The month of May has finally come to a close with stocks racing lower on Friday afternoon. It choppy month for both equities and the bond market. There seem to be growing signs that the rally in stocks is starting to breakdown. Talk of the Federal Reserve potentially "tapering" its QE program continues to overshadow the market. The sell-off on Friday appeared to be exaggerated by a massive amount of sell-on-close orders for some index rebalancing. Plus there were new fears over some obscure technical pattern called the "Hindenburg Omen". Meanwhile stock rocket-ride higher in the Japanese NIKKEI index appear to be over with another sharp sell-off on Thursday. In the U.S. the volatility index surged +19% for the month. In spite of a two-week decline for the stock market it was the first positive gain for U.S. stocks in the month of May since 2009.

Economic data last week was mostly positive. However, the newest estimate on the U.S. Q1 GDP growth was a disappointment with a drop from +2.5% growth to +2.4%. The initial jobless claims were also disappointing with an up tick to 354,000, which was about 15K more than expected. The 20-city S&P Case-Shiller home price index surged +10.87% in the month of March. That was higher than expected and above the prior month's +9.3% rise. March also marked the fast pace of rising home prices since April 2006. It is interesting to note that pending home sales, looking at April data, slowed down to a +0.3% increase, which was below estimates for +1.5% growth.

The recent surge in bond yields is having an effect on mortgage rates. According to Freddie Mac, rates on a 30-year fixed mortgage rose +0.22 basis points to 3.81%. That's a one-year high for rates. If this trend of rising rates continues it will have a negative impact on real estate sales. Although there might be a short-term burst of activity as buyers rush to get a deal done before rates go much higher.

Consumer confidence and consumer sentiment numbers were making headlines. The final tally on May's University of Michigan consumer sentiment was adjusted higher from 83.7 to 84.5. That's the highest reading since July 2007. The Conference Board's consumer confidence survey rallied from 68.1 in April to 76.2 in May, which is a new five-year high. Oddly enough, even though confidence is rising, consumer spending is not. The consumer spending numbers showed a -0.2% pullback in April, which was worse than expected.

The Chicago PMI was also a bullish economic surprise for the market. Last month the Chicago PMI had plunged to a 40-month low with a contraction-level reading at 49.0. Yet one month later this survey showed a 9.7-point gain to 58.7. Not only is that the highest reading in a year, it was the biggest one-month gain in 30 years. Numbers above 50.0 indicate growth. The Chicago area is heavily influenced by the auto manufacturing industry. These big swings may reflect the automobile factories switching gears for the new models.

Looking overseas there was a lot of focus on China and Japan. There have been growing concerns that China's economy is slowing down too much. The International Monetary Fund (IMF) lowered their 2013 growth forecast from +8.0% to +7.75%. They also lowered their 2014 Chinese growth forecast from +8.2% to +7.75%. You may recall that the latest HSBC Flash PMI data for China had fallen to a seven-month low of 49.6 in May. Numbers under 50.0 indicate contraction. The official government numbers just came out and the Chinese PMI data rose from 50.6 to 50.8 in May. Most economists were expecting a drop toward 50.1. While it wasn't a big gain, the report does remain in growth territory. Of course we have to take any government report with a grain of salt since many believe the Chinese government "manages" the official numbers.

It was a cloudy week for the stock market in the "Land of the Rising Sun." The Japanese NIKKEI has continued to correct lower. Thursday's session produced another big drop with a -5.2% decline. In just eight days the NIKKEI had fallen almost -15% from its May 22nd high. Friday's session saw a decent oversold bounce but the up trend appears to be in jeopardy.

The NIKKEI threatened to breakdown under its rising 50-dma before bouncing on Friday. Below you can see a three-month chart of the NIKKEI index and a longer-term chart to show you the scope of the recent move and Japan's rally over the last several months.

chart of the Japanese NIKKEI index:

Longer-term chart of the Japanese NIKKEI index:

(chart from StockCharts.com)

News out of Europe was relatively quiet last week. It is worth noting that the EU's unemployment rate hit a new record high of 12.2%. Italy's unemployment hit a 36-year high at 12.0%. France also had a rough week with its PPI data falling -0.9% versus estimates for a -0.2% drop. French consumer confidence fell worse than expected and French consumer spending declined -0.3% compared to +1.3% the prior month. Standard & Poor's threatened to downgrade France's credit rating if the country didn't follow through on its proposed budget cuts.

Turning back to the U.S. markets there was some interesting data on money flows. There have been 22 weeks in 2013 so far. According to one analyst on CNBC the first week of the year saw negative fund flows (investors pulling money out) and ever since there has been positive inflows into stock funds. Yet this past week saw fund inflows fall to their lowest levels of the year. The folks at Lipper research had a slightly different analysis and Lipper is saying that last week actually saw negative flows out of stock funds, marking the first week of negative flows for the year. It really doesn't matter who you believe they're both saying the same thing. Investors are putting less money to work or they're already taking money off the table, which may suggest the market's rally has topped (at least temporarily).

One of the major stories last week and for the month of May has been bond yields. The yield on a U.S. ten-year bond is up +29% for the month. According to one analyst, "you just lost two-years worth of interest in one month". It was the fourth largest percentage increase for the 10-year bond yield in 50 years.

chart of the U.S. 10-year Bond Yield:

There are very different opinions on what the collapsing bond market means for the market and the economy since rising bond yields usually means rising interest rates. One camp argues that rising rates can be interpreted as growing confidence in U.S. economic growth. Others argue that what we're seeing is a bond-market crash. Both Bank of America and Goldman Sachs are warning that the bond market could be in trouble. Goldman is forecasting yields on the 10-year note to hit 2.50% by yearend.

Alen Mattich, writing on the Wall Street Journal's Money Beat blog, is suggesting that the U.S. Federal Reserve is in a Catch-22 situation. According to Mattich, "Central banks argue that their bond purchases are meant to push down yields in order to make long term finance cheaper. But, at the same time, a sign that QE's working is rising yields."

Just in case you've been living under a rock the last couple of weeks, market pundits have been obsessed with the idea of the Fed "tapering" down their QE purchases. There has been a constant debate over whether or not any taper in QE3 would be bullish or bearish for the market. It seems that all the anguish over the Fed's future taper is premature. The Fed keeps a close eye on inflation since it is half of the organization's dual mandate. The Fed wants to avoid excessive inflation yet more than anything else they want to avoid deflation. This past week revealed that inflation continues to fall. With over 50 years of data the personal consumption expenditures inflation index saw its "core" rate fall to an all-time low of 1.05%. Thus the Fed has plenty of room to keep the QE purchases going.

Major Indices:

Thus far 2013 has been an exception year for stocks. It has been the first time since 1996 that the S&P 500 started a year with five months of gains. Looking at year to date gains (+14.3%) it's the best start to a year for the S&P 500 since 1991. Unfortunately it looks like the rally might be in trouble. The large cap index is now down two weeks in a row. Friday's close below 1635 would suggest the next stop for the S&P 500 could be support near 1600 and its simple 50-dma.

Investors should not be too surprised here. The market has been overbought for weeks and we've been expecting a pullback. I would look for a bounce from support near 1600, which would keep the larger up-trend alive. A dip to 1600 would be a -5% correction from the intraday high, which is completely normal. A breakdown below 1600 would be a different story. If the S&P 500 breaks 1600 that might suggest a drop toward support near 1540 or even 1500. A -10% correction from the intraday high would be 1518.

If somehow the S&P 500 reverses higher from here there could be short-term resistance in the 1650-1660 zone and then likely resistance at the intraday high near 1685. The trend of higher highs would suggest a potential run to 1700.

chart of the S&P 500 index:

chart of the S&P 500 index:

The NASDAQ held up reasonably well. The index only lost -0.9% for the week and is up +14.4% year to date. It is down two weeks in a row, but the NASDAQ had its best May since 2005.

In spite of churning sideways for two weeks the NASDAQ still looks overbought. Furthermore this last week has created a bearish engulfing candlestick reversal pattern on the weekly chart. I would not be surprised to see a correction back toward the 3300 area.

May's intraday high was 3532. A simple -5% correction would mean a dip to 3355.

chart of the NASDAQ Composite index:

Believe it or not but the small cap Russell 2000 index had the best performance among the major indices with a -0.01% decline. Year to date the $RUT is up +15.8%. Unfortunately, these numbers don't tell the whole story. The action this past week in the $RUT looks like a potential short-term bearish double top pattern. I suspect we're going to see the $RUT pullback toward support near the March highs in the 950 area.

chart of the Russell 2000 index



Economic Data & Event Calendar

It's the first week of the month and that usually means a lot of economic data. The ISM on Monday, ADP employment report and Fed Beige Book on Wednesday will all be closely watched. Of course the big report for the week is Friday's nonfarm payrolls (jobs) report. Economists are expecting +165,000 new jobs, which would meet the same pace as April's jobs number.

Economic and Event Calendar

- Monday, June 03 -
Eurozone PMI data
vehicle sales
ISM index
construction spending

- Tuesday, June 04 -
Australian GDP

- Wednesday, June 05 -
ADP Employment Change report (for May)
factory orders
ISM services
Federal Reserve Beige Book report
Eurozone Services PMI

- Thursday, June 06 -
Weekly Initial Jobless Claims
European Central Bank (ECB) interest rate decision
Bank of England interest rate decision

- Friday, June 07 -
nonfarm payrolls (jobs) report for May
unemployment rate

Additional Events to be aware of:

September - U.S. debt ceiling deadline

The Week Ahead:

Previously the path of least resistance for the market was higher. That may no longer be the case. Do you recall a few weeks ago how market analysts were comparing this year's rally to the bull-market days of the mid 1990s? I find it odd that there seem to be a growing number of comparisons to 2007. The U.S. stock market last peaked back in 2007. The rally stalled in July 2007, there was a summer correction lower, and then stocks rallied again before peaking in October 2007 (for the S&P 500 index). This was just prior to an 18-month bear-market that cut stocks in half.

Now consider the following. Margin debt at the NYSE has exceeded the all-time high that was set in July 2007. That means investors are leveraged up with lots of margin if stocks reverse quickly they could face margin calls. The consumer confidence and consumer sentiment numbers are hitting levels not seen since 2007 (or 2008). Yet consumer spending is falling. There appears to be a disconnect here. Stock buybacks are set to double from last year and they are poised to exceed the all-time highs from... you guessed it: 2007. Two months ago, March 2013, the volatility index (VIX) hit lows not seen since early 2007. The Market Vane investor sentiment readings have hit bullish levels not seen since June, 2007. I do not want to sound like some crazy chicken little calling for a market crash but this evidence should make an investor pause.

It is also worth noting that the trailing P/E on the S&P 500 just hit 16x earnings for the first time in over three years. Stock valuations are getting richer. Another investor sentiment hitting extremes is the number of net speculative long positions in S&P futures is approaching record highs.

I also want to mention the Hindenburg Omen again. It's a very arcane and little known technical warning signal. I am not claiming it has any relevance here but the fact that it's a topic of conversation might suggest that traders are fearful that the market's rally has stalled and they're looking for explanations. Or maybe they're looking for an excuse to sell. You know that if the market needs an excuse it will find one.

Another challenge for the market could be Japan. More specifically a currency war that may have been started with Japan's record-breaking QE program. This is more of a longer-term concern than a short-term worry. You might recall earlier this spring there were several warnings about the prospect of a currency war. In April of this year Japan embarked on a QE program to double its money supply and try and raise the rate of inflation to 2%. Their plan is a $1.4 trillion QE program, which includes buying Japanese government bonds and equity ETFs. This plan is 60% larger than the Fed's QE3.

Unfortunately, there is a challenge with this plan. Japan is trying to raise the pace of inflation. Yet inflation erodes the value of bonds. Thus, investors have naturally started selling their Japanese bonds to avoid losing money. Falling prices raise bond yields. Rising bond yields raise interest rates. Rising interest rates will crush Japan's ability to pay the interest on its debt. Japan's debt to GDP ratio is 245%. Currently almost 25% of Japan's annual budget goes to paying interest on its debt and that's with an interest rate of 0.85%. If interest rates rise too far it will outpace the country's ability to pay the interest on its debt.

How can Japan prevent interest rates from rising? They will have to have the Bank of Japan buy more and more government bonds. This is essentially monetizing their debt. It will also make their currency worth less and less. As the Japanese yen falls in value it makes their exports cheaper. Other countries trying to compete with Japan on the global market will also try and defend their exports by devaluing their currencies. Thus we face the risk of a currency war. By the way, the U.S. QE program is not much different but our official debt to GDP ratio isn't as bad as Japan's. Yet any significant rise in interest rates is going to multiply the size of U.S. debt service payments, just like Japan.

Since we are on the topic of war, there seems to be a potential proxy war evolving in Syria. As you know Syria is in the grips of a civil war. This past week there were headlines that Russia was sending Syrian President Bashar Assad's regime some high-tech surface to air missiles. Israel has vowed to destroy these missiles to prevent them from falling into terrorist hands who would like to use them against Israel. Israel has already struck twice inside Syria. Assad has promised that if Israel does it again he will retaliate. The U.S. has considered sending arms to the Syrian rebels for weeks. The latest news is Britain has announced plans to provide arms to the rebels. Russia has responded by upping the ante and is sending MiGs (war planes) to Assad's regime. It's clear that the Syria civil war has had little impact on the rise of global stock markets. However, if the bigger players start getting involved there is a danger of escalation and that could see an impact on investor sentiment.

In summary, short-term the market looks poised for more profit taking. We've been expecting a market correction. Maybe it's finally here. I suspect that a dip to 1600 on the S&P 500 will be met with buyers. If it breaks 1600 then I would turn more bearish. I am still bullish on stocks through yearend but there could be a -5% to -10% pullback in the meantime. I wouldn't rush to buy the dip but you can definitely prepare and wait for your investment candidates to pullback to support before launching new positions.

James