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Daily Newsletter, Thursday, 12/28/2006

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Table of Contents

  1. Market Wrap
  2. New Plays
  3. In Play Updates and Reviews

Market Wrap

Ho Ho (cough, sputter) Ho, Merry (cough) Christmas

Well, Santa arrived just after Christmas but his sled has a loose runner, his engine is misfiring as Prancer is no longer prancing and he's low on reindeer fuel (that would be volume). The market was jammed higher on Tuesday and Wednesday on very low volume, lower than this time last year. It didn't take much in the way of buy programs to overwhelm anyone who even thought about shorting the market. With an expected bullish period this week there were probably very few who wanted to do any selling anyway.

Certainly the fund managers are pleased to see the market holding onto all of its gains (well, don't look at the techs), and especially to see the DOW making "new record intraday highs" again. With the DOW over 12500 on Wednesday the public will surely want to buy more and of course that's exactly the idea. With significant profits on the books, which are only profits if cashed in, and a desire not to take those profits in 2006 (and have to deal with capital gains), it's no surprise to see the market held up into the end of the year. What happens in January could be a little less bullish.

With the DOW making a new all-time high this week there is the possibility that we'll see a pullback that sets up another push higher into the first, possibly second, week of January. I'll get to that later with the DOW chart and show what I'm thinking but the wave pattern suggests either a top is being made this week or else a pullback and another run higher to finish the rally. I'm currently leaning towards the pullback/new high scenario.

In addition to the price pattern suggesting to me that we're not quite done with this rally yet, there are a lot of people now talking about an early January pullback. Most now acknowledge that the market is overbought and that many have been holding off on selling before year end. Profit taking after January 1st is now expected by many. That makes me wonder if we'll get the opposite. We could see an initial bout of selling that sucks in some bears and then a quick reversal to spit them back out again. An early rally in January would probably frustrate the heck out of most bears.

A continuation of the rally would also convince most of the public that we're off to the races. Getting the public to take the inventory off the hands of smart money will not happen if the public gets scared away with a market sell off. But I think the hand off to the public will be fairly quick (I think it's been going on for several weeks already) and an early rally could/should finally be the top that I've been looking for forever it seems.

Another reason for this week's rally might have had more to do with the Fed than anything else. This chart of calculated M3, updated as of last Friday, shows money creation continues to rise at a faster pace. The annualized rate of change in money supply has now gone vertical and we know what happens next after these kinds of moves.

M3 Money Supply, courtesy nowandfutures.com

One look at this chart and you have to ask yourself what the heck is the Fed doing? The increase in the rate of growth since August is the fastest we've seen in the past 3-1/2 years shown on this chart. That's scary. The Fed is clearly worried about this economy, and causing a very significant inflation problem in the process. And of course all this money will further depress the value of the US dollar.

Speaking of the dollar, there's more and more news about countries starting to liquidate their US dollar holdings and buying euros instead. This is just the start of what could become a very significant shift in the currency market. We may have seen the peak in the US dollar domination in the world. More immediately, the last time we saw the Fed go crazy with money creation was 1999 and then the draining started shortly after 2000 began. Are we setting up for a similar situation? Could be.

At any rate, with so much free money coming into the monetary system, which has been benefiting the markets, this week's rally may have had as much to do with that as anything else. Again, without sellers around, and with very low volume, any money coming into the market would naturally lift it higher. The way it got jammed higher on Tuesday and Wednesday is what looks suspicious.

But this is the market we've got and there's always something to influence it and money will either be coming in or going out from various sources. Our job is to identify the patterns, support and resistance and play it the best we can. At least in January we'll have all the market participants back at their trading desks and hopefully the added volume and full participation by all will give us a little more clarity as to what to expect next. We need the "normal" ebb and flow of buying and selling to help us use the trading tools that rely on this ebb and flow.

Today's economic reports caused some early gyrations and the equity market pulled back in the morning, as did the bond market. The bond market sold off on the economic reports which of course drove yields higher. The move in yields is potentially significant in that the 10 and 30-year broke their downtrend lines from July. The jump in yields is potentially saying the bond market is waking up and smelling the coffee.

TYX.X chart, 30-year yield, Daily

Both the bond market and equity market have been acting under the assumption the Fed is close to lowering interest rates. For a number of months I've believed the Fed has boxed itself into a corner and can't lower rates, and is more likely to raise rates because of the inflation problem, which they're exacerbating with their money creation. The break back above its longer term uptrend line from May 2005 and its downtrend line from July 2006 is quite a bullish statement (bearish for bond prices). If the bond market is getting a whiff of a Fed on hold, let alone on the path towards a rate increase, then we're about to see rates shoot higher from here.

If bond yields continue to rally (short term it looks ready for a pullback at anytime and the broken downtrend line would be a good retest) then any improvement we've seen recently in the housing market could instantly vaporize. Also, if the bond market and stock market were rallying the past 6 months under the assumption that the Fed was close to dropping interest rates, what happens when that assumption becomes null and void? The break of the downtrend line from July in the yields will likely soon be followed by a break of the uptrend line from July for equities. Just another piece of the puzzle quietly being put in place. But shh, don't tell the sheeple quite yet. The Boyz have some stock they need to hand off first.

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Economic Reports
This morning's economic reports contained some good news for the economy. Perhaps it was too good since the bond market sold off thinking that it's another nail in the rate-reduction coffin. The stock market dropped a little also but it's not hard to hold it up this week and the major indices finished barely negative on the day.

Unemployment numbers showed initial claims rose slightly by 1K (from a revised higher 316K vs. prior reported 315K) to 317K while the 4-week average dropped by 10,250 to 315,750, the lowest level in 6 weeks. Continuing claims, which is a measure of how difficult it is for people to get reemployed, rose by 16K to 2.53M which is the highest level in nearly a year. The 4-week average also rose by about 20K to 2.51M which is a continuation to new highs not seen since last February.

The Chicago PMI (Purchasing Managers Index) came out stronger than expected considering last week's Philly Fed -4.3 number (showing contraction) and Tuesday's Richmond Fed survey -6.0 number (also showing contraction). Many were prepared for a sub-50 reading on the PMI number as well (less than 50 shows contraction). Instead the number came out at 52.4, up from November's 49.9 which was a 3-year low. The question now is whether it was a dead cat bounce or the start of a recovery. There was some good news inside the report--prices paid remained flat at 60.2 while new orders rose to 57.8 from 52 in November.

Typically, what is good for the economy must be bad for stocks since stocks sold off on the news (as did the bond market). The worry of course is that a stronger economy, along with inflation that won't get below 2%, raises the prospect for a Fed that will remain on hold if not a Fed that will be forced to raise rates further. That would of course kill the whole premise for the stock market rally (not that it really needed that reason).

Consumer Confidence rose in December to 109.0 from November's revised higher 105.3 (it was previously reported at 102.9). Expectations were for a small decline to 101.9. Consumers felt there was an improvement in the job market and generally felt more optimistic about the economy. This was also reflected in retail sales that were at least on par with expectations. While not robust at least retail sales have not been a bust in December. Many retailers are hoping the use of gift cards between Christmas and January 1st will get spending up to the 5% growth number many have been calling for. The purchase of gift cards can't be counted towards a retailer's sales until the card is used. It will be close.

Existing home sales were up +0.6% to a 6.28M annualized rate, coming in better than the expected seasonally adjusted 6.20M rate and up from November's 6.24M rate. Inventories of unsold homes fell 1% to 3.82M but at a 7.3-month supply there's still a lot of inventory to work through. But at least if the inventory can be worked off some before the spring, when a lot of homes will probably come onto the market, it may help spring sales numbers. Of course if interest rates start to head higher again, all the good news in the housing market the past couple of months could vaporize in a heartbeat.

The last report out this morning was crude oil inventories which fell by 8.1M barrels in the past week. But with an inventory level of 321M barrels it's still above the upper end of the average range for this time of year. Oil prices have been dancing on top of the $60 price support level but not showing a whole lot of bullish strength yet. Gasoline supplies rose by 3M and distillates (which includes heating oil and jet fuel) rose by 500K barrels.

Bulls need some cold weather to hit the northeast but weather forecasters (and Sylvia Brown) are predicting a warmer than usual winter and for the west coast to be colder and rainier than usual. I can attest to the rainier part in Seattle. It's even rainy by Seattle standards! By the way, Sylvia Brown also says New York City (and the east coast) should prepare for a tsunami next year. Hmm, another attack on Wall Street? Who will we blame for that one?

The stock market has risen nicely this week, thanks to Santa and his rickety sleigh, so let's see what the charts are telling us now. The DOW got its headline today, "Dow industrials climb to intraday record above 12,521 points". As long as they can keep those headlines coming the longer they'll be able to suck the sheeple in to buy the transferring inventory.

DOW chart, Daily

The DOW has rallied to a new high, which of course means the high on December 20th wasn't THE high. Sigh, another top picked and gone. So does that mean the new high being made this week is THE high? For you bears anxious to short this sucker, I think not. By making a straight shot up from Tuesday I think this week's rally is only part of the last push higher. I could be wrong on that and this daily pattern continues to caution those who are in long plays. If we're forming a small ascending wedge since October's high, which I'll discuss with the next chart below why I think we are, then the press up to the top of the wedge, along with the continuing bearish divergences, says we could be very near the top. But I think we need a pullback and then another new high and I show that in this 60-min chart:

DOW chart, 60-min

The reason I think we're forming an ascending wedge is because of the internal wave pattern. Without boring non-Elliotticians to tears let me just say all triangles, which a wedge is, are made up of 3-wave moves internally and that's what we have since the October high. In keeping with that it would look better for this pattern to see a pullback and then another push higher into the end of next week or possibly into the 2nd week of January depending on how long these two moves take. This is obviously speculation on my part but it would fit the pattern. It would also fit the Fib projection I have, based on the move up from July, at 12626 for a high.

While this fits the EW pattern I see here it also fits from the perspective of how I think the market could play out after the first of the year. In order for smart money to hand off their inventory to Joe Retailer, who typically buys the top and sells the bottom, then they can't scare him away. An early sell off in January would scare him away. But they'll need some extra fuel to get the market to spike higher and get everyone excited. What better way to do that than to pull back the first day or two, suck in the bears who just Know the market is going to sell off, and then get them to cover quickly as the market gets jammed higher again. If I could control the market that's exactly how I'd play it.

If we get a very choppy pullback over the next day or two then that will increase my confidence that we've got a new leg up coming, which should be the last one, finally, maybe, should be, hopefully... If on the other hand we start to get a sharp decline, and especially if it takes out Tuesday's 12337 low, then I'd say at that time the top is in and look to short all bounces. But not yet as I think it'll be time to buy the dip one more time.

SPX chart, Daily

SPX hasn't been quite as bullish as the DOW but I suspect it will make a new high as well before the rally is finished. A pullback to around 1420 followed by a rally up to just shy of 1440 could be the final moves for this rally. But the same goes for SPX as with the DOW--any sharp decline below Tuesday's 1410 low and the bears may be back in control of the ball.

Nasdaq chart, Daily

I can't figure out what the techs are doing. The COMP is hanging out above its 50-dma but the NDX (Nasdaq-100) and QQQQ can't get back above the 50-dma. It's been very weak relative to the big caps (which looks like rotation out of the techs) but it looks more or less like it's consolidating for another run higher. And if the funds are rotating out of techs I can't figure out why they're not rotating out of small caps. Small caps are just as hard to exit in a quick sell off as the smaller techs. If I were to guess on this chart I'd say it's getting ready to run back up and ring the bell at the underside of its broken uptrend line. But I'm not confident enough in that to recommend anything other than to get ready to sell.

SMH semiconductor holder, Daily chart

Like the COMP the semis look confused. They've been weak for so long and constantly threatening to fall down and yet no one seems able to knock them off the perch. As I look at this chart I see either a wicked sell off about to happen or else a bullish descending wedge forming since the November high (but without the confirming bullish divergences). Holding below the tight grouping of moving averages, from its 10-dma up to its 200-dma, looks bearish. It takes a rally above $35 to tell me something more bullish is in progress.

BIX banking index, Daily chart

The banks have had quite a buying spurt in the past month, taking the index from the bottom of a parallel up-channel (the uptrend line from October 2005) to the top of the channel. Daily, and weekly, RSI is as overbought as it's ever been (last May was the most recent time and that was followed by a strong sell off) and while that doesn't mean anything short term it does tell bulls to be cautious here. A break below 407, last Friday's low, would say we might have seen the high for the rally.

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

The existing home sales numbers, reviewed above, gave the home builders an early morning boost but by the end of the day it was given back. Right now this chart looks bullish--price is holding above its 200-dma, with the 50-dma coming up and getting ready to cross up through it and oscillators look ready to turn back up. I was thinking the bounce from July is over as of the December high but a move above that would say there's a chance to see this continue higher, possibly to the 50% retracement at 836. But watch interest rates now--if the break out in yields holds and presses higher then any renewed enthusiasm for the home builders could vanish quickly.

Oil chart, January contract, Daily

Oil has been trying to rally but it keeps getting body slammed back to the mat. Support at $60 is holding and I continue to think we'll see another rally leg. Nagging me is what happened to natural gas (it has dropped to lows not seen in over two years). If lack of demand is causing such a price drop, could a lack of demand for oil result in the same move? If the northeast demand for oil is going to be much less than normal and if the economy is slowing down then there is certainly that possibility. That would of course be good for consumers and businesses where cheaper petroleum products would help the bottom line. It would not be so good for holders of oil stocks.

Oil Index chart, Daily

After breaking the uptrend line from October the oil stocks are getting a little bounce. Whether this index continues to be held down by its 20-dma (bearish) or can get back above it (at least short term bullish) that should give us some clues as to what's next. If it can bounce higher then it might be able to make it back up for a test of its broken uptrend line would also be a test of its high. Any further drop from here should find support at its 50-dma.

Transportation Index chart, TRAN, Daily

After breaking below its 50-dma the Trannies bounced back up for a retest and kiss goodbye. Now we'll see if the same thing happens after breaking its 200-dma and now bouncing back up for a retest. Co-located with the 200-dma is the 10-dma which has been holding the Transports down all month. The bearish divergence between the TRAN and the DOW is a warning as far as I'm concerned. If there are fewer products to ship then there are fewer products being made which means manufacturing businesses are slowing down. Those who say the service sector more than makes up for the loss in manufacturing business could be right but I think it's all still tied together. We'll soon find out.

U.S. Dollar chart, Daily

The bounce in the US dollar has stalled at its downtrend line from October and oscillators appear ready to roll back over. The dollar should drop to a new low but I'm not sure it'll make it down to the December 2004 low of $80.39 this time but that's the potential I see before setting up another bounce in the new year.

Gold chart, February contract, Daily

If the US dollar drops back down that should help give a boost to gold whose chart looks ready to rally higher. If I've got the Elliott Wave count correct on this chart then the next leg up should be a strong one and easily get back above its uptrend line from August 2005. It's possible we haven't seen the full pullback yet, perhaps down to $600 but at this point I see that as the lower odds possibility.

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

Tomorrow will be sleepy town USA. There are no significant economic reports, it's a Friday before a long weekend and volume has already been lower than normal, even for this week. By the way, if haven't heard the news, the Nasdaq has decided to remain closed on Tuesday, January 2nd in honor of President Ford's funeral. I haven't seen any news yet for the other stock markets but the financial markets have typically been closed in the past for president's funerals. We should hear on Friday whether the other markets will be closed as well and if they are then Friday could be especially slow as traders take off for a 4-day weekend.

With the market holding its highs there's still not much of a change in the SPX weekly chart we're watching:

SPX chart, Weekly, More Immediately Bearish

As noted on the chart, there's nothing bearish about this chart yet except to say it's overbought up against resistance. But that's been true for a long time. This is clear depiction of the saying "the market can remain irrational far longer than you staying solvent trying to fight it." The daily charts will of course give us the first sell signal and the bearish divergences continue to warn that that may not be far away.

The light volume this week, lighter than we've seen in past years during this week, has made it very easy for the market to be manipulated higher. It will likely be even lighter tomorrow. If the pullback that started in the last hour on Thursday continues on Friday then I would expect it to be very choppy with lots of whipsaws. It should make for a very difficult trading day. We could get an early morning high but if so I expect it to get sold off from there so again expect whipsaws. My best advice for tomorrow is not to trade. Take the hint from everyone else who will not be at their trading desks on Friday.

If you're not into intraday trading but instead just looking for that next swing trade, I think it's still early to look for something. While I think we'll see another small pullback and push higher I consider that a risky trade (on the long side) since the move up could easily truncate (not make it up to the upside targets I identified--DOW 12626 and SPX 1440) or we might have already topped (with SPX's failure to make a new high to match the DOW as a sign of more bearish divergences. As I had mentioned above, a drop below Tuesday's lows would signify to me that a top is in. Until that happens I think we've got a little higher to go and the end of next week is when I think it'll be time to start watching very carefully for a top.

I'll be doing the weekend Wrap for Jim so we'll see if anything adds to the current picture here. I'll also be doing Tuesday's Wrap for Jim, if the markets are open. And I'll be back here on Thursday so hopefully we'll be able to zero in on the small moves over the next several days and get a better idea as to where we are in this rally. Good luck on Friday and I'll see some of you on the Market Monitor.
 

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Play Editor's Note: It is the holidays and many of our readers are traveling and spending time with family as they celebrate the season. The research side of our newsletter staff is also traveling and unavailable this evening. Our stock pick updates and new play content will return with the next regularly scheduled newsletter.


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Today's Newsletter Notes: Market Wrap by Keene H. Little and all other plays and content by the Option Investor staff.

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