Stocks hung over from strong Thursday move and ahead of long weekend.

SUMMARY:
- Stocks hung over from strong Thursday move and ahead of long weekend.
- Personal income and spending decent, PCE deflator 2.1%.
- Midwest manufacturing slows more than expected, still expanding.
- Gold continues to surge while bond yield curve re-inverts.
- Short week but a lot to prove: will Fed return to grouch mode?

Investors pause to consider FOMC statement and long holiday weekend.

Foreign markets were surging on the heels of the big Thursday gain in the US, but futures were mushy Friday morning until the personal spending and income data hit, showing the PCE did not jump higher as feared (0.2%, 2.1% year/year). That propped up the early trade and NASDAQ gapped higher on the open as stocks took the early offensive.

After SP500 tapped near resistance at the 50 day SMA, however, the market lost its bid. Unfortunately that happened in the first 10 minutes, and stocks were selling back down through the first hour. Losses never came close to getting out of hand, however, as the indices had those early gains to buffer the downside. They recovered after that initial selling and started a slow but steady climb back up, through midmorning, into lunch, and on to the last hour. That pushed the indices to positive, extending the Thursday move. As expected, however, the late trade ahead of the weekend was to the sell side, and stocks slipped to negative by the close, again sporting just modest losses.

Technically there was no damage done or advantage gained. SP500 closed at its lows but it was hardly a wild ride. Volume jumped early, died off, and then surged late as part of the Russell indices rebalancing. That pushed a lot of stocks sharply up and sharply down at the close as institutions shuffled their holdings to match the new balance. Breadth was close to 2:1 on NYSE, mediocre on NASDAQ. Some leaders moved higher, but there was no new surge upside. Basically some modest backfilling on volume that rose due to logistical issues as opposed to any new buying spree.

That left the Thursday move intact with the market looking to hold that gain over the next week and then push higher through next resistance. It always looks like a tall order after such a hard sell off, particularly when the Fed is still on the offensive and summer is just getting underway. The market does have some leadership returning from many different areas, however, and that is the ace in the hole for nearly all rebound efforts. After some testing of the move this coming week the market will try and resume building the recovery.

If it is successful we will see more stocks building their bases and making their moves. It is a bit difficult to look past the time of year and all of the issues facing the economy (Fed, gasoline prices set to jump higher once more, summer); we have had our doubts about the ability to make the move, indeed expecting another leg lower. We always teach, however, you have to go with what the market is telling you. Strong leadership coupled with solid price/volume action in the market in general is the best indicia of a healthy or improving market, and despite all of your detailed reasoning or gut feelings, the market has the last word. Sure the Thursday move could be a head fake, but you have to like the leadership that is out in front and the recovery of former leaders in energy, metals, etc.


THE ECONOMY

May PCE deflator checks in at 2.1%.

Personal income grew 0.4% versus the 0.2% expected while spending climbed 0.4%, right in line with expectations. The PCE deflator, one of the Fed's pet primary inflation gauges, rose 0.2%, in line with expectations. That kept the year over year rate of climb at 2.1%, flat with April. Personal income rose on interest income and partnership and business income. Wages and salaries were flat; another key Fed inflation watch point showed no gains. Two positives for a Fed on economic data watch.

Not bad, but the Fed cannot slip back into the bad habit of viewing economic activity, whether stronger or weaker, as necessarily leading to inflation. Inflation is monetary, i.e. depending upon the amount of liquidity in the economy relative to economic activity. If there is more money in the system than is being used to expand businesses, output, etc., then you have potential inflation issues as that excess money is used to bid up prices.

Thus just because economic data is weaker does not mean inflation chances are lower. You can have inflation and crappy economic activity as in the 1970's. The Fed has to keep its eye on the ball and look at economic activity in terms of its mandate: price stability and the maximum sustainable pace of growth. In other words, the economic activity should not be used as a measuring stick of inflation, but should be reviewed as part of overall Fed monetary policy to determine if it should try to encourage more growth while keeping inflation at bay.

Gold prices continue higher as the bond curve inverts yet again: time to kick the Fed again.

The Bernanke Fed reminded everyone of that dual mandate with its Thursday FOMC statement. To economic historians (or even those like me who just reads some history and applies the lessons) this was very refreshing: a Fed, at least on paper, that is able to segregate inflation indicators from economic growth rates.

To some in the gold and bond markets, however, it is a sign of a new Fed that does not understand the importance of keeping inflation at bay. Those were the ones going nuts when commodities shot through the roof earlier this year and helped drive bond yields higher as well before they too crashed with gold when the Fed started its tough talk.

Thursday and Friday gold was on a tear back to the upside, adding another $27 to $616. It was just down around $570 before the Fed meeting after the plunge from $730. Apparently the gold buyers feel the Fed is once again backtracking on its tough guy inflation policy. Gold is an inflation indicator, a traditional hedge against rising inflation. When gold rises money is moving into it to avoid losing value. This is no demand move due to the Chinese and Indians wearing more gold bracelets; it is related directly to the Fed statement as it turned on a dime with the announcement.

On the flip side, the bond curve started losing ground once more. Thursday the curve returned to the more typical shape with the short end below the long end. It was still flat, but the curve was pointing in the right direction. Friday that changed again with the short end rising back above the 10 year yield (5.15% 2 year versus 5.14% on the 10 year). Moreover, yields are dropping once more with both below the Fed Funds rate (now 5.25% after Thursday). The inversion is modest, hardly indicating a recession, but a flat curve is not a good sign for economic growth. Yields below the Fed Funds rate are not a good sign for economic growth as well.

Yields below the Fed Funds rate and a flat to inverted curve are not good signs for the economic future. On the other hand, jumping gold is a sign of inflation. You want to be careful and not mix the two. A slower economy does not mean automatically lower inflation. Thus gold can rise while the bond curve flattens and falls below the Fed Funds rate and you could have inflation and a slowing economy as well. The Fed has to figure out how it can control inflation and keep economic growth at its sustainable maximum.

The Fed doesn't have to jack rates up to pre-empt inflation; it can sell Treasuries, pulling in money and retiring it from the system for now. It is not doing much of that, instead relying on interest rate increases. Thus far liquidity is still too high even as the bond market fears the Fed is going to go too far with rate hikes, chasing inflation but not stopping it. That is why yields are falling and the curve is flat to inverted. The Fed recognizes its mandate, but it cannot get caught in the old habit of comparing inflation and economic growth. Again, inflation is a monetary phenomena and it can occur in strong or weak economies. The bond market is simply afraid the Fed is going to do what it always does, i.e. try to put out an inflation fire by burning down the economy.

Just an over-adjustment?

There was a lot of movement at the end of the week with the FOMC result fostering bets beforehand (speculation of 50BP, etc.) and then unwinding positions afterward. It is going to take next week to hit the mean after the gyrations back and forth both ahead of the FOMC meeting and after.

Chicago PMI fades as prices rise.

Expectations were for 59.0, down from 61.5 in May. Reality was 56.5; still expanding but slowing significantly. Employment was down (50.4 from 52.8). New orders plunged (57.2 from 69.6). Prices surged (89.0 from 76.9). Down in the wrong places and up in the wrong places. Still expanding but at a slower pace (that bond market fear) while prices are jumping (that gold market fear). Again, the Fed has to address what is the root of the problem: tamp down liquidity a bit more to get inflation in control but don't jack rates so high and get too aggressive with money supply to kill off an aging expansion. See? No problem.


THE MARKET

MARKET SENTIMENT

The sentiment indicators have faded, at least volatility. They have shown strong levels that could turn the market. After the huge Thursday surge that will have to do. Volatility was lower than we wanted though it did hit a post 2003 high this month. Bulls and bears kissed. The put/call ratio camped out over 1.0 for almost a month. Again, the work has been done unless this is really going to be a much nastier sell off requiring volatility up in the forties as it was in late 2002.

VIX: 13.08; +0.05
VXN: 17.89; -0.04
VXO: 12.44; +0.16

Put/Call Ratio (CBOE): 0.96; +0.28

Bulls versus Bears:

Bears rose but so did bulls, and after kissing last week that just kept them from a crossover move that historically is a very strong indication of sentiment being really ripe for a move. With the strong price/volume and leadership move it looks as if the sentiment did its job.

Bulls: 37.4%, back up from 35.6% last week. That stalls somewhat the sharp decline the prior week (down from 38.7%), but still at a low level after a high at 53.2% at the April peak. It surpassed the 42.3% hit on the last low. The current level puts it below the May and October 2005 readings that saw new upside runs.

Bears: 36.3%, up from 35.6%, but not enough to crossover the bulls, typically a surefire indication that the market is ready to rumble. Still chasing the bulls and would have caught them but for the Thursday rally. Nice climb to a new post-2002 high as it eclipses the March 2006 high (33%) and well above the 2005 highs that spawned new rallies (30% in May 2005, 29.2% in October 2005).

NASDAQ

Stats: -2.29 points (-0.11%) to close at 2172.09
Volume: 2.936B (+30.07%). Volume surged as NASDAQ gapped higher but could not hold the move. Lots of quarter end volume and rebalancing of the Russell indices. Thus we cannot make too much of this high volume close to the week and the month.

Up Volume: 1.466B (-569M)
Down Volume: 1.381B (+1.187B)

A/D and Hi/Lo: Advancers led 1.48 to 1. Positive on a down session, stronger than the index itself. And, of course, NASDAQ breadth was huge Thursday on the follow through.
Previous Session: Advancers led 3.92 to 1

New Highs: 132 (+31)
New Lows: 58 (-15)

The Chart: http://www.investmenthouse.com/cd/^ixic.html

Gapped higher but that did not last. Moved over the December 2004 high (2177) but couldn't hold the move. Very half-hearted effort, but given the huge Thursday move the action was typical, i.e. just sluggish. NASDAQ remained above the 2004/2005 up trendline (2161), and we are looking for NASDAQ to hold this level this coming week if this move means much. Lots of near resistance at that December 2004 high and the 50 day EMA (2189). A test of the trendline sets up a run at that next level as NASDAQ tries to work its way out of a hole.

SOX (-1%) was the weakest again, but the loss was modest, holding onto most of the Thursday surge. It could not, once again, break through the 18 day EMA (447.76), the resistance in this downtrend. That is what has to change if this index is going to add to the follow through move by the other indices. Has set up the bottoms for a double bottom, so it can deliver. Of course the US postal service can deliver as well. It just takes time and sometimes the package gets lost.

SP500/NYSE

Stats: -2.67 points (-0.21%) to close at 1270.2
NYSE Volume: 1.914B (+1.47%). Strong trade once more, holding above average as the NYSE indices spun their wheels. You can call it churning (high volume turnover after a move higher), but with the Russell rebalance it was related to getting index funds adjusted to the new weightings.

A/D and Hi/Lo: Advancers led 2.21 to 1. Very positive breadth given the close in SP500; the small and mid-caps were advancing quite well as energy and metals recovered and the Russell adjusting.
Previous Session: Advancers led 5.46 to 1

New Highs: 119 (+26).
New Lows: 80 (-45)

The Chart: http://investmenthouse.com/cd/^gspc.html

Rallied up to the 50 day SMA (1276) early and then sold off. An afternoon rebound moved right back up to that point but then gave way once more as the last hour swoon took over. SP500 closed at the session low but with very modest losses. We could see some backing and filling with the 50 day EMA (1267) or the 200 day SMA (1262) before making another run at the next resistance.

SP600 (+0.78%) continued higher Friday, moving through the 50 day EMA (373). Good follow up action to the Thursday break higher, helped by the rebalancing in the Russell indices. Heavy resistance at 380 to 382 with the 50 day SMA (378) just above that level. A move up to that next resistance and then some testing sets up the next move higher.

DJ30

The blue chips rallied through the 50 day SMA (11,187) but could not hold the move, fading with the rest of the market and closing below that resistance point. Volume was up as well, still above average. Some testing back to price support at 11,000 and the 50 day EMA (11,101) sets up the next break higher to take on some important resistance from 11,200 to 11,317 (March closing high). Nice test and blast off of the 200 day SMA, and a test of the 50 day EMA holding most of those gains sets up the next blast higher.

Stats: -40.58 points (-0.36%) to close at 11150.22
Volume: 365M shares Friday versus 337M shares Thursday. Stronger and continued above average volume as DJ30 reversed at resistance. Typically not a good sign, but with the follow through Thursday in the indices we are not viewing this as a reversal.

The chart: http://www.investmenthouse.com/cd/^dji.html

MONDAY and a short week.

Monday the market will close at 1:00ET ahead of the Fourth of July holiday. Thus it is not going to give us any indication of where the real strength lies for the week. Thursday was a strong session but there were undercurrents to end the week with the Russell indices and shuffling a lot of positions made on bets regarding the Fed. Thus we don't expect any real clarity until later in the week after the holiday and more of the market gets back into the game.

Of course it will be the heart of summer and that means more summer trade. The Fed is in the bag and now earnings is the key. We are seeing some warnings, some earnings surprises going both ways, and we are going to see a lot more this week and next, then the earnings flood. Thus far the warnings have been rather quiet but the technology earnings already out and the warnings are not positive with respect to the future. That will be huge for the market, and it is something the Fed needs to be aware of as well. It is not catering to the market by recognizing that earnings expectations are falling. That is a solid leading indicator of the economy's path.

Along with earnings is a heavy economic agenda. Construction, ISM, factory orders, the jobs report. After the FOMC meeting the market will get a lot of economic data to chew on as well as anticipation of earnings. As my wife says, it will make it or break it, meaning it will bring things to a head. The market has something going for it with the follow through and leaders re-emerging.

On the flip side, the so-called bond vigilantes and gold bugs will be screaming about a once more soft on inflation Fed. The bond market is anticipating that somewhat with this fall in yields and slight inversion once more after the FOMC statement. In other words, the bond market anticipates the Fed will be bullied again and thus we may see the return of the grouchy Fed as it again tries to reassert itself as a bad hombre with respect to kicking inflation's butt. If it does, once more the market will get antsy.

What we need to do is stick to the nuts and bolts, watching price/volume action and leadership. We don't want to forget the bond market, and with SOX back up at the 18 day EMA resistance again, it is worth watching as well.

Leadership. We noted it was stirring over a week back just as the market looked ready to head lower. We expected another leg lower, but the leaders did not sell off and the market checked up. It then delivered a follow through Thursday on strong volume. Leaders are now emerging from many areas. Even with our doubts we did not ignore strong stocks moving higher. We have thus been accumulating positions in strong stocks since, and we are going to continue doing so. A market test of that big Thursday move that holds support will set up some leaders for a further move. We look to take advantage of that.

Support and Resistance

NASDAQ: Closed at 2172.09
Resistance:
2177 is the December 2004 high.
2185 to 2182 is the September 2005 peak and interim high from November 2005.
The 50 day EMA at 2189
2205 is the December 2005 closing low
2218 is the August 2005 peak before the sell off through October 2005.
The 200 day SMA at 2228
2234 is the early June high
2240 is closing low in February range.

Support:
2162 to 2155 from December 2005 and September 2006
2160 is the August 2004/April 2005 up trendline.
The 18 day EMA at 2141
2100 from the early and mid-2005 peaks
2063 is modest, soft support
2050 from the summer 2005 lateral range lows.
2045-47 from June and October 2005 lows and June 2004 highs

S&P 500: Closed at 1270.20
Resistance:
1272 to 1268 is the November and December 2005 closing highs and March 2006 closing low
The 50 day SMA at 1276
The late January peak at 1285
The early June high at 1288
1297.57 is the recent February high.
1315 is the May and May 2001 peaks
1317, the recent intraday highs from April.
1324 to 1329 from the October 2000 lows.

Support:
The 50 day EMA at 1267
The 200 day EMA at 1262
The 18 day EMA at 1254
1245 is an old trendline from the August 2003/August 2004/October 2005 lows.
1225 from the March 2005 high
1213 from December 2004 high to 1215
1205 from the August lows

Dow: Closed at 11,150.22
Resistance:
The 50 day SMA at 11,188
11,279 is the late May high
The March 2006 highs at 11,329 to 11,335
11,350 from the May 2001 peak
11,401 from the September 2000 peak and April 2001 highs

Support:
The 50 day EMA at 11,101
11,097 to 11,137 is the last peak from the February top.
11,044 is the January high.
10,965 from Q4 2000
10,931 is the November 2005 high
The 200 day SMA at 10,908
10,890 is the December 2005 closing high.
10, 737 to 10,730 from December and February lows
10,705 - 10,965 from July/August 2005 range top to bottom
10,678 to 10,665

Economic Calendar

These are consensus expectations. Our expectations will vary and are discussed in the 'Economy' section.

July 3
ISM Index, June (10:00): 55.0 expected, 54.4 prior
Construction spending, May (10:00): 0.2% expected, -0.1% prior

July 5
Factory Orders, May (10:00): 0.0% expected, -1.8% prior

July 6
Initial Jobless Claims (8:30): 313K prior
ISM Services, June (10:00): 59.0 expected, 60.1 prior

July 7
Non-farm payrolls, June (8:30): 168K expected, 75K prior
Unemployment rate, June (8:30): 4.6% expected, 4.6% prior
Hourly earnings, June (8:30): 0.3% expected, 0.1% prior
Average workweek, June (8:30): 33.8 expected, 33.8 prior

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at InvestmentHouse.com

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