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InvestmentHouse Weekend Update:

http://www.investmenthouse.com/1weekendmarketsummary.htm

- Bullish bias holds to the end as stocks drift higher on low volume.
- Economic data paints the same picture: expansion losing steam.
- Bond yields tank as ‘new’ Fed study reveals inversions lead to recessions.
- The return of money supply to monetary policy: why Bernanke is far superior to Greenspan.
- Market ready to start the mean season with a lead in from a late summer rally.

Stocks fight off early attempt to sell, continue the rise for the week.

Stocks handled the jobs report that was basically in line and showed a modest dip in hourly earnings month to month, rising pre-market and on the open. It did not take long for that move to lose its direction. With the lower ISM and tumbling construction report at 10ET the market really got the dips with NASDAQ and SOX turning negative. Indeed, the chips were down pretty much from the open as some gains were booked and some big names struggled (e.g. BRCM had its antitrust case against QCOM dismissed). The upside move looked to be out of gas.

There was not much selling volume, however, and the indices started to show some life an hour into the session. Without the volume the sellers could not keep a lid on a rebound. That rebound turned into a morning, lunch, and then afternoon rally as the bullish bias for the week was not ready to give way to the fall.

Technically SP500 made a nice move, pushing well past 1305 and to the top of the March and April range. Sure wish it would have made the move Thursday; things really could have turned interesting. Instead we get a low volume rise to finish the week, basically on a lack of interest ahead of the start of fall. That does not provide a lot of confidence the move will stick.

NASDAQ rallied over the early July high as it too cleared some resistance, though it again struggled at the old up trendline starting in 2004. SP600 rallied up to the 200 day SMA intraday and then faded to the close; it made it to the resistance we though it would, and it did not go a nickel further.

SOX was the stick in the mud, falling for the second session and the only index t close negative. It was one of the leaders in the rally off the July low; well, maybe it just came to life and seemed to be a leader after a pretty good butt-kicking after peaking in February. In any event, it pulled back toward the 10 day EMA. That can be rather innocuous, just a test after a good run. After all it was moving up while SP500 slid sideways last week. It also tends to be an early warning canary for the techs as was the case when this downtrend started and continued lower. It turned lower ahead of all the other indices and then they followed. That makes this test quite important as SOX has a nice reverse head and shoulders going. If it can continue higher here that is a major support for the SP500 as it breaks toward its highs, not to mention NASDAQ as it tries to clear its own version of a reverse head and shoulders.

Overall it was good to see the market generally hold its gains and push higher even as semiconductors rested. We took some more gain off the table as we had been doing all week in what turned out to be very good timing for the semiconductors that we were cashing in on Wednesday. Most of our positions remain very well . . . positioned, so we let many of them run without closing positions wholesale.

The reason being, aside from the solid patterns, is that early September often gives solid pops higher as new money hits the market. In good economies the move can continue. In so-so economies you get the pop and then some selling. Only in really crappy times (e.g., 2000 and 2001 was there no upside pop. Even in the bottoming process in 2002 when the market was diving, it managed an upside move the first part of September. Moreover, it can rally into September and still continue upside as the new money hits.

Thus we look for some more upside to start the week. After that it depends upon the market’s read of the economic future. Bonds are not necessarily happy, but the indices have fought back into some pretty good patterns. As long as they can hold those even if there is another pullback then the outlook is much improved.

THE ECONOMY

Friday data shows the economy is hanging in but still getting a bit flabby.

The jobs report was mostly in line as was the ISM. 128K jobs created versus 125K expected. The unemployment rate fell back to 4.7% from 4.8%. Hourly earnings rose 0.1% versus the 0.3% expected and the 0.5% in July. The ISM fell to 54.5 from 54.7 (54.7 expected), continuing the weakening from the October 2005 peak over the past year (58). Prices remained over 70 while new orders weakened to 54.2. Interestingly, employment improved to 54 as the rest of the report softened. Typical; we have said all along employment lags in the business cycle. Michigan sentiment moved up nicely from the preliminary reading (82.0 versus 78.7 prior and 79.0 expected). Construction was weak; hard to argue around a 1.2% drop when you expected it to hold steady.

ECRI shows modestly easing inflation and continuing slowing growth.

ECRI’S future inflation gauge continued to soften in August, down to 123.1 from 124 in July. It peaked in October with a 5.5 year high, but it is stubbornly refusing to give us a sharper break lower.

ECRI’s leading economic index held steady but at the 2006 low with its 4-week annualized rate falling again, down 1.7% to a 2 year low. At this level ECRI is still forecasting slowing growth but no recession.

Bond yields continue their fall, cracking below 4.80%. New Fed study reveals what we all knew.

Man what a week for bond yields. They started the week far below the Fed Funds rate (5.25% after the last Fed rate hike) ranging from 4.85% to near 4.9% with an 8 basis point spread between the 2 year and the 10 year. The 2 year and 10 year dove lower Friday with the 2 year outpacing the 10 year to the downside. At the close Friday yields were 4.76% versus 4.73%, just a 3 BP inversion. That is not enough to really scare up a recession, but as discussed Thursday, the spread between the Fed Funds rate and nominal bond yields is huge, almost 50 BP with the 2 year note. What nominal yields are saying, indeed screaming, is that the Fed Funds rate is too high for the economy, not too mildly suggesting the Fed should think about cutting some rates.

Interestingly, the Chicago Fed has produced a study of bond yields and the correlation to economic cycles. The study indicates what we all knew it would: inversions between short term bond treasuries and longer term treasuries tend to foretell economic slowdowns. The Fed study suggested a 30 BP inversion between the very short term yields (e.g. 30 day) indicates a recession. The study also concluded that the longer the inversion the more likely a significant economic slowdown.

Now Mr. Greenspan was telling us last year not to worry about an inversion, that it was due to extraneous factors such as heavy foreign buying of treasuries. There is no doubt that is ongoing, but even Mr. Greenspan said he was not sure to what extent the buying contributed to the inversion. Thus he was saying ‘trust me, don’t worry’ about an inversion, but in the same breath implied the trust was not well placed. Now the Fed itself has concluded it doesn’t matter what the reason is; big inversions or inversions that last a long time foretell economic slowing.

This report is similar to other government grants to fund a study that concludes if kids stay up past midnight and don’t do their homework they don’t perform as well at school. Who needed a study to conclude that? Just look at history. Same with this report. The problem is, Greenspan made it necessary to do this with his speculation and resultant conclusion that the inversion was not as good an indicator as in the past. Of course being a politician Greenspan hedged his statement, but nonetheless that sent us down the wrong path on monetary policy once more, and likely the Fed has raised rates too long without really attacking the root of the problem, i.e. excess liquidity until AFTER Greenspan left.

Money supply coming back into favor as a Fed tool?

We have all heard the past few years about how money supply is no longer a very good indicator for the economy or for what should be done with monetary policy. Seems strange; after all monetary policy is part and parcel money supply. As strange as it seems to anyone with common sense, however, money supply has diminished in its apparent importance, at least to the academics, or more accurately, the Greenspan academics.

That is why, even with 1.5 years of rate hikes under Greenspan, inflation still managed to rise above the Fed’s comfort zone. Up to 2006, when Greenspan retired and Bernanke took over, money supply was growing at a 6.2% annual rate. It was going strong even as Greenspan raised rates to purportedly prevent inflation. But inflation is a monetary phenomenon, i.e. too much money for the economic growth rate. In other words, economic activity is not great enough to absorb all of the money in the system, so that excess money is used to bid up prices because money is seen as cheap. You can raise rates all you want, but if there is still excess money compared to economic activity, prices rise. Indeed, you EXACERBATE the problem with high interest rates and high money supply. Many borrowers cannot gain access to money they need because of high rates, but there is still money circulating that is not being invested because those wanting to invest it cannot borrow at the high rates. Thus the economy slows more but money supply remains high. That equals inflation.

Bernanke’s first order of business, despite saying he was going to continue Greenspan’s policies, was to cut the money supply growth rate in order to sop up the excess liquidity. He started selling treasuries to get money out of the system. Money supply growth dropped from 6.2% to 0.2% this year. He did not pull a Greenspan as back in early 2000 and suck the economy dry of money all at once. He did not even start contracting money supply. After all of the rate hikes he did not want to crush the economy, and he knew the impact of the rate hikes was not fully felt. No, he just curtailed money supply growth in order to let the economy continue to run and work at sopping up the remaining excess itself. Thus you don’t get the vapor lock you got in early 2000 when suddenly there was no more money. Not surprisingly we have seen inflation pressures peak here in the US as shown by ECRI.

We have said it before, despite his public maligning and his ‘loss of economic manhood’ as Kudlow proclaimed, Bernanke has been focused and even-handed in his views and application of monetary policy. We are reminded of Ronald Reagan, who was ridiculed as a simpleton but whose economic policies proved to be right on the mark and brought the US back from an interesting but failed economic experiment in the 1970’s to once again the world economic powerhouse. After years of getting ‘Greenspanned’ and brainwashed by his approach to monetary policy that, despite the ‘maestro’ label was a disaster as shown by a track record no better than any other Fed chairman (indeed the size of his disasters were unprecedented but for the 1929 Fed), we are now seeing what we believe is the work of a true scholar of monetary policy, one that understands, appreciates, and uses history in his formulation of policy. We hope we don’t eat these words; we might still get a recession out of this but there would be an asterisk because Bernanke inherited a system that had inflation built into it due to Greenspan not lowering liquidity, inflation he had to get under control before he could really take action. If he pulls it off without a recession, however, it will be a great feat, similar to winning the World Series after being down three games to none or coming back to win the Rose Bowl after being down 12 points with less than 5 minutes to play.

THE MARKET

MARKET SENTIMENT

VIX: 11.96; -0.35. VIX remains at very low levels, holding in a very tight range the past two weeks. This is the level where the market has run into trouble, i.e. topping in past rotations. It can move at this level, however, for a long time before it takes its toll and the market sells.
VXN: 16.8; -0.59
VXO: 11.02; -0.29

Put/Call Ratio (CBOE): 1; +0.1

Bulls versus Bears:

Bulls: 42.1%. After a sideways move for a few weeks, bulls are starting higher, rising from 40.0% the week before (40.2% and 41.5% the week before). Bulls are still well below the early 2006 highs and even the April high. The low of the cycle was in June at 38.7%. It remains below the levels hit on the last market sell offs in October 2005 and March 2006, but above the June low when it kissed the bears.

Bears: 33.7%. Continuing the decline from 34.7% last week and the 36.6% the week before and 37.1% hit in July. The 37.1% was the highest level in this entire cycle, easily clearing the 34.4% hit in late June back when bulls and bears kissed, just missing a crossover. Hit a new post-2002 high in that late June move, eclipsing 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: +9.41 points (+0.43%) to close at 2193.16
Volume: 1.383B (-22.19%). Low volume to close out the summer, not expected given the three-day weekend ahead. A decent increase in volume as it moved higher this week, but volume still remained below average; it was, after all a summer rally.

Up Volume: 808M (+134M)
Down Volume: 472M (-613M)

A/D and Hi/Lo: Advancers led 1.19 to 1
Previous Session: Advancers led 1.1 to 1

New Highs: 96 (-8)
New Lows: 28 (-4)

The Chart: (Click to view the chart)

NASDAQ continued its move higher Friday, topping off a solid upside week, the third leg higher in its late summer rally off of the mid-July lows. It made it just past the July high (2195.50) on the Friday close, hugging the August 2004/May 2005 up trendline (2197), unable to punch on through. It showed a hanging man doji on the candlestick chart, and that often indicates a move is running out of gas and needs a breather. NASDAQ is working in a 16 week base, forming a 12 week reverse head and shoulders. It may need a short pullback to set up a better breakout move, perhaps after a move toward the 200 day SMA (2225) to start the week. NASDAQ continues its attempt to put together its recovery base; if it holds up and avoids a serious breakdown that bodes well for the rest of the market.

SOX (-1.05%) lagged all session and was the only index to close lower. It fell back through the 90 day MA (446.71) and below the mid-August closing high (446.11) on the close, but it did hold its 10 day EMA (441.25). This is where we want it to hold and deliver more upside this week. SOX can be a harbinger for the rest of the market. If it holds and rebounds that is a very good signal. We will see; still very concerned about September after the initial few sessions.

SP500/NYSE

Stats: +7.19 points (+0.55%) to close at 1311.01
NYSE Volume: 1.126B (-15.14%). Volume hit the low for the week, but that did not stop prices from climbing. Without any big buyers the market bias for the week took hold and the NYSE indices moved further upside.

A/D and Hi/Lo: Advancers led 1.92 to 1. Solid breadth as the large caps came back to life and joined the small caps in the upside move.
Previous Session: Advancers led 1.49 to 1

New Highs: 178 (-4)
New Lows: 16 (-3)

The Chart: (Click to view the chart)

Sweet price move from SP500 as the large caps came back to life after stalling Wednesday and Thursday on rising trade. They were churning as money moved around, but once that was over the upside drift kicked in and SP500 put the moves on 1305. If it can hold the move to start next week there will be more short covering to drive it higher. SP500 has now risen to the top of its March and April trading range. If it breaks through to the upside the shorts will howl and it will move. It is set up to make that move as long as the buyers come in to start the fall.

SP600 (+0.28%) made it to the 200 day SMA as anticipated, and that was all it wrote for the week. It faded back off that level, holding a modest gain to the close. It continues working on the bottom of its 16 week base, making a couple of higher lows and higher highs in August. That is good technical action in building the pattern, but near term it looks as if it is going to come back after the 200 day SMA test before taking it back on. Key index for the market as it along with NASDAQ is a growth index, relying on an expanding economy to post gains. Thus if it continues base building here that is a good indication for the market down the road.

DJ30

DJ30 jumped higher along with SP500, clearing resistance at 11,400 and taking a bead on the prior high at 11,670. It looked to be slowing and ready for a test, but the large caps enjoyed what buying there was on Friday. Still likely to test before it is able to take on that May high.

Stats: +83 points (+0.73%) to close at 11464.15
Volume: 168M shares Friday versus 156M shares Thursday.

The Chart: (Click to view the chart)

SEPTEMBER BEGINS

One of the more feared months of the year kicked off Friday, and it was a gain. It is often a gain early in the month as some new money is put to work. Even after Labor Day it can post a gain as the summer officially ends and the fall begins. All the players have to get back to work and put some of that money to work. Once that is over, the true colors of the month come out.

The indices overall still look good heading into the fall, but of course it was a low volume rally to end the summer, sort of a late summer fling at the beach before the fall semester starts. Volume started to rise toward the end of the week, but it was still low overall. That is what, despite the nice move to end summer break, is what makes this such a serious transition point.

It is still somewhat of a mixed market with NASDAQ and SP600 still lagging the large cap NYSE indices. The small caps and NASDAQ are still below the 200 day SMA and still have quite a bit of work to do. They are putting in some good work on a bottom, but have not made the break yet. They are growth indices and thus economic indicators, and if they can keep building their bases, even after a September sell off that is a good indication for the market overall.

In other words, even if we get a sell off in September that does not mean the market is saying the economy is going into the tank. They can sell and still hold their current bases, indicating an economic slowdown but no crash. Indeed we expect the market to run into some September issues even given the nice move to end the summer and a few more upside sessions to start the post-Labor Day market.

The changeover in the ‘season’ of the market is always something of a wildcard. The market is set up well heading into September and the leaders look solid. Thus we let many of our plays hold over into next week. We will meet more upside by taking some more gain as it presents itself. Then we see how the leaders move. Really watching the semiconductors to see if the Thursday and Friday test was just that. Strong chips such as NVDA have faded back and are in position to continue the breakout if that is in the cards. If upside volume comes in strong we are going to be ready for these.

This is one of those times that you like what you see but you have to be ready to take what the market is going to give. If the market starts to distribute at some point next week we will be glad we have taken some gain off the table and then move to close out positions. We will be looking at safety zones for the upside such as healthcare and drugs as well as some downside plays. If that strong upside trade comes in we will look for rebounding leaders such as those chips along with technology in general.

Support and Resistance

NASDAQ: Closed at 2193.16
Resistance:
2190 is the July 2006 high and is giving way
2197 is the August 2004/April 2005 up trendline
The 200 day SMA at 2224.5
2230 is the June 2006 peak
2250 is the March 2006 closing low.

Support:
2185 to 2182 is the September 2005 peak and interim high from November 2005.
2177 is the December 2004 high.
2168 is the August intraday high.
The 10 day EMA at 2163
2158 from the May 2005 low.
The 50 day EMA at 2131
2100 from the early and mid-2005 peaks
2072 is the June closing low
2050 from the summer 2005 lateral range lows

S&P 500: Closed at 1311.01
Resistance:
1311 is the April closing high.
1315 is the May and May 2001 peaks
1324 to 1329 from the October 2000 lows.
1326.70 is the May 2006 high
1334 is an October 1999 peak

Support:
1302 the recent August highs
The 10 day EMA at 1300
1294 is the January 2006 high and 1297.57 is the February 2006 high.
The early June high at 1288
The late January peak at 1285
1280.37 is the recent July peak.
The 50 day EMA at 1280
The 200 day EMA at 1277
1262 is an old trendline from the August 2003/August 2004/October 2005 lows.

Dow: Closed at 11,464.15
Resistance:
11,642 is the May 2006 closing high
11,670 is the May intraday high

Support:
11,401 from the September 2000 peak and April 2001 highs
11,384 is the August intraday high.
The 10 day EMA at 11,357
11,350 from the May 2001 peak
The March 2006 highs at 11,329 to 11,335
The 18 day EMA at 11,307
11,279 is the late May closing high
11,243 is the early August peak closing high.
11,228 is the July closing high.
The 50 day EMA at 11,203
11,097 to 11,137 is the last peak from the February top.
The 200 day SMA at 11,068

Economic Calendar

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

September 6
- Productivity, revised (Q2) (8:30): 1.6% expected, 1.1% prior
- ISM services, August (10:00): 55.0 expected, 54.8 prior
- Crude oil inventories (10:30)
- Fed Beige Book (2:00)

September 7
- Initial jobless claims (8:30): 316K prior
- Wholesale inventories, July (10:00): 0.7% expected, 0.8% prior

September 8
- Consumer Credit, July (3:00): $7.0B expected, $10.3B prior