price has slowly inched higher in the past month. Based on some shorter term Fib projections for the move up I'm not sure SPX will make it that high. If we get a pullback Thursday/Friday and then another push higher into next week, start watching some Fib projections I have in the 1447-1448 area for a potential high. So it's a little wide but I like the 1447-1455 area as the zone for finding a top. Depending on what vehicle you use for trading, and with a high of almost 1442 today you can see we're very close (if I've got the right numbers). It doesn't mean it will be THE top but it does mean the setup is there to try it again.

The DOW has a very similar short term pattern as SPX and it looks like we're due a minor pullback Thursday/Friday and then a final small push higher into next week. I've got upside targets for the DOW near 12700. It's also possible, but is not my preferred EW count, that today's high was the end of the run. It will be important to watch any pullback now--if it starts declining rapidly in an impulsive fashion (no overlapping highs and lows) then it becomes more probable that we've put in an important high.

But if we see a sloppy choppy sideways/down consolidation then we should expect another push higher out of it. That new high is the one I would like to see as I think it would be a very nice setup for my next attempt at a long term short position. This one might actually stick for a few months (I was going to say years but I don't want to get ahead of myself). Bottom line for me, as mentioned above, is that this is not a time to chase this market higher.

Good luck in your trading and hopefully we'll have a little better idea when I'm back here next Wednesday. In the meantime I'll try to call where we are on this with the intraday updates on the Market Monitor. See you there.
 

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