The stock market rally continues to surge higher with the S&P 500 index extending its gains to four weeks in a row. For anyone keeping score the S&P 500 index is now up 1,001 points from its March 2009 low of 666. The large cap index is also up almost 77% of the trading days in May. Another piece of stock market trivia was the Dow Jones Industrial Average uncanny midweek strength with the index up 18 Tuesdays in a row. That has never happened before not that it means anything.

This remains a broad-based rally with financials, technology, and transports all rising. The transportation average is up +23% for the year. The small caps Russell 2000 index is up +17.3% year to date. Biotechs are a stand out with a +29.7% surge year to date. The sudden rally in the U.S. dollar is crushing gold and silver with gold down almost -$90 for the week. Gold shorts have reached all-time highs. Oddly enough the rise in the dollar is not pushing oil prices lower.

There were a number of economic reports out last week and the data was mixed. The regional economic reports continue to show the U.S. economy sliding lower but consumer sentiment was the positive surprise for the week. On Friday the University of Michigan Consumer Sentiment Survey came out at 83.7. That was up from 76.4. Friday's reading is the highest level since July 2007. Normally, during non-recessionary years, the sentiment has an average of 87.6. I suspect this sudden improvement in consumer sentiment is a reflection of rising home values and the rising stock market, which generates a wealth effect. That's exactly what Fed Chairman Ben Bernanke wants. If a consumer feels wealthy they will spend more but we'll talk about that later.

The Philly Fed manufacturing index plunged from -2 to -5.2 in May. Numbers below zero indicate economic contraction and suggest recession. The New York Empire State manufacturing survey reversed from +3.1 to -1.4. Another negative surprise was the industrial production numbers, which dropped -0.5% in April, from a downwardly revised -0.3% in March. Retail sales in April rose +0.1% versus a -0.5% drop in March. Weekly jobless claims bounced +32,000 to 360,000, which was above estimates.

Another issue were the inflation gauges. There is no inflation unless you look at energy and food. The latest reports actually suggest a more deflationary environment. The Producer Price Index dropped -0.7% in April, down from -0.6% in March. The Consumer Price Index fell -0.4% versus estimates for -0.3%.

The homebuilder confidence index broke a three-month down trend with a bounce in May. The survey of builders came in at 44 in May, up from 41 in April. Yet this confidence was not very evident in the housing starts data. A couple of days later the national housing starts showed a -16.5% plunge from 1.036 million in March to 853,000 in April. This is the lowest reading on housing starts in five months and the biggest one-month drop in over a year. Multi-family housing starts plunged even faster with a -39% drop. If residential real estate is recovering why the slowdown in starts? Lumber prices are plunging as well if there was a big construction boom in housing then demand for lumber would be higher. Something doesn't smell right in the homebuilder industry.

An anecdotal story to the consumer spending issue is Wal-Mart's (WMT) earnings report. The company reported earnings a few days ago and WMT missed the earnings estimate, missed the revenue estimate, and reported a drop in same-store sales. If that wasn't bad enough management guided lower for the second quarter. WMT is the biggest retailer on the planet. If the economy was improving it would be reflected in WMT sales. Granted you could argue that the rising stock market and rising home prices may have not have much of a "wealth effect" influence on the average Wal-Mart shopper. The company's disappointing results remain a potential warning signal for the broader economy, especially since consumer spending is considered 70% of the U.S. economy.

Looking overseas there were plenty of headlines from Europe. The Eurozone is stuck in recession with its Q1 GDP estimate coming in at -0.2% growth. That was improvement from the prior quarter's -0.6%. Germany's GDP was +0.1%, France reported -0.2% growth. Italy said their economy fell -0.5%. Meanwhile Eurozone industrial production rose +1.0%, up from the prior month's +0.3% reading.

Japan was making headlines with its Q1 GDP estimate coming in at +0.9% growth, which was better than expected. Japan also said its core machinery orders surged +14.2% month over month compared to +7.5% the month before. The Japanese NIKKEI stock market index continues to surge and rallied past the 15,000 mark for the first time since January 2009.

We did hear some good news out of China with the country's retail sales coming in at +12.8%, up from +12.6% the prior month. China also said its industrial production rose +9.3% versus the prior reading of 8.9%.

Major Indices:

The S&P 500 index posted a +2.0% gain for the week and is up +16.9% for the year. It's up +23.2% from the November 2012 low. The strength in this large cap index is impressive. Unfortunately the index just closed near its multi-month trend line of higher highs. Thus odds favor a short-term pullback (see the daily chart below).

If somehow the rally continues then 1675 and 1700 are potential resistance levels. If the index pulls back then 1635, 1620 and 1600 are potential support levels. Although in February and April the index saw dips to the 40-dma and 50-dma, and if it saw a similar dip now that would break below the 1600 level.

chart of the S&P 500 index:

The NASDAQ has been on fire with a steady stream of new relative highs. It posted a +1.8% gain for the week and is up +15.8% for the year. The nearly non-stop run from its mid-April low leaves the index very short-term overbought and definitely due for a pullback.

The index closed Friday right at round-number resistance at 3500. The NASDAQ is so over extended that any correction could be painful. The 3400, 3365, and 3300 levels are potential support levels. If somehow the rally continues then 3550 and 3600 are possible resistance levels.

Hypothetically, if the market were to suddenly see a -5% correction then the NASDAQ would drop to 3,325.

Daily chart of the NASDAQ Composite index:

The small cap Russell 2000 index is also up four weeks in a row. This index posted a +2.1% gain for the week and is up +17.3% for the year. I've been warning readers that the 1,000 level could prove to be round-number, psychological resistance for the $RUT. It looks like we're going to find out soon if that's true or not. The $RUT is so overbought that the nearest support is probably the prior resistance near 955.

chart of the Russell 2000 index

Economic Data & Event Calendar

We are about to start the third full week of May and the economic data slows to a crawl. We'll see existing home sales and new home sales data. The real "event" for the week will be the release of the FOMC minutes from the prior meeting and Chairman Bernanke's testimony before congress on Wednesday. Mr. Bernanke will be providing the Fed's "economic outlook". The meeting starts at 10:00 a.m.

Economic and Event Calendar

- Monday, May 20 -
(nothing significant)

- Tuesday, May 21 -
(nothing significant)

- Wednesday, May 22 -
existing home sales for April
FOMC minutes
Fed Chairman Bernanke speaks before congressional committee

- Thursday, May 23 -
Weekly Initial Jobless Claims
new home sales data

- Friday, May 24 -
Durable Goods Orders

Additional Events to be aware of:

May 27th - U.S. market closed for Memorial day
September - U.S. debt ceiling deadline

The Week Ahead:

The market's trend is clearly up. Yet we all know that stocks don't go straight up. There are ebbs and flows. Right now we're way over due for an ebb lower. Currently the U.S. market is very overbought. The number of S&P 500 components above their simple 200-dma is almost 94%. The last time this reading was this high was back in early 2011, right before the market peaked.

Another market internal reading at extremes is the S&P 500 bullish percent data, which calculates how many S&P 500 components have a point & figure chart buy signal. Right now bullish percent number is at 89%. Usually readings above 70.0 are considered overbought. The last time the S&P 500 bullish percent was this extreme was the first quarter of 2011. You guessed it - right before the market rolled over. Now I'm not declaring the market is going to reverse tomorrow. I want to caution you that the market is reaching extremes. Odds are growing for a retracement lower. A -3% to -5% pullback would be healthy at this point and also provide us a better entry point than chasing stocks at their highs.

I do think part of the challenge for market bears is the lack of alternatives for investors. Where else are they going to put their money? Gold has lost its luster. Bond market experts are calling a top in bonds. Trying to short the market is fighting the fed and several of the world's major central banks. There was some research done on the Fed's QE program and the U.S. treasury's scheduled issuance. Right now the treasury is not going to issue enough debt in 2013 to meet the Federal Reserve's demand. That means the Fed will have to buy treasuries on the secondary market. This will encourage normal bond buyers to put their money in other assets, potentially the equity market.

Overall I am troubled by the disconnect between the stock market and the reality in the economy. We just saw two of our regional manufacturing survey's turn negative. The trend of economic data has been bearish for months now. Yet stocks continue to ignore economic data. Previously the stock market would stumble and quiver any time someone suggested the Fed might cut back on its QE program. Yet this past week there has been a switch. A couple of influential analysts and hedge fund managers have suggested that when the Fed "tapers" its QE program it will be bullish. If they don't taper (reduce their QE) then it would be bearish and suggest the economy is getting worse.

One thing we have to keep in mind is that the market is always right. We don't want to fight the trend. Yet that doesn't mean we have to chase stocks higher when we're seeing some warning signs. These are probably just short-term warnings signs on the market internals. I do think we're in a buy-the-dip sort of market. The question is how much of a dip do we wait for? Personally I would be tempted to wait for a -3% to -5% decline or a dip toward the key moving averages or trend of higher lows. If and when you do initiate new positions consider starting small and then add to it as the trade progresses.