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Market Wrap

Stretching the Rubber Band

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Everyone acknowledges the fact that the market is stretched to the upside. The DOW has now made it 29 up days out of the past 34 and (yawn) another record closing high. While we all know the DOW does not fairly represent the stock market we do know that it is the most watched index. The DOW sets the mood of the majority of traders, certainly the retail traders. No one is talking about the techs and small caps lagging the market because, well, they're not as bullish. CNBC is not the only one guilty of being optimistic about whatever they can find to be optimistic about. I stopped listening to them a couple of years ago because frankly they were (and are) a joke when it comes to reporting real news about the market. Bloomberg generally has much better news. Even the European version of CNBC is better than the U.S. version.

Speaking of Bloomberg, I came across an interesting article today, written by Caroline Salas and titled "Junk Bonds May Repeat Crash of 2002 on LBO Credits (Update2)". The article deals with the issue of how much debt is being created through leveraged buyouts (LBOs) and how worrisome it is for the market. Dan Fuss, vice chairman of the $10.7B Loomis Sayles Bond Fund, which is one of the best performing bonds funds over the past 10 years, has been expressing concern lately about the froth in the market. He says it's showing an unmistakable sign of a market bubble (to which I say just add it to the list). Yields on the high-yield, high-risk bonds (commonly referred to as junk bonds) are near record lows relative to virtually risk-free government bonds. Sales of these riskiest bonds have increased 39% in the past year even as the economy slows. People are taking higher risks for lower return and that is the definition of bubble mania.

Fuss, who has been working in the banking and securities industries since 1958, said "I haven't felt this nervous about a market ever." Default rates in the junk bonds have been running at very low rates and this masks the danger. But if the economy slows down then the default rate will start to climb and there are several people predicting a default rate that exceeds that which we saw in 2002 when the likes of Enron, Worldcom, and Adelphia were filing for bankruptcy.

More than half of the junk bonds sold this year were used for LBOs and mergers and acquisitions (M&As). I've discussed the easy money situation in the past and how credit has exploded higher in a parabolic climb to extraordinary levels. The amount of liquidity in the world markets is unprecedented. It's a big reason we saw the subprime mortgage market get carried away where dogs were getting mortgages on their dog houses and then borrowing money on their houses to buy bigger dog bones. Then they'd use the value of their bigger bones to leverage additional borrowed funds to invest in their local cat house. Sounds kinky if you ask me.

Money has become so easy to obtain that lenders are looking the other way when it comes to risk assessment. Part of the reason is that they don't have to sit on the risk--they repackage the loans and sell them to unsuspecting investors hungry for more junk bonds. The trouble with this is that those loans could come back to haunt the banks when it's proven that Fido was not eligible for the loan and had no proven income-earning capability to make payments. Being the stud of the neighborhood, especially in the cat house, doesn't qualify.

With the extraordinarily easy access to money investors have agreed to let borrowers choose to make interest payment in cash or in additional bonds. Did you catch this? They can make payments by borrowing the money to make the payments. This is the equivalent of you or I getting another credit card, getting a cash advance and then using that money to make payments on other credit cards. Any sane financial advisors would slap you silly for getting yourself into financial trouble like that. And yet we now accept it as a normal investment/business practice. Frothy? Oh yea.

This ties in directly with what happened in the subprime market. It also manifests itself in the covenant-lite loans I mentioned a couple of weeks ago. More than $100B of these loans have been completed this year compared to $36B in the previous 10 years. This is incomprehensible beyond words. And this is the "new paradigm" that Greenspan and Bernanke welcome as part of the creative financial tools that are stabilizing the capital markets. I respectfully disagree.

As a reminder, the convenant-lite loan is one where the bank can offer a "covenant holiday" to the company who borrowed the money and not required immediate payment of the loan for not meeting one of the covenants (inventory, accounts receivable, margins, etc.). The bank is usually very interested in the health of the business so that they understand the risk of their loan. But now they don't care as much because they've been selling off those loans to other poor saps, er I mean, investors.


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Another example of borrowing more to pay their debts is through the use of toggle bonds. Univision and Realogy were used as examples who used this "creative" financial tool. The Los Angeles-based Spanish-language broadcaster and real estate broker, respectively, financed their takeovers in part with these toggle bonds which gives them the option to pay interest with more bonds. This is just another example of how easy it has become to obtain more and more credit. Our markets are being built on credit, not cash. And all credit bubbles collapse quickly which will of course complete deflate the asset base upon which this credit was built. Fido's house will go poof!

As Mariaroso Verde, managing director of credit market research at Fitch Ratings, says, "Structural risks are rising. They've simply being masked by the low default rate." There will be a rude awakening and probably not far in the future.

One of scary things about all this is how it's looking like 1929 all over again, but this time by an order of magnitude greater. People have studies this LBO phenomenon and compared it to what was occurring in 1929 as business was starting to deteriorate. The problems were masked until, well, they weren't. A recent piece by Bill Fleckenstein referred to a piece written by Frederick Lewis Allen, titled "Only Yesterday". In it he looked at the huge increase in mergers and the "promoter" who were getting fabulously wealthy by encouraging what in hindsight were very foolish things. Today's "promoters" are the hedge funds. And while the promoters were talking up the market the economy was softening. Trouble was brewing but the party continued until the support stilts were knocked out from under it. The similarities to today are pretty scary.

But enough with the scary stuff. Just don't get hoodwinked by what's going on out there--stay vigilant and protected. Let's review today's economic reports.

Economic reports
We got some more data on housing starts and permits and then some numbers on industrial production and capacity utilization. The last report in the morning was crude inventories.

Housing Starts and Building Permits
After hearing on Tuesday that the home builders' confidence index fell to a 16-year low so it should have come as no surprise to hear today that building permits fell -8.9% to a seasonally adjusted rate of 1.429M units, the lowest since June 1997. It was the largest percentage decline in 17 years. Ouch. Permits are down -28% over the past 12 months. Must be a bottom though--the home builders rallied on the news.

New housing construction was up +2.5% to a seasonally adjusted rate of 1.528M which was higher than the expected 1.48M. Starts are down -16% over the past 12 months. If you'll remember a few weeks ago I showed some data that points to the need to see housing starts in the neighborhood of 800-900K before we can expect a bottom. Therefore the little rally in the home builders today might be a little premature.

The Fed reported 44% of banks had tightened lending standards. Poor Fido is going to have to go find funding elsewhere now that the banks might actually check to see if he has a job before making a loan to him. The tightening obviously hit the subprime and "nontraditional" loans but banks are also reporting tightening their standards for standard mortgage loans. This will clearly have a dampening effect on the housing market as fewer buyers will qualify for over-inflated housing prices.

Industrial Production
Output from factories, mines and utilities all rose in April, up +0.7%. This number has been a bit of yo-yo the past 6 months so it's hard to discern a pattern. Utility output was up +3.5% due to a cold spell in the country, but even this followed a sharp drop of -7.5% in March due to the warmer weather that month.

Capacity utilization, a key measure of inflationary pressures used by the Fed, rose to 81.6%. It was interesting to see bond yields increase rather sharply yesterday and leakage of this kind of information may have been one of the reasons. With production up and higher capacity utilization (which means less capacity to absorb growth which in turn can increase inflationary pressures), along with inflation rates that are not coming down that quickly, there is no reason whatsoever for the Fed to cut rates. If anything they're going to stay on inflation and rate-hike watch. But no matter to the stock market. Life is good--pass the credit please.

Crude Inventories
Crude supplies rose for the 4th straight week, up +1M barrels to 342.2M, and up +9.9M in the past month. API's report had the increase even higher--up +5.2M barrels to 349.9M.

Gasoline imports helped the inventory picture there--up +1.7M barrels to 195.2M, and up +2.1M over the past 2 weeks. Distillate stocks were up +1M barrels to 119.8M. The refineries increased their utilization rate to 89.5% from the prior week's 89%.

With all the discussion about the over-inflated stock market above you'd think I'd be screaming to sell this market now. Soon but not yet is what I'm thinking. Let's take a look at the charts, starting with another look at the DOW's weekly chart (I won't be updating the individual DOW charts that I showed last week).

DOW chart, Weekly

The weekly oscillators are into overbought and flattening out. We of course don't know if they'll tip over into a sell signal or instead go flat like they did from October to February. But it's just another reminder that the market is overbought. There are a couple of Fib projections to keep in mind: one, 13493 is where the move up from March 2003 has two equal legs up (very common for a market to make measured moves like that); two, the 2nd leg up, which started in October 2005 is a 5-wave move and equality between the 1st and 5th waves (most common relationship) is at 13453.

The lower Fib has been tagged as of today (and slightly exceeded). The slightly higher Fib is only 6 points away. These Fibs don't mean the DOW will stop here but it does mean to be careful if it looks like we're getting to roll over as this is a logical place to find a top. But if the rally keeps going, in what will clearly look like a blow-off top and could easily extend much higher in a frenzied attempt to own any and all stocks, then a 5th wave extension (to where it would equal 162% of the 1st wave) is at 14389. For those who were calling for DOW 14400 this year, to which I laughed, I'm not laughing quite so hard anymore.

Zooming in a little closer with the daily chart to look at the leg up from March, it's quite possible we're a lot closer to the top than that 14389 target.

DOW chart, Daily

The new highs are being met with bearish divergences on the oscillators and while we know that can continue for months, again it tells us to be cautious now. What happened in February will happen again but only faster and harder. The trick is identifying from what level that drop will occur. The first Fib projection for the move up from March 14th, where the 5th wave will equal 62% of the 1st wave, is at 13564. It doesn't mean the DOW will get there, or stop there, but it makes for a good upside target and a place where I'll be watching for a setup to get short. The next higher, where wave-5 = wave-1, is at 13782. As I've been calling out on the Market Monitor each day for the past week, I'm looking for a little more upside before thinking about the short side.

Now zooming in even closer to help identify the potential end for this move, the 60-min chart shows a potential ending diagonal for the 5th wave, which is a bearish ascending wedge.

DOW chart, 60-min

Whether this ascending wedge pattern plays out or not is yet to be determined but the bearish divergences at new highs suggests that it could be the correct interpretation. If so then the 12564 upside target has a lot of potential to be the high. These wedge patterns can be tricky figuring out which leg up is actually the last one but if price plays out as depicted in green then I'd look for a setup to try the short side at the end of this pattern.

Speaking of ascending wedges, I've been following one on SPX since its March low:

SPX chart, Daily

The highs and lows are getting closer together and momentum is waning. This looks like a pretty classic ending to a rally, especially for a 5th wave. This pattern could fail at any time and a price drop through any previous low is a sell signal at this point. In the meantime I see the possibility for SPX to push up to 1537 as per the daily chart (not quite so high on the 60-min chart) which is where the 5th wave would equal 62% of the 1st wave. At this time I'm thinking SPX is going to give us a double top against the 2000 high. We're already in the ball park to call a double top, including if it goes slightly higher.

The 60-min chart zooms in to take a look at how the final 5th wave (I think) is playing out:

SPX chart, 60-min

It looks like another ascending wedge pattern and has the overlapping corrective wave structure that supports this interpretation, along with the bearish divergences as it keeps testing the 1514 area. The dark green price path is my preferred wave count at the moment which calls for another week or so of a choppy climb up to the 1522 area for the high. But as mentioned with the DOW, there are a couple of ways to interpret this price action and failure could occur at any time, including right from here. At any time a previous low is taken out, so in this case below 1500, that will be a sell signal.

Backing out a little again I wanted to show an update to the NDX weekly chart and how price pressed slightly above the trend line from January 2004 through the January 2006 high. It's currently looking like a throw-over but there are still 2 days left to this week so we'll see how it ends up.

Nasdaq-100 (NDX) chart, Weekly

A throw-over followed by a drop back inside the ascending wedge pattern creates a sell signal so right now the NDX is on a sell signal. If it can rally back above last week's high, and close above, it will negate the sell signal. I'm getting a little ahead of myself, with 2 days left in the week, but if that candlestick closes anywhere near where it is right now it's going to look like a bearish hanging man that followed two bearish long-legged dojis at resistance. Right now the weekly chart should have bears salivating. Just be careful in this over-hyped market. Blow-off tops can develop a life of their own.

The next chart shows the relative strength of the Nasdaq as compared to the S&P 500. This is a common technique to find weaker or stronger indices, sectors or stocks. This comparison is important because it visually shows you the bullish aggressiveness (or lack thereof) in the market. When market participants are feeling especially bullish they go for the smaller high-beta stocks, so the tech stocks and small caps. This chart shows a weakening in tech stocks relative to SPX.

NDX vs. SPX Relative Strength chart, Weekly

There's been a sharp drop off in the Nasdaq as compared to SPX and this is bearish. When investors do not have the confidence to big these stocks higher but instead run into the safety of the big caps (which we've been seeing, especially into the DOW), then it's your cue to start unloading stocks as well. This is probably one of your better sell signals for longer term market timing (and just the opposite for timing when to get back into the market). I show a similar RS chart for the RUT following its charts below.

Nasdaq-100 (NDX) chart, Daily

The chart pattern for the final move up in the techs leaves me guessing a bit for the very short term. I show Fib projections for a 5th wave up (if we haven't already seen it) at 1925.73 and then 1962.05 so that's the upside potential. But price has been struggling at the trend line from January 2004 and oscillators have rolled over. It's possible the oscillators are sinking back down while price consolidates in which case it's a bullish setup. The uptrend line from March should hold if there's more upside to go. But a break below the key level at 1857 would be a sell signal.

The 60-min chart shows just how messy the price pattern has become:

Nasdaq-100 (NDX) chart, 60-min

There is the possibility for a very bearish wave pattern to be setting up here--with multiple 1st and 2nd waves to the downside. This wave count (dark red) suggests a very fast and strong sell off is next. If it happens there will be no question that a high has been put in. But these very bearish setups rarely follow through and therefore I'm looking for this to resolve higher. Two equal legs up from May 1st is at 1915.40 and is my preferred wave count at the moment. If it chops up and down in a sideways pattern instead (light green) then it will be another week or more before heading higher again.

A rally without the semis is like a day without sunshine. Considering the nice rally we had today, the lack of participation by the semis is worrisome. And when I look at the price pattern I'm thinking the rally in the semis is done. Here's a really wide-angle view with its monthly chart:

Semiconductor Holder (SMH) chart, Monthly

This is shown with the log scale so that the squiggles after the 2002 low can be seen. After the sharp drop into the 2002 low the triangle consolidation pattern should be bearish and as the EW labels show, wave-e is usually the last wave in the triangle. The pattern of the bounce off the March low looks complete and therefore this could be done and ready to tip back over. A drop below 37, and most especially below 36, would say the triangle consolidation is finished and down we go. That would obviously be a bearish sign for techs and in turn for the broader market.

The RUT has just as ugly a chart as the NDX--price action over the past month can easily be interpreted two ways. It's either consolidating for another run higher or it's already topped out and getting ready to take a dumper.

Russell-2000 (RUT) chart, Daily

The uptrend line from March was broken on Tuesday and today's bounce didn't quite make it up to the broken trend line to see if we'd get a kiss goodbye or not. That trend line is located near 825 Thursday morning. The oscillators look bearish but if they're "resetting" while price consolidates then it's actually bullish. A break below 807 would be a confirmed sell signal otherwise I'm thinking at least another test of its high, which is shown a little more clearly on the 60-min chart:

Russell-2000 (RUT) chart, 60-min

The internal price pattern in the pullback from last week's high gave me the impression it was in a bullish descending wedge. The green price depiction is currently my preferred wave count and calls for a rally at least up to 838 for two equal legs up from May 1st. But if it turns back down from here and drops below 811 then we get a sell signal, confirmed with a drop below 807.

This is the RUT relative strength chart as compared to the SPX and gives us a heads up if it breaks any lower.

RUT vs. SPX Relative Strength chart, Weekly

First it has broken its uptrend line from August 2004. So that's already telling us that the rally in the RUT from that time is already falling short of the rally in SPX. Once again, flight from small caps into large caps is a defensive move. It means smart money is quietly slipping out the back door while the band plays on. From a slightly shorter term perspective, the trend line along the lows since September 2005, what could be easily considered a H&S neckline, is being tested now. If that lines breaks then it's confirmation that they're abandoning the small caps. You should do the same.

Another continuing bearish indicator for the market is the number of new 52-week highs vs. new price highs in the NYSE:

NYSE (NYA) vs. New 52-week Highs, Daily

It's looking like another ascending wedge for NYSE which doesn't have a whole lot of head room left. Waning momentum is typical in these patterns and the decreasing number of stocks participating in the rally, as evidenced by the fall off in new 52-week highs, is cause for concern. It doesn't tell us the market will fall apart tomorrow but instead is another one of many warning flags that are popping up. Dont say you weren't warned the next time the market drops hard, a drop that I expect will make the drop from February, and even from May 2006, look like a little blip.

And now I'll quickly run through the rest of the charts as I'm rapidly running out of time before I have to hit the send button. First the banks:

BIX banking index, Daily chart

I'm not sure if the banks topped on that last run higher or if there's another leg up to go. If they do rally a little more then I see a double top in its future.

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

The "bottom-must-be-in" crowd was out today. It's another attempt to call the bottom, one of many more to come. I'm thinking there could be a larger bounce coming though and it's based on the corrective wave structure of the drop from its April high. If the index breaks above 625 I could see another bounce up towards its 200-dma and the trend line I've drawn in, currently just above 665. The alternative is a very swift decline from here that should break below the mid line of its down-channel (dotted line).

Oil chart, ETF (USO), Daily

The decline in oil looks enough like a bull flag to say this is going to resolve higher from here. USO needs to get back above 51.90 to negate its bearish pattern.

Oil Index chart, Daily

The push back up in the oil index gives me the impression it's going to go for a Fib projection near 711 where its 1st and 5th waves will be equal. The bearish divergence cautions those who are long these stocks. It should be topping soon if it hasn't already.

Transportation Index chart, TRAN, Weekly

This weekly chart shows how price is pressing up against the trend line along the highs since May 2006 which are being accompanied by bearish divergences. The steep up-channel from March looks about done at the same time (5-wave move up). Maybe a little higher but this one is about to roll back over.

U.S. Dollar chart, Weekly

The weekly chart shows the US dollar is strengthening but there are still very few believers in the greenback. The bearish sentiment continues to support the probability that we'll see the dollar rally out of its descending wedge pattern. But the shorter term pattern leaves me guessing as to whether or not we're going to see another test of the low before a bigger rally gets started. In either case it should rally out of here.

Gold chart, StreetTrack Gold ETF (GLD), Daily

A strengthening dollar is of course not good for the metals and the weekly chart of gold (GLD) shows the likelihood that we've seen the high for at least a weekly cycle of the oscillators. Gold has broken its uptrend line from September 2006 so a retest of it that fails would be another sell signal. We should be in for a large correction back below 55.

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

Tomorrow's LEI report and Philly Fed survey can sometimes move the market but I suspect it will not have much impact. Friday looks like another quiet day as far as economic reports go.

There hasn't been much of a change to the weekly SPX chart but this week it has pushed above the 1510 area so it bears watching closely from here.

SPX chart, Weekly, More Immediately Bearish

There's nothing hinting of a sell signal yet as the white candles continue to pile on top of each other. It's pretty easy to see how stretched this is to the upside which only means it will come back down hard but we don't know when that will be. We might even see it rally through the summer and truly mimic 1929.

The price patterns hint of some consolidation tomorrow and Thursdays of opex week tend to be relatively quiet days. The ascending wedges that I've shown on just about every chart tells us to be cautious about the upside but recognize the trend is clearly still up. But these wedges are also typically filled with choppy price action and they're hard to trade. Don't force trades right now, especially since they could be finished in less than a week. It's much better to save your ammo at times like these.

I see this market chopping its way a little higher into next week and then a hard fall. But this market has had a tendency to take a lot longer than I think it will take and therefore it could take two weeks instead of one. If you're into quick day trading then this market will test your skills. If you're looking for swing or position trades, then I think it's a good time to wait on the sidelines and let this pass. Assuming we get a break down soon, the broken uptrend lines and key levels will clue us as to when to look for the bounces to get short.

Continue to exercise more caution than usual, especially if you play the long side. Use protection and have stops in place (or buy puts if the price drops through a certain level). In the meantime if you're long then continue to enjoy this euphoric credit-induced rally. Just don't overstay your welcome and be quicker to take money off the table so as to have to buy back cheaper. We're certainly at the point where upside gain is minimized as compared to downside risk.

Good luck and I'll be back next Wednesday and on the Market Monitor tomorrow. See you there.

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