The +115 point Dow rally was attractive on the surface but there are underlying problems.

Market Statistics

Normally a +115 point Dow gain would be a reason for celebration. However, even after the bounce today the Dow still closed -180 points below Monday's five-year high at 14,081. Despite the gains we had a lower low on Monday and today's close was a lower high. The Dow will have to have two more days like today just to return to Monday's highs. On the surface it appeared to be a bullish rally but it was just another day of short covering and lackluster dip buying. There was no conviction.

S&P support over the last month has been 1495-1500 (1497) and it closed right on that prior support, which may now be resistance.

The market rallied on the strong defense of QE by Ben Bernanke in his Senate testimony. He was confident and somewhat combative in his comments, which were aimed at his fellow FOMC members as much as to the Senate committee. After the testimony analysts are more or less convinced the Fed will continue QE into 2014 despite a pledge by Bernanke that the FOMC will "review" asset purchases at the March 19th meeting. The Fed reviews them at every meeting so that comment from Bernanke to the committee was discarded as unimportant.

Bernanke emphasized again that the QE would not change until there was a significant improvement in unemployment. If the sequestration takes place as expected there will be another 750,000 workers out of a job. He implored the Senate to modify the sequester to produce smaller spending cuts today and increasing only as the economy improved. I am not holding my breath on that outcome.

Bernanke's strong commitment to QE and assurances that size does not matter when looking at the Fed balance sheet, should go a long way towards ending the daily questioning of when they will start cutting back on QE purchases. He answered questions about the growing Fed balance sheet saying it does not matter because the Fed does not have to sell its treasuries and can simply allow them to pay out. That would prevent the sudden surge in interest rates that unwinding the balance sheet could produce. Bernanke said the result of QE on the economy was more important than the size of the balance sheet. Bernanke will repeat his testimony to the House Banking Committee on Wednesday.

Treasury yields fell after the testimony on expectations for QE to continue the rest of the year.

Ten Year Yield Chart

News surrounding the Italian elections moderated from the bleak outlook we saw on Monday afternoon. Berlusconi and Bersani are expected to form a coalition that will force hardliner "throw the bums out" Beppe Grillo into a minority position and allow the euro mandated reforms to continue. Berlusconi and Bersani said they would do whatever is necessary to avoid a new election. The Italian FTSE MIB Index fell -799 points to 15,552 as a result of the unexpected vote.

The reason Italy matters is that it is the third most indebted country in the world at more than $2 trillion. If it were to default the resulting damage to the global financial system would be traumatic. Italy is too big to fail and the EU will do everything in its power to prevent Italy from defaulting. However, if the debt starts crashing as a result of a change in governing policy there is nothing the EU can do to stop it. They will try buying bonds but they don't have enough money to hold off more than a token decline. If the new Italian government backs off the austerity pledges this could start the dominos falling. The Italian economy is not growing fast enough to pay down that debt and without a miraculous recovery it will never grow fast enough to pay it back. They will just continue to add to it until the system crashes.

There was a flood of economic data in the U.S. and a couple of the numbers immediately drew claims of bad data. New Home Sales surged to an annualized pace of 437,000 in January from 378,000 in December. That was a +15.6% increase in one month and the largest single month gain since the early 1990s. The pace of sales was the strongest since the summer of 2008 just ahead of the housing crash.

Analysts were expecting sales of 383,000 and immediately questioned the data. Months of supply fell sharply from 4.8 to 4.1 and the inventory level is nearing historic lows. Home prices rose +2.3% in January. Some analysts believed the surge came from buyers putting end of year bonuses into a new home while interest rates are near record lows. The housing data is prone to revision so next month's numbers could see January revised lower.

New Home Sales Chart

The Consumer Confidence for February soared from 58.6 to 69.6 and well above expectations for a small gain to 61.0. The +11.2 point gain was the largest since late 2011. It is now only 3.5 points away from its post recession high.

The expectations component spiked from 59.9 to 73.8 in the +13.9 jump is the biggest gain I can remember in recent years. It should be noted the expectations component declined from 84.0 in October to 59.9 in January. Recovering half of that four month slide in just one month is definitely questionable.

The present conditions component rose from 56.2 to 63.3 and a much milder increase of 7.1 points. Buying patterns declined in homes and appliances but increased for autos. The percentage of respondents planning on buying a home declined from 5.4% to 3.7% and appliances from 48.8% to 46.7%. Auto buyers increased from 10.4% to 11.1%.

The sharp decline in home buyers to the lowest level in two years conflicts with the sharp spike in new home sales and further calls into question the home sales numbers.

In January the confidence numbers fell to the lowest level in a year as paychecks shrank and fiscal cliff headlines were abundant. It is hard to understand what improved in February since gasoline prices rose nearly 50 cents and the sequestration headlines are filling the airwaves.

Consumer Confidence Chart

The Richmond Fed Manufacturing Survey for February spiked +18 points to +6.0 after hitting a six month low of -12.0 in January. The Richmond report has been very volatile lately and suggests uneven economic progress in the region.

The new orders component rebounded from severely negative at -17.0 to flat at zero and neither expansion or contraction. Backorders improved slightly from -19.0 to -12.0. Employment was the only component that moved strongly into expansion territory with a move from -5.0 to +8.0. That is only the second time since August that the component was in expansion territory.

Despite the rebound back into expansion territory the trend for business in the Mid-Atlantic region is still down. The sequestration will further add to the economic weakness as government orders slow and unemployment in the region rises.

Richmond Fed Chart

Mass Layoffs in January recovered from the end of year spike to return to the recent trend. The mass layoff events spiked to 1,749 in November with 172,879 workers impacted. For January the events declined to 1,328 and only 134,026 workers impacted. Manufacturing layoffs were 43,068 and 32% of the total.

The FHFA Purchase Only House Price Index for December saw prices rise +5.8% over December 2011. That compares to a +5.6% YoY gain in November. The Case Shiller Home Price Indexes for December showed a +6.8% YoY gain compared to +5.5% in November. Both of these reports were lagging data that was already priced into the market.

The economic calendar for Wednesday is headlined by a repeat performance by Ben Bernanke in front of the House Banking Committee. The activity level picks up on Thursday with the GDP, ISM Chicago and Kansas Fed Survey.

Economic Calendar

Also on Wednesday is the Apple shareholder meeting. The meeting took on added importance about 1:30 today when Doug Kass tweeted he was hearing rumors about a stock split announcement at the meeting. He later tried to walk back his comments saying it was just a rumor but the twitter-verse was already on fire with re-tweets of the rumor. The rumor came near the low of the day with Apple in negative territory so it would have been suspect regardless of who tweeted it. Apple shares spiked $10 on the news and finished the day with a +$6 gain. Apple shares have now traded under their 50-day average for 96 consecutive days. The last time that happened was in May 1996.

Apple Chart

Home Depot (HD) posted earnings that surged +32% as a result of the improving housing market and the reconstruction efforts following hurricane Sandy. HD reported earnings of 68 cents compared to estimates of 64 cents. HD earned 50 cents in the year ago quarter. However, the chain said the extra week in Q4 quarter added +7 cents to the earnings. In theory that would have meant they missed estimates after the calendar adjustment but nobody seemed to care.

Revenue rose +14% to $18.25 billion from $16.01 billion. They estimated hurricane Sandy added $242 million in sales. Same store sales increased +7%. Purchases over $900 rose by +9%. The CEO said he expected the current improvement in the housing market to last for two years before the "real" recovery begins. He called this a "workout" period where the foreclosures still made up the majority of sales. Once those are out of the system the real market will appear.

HD also increased its dividend by +34% to 39 cents. The bigger news was the announcement of a $17 billion stock buyback through 2015. That replaces and increases a prior buyback announcement. HD said it bought back one billion shares through February 3rd. Shares of HD spiked +6% on the news.

Home Depot Chart

JP Morgan (JPM) held an analyst meeting today and said it would trim about 19,000 jobs over the next two years as it shrinks the unit it had grown to handle troubled mortgages. That unit grew from 20,000 to 50,000 workers as the mortgage mess grew to monopolize banking activity. The mortgage unit will account for about 15,000 of the job cuts. The remaining 4,000 will come from the consumer banking business mostly from attrition in the branches. Even with the job declines JPM is planning on opening 200 new branch offices. Overall employment would fall from 259,000 to 242,000 by the end of 2014. The bank is targeting $1 billion in cost cuts.

CEO Jamie Dimon said the controversy over splitting the CEO and Chairman jobs was a "sideshow" for the bank and its investors. He asked investors to continue to allow the board flexibility to make decisions. He said the board was currently 11 directors and any six could fire him at any time. Leave the board alone and let us do our jobs. In a Q&A session he said fiscal policy was a legitimate worry for investors and interest rates could rebound too quickly. Dimon said he would focus on continuing to raise the dividend and do buybacks. However, if buybacks became too expensive because of a rapidly rising stock price he would push for a special dividend.

JPM has resistance at $49 and I would be a buyer on the next move over that level.

JPM Chart

Priceline (PCLN) spiked +$25 after the close after reporting earnings of $6.77 compared to estimates of $6.54. Revenue rose +20% to $1.19 billion. For Q1 the company expects earnings to rise 30-37% but there was a warning. Using language I have not heard before the company said because of troubles in the euro zone and other global concerns, "variability around its guidance is elevated." I have to give them at least a B+ for creativity.

Priceline Chart

I am worried about the market's future. In one fell swoop Europe has come back to haunt the headlines and will probably be there for weeks. The sequester headlines are heating up and while most traders are still expecting a resolution of some form the time is running out. The economic calendar is cluttered the rest of the week and then we have Nonfarm Payrolls next week. Earnings are basically over and there is nothing other than the Fed to push the markets higher.

The indexes have backed off their highs and made a set of lower lows on Monday. The internals were positive on Tuesday but very lackluster given the triple digit Dow gain and what appeared to be very strong economic data.

Since January 28th the support on the S&P has been 1497. Yes, 1495 and 1500 are the most repeated numbers but 1497 was where the intraday declines ended. Yesterday that support failed by -10 points. Today the rebound stalled at that 1497 level, which appeared to have become resistance. If the market weakens on Wednesday and fails to close back over that 1497 level then all long bets are off and the odds are good we are going lower, possibly to 1450 or even 1400. The gains since December have been so strong there is a lot of profit at risk.

The first few days of a failed market top are normally met with high volatility and big market swings. The bears are lacking conviction and the traders in cash on the sidelines are buying the dips. Short squeezes are routine occurrences. Once a pattern emerges of lower highs and lower lows the bears gain confidence and the buyers step back to the sidelines to watch the profit taking play out.

I believe that is where we are today. After more than a month of very small intraday ranges, the smallest since 1986 for the Dow, the ranges have opened up to triple digits on a daily basis and with alternating gains and losses. That is a recipe for a decline.

For the rest of the week we should focus on that 1497 level as support and resistance. Further declines below that level should be sold and rebounds above 1497, call it 1500 to be safe, could be bought. Just watch for a continued pattern of lower highs as a leading indicator for a bigger sell off. The 1480 level would be the next inflection point to the downside as short term uptrend support.

S&P Chart - Daily

The Dow broke well below support to 13,785 on Monday and only managed to reclaim prior support at 13,900 at today's close. Like the S&P the prior pattern has failed. The climax spike on Monday to a new high at 14,081 was immediately sold for a -297 point drop. The +115 point gain today is just barely over one third of that loss. As in the S&P we have a lower low on Monday and a lower high today. If we make another lower low the target becomes 13,500. Watch the 13,900 level as the key inflection point on the Dow.

Dow Chart

The Nasdaq was the least reactive on Tuesday with only a +13 point gain to close at 3129. That is roughly 85 points below its high last week at 3215. This lackluster performance was due to weakness in the big caps and it would have been worse but Apple rallied +$10 into the close. The 3125 level is critical for the Nasdaq and fortunately it closed over that level. Unlike the Dow and S&P today was actually a lower low. The Nasdaq declined at the open to 3105 before rebounding intraday. If that 3105 level is broken again the bears will likely show up in force.

The uptrend support at 3130 is now acting as resistance and the next support level is 3085. A break there is a free fall event.

Nasdaq Chart

On the Russell 2000 uptrend support has broken and horizontal support at 895 has been tested four times. If that level breaks it could produce a free fall event.

Russell 2000 Chart

I believe we have reached an inflection point in the market. There may be a lack of positive headlines to push the markets higher while negative headlines seem to be increasing daily. The Q4 earnings cycle is over and guidance was not good. With the sequestration headlines increasing in intensity and the warnings about job losses and reduced spending being joined by the return of the European debt crisis the bad news bulls will have to suck it up if they are going to power higher. We have all heard the phrase "climb the wall of worry" and that wall just grew by several stories.

Enter passively, exit aggressively!

Jim Brown

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