Saturday, March 24, 2007

Stocks slumber through post-Fed hangover, avoid any immediate selling.

- Stocks slumber through post-Fed hangover, avoid any immediate selling.
- Jobless claims remain in very good shape.
- Leading indicators sag for second month, continuing the trend lower.
- A rest before resuming the move would do the rally good.

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This weekend we have another installment of the video newsletter. We also have a transcript available for following along, reading on its own, or other use as you may see fit.

To view the Video Market Summary please browse to the following links. There are two this week to accommodate some additional information:


Well everyone the market did what we thought it couldn't: it followed through on the reversal two Wednesdays ago. Kind of poetic justice that the follow through was on Wednesday a week later. There was a Fed-assist on the follow through. What happened was the Fed dropped the language that rates may need additional firming in the future. And even though it had a lot of other language we and many others consider hawkish in its statement, the market took it as a positive that the Fed was on its way to changing from a bias towards tightening to a neutral bias.

Thus the big move up on Wednesday. It was not unanimous. The NASDAQ was the clear leader: it gave the 2% gain on rising volume, had great breath, and solid leadership. S&P 500 was up as well, but its volume didn't even crack average. That's always a warning sign when a big move is made, that volume doesn't follow. All it takes is one index to have a follow-through, however, so despite the lagging in the other indices, we did in fact have a follow-through. We need to keep watching how S&P 500 and the other NYSE stocks tagalong. Are they going to go with the NASDAQ or are they just going to tag along. NASDAQ has leadership and that can handle it the task, but as the market moves up towards the prior highs and the old trendline channels it has to have more cylinders hitting than just NASDAQ to make a break and continue on a new and sustained rally.

There was some other good news this week as well. After the Fed changed its bias, the bond yield curve almost immediately reverted to positive. It was not a big move and finished the week with the two year bond at 4.60% and the 10 year treasury at 4.61%. A little bit of a positive reversion, but it's more flat than anything. A flat curve suggests slow economic times ahead. But we also have consider also that were moving from an inverted curve to flat and hopefully onto a good positive sloping curve, which will be a good sign for economic times down the road.

Now, what we've had thus far is the slowing economy and the curve was inverted in conjunction with that. Now if the yield curve starts to revert to positive perhaps will see economic readings picking up. ECRI has forecasted a return to expansion later on after the summer. Things seem to be falling into place along those lines. More about that later.

Now technically there was that follow through that set the stage for a further rally following the break from the late 2006 uptrend. After the strong uptrend that was in place since August and July of 2006 broke, the market entered into the correction. It formed a short double bottom with that reversal two Wednesdays back and now the follow through. That indicates it can continue the recovery move and go on up and challenge those old highs and the uptrend channels. There was great volume on NASDAQ, good breadth, and solid volume in leadership. As for leadership, energy stocks are performing very well, particularly the drillers and refiners, the metals, and some chip stocks rallied well with others preparing to make a break as well. That is new leadership coming in with the old leadership has been shown by energy and metals. Even the financial group, after they imploded in the selling, are recovering, and if they can come around the S&P 500 might actually move up with NASDAQ, and maybe they can share leadership up to the old highs.

After the Wednesday surge the market put in a couple lateral moves, although Friday stocks moved higher though volume was lower and breadth lagged. Many lamented this action, but the sideways meander to close the week is really good action. What would like to see as we talked about in the reports this week is for a couple more sessions laterally. That would build a nice handle to the double bottom and give a launching pad to jump up and take on those old highs late in February and the uptrend channels.

The problem is the double bottom is very short, only 4 to 5 weeks long. Historically those have a hard time holding up and sustaining long rallies. Sure that is enough to take us up toward the old highs, but then the question becomes is there enough strength or enough consolidation to continue a rally beyond those levels and sustain a rally. After all that is what you are looking for. We can play these up and down rallies, but you like these 5 to 6 month rallies as in 2006. Next week is going to start the big test as to whether we can move up from this little lull after the big Wednesday move higher that provided the rally follow through.

Follow through is important and we want to review this some because what happens is there is the cessation of the selling where shorts cover and drive prices up along with some bottom fishing buyers trying to pick the bottom and buy stocks while they are lower. The important feature of follow through is that after that initial surge you have 4, 5, 6, 7 days where the buyers and sellers fight it out, and then the buyers surge back in in a big way, and they want back in at a higher price and still buy stocks. That shows it is not just a one day wonder. The buyers moved back in, the sellers try to sell it off but fail, and then the buyers come back in and say 'we want more stocks' and they come in with force. That gives it the power, shows it has the strength to drive higher and sustain a rally. That is why we are always looking for a follow through as it sets the stage for a rally. It does not guarantee a rally will be successful, but every successful rally has a follow through session.

There are some reasons we like this one (and some we don't). We like this one because there is leadership that was not all taken out in the selling. They have set up bases and are ready to run. The market is not overrun with leaders from every sector; it is not a huge swath of the market with good bases. But there are several sectors that have good, longer bases such as in energy, metals, medical, and some technology, particularly chips. Others still have work to do. That is the neat thing about a follow through, however. At the time of the follow through there are stocks that surge higher. As the move progresses, other sectors continue to work on their bases and they then break higher in waves as the rally continues, giving it continued strength. First one group breaks out while another forms up, then another forms up and breaks out, giving you waves of breakouts that sustain a rally as back in 2006.


A lot of the issues swirling around the market correction relate to the economy. Economic issues were big again this past week. Housing starts and existing home sales on Friday were highlights given the concern surrounding housing. Friday we got some pretty decent news with respect to housing with existing sales rising 3.9% versus the expected decline. Once again there is not a cataclysmic disaster in the housing market as being predicted. It is not occurring just yet, at least in existing home sales that make up 80% of the housing market. Now there may be more problems than appear because some people are pulling their homes off the market because they are not going to get the price they want, and that is masking some weakness in the existing home sales. We will find out more about that as the summer moves on. But we can take some comfort in that the market is not falling off a cliff just yet despite predictions it is doing that.

This looks like a classis mid-cycle slowdown in the economy. It has everyone scare because they are used to an expanding economy since late 2002 or early 2003. Many maligned the economic gains, but there is no denying the gains coming out of the recession were strong as they rivaled growth rates not seen since the early 1980's when the economy blasted out of the 1970's malaise. Just as a market rally runs out of steam as it gets further along with the gains getting smaller and smaller, it corrects back, then resumes the rally, the economy does the same thing as the gains lost strength and even turns negative for some months. But if the underpinnings of the economy remain strong, well, it picks back up and expands once more. As we have discussed of late, ECRI shows an expansion resuming at the end of the summer. It forecast the slowdown we are in now and then an expansion later. There are things that can forestall that, but for now it looks to be on track.

This is very similar to 1994-1995, when we had that big burst of activity when we came out of the recession in 1992 and then things slowed down. We had the Fed becoming active in 1994 when it became scared of its shadow just like it did in this past tightening round. Then the Fed backed off and the market rallied. Lo and behold that is exactly the same thing that happened last August when the Fed paused. The market anticipated this by a couple of weeks and started the 2006 rally.

So we have a very similar situation with a mid-cycle slowdown; we have seen this before in history. A lot of people like to panic when the economic numbers downturn, and that is what we are experiencing now. There is still a whiff of inflation that is an Alan Greenspan hangover that he gave Bernanke that he is having to fight with, and there are some issues still with the housing market where there may be another shoe to fall. The main obstacle facing it is oil with price back up over $60/bbl after Iran kidnapped some British servicemen at gunpoint. But the main problem we are having is with gasoline as some refineries are down for maintenance after hard use and fires because they are being run hard. You have to have maintenance and when they are run hard you have fires and they go down. We have plenty of oil but the ability to turn it to gasoline is the problem. Oil inventories were way up once more but gasoline inventories were way down because they cannot make enough with current capacity outages. Consequently we are getting gasoline over $3/gallon in areas of the US. With wholesale prices hitting over $2/bbl at the end of the week, we are going to see $3/gallong gasoline across the nation before too long.

That is a serious problem. If we have people who are a little skittish about their mortgages and their wealth because of their home values, then if we ladle on top of that $3/gallon gasoline, then we have a problem for those folks. That combination can be trouble. And that is usually the problem you have; it is never just one thing that can bring down an economy, but a combination or confluence of events and some serious events that curtail spending whether it is the consumer, business or both. Right now it is the consumer with the housing and gas issues because businesses simply pass along their costs to their customers. Not all can do it 100% dollar for dollar, but we all pay higher prices for goods when the producers have higher energy prices. This is the main cloud on the horizon. We could handle the housing market, but if oil remains high throughout the summer we could have a problem pulling out of this slowdown at the end of the summer as ECRI suggests we will do.


That gives us the background on the market and the economy. What are we going to do about it this week? We still have a market that has corrected and has shown a follow through off of a nice little, but short, double bottom base. It is now building a handle, a lateral quiet move that often precedes the next breakout higher. It looks like the recovery in stocks will continue next week. The question is how high can it go? Historically, the majority of these short 4 to 5 week bases in a correction don't pan out into a sustained new rally. What that means is the market is going to rally up to the old trendlines or highs, then start to struggle and correct back, finishing the base, i.e. testing those old lows hit on the intraday reversal two Wednesdays back.

Now what we see is NASDAQ recovering back up to 2500ish (the trendline) or the February high at 2531. SP500 is looking at 1455ish; 1462 was the February high. Those are the points we have to look at as natural resistance as this short base with NASDAQ leading with some metals, energy and medical thrown in as well. If that is the case with NASDAQ primarily leading the market is going to have trouble when it gets to those levels. If SP500 and the financials come around that will help, but we are still very skeptical that the market can make the move that breaks this resistance and resumes a sustained run given the short base compared to the long run higher prior to this correction.

This is still a playable, tradable rally up to that point as we are looking at over 50 NASDAQ points. We still see some great stocks setting up for a move higher. We took some gain on positions that rallied well last week and we also bought into new positions starting good moves. We are also letting positions run higher and we will let them do that as long as the market shows us it still wants to move up. When it gets to the old highs and it starts to stall we have to be careful because history is on the side that the market goes back and tests that intraday low hit two Wednesdays back because the base simply wasn't big enough. If it does breakout to a new high you still have to be concerned that the short, narrow base did not give the market enough consolidation time to sustain a breakout or a run of significance after the breakout.

If that is the case we will be ready for it and start taking gain off the table when the stocks move up toward those levels. Many leaders have already broken through their prior highs and are having no trouble running. For most of the market, however, as we get close to those old highs and it starts to slow and/or we see some distribution, prudence says we take some gain off the table, button up positions, see what the market is going to give us and then we take it. That is how we play the game. We always look at what the market and big picture is telling us. We look at what resistance points there are, what support points there are, we look at the economic indications, and then we move forward. We look at the big picture to prepare, but then we let the market show us what to do.

There is a lot of economic data this week from new home sales, final GDP, consumer confidence, personal income and spending, to the Chicago PMI. That regional one is important due to the slowdown in manufacturing. Be prepared. We are still not likely to see any changes in the data as we are still in a slowing phase right now that has everyone worried. But note: people will say 'gosh the economy is slowing' and think that the market is going to slow as well. The market factors in economic increases and slowdowns ahead of time. The rally started to distribute and show topping signs before the sub-prime issues became mainstream. Even if the economic data gets worse the market won't necessarily follow because the market is more of a leading indicator. Maybe this correction turns into something a lot worse and is foretelling a serious economic slowdown ahead. We will have to watch how it performs as it rallies further and keep an eye on gasoline prices as well. As noted, ECRI is suggesting a resumption in the expansion, but that can change if there are significant changes in the economy.

We hope you had a great week. It was a lot of fun watching positions run higher, taking some gain, and moving in on some new good movers. This rally is setting up for more upside with the nice lateral move to end the week, and we are looking to play that up to the old trendline channels or highs and see how the market is acting at that point. With that further rally we will have gain ripe for the picking, then we see how the move plays out and whether it shows the strength to continue on or wants to test again. We have our feelings as to what it will do, but we always have to temper that with what the market is telling us and not look at the market with any preconceived notion as to what it ought to do. Have a great weekend and we will be at it again this week as the market tries to rally on up to the prior highs.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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