With the Dow only about 100 points from its historical closing high the pressure is on Bernanke not to disappoint.

Market Statistics

The Dow closed 90 points below its historic closing high of 15,409 and the FOMC meeting is tomorrow. This is the equivalent of the passengers on the Titanic dancing the night away with the iceberg only a few miles ahead. The only difference is that those passengers did not know there was an iceberg but investors today are fully aware the rally could come crashing down at 2:PM on Wednesday.

The Dow completed six consecutive days of triple digit moves and that has not happened since October 2011 when there were nine consecutive days.

Let's hope the post meeting result is not the same as we saw in 2012. Prior to the June 20th FOMC meeting the S&P rallied +50 points. After the meeting all 50 points disappeared in only three days.

June 2012 S&P Chart

The market actually has more risk this June because of the potential for a change in QE. If Bernanke is unsuccessful in walking a fine line between warning about future changes and explaining that those changes will be minor and QE will continue for many more months then we could easily give back all our recent gains.

The market rallied sharply today despite some disappointments in the economic reports. Housing starts rose from 856,000 in April to 914,000 in May but that was less than the 950,000 analysts expected. The increase was mostly in multifamily units and not single family homes. Starts rose +2,000 for single family to a rate of 599,000. Multifamily starts rose by +56,000 to 315,000. Clearly the +2,000 for single family was the equivalent of a rounding error or 0.003% increase compared to a +21.6% gain in multifamily.

The sharp increase in multifamily units is good for the economy because it takes more workers and a lot more raw materials to build an apartment house or condominium than a single family home.

Permits, a prelude to starts, declined by -3.1% to 974,000 and completions fell by -0.9%. Single family permits rose by +1.3% but multifamily permits declined by -10%. The sector has improved significantly over 2012 and starts are up +29% year over year.

Note the decline in the last two columns on the chart. April and May should be strong months for starts because of the weather factor.

Housing Starts

The Consumer Price Index (CPI) rose +0.1% in May after declining a total of -0.6% in the two prior months. Analysts were expecting a +0.2% gain. The core rate rose +0.2% for May after two consecutive months of +0.1% gains. There is barely any inflation at all and this is troubling for the Fed.

The year over year inflation rate in consumer prices is now +1.4% with the core rate +1.7%. That is the lowest core rate in a year.

The inflation rate for goods was zero for the second month. It has been fractionally below zero for the last eight months with a +0.2% in January and three months of -0.1% with the rest of the months at zero. This is the deflation worry for the Fed. When prices for goods are not rising it means there is an oversupply and demand is weak. Producers are fighting for market share by lowering prices.

The inflation rate for services has been rather steady at +0.2% per month for the last 8 months with April at +0.1% and January +0.3% as the only deviations. Services are rising because of increasing employee costs.

The main boost for the CPI was a sharp uptick in housing costs. Without the +12% year over year gain in housing prices we would be seeing significantly lower inflation numbers and the Fed would be bending over backwards to increase QE rather than taper it. Also prices of imported goods from China and Japan are falling and that negatively impacts the inflation numbers. Those trends are not likely to change.

The only sectors with major price increases are food and energy. Crude prices are nearing $100 again and the 2012 drought has reduced supplies of grains and animal products. The Fed is faced with turning a blind eye towards the rising food and energy prices while combating the weak prices for consumer goods. It is the proverbial rock and a hard place for the Fed.

CPI Chart

German investor confidence as represented by the ZEW Index rose from 36.4 to 38.5 in May. Analysts were expecting a rise to 38.1. That was the biggest gain in a year and suggests the German economy is accelerating. German industrial output jumped +1.8% in April as construction activity accelerated after the winter weather passed. The Bundesbank said on Monday the GDP should improve "markedly" for the quarter. Unfortunately they also said it would slowdown in the coming months. The bank cut its full year GDP estimate to +0.3% from +0.4%. Personally I don't think that 0.1% is material the overall number still stinks. They cut 2014 estimates from +1.9% to +1.5%. New car sales fell in May after a slight uptick in April. However, the German car market has been declining for its sixth consecutive year and is going to set a two-decade low in 2013.

The euro debt crisis appears to be fading from the headlines even though the problem still exists. Spain, Italy, Greece, Portugal and France are still deep in debt and the slightest crisis could plunge the eurozone back into turmoil. For now Draghi says the euro area economy is showing "some improvement" but the ECB will "remain accommodative for as long as necessary."

The better than expected German investor confidence pushed the U.S. futures up on Tuesday and helped trigger the opening short squeeze.

The U.S. economic calendar for the rest of the week is full but the FOMC meeting and the Bernanke press conference are really all that matters. The FOMC announcement is 2:PM and the press conference at 2:30 ET.

Once past the FOMC volatility event the Philly Fed survey on Thursday will be important but it may be ignored if the Fed event rocks the market in some way.

Economic Calendar

President Obama confirmed that Bernanke will not be reappointed when his term expires in January. He did not specifically say that but in an interview with Charlie Rose he said "Bernanke has done an outstanding job" but he has remained in the post "longer than he wanted and was supposed to." He likened Bernanke to FBI Director Robert Mueller, who stayed on for two years after his term expired and is leaving in September. Basically Obama was officially floating the trial balloon that Bernanke would not be reappointed without actually saying those words.

This is not a surprise. Bernanke has been widely expected to leave the position when his term expires on January 31st. Janet Yellin is the assumed successor but a wide range of candidates have been mentioned. By talking about Bernanke in the past tense the president was dropping bread crumbs to see if the market would tank and to see who the market was going to suggest as a possible replacement. Obama said, "He has been an outstanding partner along with the White House, in helping us recover much stronger than, for example, our European partners, from what could have been an economic crisis of epic proportions." His use of "has been" instead of "is" in the various comments was the clue.

Former Fed Governor Laurence Meyer said Obama "essentially fired Ben Bernanke on the spot and gave him a fairly tepid testimonial afterword." Meyer said "I almost fell off my chair when I heard the president's remarks."

Bernanke has already broken with tradition when he decided not to attend the Federal Reserve's annual central banking conference in Jackson Hole this year where he typically gives the keynote address. Bernanke said recently he has "spoken to the president" about his future and felt no personal responsibility to stay at the Fed to oversee the reversal of his policies.

How would you like to take over as the chairman of the Fed and be forced to unwind what will be about a $4 trillion balance sheet and endure the market turmoil that will result? I am sure Bernanke understands that even if he leaves in January he will be blamed for the economic and market volatility that is sure to follow the unwinding of the Fed's current policy. The only positive note for him is that he won't be the person in the hot seat giving congressional testimony and being grilled by lawmakers on why the markets are in turmoil. The new guy or girl should demand combat pay before they accept the position because they will definitely be forced to earn it. The appointment is a four-year position and that is about how long it will probably take to get past the volatility.

In stock news today it was pretty quiet. Volume was low at 5.6 billion shares so there was no conviction to the rally. NYSE volume was the third lowest day since Tuesday after Memorial Day.

After the close Nvidia (NVDA) said it was going to license its revolutionary "Kepler" graphics processing unit or GPU core to other chip makers. This technology allowed computer makers to build desktop machines with up to 540 cores for a minimum of cost. It revolutionized the high demand engineering and CAD/CAM design industry. Nvidia has previously licensed this technology to Sony (SNE) for the Play Station product. Nvidia said the proliferation of computing devices especially the Android operating system devices means there are more opportunities to license the technology. This is a big deal for Nvidia and should boost their royalty income significantly. Nvidia already receives hundreds of millions of dollars a year from Intel for its graphic technology licenses.

In similar news there was a report that Microsoft (MSFT) is going to build a version of its Surface tables using chips from Qualcomm even though they will still use the Nvidia Tegra processors for other Surface models.

Nvidia's chart has been fairly unimpressive despite its league leading GPU technology.

Nvidia Chart

Adobe Systems (ADBE) reported earnings after the bell of 36 cents that beat estimates of 33 cents. Revenue decline -10% to $1.01 billion. Adobe said it added 221,000 Creative Cloud subscriptions in Q1, taking the total to 700,000. Adobe began offering its Creative Suite of programs by subscription only in Q2-2012. The move to a subscription model lowers revenue in the short term but increases it long term since users are forced to continue subscribing to continue using the products. Previously a purchaser could continue using that version of the software forever. Adobe said it would no longer develop licensed versions for purchase.

The company guided for the current quarter to between 29-35 cents. Analysts were expecting 35 cents. While that appears to be less than expectations the stock soared +$2.50 in afterhours trading.

Adobe Chart

Carl Icahn has not given up on Dell as some recent headlines have stated. Late today headlines broke saying Icahn wants Dell to undertake a tender offer for 1.1 billion shares of Dell at $14 each. The tender offer would be financed by Jefferies and Icahn. They would use $7.5 billion in existing Dell cash and sell its receivables for another $2.9 billion. Jefferies would put up $1.6 billion and Icahn would add $2 billion if needed.

He also said he bought 72 million shares from Southeastern Asset Management making him the second largest shareholder in Dell. Southeastern still holds 74 million shares. Icahn has 152.5 million shares (8.7%) compared to Michael Dell's stake at 273 million or 15.6%. Michael Dell is prohibited from voting his shares at the July 17th shareholder meeting to approve his own offer. Michael has offered to take the company private for $13.65 per share.

Icahn said "Despite Dell's own dire projections, the company's own consultant BCG, which they neglected to mention in their last report, stated in the most conservative case, that Dell would have operating income of $3.3 billion in calendar 2014." Icahn then said, "After the tender, if everybody tenders, there will be 670 million shares outstanding, which will earn $3.72 per share. Don't you think the stock will be worth more than $14?" Obviously the key is to get 1.1 billion shares to tender after Icahn stated his bullish case. Icahn said he and Southeastern would not tender their shares. Existing shareholders could tender up to 72% of their positions. Dell shares barely moved on the news.

Dell Chart

Crude prices rose a little higher to $98.50 on the escalating problems in the Middle East. The potential for increasing hostilities surrounding Syria and the possibilities for a proxy war between the U.S. and Russia is growing. President Obama and Russia's Vladimir Putin met at the G8 gathering in Ireland and it was not a pleasant meeting. The leaders traded verbal jabs and Obama appeared defeated while Putin was defiant.

Putin railed against efforts to supply arms to the Syrian rebels and derailed every attempt at an agreement among G8 leaders to reach a consensus. Putin reportedly clashed with multiple leaders and remained isolated from the various discussion groups. Putin warned he would sell additional weapons to Syria if the U.S. followed through on its recent comments to supply small arms to the rebels. He hinted that Obama tried to isolate Russia as Putin's comments became increasingly anti-Western.

You can tell from the picture below this was not a happy photo session. Nobody was cracking jokes or talking about their grandkids.

Obama and Putin

Crude Oil Chart

The markets surged on low volume ahead of the FOMC meeting and broke through the three week down trend. It is hard for me to believe that investors are expecting Bernanke to be so bullish in his comments that the markets would breakout to new highs ahead of the summer doldrums. Anything is possible but that would be a low odds trade.

It is more likely this was a move by shorts to cover ahead of the announcement just to avoid that unexpected breakout to new highs. There were sell imbalances at the close but those were matched up with late orders.

The S&P pushed through initial resistance at 1645 to close at 1651. While it is not a rousing breakthrough it does count.

I am not going to try and make too much of the day's gains or the relative position of the markets because everything can change in a heartbeat after the Fed meeting. Everything up to this point was positioning and the real move will begin on Thursday. The actual day of the announcement is typically volatile but the real direction appears the day after.

However, if we see any further gains it could cause some serious short covering and price chasing as we approach the end of Q2. Fund managers are sitting on a razors edge this week as they eye the quarter end and the Russell index rebalancing on June 28th. The next two weeks are going to be extremely volatile.

As a point of control the analyst consensus for the S&P 500 to close 2013 is now 1654 only 3 points higher than today's close.

S&P Chart - Daily

The Dow chart shows the same breakout pattern as the S&P. However, the Dow chart is deceptive. The Dow closed only 90 points away from an historic closing high at 15,409. There were several days with higher intraday spikes but none held. If they Dow were to close over 15,409 that would be a flashing signal similar to waving a red flag in front of the bull. We could immediately blast higher. No fund manager will want to tell customers at the end of June they are heavily invested in cash when the market is breaking out to new highs.

Dow Chart - Daily

The Nasdaq surged as well despite another negative day from Apple. Google gained +14 to lead the charge. The Nasdaq is only 20 points away from a 12 year closing high at 3502. Multiple sectors are outperforming especially the semiconductors, which broke out to a new high today.

This is a bullish setup with the Nasdaq only one good day away from new highs. The news from Adobe and Nvidia after the close could start the morning gains but it is going to depend strictly on Bernanke on whether it will continue.

Semiconductor Index Chart

Winners & Sinners

Nasdaq Chart

If you want a confirmation of bullish sentiment you only need to look at the Russell 2000. The index closed at a new historic high at 999.98. It traded over 1,000 for most of the afternoon but could not close the deal. That is a historic threshold and it would appear we are going to cross it.

When you consider the potential for a severe market disruption after the FOMC announcement you would think fund managers would be a little more cautious. Apparently we would be wrong. Fund managers are not showing any reluctance to buying and holding small caps ahead of the Fed meeting. That is amazingly bullish. Foolish maybe, but still bullish.

The Russell indexes will have their annual rebalance on June 28th so fund managers will have their hands full trying to balance (no pun intended) the desire for performance with the need to shuffle portfolio holdings on June 28th. Fortunately funds that simply track the Russell indexes only have one date to worry about and they are not concerned about the Fed meeting volatility. Those funds that pick stocks and focus on small caps are not normally concerned about the index rebalances. How much those different fund types will be impacted by the volatility is unknown.

At the risk of repeating myself I view today's historic close as very bullish. However, we always have the risk of a double top forming when that close is impacted by alternative events like the FOMC meeting.

Russell 2000 Chart

I started this commentary with a somewhat bearish outlook. It appeared to me that the Fed rally had already happened. Investors were factoring in what they felt was going to be a benign performance by Bernanke and another FOMC statement that duplicates the last one. This is still a possibility.

The more I researched and read the more I began to believe that Bernanke could wander from what everyone assumes he will do. After Obama threw him under the bus in the weekend interview and after the equity markets moved up to test the old highs there may be an opportunity here for him to be a little more bearish.

He could use the extreme bullishness we are seeing in the equity market to lean a little more towards the taper talk rather than try to smooth over the prior comments. Apparently the prior comments no longer need smoothing. The market dip has been erased and everyone seems to be resigned to the future taper process.

The current analyst consensus is for the first QE cutback to be announced at the September meeting. The historical summer market swoon will be over and the GDP will be improving based on recent estimates. The Fed will have seen three more payroll reports and will have a good idea if the sequestration is going to have any lasting impact.

Since the analyst community is leaning towards a September announcement Bernanke may imply the same target and the damage to the markets will be minimal.

Obviously any guesses about what he or the Fed may say are just that, guesses. Nobody can predict with any accuracy what the market reaction will be. About the only thing we can count on is the big market move on Thursday. Historically that is when the market direction appears but then we are making history on a daily basis as the markets retest their highs so anything is possible.

Be prepared for a sell the news event.

Enter passively, exit aggressively!

Jim Brown

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