Wednesday's decline was caused by the FOMC minutes and Friday's rebound was sparked by St Louis Fed head James Bullard and German IFO.

Market Statistics

The market fell off a cliff on Wednesday when the FOMC minutes suggested there was more dissension among the Fed ranks over continuing the current QE programs for the rest of 2013. Even though the official FOMC statement is for continued QE until unemployment declines to 6.5%, and that is likely to be a couple years from now, there are fears the Fed is going to change its plan. Those fears caused a bout of selling on Wednesday and Thursday. At least the selling was blamed on the Fed regardless of the real reason.

On Friday James Bullard was interviewed on TV and he hammered a nail into the rumor of an early end to QE. He said, "I think policy is much easier than it was last year because the outright purchases are more potent than the Twist program…I don't think the markets have fully absorbed that switch. This is a monetary policy that packs a punch." Also, "The Fed's very aggressive easy money policy is going to stay that way for a long time."

He said investors should not be thinking in terms of dates for the ending or winding down of QE. Instead "You should be thinking in terms of how the economy is going to perform…substantial improvement in labor market conditions does not happen overnight."

He did say that once the economy improved significantly the Fed should taper off the QE programs but the context was well into the future and not likely to be 2013. He said he expected the economy to grow by +3% in 2013 but admitted he was optimistic. Most analysts are expecting only 2.1% and the CBO only 1.4%.

Bullard is a voting member of the FOMC so what he says counts more than the various nonvoting Fed presidents that have been talking down the easing scenario. His comments were instrumental in triggering the short squeeze early Friday morning.

San Francisco Fed President, John Williams, was also talking the market back up. He said the bank's primary concern is lifting the economy not worrying about the size of its balance sheet and how it is going to unwind it in the coming years. He said the current $3 trillion Fed balance sheet should in no way deter the Fed from continuing QE until the economy is significantly better.

The comments by Bullard were especially uplifting to the markets because he is one of the more hawkish members on the committee. Only five of the 17 are more hawkish than Bullard. Plosser, Lacker and Fisher are the most hawkish and George and Kocherlakota just slightly more hawkish than Bullard. If he believes QE will last a "long time" then odds are very good QE is here to stay. The one-two punch of two Fed speakers kicked the markets back into rally mode and shorts were forced to cover but the onslaught of Fed speakers was just getting started.

Boston Fed President, Eric Rosengren and Fed governor, Jerome Powell, said critics should be focusing on the positive side of QE and the increased economic benefits including future tax revenues as a result. Critics should consider the cost of inaction rather than worry about future challenges in tightening policy.

Rosengren actually mentioned the benefit to the government of the Fed's bond buying. He said the rock bottom interest rates on treasuries allowed the government to lower its debt to GDP. Basically it allows the government to continue financing 40 cents of every dollar it spends without a significant increase in its debt service. We all know this is going to end badly but for now the government has a blank check to spend like there is no tomorrow.

Bloomberg reported on Friday that Bernanke had played down concerns that monetary policy was fueling asset bubbles at a private meeting with bankers. They cited anonymous sources.

Bernanke will get a chance to repeat his comments for the public record when he testifies before the Senate on Tuesday. That will be must see TV given the very public battle over ending QE and the rising Fed balance sheet. You can expect some volatility in treasury prices ahead of that event.

The tsunami of Fed speak simply overpowered the markets and lifted the Dow to a +120 point gain and the eighth consecutive positive Friday close for the Dow.

The U.S. was devoid of meaningful economics on Friday but we got plenty from overseas. The German IFO Business Climate index rose +3 points from 104.3 to 107.4. That is the highest level since March and the biggest one month gain since July 2010. The present conditions component rose from 108.1 to 110.2. The expectations component spiked from 100.6 to 104.6 and was the biggest contributor to the headline gain. Wholesalers and manufacturers feel better about the future after sentiment deteriorated slightly last month. The wholesaler component rose from -1.4 to +6.3. Manufacturers rose from +2.8 to +9.5 and the construction sector improved from -0.2 to +6.9. The sudden improvement in sentiment in Germany lifted markets all across Europe.

The economic calendar for next week is chock full of critical events. There are four regional Fed manufacturing reports, the national ISM and Chicago ISM and Bernanke testifies on both Tuesday and Wednesday. Before we even get to Bernanke the Italian elections on Sunday could set the tone for the week.

There are four candidates for the position of Prime Minister and two of them have criminal records. One of them, billionaire Silvio Berlusconi, is still under indictment for several offenses. He is in second place in the polls. One is a comedian, Giuseppe Grilo that has a foul mouth where every sentence is laced with obscenities and he also has a criminal record. He is in third place. In first place is Mario Monti, the current office holder. If one person does not get a majority he will have to form a coalition government with one of the other candidates. It is a recipe for disaster with each of the trailing candidates diametrically opposed to Monti. If Monti does not win it could throw the Italian recovery into disarray and restart the entire euro crisis problem all over again.

If Berlusconi wins he has hinted he may cancel the austerity programs and withdraw Italy from the eurozone. That would be a disaster for Europe and kill the global markets. One campaign promise has been to cancel property taxes and that saw him surge in the polls. Nordea Bank is predicting a -15% drop in the European markets if Berlusconi and his anti euro allies come anywhere close to a majority in the election. Italy has the third largest bond market in the world and yields would immediately rocket higher and trigger losses around the world.

In the U.S. Bernanke's Senate testimony on Tuesday will be the key for the week and he gets a "do over" on Wednesday in front of the House. If he does not like the market reaction on Tuesday he can rephrase it for the Wednesday's show and tell. I expect him to remain rather firm on the QE front because it does not work unless the main banks believe it is going to continue. If they thought it would end soon they would just sit on their money and wait for the end of QE to appear. He has to be positive on the economy and firm on QE.

The GDP revision is out on Thursday and analysts are expecting it to turn positive to show +0.5% growth. That is up from a -0.14% decline in the first release. Obviously a better than expected number would be very positive for the market but it would put the pressure back on the Fed. However, there are some analysts that believe the first GDP estimate was too high. They claim a smaller than predicted drop in inventories suggest the GDP revision could actually be weaker rather than stronger.

The national ISM Manufacturing Index on Friday is the last major event. Conditions are expected to decline to 52.5 and just barely above contraction territory.

Friday is also the deadline for the Sequester. The administration has been putting various people in front of the cameras all week whining about how bad it will be for jobs and the economy. You would think it was the end of the world as we know it. What you are not hearing is that the sequester was Obama's plan in August 2011. The press has lost that point in their coverage. The idea he hatched with Boehner and Reid was to agree to something so draconian that both houses of Congress would have to work together to come up with another plan before the Sequester kicked in. Surprise, there was no compromise.

The administration is going into panic mode over the potential spending cuts of $85 billion in 2013. They claim airlines will not run on time. 230 airports will be forced to close. Food safety checks will not be done. Homeland Security personnel will be laid off. More than 800,000 jobs will be lost in the Pentagon. That is a slight exaggeration since only 24,000 actually work at the Pentagon. The 800,000 includes military personnel and defense department contractors. The CBO estimates the Sequester will cause a loss of 750,000 jobs in 2013 alone and then it repeats in 2014. The CBO is projecting the full year GDP to rise only +1.4% and unemployment to rise to 8.0%.

Yes, despite the -$85 billon in spending cuts the government spending will still increase in 2013. The spending will rise from $3.796 trillion to $3.883 trillion. The $85 billion sequester equates to only about 2% of the total budget. The budget is still increasing and the $85 billion sequester will only force it to grow slower. We can expect a lot of fireworks out of Washington this week. The administration is portraying the $85 in spending cuts as financial Armageddon. However, he just passed a $160 billion tax hike and is trying to get more with his demand to raise taxes INSTEAD of letting the spending cuts take effect.

If politicians can keep from self destructing from excessive amounts of hot air they might get something accomplished to further delay these spending cuts. I seriously doubt they will be replaced but they could be delayed once again. The market would celebrate that announcement even though it would have no impact on the future.

Economic Calendar

Moody's Investor Service downgraded the U.K. from AAA to AA1 on Friday citing weakness in the medium-term outlook. Moody's said the rising debt burden and subdued growth prospects were weighing on the British economy. They said the rising debt burden reduced the "shock-absorption capacity" and that was unlikely to change before 2016.

Depending on what happens to the Sequester, the March 27th budget resolution and the May 18th return of the debt ceiling the U.S. may be in for another round of ratings downgrades as well.

Contrary to popular opinion the U.S. economy is not doing as well as it would appear on the surface. The Philly Fed Survey on Thursday fell from -5.8 to -12.5 and the lowest level since July. A negative reading indicates contraction. This was the second strong decline from the +4.6 reading in December. New orders, backorders and inventories all declined. All the analysts were expecting a rise in activity. Moody's was predicting a rise to +4.5 in the headline number.

The impact of the fiscal cliff in Q4 was a stall in the recovery process. Corporations did not want to spend money, hire workers and build inventories if the cliff was going to result in a hit to the economy. By postponing the cliff until March 1st those businesses now have to deal with the remaining cliff issues, sequester, budget and debt ceiling over the next two months. That is not an environment conducive to an expanding business environment. Businesses want certainty in the outlook before they spend their hoarded cash. They are not getting that certainty as evidenced by the Armageddon warnings by the administration this weekend. Business conditions are NOT going to improve until the political issues are settled.

Philly Fed Chart

Retail gasoline prices have risen for 36 consecutive days and averaged $3.78 on Friday. Four dollar gasoline is firmly entrenched on both coasts and we are still a long way from the normal seasonal highs in late April. We could easily see another 50 cent increase in the price. This is seriously degrading the purchasing power of the blue collar consumer.

Gasoline Futures Chart

Europe is likely to remain in recession for the rest of 2013 according to the EU Commission. The commission said on Friday the EU GDP would decline by -0.3% in 2013. Previously they had expected minor +0.2% growth. Europe in a continuing recession will be negative for earnings from U.S. multinational companies. The Markit preliminary eurozone PMI for February fell to a two-month low of 47.3 from a January reading of 48.6. A reading of less than 50 signals contraction.

European unemployment is continuing to rise and that suggests the economics for the area are weakening further. The dark line is the 27 EU countries. The thin line is the 17 eurozone countries that use the euro currency.

European Unemployment Chart

It is not just Europe in recession today. The Organization for Economic Co-operation and Development (OECD) consists of 34 countries. Today 45% (15) of those countries are in recession. It is naïve of us to expect U.S. corporations to post large increases in earnings when much of the world is in recession. The U.S. market has decoupled over the last couple of months but it will not last forever.

Earnings for Q4 have ended with earnings growth of +3.0% thanks to a 14% gain in financials and 10% gain in energy and basic materials. Revenue growth was +3.8% thanks to an 18% gain in financials. More than 67% of companies beat estimates on revenue growth.

In July 2012 the consensus estimates for Q4 earnings growth was +14%. Clearly those estimates were off by a mile. Estimates for Q3-2013 are now 10% and Q4-2013 14%. Unless the global economy suddenly recovers I would bet those estimates are going to decline sharply as well. The U.S. economy is just limping along and there is not much to be gained at this point by further cost cutting. Companies need sales or the numbers are going to decline sharply.

According to Factset 79% of the S&P companies that issued guidance for Q1 have issued negative guidance. The five year average is 61%. The market has been blind to declining estimates, deaf to earnings warnings and in denial about the sequestration actually happening. This is not a solid foundation for the rally to continue because eventually fundamentals will come back to haunt us.

Meanwhile some companies are still surprising to the upside. AIG, once given up for dead, reported earnings of 20 cents compared to estimates of 7 cents. That is the first earnings report since the government sold off the last ownership stake in the AIG in December. AIG has now repaid all $182 billion of the government bailout and undergone massive restructuring. Shares of AIG rallied +3% on Friday but remain under strong resistance at $39. Some analysts believe that AIG is now a buy because the government ownership is over. Others believe it is fairly valued until they can produce a string of positive earnings surprises. Those skeptics believe the asset sales and restructuring have left the company at the starting gate to rebuild its business. Time will tell.

AIG Chart

Hewlett Packard (HPQ) rallied to its biggest one-day gain since 2008 after posting earnings of $1.2 billion. In the prior two quarters HP had lost $15.3 billion. Just posting any earnings was better than most analysts had predicted given the sharp decline in PC sales worldwide. HP said revenue from PC sales declined -8% in Q4. The bar was set so low for HP that any positive news was a surprise. Shares in HPQ rallied +12.3% to a six-month high on the news.

HPQ Chart

WebMD (WBMD) spiked +25% after reporting a better than expected Q4. Revenue fell -12% to $132.7 million but that was $8.5 million better than expected. Revenue for the full year declined -16% to $469.9 million. The company projected another 8% decline in 2013. The web portal is suffering because drug companies are spending less to advertise as drugs fall off patent. The bounce came after the company said it had signed contracts to play a unique and important role in the launch of new drugs but the revenue would not begin to flow until 2014.

WebMD Chart

Retailer Abercrombie & Fitch (ANF) fell -4.4% after the company forecast a loss for Q1. The retailer said the consumer environment in Q1 was weak citing a tough economy. The CEO said he was "very concerned about the macroeconomic situation in Q1." The company predicted a "slight loss" for Q1 compared to a 25 cent profit in Q1-2012. For the full year Abercrombie predicted sales that would be comparable to 2012.

ANF Chart

David Einhorn scored a win against Apple (AAPL) in court on Friday. The court issued an injunction preventing Apple from bundling multiple proposals into one vote at the shareholder meeting next week. The one Einhorn wanted to prevent was a proposal by Apple to do away with preferred stock without shareholder approval. Einhorn wants Apple to issue him preferred stock hence the conflict. Einhorn wants Apple to issue an iPref perpetual preferred stock with a 4% dividend. Apple has $137 billion in cash and Einhorn wants some of it. Most institutional shareholders were against the Einhorn action because they want to void preferred stock issuance. They believe the cash belongs to all shareholders not just a preferred holder.

Apple shares have been holding on support at $450 and the faithful are hoping for an announcement from Apple at the meeting that will lift the stock. The meeting is 9:AM on Wednesday.

Apple Chart

On a positive note the AAII Investor Sentiment Survey showed that bullish sentiment declined for the fourth consecutive week to settle at 41.8%. That was a decline of -0.5%. Bullish sentiment topped out at 52.34% on January 24th. Bearish sentiment rose +3.8% to 32.5%. Bearish sentiment bottomed at 24.27% on January 24th. Falling bullish sentiment is actually bullish on a contrarian basis. The higher the bullish number the less likely the market will continue rising.

The S&P-500 lost ground on a weekly basis for the first time in seven weeks. The loss was minimal at -4 points but it all counts in the sentiment polls. The longer a positive streak the more likely investors will bet against it. Now that the streak is broken investors can breathe a sigh of relief and buy the dip.

The FOMC minutes were the excuse for the selloff. It could have been anything from the EU PMI or the cutback on housing in China but they chose the minutes. When the markets are over extended investors are looking for any excuse to take profits. Nobody wants to be the first person to sell but they are more than willing to take profits as part of a group. The FOMC minutes were the "listed" excuse last week but in reality it was just profit taking.

The two days of profit taking on the S&P were just what the doctor ordered. The overextended market was turning frothy at the top and the internals were weakening. The SPX fell to 1497 for about 20 minutes on Thursday after holding above support at 1500 for the majority of the day. Volume was 7.7 billion shares and the strongest since December 21st. Volume on Wednesday was the second strongest this year at 7.5 billion shares. Advance-declines were nearly 4:1 negative on Wednesday with declining volume nearly 7:1. This was a decent bout of profit taking and the VIX shot up to a two month high at 16.

In theory this was all that was needed to relieve the overextended pressure and let new buyers into the market. Market theory seldom works in practice. I would love to see a new high this week but there is a tsunami of economic events that could smash us flat beginning with the Italian elections.

On a purely technical basis the risk would be a return to the 1530 high close from Monday and fail again. A second failure could further weaken sentiment and that coupled with negative global or economic news could be a witch's brew of negativity.

As long as we don't decline below 1495 the short term uptrend is intact as seen on the daily chart below. The 30 day average is short term support followed by 1495.

S&P Chart - Daily

Stepping back to the weekly chart the 1475 level is decent support but I fear a retracement of that magnitude would penetrate that level. There are multiple levels of converging support in the 1425-1475 area and decline to any of them would still be a continuation of the longer term uptrend. Note in the weekly chart below there is strong uptrend support as well as the 50-week average. We could easily decline to 1425 on a combination of bad news and weak Q1 earnings but still remain in a bull market and ready to move higher again as conditions improved.

S&P Chart - Weekly

The bigger risk is for a continuation higher in the next couple weeks on a simple force of will to 1550-1565 and a new historic high. That would complete a triple top and given the long term overextension we could easily be susceptible to a much deeper decline. At 1565 the S&P would be up +135% from the 2009 lows of 666. There were two decent corrections in the journey but those are long past.

Getting beyond the 1565 level is going to be a major undertaking on weak earnings guidance, 45% of the OECD in recession and China clamping down on monetary policy again due to rising inflation. The 1550-1565 level is where I would expect fundamentals to come back into focus. Fed QE is a powerful tool capable of pushing the equity markets higher but even rampant QE has its limits. Fundamental credibility has not disappeared. It is simply being ignored in the bull's quest for a new high. Once that quest has been satisfied we could see those fundamentals come back into focus.

S&P Chart - Monthly

The Dow declined to a four week low of 13,834 on Thursday. The +120 point rebound on Friday was mostly short covering and the big gain by Hewlett Packard. Only six Dow stocks gained a dollar or more. Those were HPQ, AXP, HD, IBM, MCD and XOM.

The Dow closed exactly at 14,000 and the battleground for the last four weeks. The gap open high on Wednesday was 14,058 and it was immediately sold. The blue chips should be doing well because of their liquidity and earnings power. Fund managers cautious about the market's continued struggle at this level could store cash in a Dow stock and be confident they could extract that cash quickly if the rally ended. While that is the case the Dow has not been able to sustain any gains over 14,000. The historic high close is 14,164 and the intraday high was 14,198. Both were in October 2007.

The megaphone pattern on the daily Dow chart is dangerous. The widening of the highs and lows is common at tops and the next decline could be to a lower low. Conversely the next high could also be a higher high but it needs to be much higher to break the pattern.

Dow Chart - Daily

The weekly chart shows the Dow is at the upper edge of its uptrend channel. I value the gray line more than the red one because the gray line is anchored at multiple points. The red line is only anchored once and the right side is in the process of determining the upper anchor. The blue support lines are well below the current level and suggest any material selling could persist for as much as 1,000 points.

Dow Weekly Chart

The monthly chart shows a double top and a dangerous inflection point. This would be the perfect spot for a failure and a decent correction to begin. That is not to say that is what will happen but it puts added importance on the Dow breaking through 14,000 with conviction.

Dow Chart - Monthly

The Nasdaq chart is a picture perfect example of breaking out to a new high close only to be sold hard back to initial support. The new high close over 3213 on Wednesday was hammered to hit 3118 on Thursday. Buyers stormed in at support for a decent +30 point gain on Friday. Unfortunately it left the index well below that 3213 high close. After slugging it out for nearly two months to fight higher from 3100 those gains were nearly erased in only two days. For once it was not the fault of Apple and Google. Both declined but the declines were minimal. It was broad based profit taking after two months of gains.

The Nasdaq has to remain over support at 3125 or the bears will come out in force once again.

Nasdaq Chart - Daily

The Russell was the track star in the race to historic highs and it was the leader on the downside as well. The Russell lost -31 points or -3% on those two days of selling. Support at 900 was rock solid with the low at 900.48. Buyers showed up in force and the Russell rebounded late Thursday and that was continued on Friday with the close at 916 to regain half the points lost.

Now we have the ideal sentiment indicator once again. A decline below 900 means sell everything while a new high indicates a new leg higher has begun.

Russell 2000 Chart - Daily

I said last weekend, "The market will pick an excuse and all of a sudden stocks will be sold and everybody will be wishing they had stop losses. Bull market corrections are normally short, sharp and scary. Be prepared and profit from it."

In a perfect world if you had stops you locked in profits and were able to buy the dip when support was hit on Thursday afternoon. Since most of us don't live in a perfect world we can only wish we had followed that plan last week.

The market this week is likely to be pushed around by headlines. There are a couple dozen on the economic calendar with the Sequester, Italy and Bernanke the three most likely to move the markets. I would be cautious about new entries until we see which way the market is headed. Much of Friday's gains were short covering and next week will be a testing phase to see if there is any conviction by those who bought the dip.

Enter passively and exit aggressively!

Jim Brown

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