Stocks are in breakout mode. Across the globe stock markets are surging. China and Japan both soared nearly 6% last week. Most of the European markets rallied nine days in a row. England made it ten. Here in the U.S. the two-week rally has lifted the S&P 500 more than 11%. The Dow Industrials' 950-point gain also scored an 11% climb. The NASDAQ, even with Friday's pullback, has soared more than 12% and the small cap Russell 2000 index has exploded with a 14% gain in the last two weeks.
It's been one of the best two-week runs in years both here and abroad. Can it continue? Last week I suggested we watch the transportation sector and the semiconductors. The Transports managed to push past technical resistance at the exponential 200-dma and the sector also closed above round-number resistance at the 3500 level in spite of an earnings warning from UPS but more on that later. The rally in semiconductors has certainly continued. This sector's rally started more than two weeks ago with the bounce off its July 8th lows. Intel's better than expected earnings gave this sector a boost and now the SOX index is hitting new ten-month highs. Technology is poised to lead the market higher but short-term this sector is way overbought and due for a correction.
Chart of the Transportation Index:
Weekly Chart of the SOX semiconductor index:
Thursday's breakout in the S&P 500 past resistance in the 950-955 zone was a potential game changer. This rally may have started with short covering and I'm sure last week had more than its fair share of short covering but the breakout has put fund managers at risk. We've discussed this before. A lot of professional money managers missed the rally from the March lows because they didn't believe it claiming it was just another bear-market rally. The May-June consolidation formed a head-and-shoulders top, which forecasted a significant decline. If you're a money manager why buy stocks with the S&P 500 at 900 when you might get a chance at 850 or lower? When the H&S pattern didn't break and the short covering began managers began to panic again. Not only do money managers fear to under perform their benchmarks like the S&P 500 index they also fear under performing their peers. Under performance means they could lose assets due to client redemptions, lose their bonus or even their jobs. With the market in rally mode professionals are forced to chase stocks higher whether they want to or not. Talk about having performance anxiety!
During the month of June the market struggled. The rally was tired and investors needed another catalyst. Better than expected corporate earnings has renewed hope that the economy is truly on the road to recovery. Bear in mind that the market has selective hearing and only hears what it wants to hear. Are corporations beating lowered expectations? Great! Never mind that most of these companies are beating estimates due to drastic cost cutting and layoffs. Aside from Microsoft (MSFT) investors are ignoring most of the revenue misses if the company can beat the net profit estimate. Investors are also ignoring falling consumer sentiment numbers. They're ignoring a worse than expected GDP result from Britain and the fact that Japan, the world's second largest economy, is sliding deeper into deflation. They're ignoring third quarter earnings warnings from the likes of Fedex (FDX) and UPS, two of the largest delivery companies in the world who are extremely connected to the health of the domestic and global economy.
I'm not saying there isn't any good news out there. China's economy is growing thanks to the government's massive stimulus package. Germany's economy, Europe's largest, is showing signs that it's on the verge of turning positive again after some extremely bad quarters. Closer to home investors have cheered a rising number of companies that have raised their earnings guidance going forward. One of my concerns is that historically as an economy claws its way out of recession it is very common for the economy to see a one or two quarter bounce into positive territory before rolling over again. The third and fourth quarter could be that kind of bounce, which sets up for a rather disappointing 2010.
Big picture nothing has really changed. We are still facing rising unemployment, which pressures consumer confidence, which saps retail sales and services, etc. You know the drill. Unemployment is expected to rise toward 11% in 2010. This will fuel consumer savings and a rising savings rate is going to make this a really slow economic recovery. Last week's data on the housing market is showing a temporary improvement but I think it's a mirage. We still have an oversupply of homes for sale and a declining number of consumers that can qualify to buy them. Too many homeowners are underwater with their mortgage and can't sell their home. Combine that with rising unemployment and you can see why foreclosures will continue to rise.
Do you remember how foreclosure filings were reaching more than 300,000 a month? We're only a couple of months away from the next tidal wave of foreclosures and we'll see another one in 2010-2011 as a massive amount of option-ARM mortgages reset at a higher rate. Even if we ignore the rising rate of foreclosures the housing sector is not going to bounce any time soon. Banks are already holding on to a large amount of "shadow" inventory. These are homes they have repossessed but have not placed on the market. The banks know that oversupply will keep prices depressed and compound their losses. If it looks like prices do start to improve these banks will start releasing more inventory. The residential real estate market could languish for the next couple of years. Let's not get started on commercial real estate, which remains a huge black cloud over the financial system.
That's enough of the long-term concerns (inflation, anyone?) let's look at short-term. I said earlier that it looks like the game has changed. The markets have broken out from their trading ranges. While we are still in the middle of second quarter earnings the tone has already been set. It will take some serious misses to dampen investor sentiment. This week the key events to watch will be the Federal Reserve's Beige book report on Wednesday and the U.S. GDP report on Friday. Estimates are pretty wide for the GDP number and investors might be able to write off a negative number as looking in the rear-view mirror while a positive GDP number would only boost the market. Looking past this week the next big event is the August 7th non-farm payrolls (jobs) report. If the jobs number disappoints it could spark some serious profit taking.
Short-term my bias is bullish yet after a two-week +10% run we don't want to launch new positions now. The challenge will be to wait for a dip and it might be a multi-day dip. Stocks don't normally move in a straight line like the last two weeks. Three days up, two days back is normal. After almost ten days up how big of a pullback is going to qualify as normal? Broken resistance near 950 should now act as strong support for the market. Overhead we can watch for resistance near 1,000-1,010 and the 1,040-1,050 zone.
Weekly Chart of the S&P 500 index:
Historically August and September are negative months for the stock market. A decline through August-September and into early October normally sets up for a strong fourth quarter rally. It looks like this year the market might be able to ignore any seasonal trends. Goldman Sachs issued some bullish comments last week and suggested the second half of 2009 will see one of the biggest gains in years. They might be right.
~ James Brown