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Market Wrap

The Fed Giveth and the Fed Taketh

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What was perceived as bullish in the FOMC statement last week was perceived a little differently today when Bernanke spoke before the congressional Joint Economic Committee. While he said the U.S. economy will probably achieve moderate growth this year, with a gradual reduction in the inflation rate, he acknowledged the risks from the contraction in the housing industry. Nothing new there. But then he went on to reiterate the Fed's stance on inflation and both the bond and equity markets tanked.

Bernanke said the big risk that they're concerned about is that "core inflation remains uncomfortably high." He did add that core inflation "seems likely to moderate gradually over time." Too late, everyone hit the sell button. The problem is we've had a couple of Fed governors speak, since the FOMC announcement last week, of their concern about inflation rates, how they're more worried about it than economic growth, etc.

This has been such a consistent message that quite honestly I'm not sure how the market is getting mixed messages from the Fed. They're saying "read my lips--no rate cut!" As long as we continue to have a credit (liquidity) expansion, the risk will be inflation and the Fed will go down in flames fighting the inflation monster. All those who will lose their jobs or businesses or houses? Sorry, we're fighting the inflation monster; you're on your own. Continue to keep an eye on the bond market since that's where we should see how close the Fed could be to relaxing interest rates.

I'll show the chart of the 10-year yield again as we watch these rates for some clues.

10-year Yield (TNX) chart, Daily

The uptrend lines from June 2003 and June 2005 are important. They've been tagged several times and it's obvious they're support. Should they break then it will be telling us the Fed is probably getting closer to dropping the Fed rate. In the meantime, even though the bond market has been as bewildered as the stock market, it's looking like we could be starting a new uptrend. The higher these rates go, the more painful it will become for the housing industry, and the more it will cause a slowdown in the economy.

Speaking of housing, Jim covered the problem very well in last night's Wrap. The "food chain" starts with the first time buyer and without him/her, there is no chain. An article not long ago by John Mauldin (highly informative free newsletter) referred to the "Plankton Theory". All sea life, which feeds on other sea life, is totally dependent on a healthy plankton population. Take away the plankton and our oceans would be in a world of hurt. So, take away the first time buyer and our housing industry is going to be in a world of hurt.

In a Sunday night update on the Market Monitor I had used the analogy of a column of blocks, each block representing the various buyers with the poorest (first-time) buyer as the bottom block and the super rich as the top block. Take away the first time buyer and the whole column collapses. This is why it astounds me that economists, including the Fed, say the subprime problems, and the tightening of credit standards, will be contained within that small group affected by this. Hello! I don't eat plankton but I do like salmon and I know they eat other creatures who ultimately depend on plankton.

In addition to the first time buyer, the tightening in credit standards will affect everyone. I know many people with great credit ratings who got 80/20 loans, interest only, negative amortization, etc. and those kinds of loans will simply dry up. Even if you have a good credit rating the banks will be insisting on the kinds of credit standards most of us had to abide by not many years ago. This will significantly reduce the available pool of people who can afford today's high-priced homes. The buying pool of people for homes will shrink, pure and simple, and with more and more homes coming onto the market it's just going to make the supply vs. demand ratio that much worse for sellers.

During the housing boom everyone was talking about how beneficial it was to the overall economy. The number of new job created related to the housing industry accounted for about 2 out 3 new jobs created when housing was booming. Economists generally agreed about the addition to GDP from the housing industry. Now that housing has slowed down significantly these same economists say there will be little impact. These economists have their noses 2 inches from the numbers and haven't looked up to see what's happening.

As Bernanke stated, "Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy." Maybe these people have too much schooling and all that book knowledge replaced common sense. I'm being super critical here and I apologize if my remarks offend anyone (as I know they have) but my goodness am I missing something here? How can housing be so helpful when it's booming but have no ill effect when it's crashing?

To be fair though, Bernanke did acknowledge this risk in further comments. He said the downside risks to his moderate growth outlook include the "substantial correction in housing" and that many individuals could experience "severe financial problems". But that's a concern about those individuals who get caught in the mess the Fed created (with their easy money and credit policies and encouragement of the use of adjustable rate mortgages right at the time the Fed started raising rates).

Bernanke continues to feel the subprime problem will be self contained. As he said, "The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." Mr. Bernanke, I strongly suspect those words will come back and haunt you.

Bernanke defended his stance that the economy should continue to experience moderate growth and refuted Greenspan's comment about the risk that we could have a recession later this year. He commented, "I would make a point there seems to be a sense that expansions die of old age. . .I don't think the evidence supports that." Unless I'm misunderstanding his comment it would appear he is refuting the normal business and economic cycles as if to say he can stop the down cycle. First Greenspan says he can stop the Kondratieff cycle (54 year cycle) and now Bernanke says he can stop any contraction in growth (recession). The arrogance of these people is really mind boggling. The market will prove them wrong eventually and the longer they try to hold this up with easy credit and monetary stimulation, the harder the fall will be.

Another risk to the moderate growth scenario that Bernanke mentioned was capital spending. He commented on the February durable-goods number which showed further slowing and this is one of the better leading indicators (companies slow down their capital spending when they're unsure of the immediate future, just as people will start saving when they think there could be trouble ahead).

But Bernanke expects the capital spending to improve later this year. I'm not sure that's wishful thinking or something he knows but is not telling us. He probably thinks those pallets of cash he has slung underneath his helicopter will be used to save the day. Little does he realize (apparently) that he won't necessarily be able to stimulate demand, no matter how cheap money becomes, if people are afraid to take on more debt.


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Durable Goods
Speaking of durable goods, it was the only economic report today (other than crude inventories. As mentioned above, it came in weaker than expected. This is another common theme--all these economic performance metrics are consistently being over estimated by economists, the same ones who are telling us we'll have "moderate growth" this year and the same ones who consistently miss the signals that we're entering a recession.

The durable goods number was a disappointment. At +2.5% it was less than the +3.8% that was expected. But the bulk of even that gain was due to a big bounce back up in aircraft orders which had taken a big hit in January. Excluding transportation orders the number was down -0.1%. The reaction from several economists after seeing the data, and the prognosis for the rest of the year, was quite negative. This negative number follows a downwardly revised number, from -8.7% to -9.3%, for January.

So the market didn't have much to celebrate over today. But in reality the market is very nervous right now, as evidenced by the plunge in equity futures Tuesday night after the rumor of an Iranian attack on a U.S. Navy ship. Even after the Navy denied any such attack, futures only recovered some of their loss. The market was primed and ready for a decline and the durable-goods number and Bernanke got the blame. The same message from the Fed last week, and for the last months, has not changed but today it was perceived as bearish. And therein lies the secret to the market--the mood of investors is changing and that's why it appears we're heading into rougher waters for the stock market.

Today's decline could have just a little more to go on the downside but I think we're close to getting a bounce. If you check out the put/call ratio in the table at the top you'll see it finished at 0.88 which is very high. Too many people got scared, spiked the VIX back up and bought a bunch of puts. We're probably oversold enough to give us a bounce. It could take us into Friday for an end-of-month/quarter finish without any significant damage to portfolios. How that sets us up for the following week could be interesting. Let's see what the charts are telling us.

DOW chart, Daily

There's still a lot of similarity in the daily charts of the main indices. There are some mixed signals on the shorter term charts, which I'll review, but the daily charts are in synch. After tagging its 62% retracement of the decline from the February high (to within 2 points), there were some bearish candlesticks near the high and this was followed by today's big red one. As can be seen on the chart, the 50-dma, currently at 12465, also proved to be too much to get through. Now it looks like a confirmed sell signal by the candlesticks. If the wave count is correct we should prepare for a very strong decline to follow but the strength of it may not become apparent until next week or the week after.

DOW chart, 120-min

As will be seen between the 4 main indices that I'll show 120-min charts for, the wave counts are a little different between them. That has to do with how and where the bounce topped. For the DOW I'm using last Wednesday's high as the end of the 2nd wave correction (large blue wave-2 on the chart). This interpretation suggests today's decline should be close to finishing a small degree 3rd wave down (wave-(iii) in dark red) which could use a minor new low tomorrow to finish it. This would then be followed by a shallow 4th wave correction and then another drop into early next week to complete the next larger degree 1st wave down (wave-1). That would then be followed by a larger correction that takes up most of next week.

The two other possibilities have to do with how the decline started (see SPX below for a slight difference that matches the light red (pink) depiction on this DOW chart. The bullish possibility, in green, says we've got a much larger rally ahead of us and that this decline is simply correcting the rally leg off the March 14th low. While I don't see that happening, I'll let price lead the way. Any rally back above 12500 would have me getting much more bullish this market.

SPX chart, Daily

MACD curling back over and RSI curling over at its downtrend line--what's not to like about this chart if you're a bear? Any rally back above 1440 would have me getting much more bullish but for now I think short is the place to be. By the end of April/beginning of May we should see SPX back down to its uptrend line from 2004. This is the bottom of its parallel up-channel that has contained price for nearly 3 years.

SPX chart, 120-min

If you compare this SPX chart with the DOW 120-min chart you'll see I labeled the high on Monday as the end of the rally from March 14th. This says the rally ended with a truncated finish (not a new high for the last leg up) which is entirely possible, especially in a bearish environment which I believe we've entered). This count suggests a new low tomorrow (assuming we get it) would finish up the 1st wave down, labeled wave-1 in dark red) and sets up a bounce that will probably take us into Friday for wave-2 and then wave-3 would follow early next week.

So the difference between the DOW and SPX makes a big difference for the rest of this week and especially next week. The clues will come from the next bounce. If we get a shallow choppy bounce followed by new lows into Friday then next week should see a larger upward correction. But if we see a bounce get a little larger and take us into Friday then next week could get ugly. This is something I'll be watching very carefully on the Market Monitor during the next two days and will try to get people positioned properly for it.

OEX chart, Daily

For you OEX traders (mostly spread trades but I know many of you trade long options as well), this chart is basically the same as the SPX, and DOW, daily charts. The smaller gyrations day to day don't affect you if you're in the spreads. A rally above 660 could threaten those of you in bear call spreads, depending on how close and which month you're in. I could see a rally up to at least 700 by May if the bulls go wild on us. But if the decline proceeds as depicted then a drop to the 590 area by early May is in the cards. A drop through 635 would probably be a good level that if broken says bombs away.

Nasdaq-100 (NDX) chart, Daily

The NDX banged around for a little bit between the two uptrend lines from November (along the bottoms of that mess between November and the end of February). Breaking back down after that beautiful kiss goodbye at the high for this bounce is bearish. A break below 1760, the previous high in the bounce off the March 5th low), would confirm the bearish price pattern. Then I see a relatively quick move back down to its uptrend lines from March 2003 and August 2004.

Nasdaq-100 (NDX) chart, 120-min

I'm using a similar wave count for the move down as I used on the DOW--it calls the top last Thursday morning. It's not a clean pattern (actually it's ugly), especially the move down to the low on Monday and I'd have to say this one makes me a nervous bear. The whole pullback smacks of a corrective feel. Therefore, the bullish wave count suggests the current pullback could be followed by a strong rally (green arrow).

Any rally back above its downtrend line, currently near 1795, would have me out of bearish plays and watching for a bit. A break of the downtrend line followed by a successful retest would have me long and seeing where it goes. In the meantime, thinking it would have a hard time rallying while the others are tanking, I'll stick with the bearish wave count (dark red) that calls for a bounce, maybe into Friday, followed by some strong selling next week.

Russell-2000 (RUT) chart, Daily

The RUT almost made it back up to tag its broken uptrend line from August but couldn't quite get there before being pulled back by the others. After a small doji candlestick we've got two red candles and that serves as a reversal signal. There's no cross down in MACD yet to confirm but it looks like it could do it soon (and it's a lagging indicator). Stay short unless it rallies back above 811. It may only be good for a quick test of that uptrend line and it would complete a 5-wave move up from March 5th. From there we'd have to see what develops since it could be just the first wave of a larger rally or it could be last wave up in the rally from July. But we'll worry about that if 811 is taken out. Until then, stay short.

Russell-2000 (RUT)chart, 120-min

The move down in the RUT is about as ugly as the one for NDX. I feel like I have to force a count no matter which way I'm leaning. The count on this chart is more like the one I have for DOW--a choppy continuation lower for the rest of this week and then a larger upward correction next week. Hopefully by Friday I'll have a better feel for which short term pattern is the most likely.

BIX banking index, Daily chart

Follow the money. If the banks are the money then we should be following them down. This chart looks bearish as the bounce failed to stay above the 50-dma and couldn't quite muster up enough strength to test its broken uptrend line. Now today it has decisively broken back below the 200-dma. This probably set off some sell stops on the banks today as it gapped down and closed at its low. This should proceed much lower from here but probably not before it does a retest of its 200-dma sometime in the next few days.

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

This one actually makes me nervous thinking about the bearish side right here. Either this is incredibly bearish and look out below or else the pullback from the bounce high is only part of a larger upward correction (think of a larger a-b-c and this pullback is just the b-wave). The bounce was very short, not even retracing 38% of the decline from the February high. But all those who were proclaiming the bottom is in for housing (the Fed finally got off that kick), and were buying the bottom, are probably the ones who can't get out fast enough. I had been warning that this is going to look like the tech bust by the time it's done, and we'll hear many more bottom calls along the way. Whether this drops straight from here or after another bounce back up, this is a long way from the bottom, a long way.

Oil chart, May contract, Daily

Just as equity traders have itchy sell fingers, oil traders have itchy long fingers. As soon as the rumor started about Iran's attack on a U.S. Navy ship (would they really be that stupid with two aircraft carriers in the area?), oil spiked to 68.09, up $5 from its close. Someone either made a lot of money on that rumor or got stopped out and lost a pile. I'm sure there were a few "kind" words uttered after getting stopped out (from a short position) and then watching oil come right back down to within a dollar of where it was, but still up. Oil closed back below its broken uptrend line from January so I'm not entirely sure what's next. I suppose you could say its gap at 65.11 was closed but I could see it pressing back up there, with some real trading this time, to retest its broken uptrend line while more legitimately closing that gap. From there it will probably be ready for another pullback.

Oil Index chart, Daily

Oil stocks look very strong here, almost too strong. Ideally, from an EW perspective, it should do a little consolidation and then another high in order to give us a 5-wave move up from early March. Whether that will then finish a 3-wave correction from the January low or instead be the start of something even bigger to the upside is hard to tell from here. A 5-wave move up would at least be followed by a pullback to correct the leg up from early March and then we'd have some clues as to what's next.

Transportation Index chart, TRAN, Daily

The pattern in the Trannies looks the same as the broader market, even more like the banks than the major indices. In that respect I'm leaning bearish this sector. I'm looking for a quick move down to its longer term uptrend line from March 2003.

U.S. Dollar chart, Daily

After dropping to the bottom of a small parallel down-channel for price action since its high in January, it looks like the US dollar is ready for a bounce. If the EW pattern is correct then the bounce should be very choppy and directionless before setting up the next leg down. A rally above its downtrend line from November 2005, currently near 84.50, would have me more bullish the dollar.

Gold chart, StreetTrack Gold ETF (GLD), Daily

If the US dollar is getting ready to rally it should put some downward pressure on the metals. I have an EW pattern that suggests gold is ready to drop. Also, gold has been trading in lock step with equities for quite a while now, including its big rally. Gold traders have to ask themselves why it would peel off from this formation now. I hear many arguments from gold bugs that it's good to be in gold because it's an inflation hedge.

The problem with this argument (and I'll grant you it's a good one), is that one of the reasons gold has done so well is for the same reason stocks and real estate have done so well--easy credit and excess liquidity. This easy money has made it extraordinarily easy to buy stuff, including gold. So if an expansion of credit has made it easy to buy stuff what do you suppose will happen during a credit contraction phase? Yep, people will sell stuff. What made gold go up will also make it go down and that's why I think gold will continue to trade in lock step with equities.

The chart shows a large A-B-C upward correction from the low in early October (which is a larger degree b-wave in the pullback pattern from the May 2006 high) and that calls for a large c-wave down (which will be made up of 5 waves). I show a 5-wave move down into May for a larger degree 1st wave of wave-(c). In other words it would have much lower to go after an upward correction into the summer.

One other possibility, and not nearly as bearish, calls the entire move from the May 2006 high as a big sideways triangle and that interpretation say GLD will only pull back to around $60 at the most. That one says the uptrend line from July 2005 will support the pullback.

Looking at the chart, another clue as to what's next comes from the volume. After the strong volume decline we've seen volume taper off during the following bounce. This is very typical for a correction and points lower whether it's from here or from slightly higher first.

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

The economic number of importance on Thursday will be the GDP for the 4th quarter. There are no expected surprises and I don't think we'll see any appreciable moves out of the futures after the 8:30 reports. Friday's numbers will be far more important and potentially market moving as the Fed uses these as part of their "data-dependent" analysis.

SPX chart, Weekly, More Immediately Bearish

The weekly chart is potentially bullish here if price turns back around and heads back up. With weekly MACD curling up near the zero line it could support a very bullish move and is one of the reasons I'll get long if we get new highs. There was a blow-off top in 1987 that started at this time of the year following a similar sharp pullback. It wasn't until the blow-off top finished after the summer that the cracks started showing and then crashed in October. Will the same thing happen this year? Never say never. Getting long if this presses higher could be a nice ride.

But SPX found resistance at the top of its parallel channel and a continuation lower could easily flip the oscillators right back down. In fact they could then go flat in oversold and indicate a strong trend in progress. That's when you move over to your moving averages and let them be your guide.

So for tomorrow I'm hoping we'll see an early-morning drop to a new low below today's and then that should be followed by some kind of corrective bounce. It will either be a shallow choppy bounce, which would indicate more lows probably into Friday, or a sharper bounce back up that could extend into Friday. The latter would likely set up a strong decline next week. Also, a bounce into Friday would fit the end-of-month/quarter window dressing.

If the market is going to follow the bullish path I depicted on the charts above, we wouldn't know it until this week's highs start getting taken out. If that happens then abandon the short side and wait to see if we get breakouts to the north.

Good luck in your trading. Stay bearish until proven otherwise and be careful of those bear market rallies. As we saw with the one up to last week's high, they can be bear killers. As I had been warning about that bounce we did in fact see just about everyone turn mega-bullish. All those new bulls are what fuels a strong 3rd wave decline. Now we'll just have to wait to see if we get follow through to the downside or not. See you here next week or on the Market Monitor tomorrow.

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