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InvestmentHouse Weekend Update:

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

- Market cannot finish the consolidation before distribution again sets in.
- Everything is coming in threes of late, and it is not lucky threes.
- Stocks face an important test heading into expiration week.
- Fed-speak turns to page two of the script.
- Still some great stocks setting up more upside, but have to gear up for some downside as well.

Another NASDAQ breakout attempt gets shipped back to the factory.

After a week of consolidation on the NYSE and a midweek break higher on NASDAQ thanks to Cisco’s earnings, stocks were ready to start higher on Friday. There was even some exasperation among the NYSE floor traders about the market going nowhere for the week. After a 6 month run I guess they get a bit spoiled. That worry added a bit of upside impetus and the indices started the session higher even with oil bumping up against $60/bbl and piercing that level early in the oil session.

After the initial bounce sellers moved in rather quickly and started taking the market lower, but there was nothing major to the downside, just more consolidation in the market. Oil was bumping $60/bbl still, again poking its nose through that resistance a couple of times. There was Fed-speak from a triumvirate of Fed dignitaries, Poole, Pinalto, and Fisher. Though their commentary varied in some respects, it centered around the theme since the last meeting: pleased with the direction of inflation, but not convinced the cycle was over. They even went the next step and said that if the economy remained strong they were not averse to pushing rates higher.

The third shoe falls.

Just as afternoon started the third piece of news hit. At an industry conference MU stated that it did not see any catalysts ahead to push chip sales. Whatever starch was left in the session at that point went limp when this third piece of news hit the market. NASDAQ lost 20 points in 40 minutes, and then wandered lower another 12 points before a last hour bounce cut a few points off the losses. The NYSE indices sold to session lows as well, but the techs were the clear downside leaders. Well, not the only downside leaders. Financials were weak again as well as the effects of the HCS story and sub-prime mortgages lingered even after the Thursday rebound in financials after the story first hit.

NASDAQ and the other indices finished near session lows as volume rose. NASDAQ gave back the Wednesday upside break and more, and it did it on volume as strong as the upside move. That was the third time a distribution session gave back a stronger volume upside break in the past month. As in baseball you typically only get three strikes in the market. While NASDAQ did not break down as a result of the Friday move the distribution continues to show the sellers gaining the upper hand as the index tries to consolidate and break to another post-2002 high.

Technically it was another distribution session, the seventh on NASDAQ since late November. Not a huge amount but it is the timing of three key sessions, all on the heels of upside strong volume and price breaks. Each attempt to break higher gets sold off. The NYSE industries suffered some distribution sessions as well and did so on Friday, but thus far none of them have broken their trends higher. Indeed after the strongest distribution bout in late January they caught support and then surged to new all-time or post-2002 highs.

Friday’s internals were weak along with the distribution with breadth running -2:1 or better. Down volume swamped up volume by a 3:1 margin. The NYSE indices managed to hold near support, the small caps at the 10 day EMA and the large caps at the 18 day EMA, though the move down to that level was mostly a jolt lower. Nonetheless they managed to hold support as did many leaders. We were looking for a pullback to allow some of the strong movers to test and set up for the next run higher. Friday’s drop is giving them the opportunity for a pullback, but they were definitely under pressure and backpedaling Friday as some of their membership crumbled.

Expiration likely to add some extra downside pressure this week.

The concern following a seven month rally is when it is going to correct. The action Friday where NASDAQ once again gave back a solid break higher on a stronger downside move again raises the specter of a looming correction. Leaders breaking lower on rising volume as well only reinforced that concern.

On the other hand, but for the higher volume selling and some leaders giving up, we are getting the pullback we wanted in the leaders to set up some better entry points. Maybe they will once again shake off the effects of the distribution, regroup, and move higher. After all, the indices did not break down Friday though they did suffer a setback, particularly on NASDAQ as it has yet to make and hold a new post-2002 high.

That leaves the indices coming into a key week where they will try to finish out a consolidation and hold their trends for another try upside. It is also expiration week, however, and that tends to exaggerate the momentum. The past two expirations have been down weeks, and this time it has some downside momentum building already. Throw in the continued undercurrent of worry the sub-prime mortgage situation raised last week and you have the potential for a more volatile week.

THE ECONOMY

Fed-speak, page 2: stronger GDP growth means rate hikes.

The Fed speakers were also in threes on Friday with Poole, Pinalto, and wing nut Fisher reading from the tough love script passed around the past couple of weeks. Each one noted that inflation was moving in a positive trend. Hurray. On the other hand, they were not convinced its back was broken. Poole noted that the Fed could not let inflation stabilize above 2%, and if there was an upside GDP surprise the Fed could be prompted into a rate hike. Fisher chimed in that if inflation did not continue its positive trend the Fed would push rates higher.

It seems something of a game of charades with the Fed as they trot out this speech about growth requiring rate hikes. They repeat it often, but most modern economists now concede to history that growth does not cause inflation, bad monetary policies do. The economy can grow gangbusters without inflation as long as there is enough money to keep supply unfettered but not too much such that there are unneeded funds whose only use is to bid up prices for goods and services. It is a fine line to walk and harder for the Fed to explain to laymen. That is strange given that much of the US still remembers the 1970’s when there was no growth, no jobs, but double digit inflation followed by the 1980’s and 1990’s when there was tremendous growth, huge revenue surges, and yet no inflation.

Nonetheless the Fed fosters this fiction that growth means inflation. That is okay as long as things work out and the Fed is able to keep monetary policy right and fiscal policy from the legislature allows business to invest and grow. The problems occur when one or both screw the pooch and the Fed is forced into practicing what it preaches. That is when the real problems arise with unnecessary rate hikes and the deleterious effects the bring because they typically occur at the peak of the business cycle and all they do is foster a more rapid economic decline.

Housing shoe still to drop.

There was a mitigating statement or two from Poole that will keep the Fed in neutral for the foreseeable future. The most important was the recognition that the housing market has not yet stabilized. As long as housing struggles the Fed is not going to think about raising rates. The Thursday news regarding sub-prime mortgages only reinforced the Fed’s current pause. Typically the sub-prime is the first area to crack when the housing market starts to struggle, and then the others start to domino.

Now the Fed could do the wrong thing and view the failures in sub-prime loans indicates lenders are too easy and thus put restrictions on lenders and otherwise tighten credit. It is way too late for that. Once you have problems cropping up the cows have left the barn and Elvis is already in Graceland. If you do the wrong thing and tighten at that point all you get is a further slowing in the economy without fixing inflation. Then you get slower growth and inflation. That starts to look more like the 1970’s, and frankly, there are very few things from the 1970’s that we want to relive.

Bernanke seems a bit too sage to fall into that trap, at least right away. All of his moves thus far appear to show a strong understanding of history along with economic cause and effect. Sure he messed up at first giving Bartiromo an exclusive that she held until her show when the next trading week began and spoke a bit freely in front of Congress, but he did put a lid on it after that, at least until a week ago when he got into the entitlement argument. He needs to watch that and stick to his promise to stay out of the policy arena.

The danger is if inflation as measured by the Fed does not drop off and Bernanke then comes under heavy pressure to hike based upon the Phillips Curve view of economic relationships the Fed espouses in public. More than once the Fed has, as Archie Bunker put it, ‘painted itself into a corner and thrown away the key’ (there we go, dissing the seventies and then quoting a show from that era). If Bernanke is smart he can always use the potential housing issues as kind of the ultimate trump card as that has the potential to get very ugly quickly and without a lot of warning. Thus far Bernanke has acted smart. Smart is as smart does (or something like that).

THE MARKET

MARKET SENTIMENT

VIX: 11.1; +0.66
VXN: 17.11; +0.97
VXO: 10.86; +0.77

Put/Call Ratio (CBOE): 0.94; +0.1. Jumping right back up toward 1.0 as the selling increases. It has to close above 1.0 a few times before you start to thinking about reversals.

Bulls versus Bears:

Bulls: 52.2%. Modest decline from 53.3% after bouncing up from 50.5% a in late January, and after grazing past 55% (the 55.4%) just before. Still quite a bit of bullishness though backing down from the 55% threshold considered bearish as it signals pretty much everyone is in the market.

Bears: 22.2%. Moving in a direction more favorable to market upside as bears bounce back from flirting with the 20% level considered bearish. Up from 21.1% last week and 20.9% before where bears flirted with the 20% bearish threshold. As with the bulls, it is still too close at this juncture as it indicates not enough pessimism. When bears are low it is the same as high bulls: everyone is in. Hit a new post-2002 high in that late June 2006 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: -28.85 points (-1.16%) to close at 2459.82
Volume: 2.147B (+6.16%). Volume jumped back well above average, rivaling the trade from earlier in the week when NASDAQ gapped higher on the CSCO earnings. Once more the selling volume jumped up after an upside break attempt as the sellers entered. Three upside breakout attempts, three downside distribution days on their heels.

Up Volume: 548.684M (-397.833M)
Down Volume: 1.633B (+637.438M)

A/D and Hi/Lo: Decliners led 1.94 to 1. Breadth on the Wednesday upside break was not as strong as this downside breadth.
Previous Session: Decliners led 1.04 to 1

New Highs: 100 (-3)
New Lows: 21 (+4)

The Chart: (Click to view the chart)

Gapped higher but that did not last long. Nonetheless, the downside was not out of hand at all, just a test of the Wednesday break higher. Then the bottom fell out just after lunch as MU commented that there just was nothing in the foreseeable future to push chip prices. That has the same effect on techs as a statement by a presidential candidate that taxes need to be raised: values plummet. NASDAQ dropped a quick 20 and then worked off another 12 before a modest last hour bounce. It gave up the Wednesday break higher, the December high (2471) and the 18 day EMA (2463). It is still in the range that started in November and has the 50 day EMA (2439) in the middle as support. The continued distribution, however, is undermining the lateral move.

SOX (-1.38%). Once more SOX rallied early, helped by a sector upgrade, testing 475 on the high. It then reversed and fell through the 50 day EMA. It closed between that 475 resistance and 450 support, making a lower high in the process. That high coincides with the September and October peaks but is well below the November and December peaks near 490. Something of a toppish pattern forming, but it is still slugging it out. Putting it this way, it is not a pattern we are lining up to buy into.

SP500/NYSE

Stats: -10.25 points (-0.71%) to close at 1438.06
NYSE Volume: 1.636B (+2.17%). Volume was the highest since the new money hit the NYSE to start February. It was on a down session so there was some clear distribution as the financials sold off harder, putting a drag on the indices.

Up Volume: 419.719M (-328.272M)
Down Volume: 1.195B (+362.498M)

A/D and Hi/Lo: Decliners led 2.32 to 1. Rivaling the upside breadth when SP600 and SP400 were breaking to new all-time highs. Shows the selling was strengthening outside of just some volume.
Previous Session: Decliners led 1.09 to 1

New Highs: 156 (-26)
New Lows: 12 (+5)

The Chart: (Click to view the chart)

SP500 plunked down onto the 18 day EMA (1436) hard as volume jumped back above average. It managed a modest bounce late to hold that near support, recovering 4.5 points to do it. That also keeps it close to the January high at 1440, roughly holding its breakout to a new post-2002 high. It is still in its trend after Friday easily above the 50 day EMA (1420). It is under pressure from the financial sector that, after rebounding Thursday from the mortgage scare, had second thoughts. It has shaken off prior distribution bouts and now it has another one to try and work off.

SP600 (-1.03%) struggled as well, but it had a better position to work from having broken to a new high and running higher as the rest of the market moved laterally. It sold to the 10 day EMA and managed to hold that near support similar to SP500 holding the 18 day EMA. Thus far a normal test in the small caps though on rising volume. A new leader in the market rally, and thus important that it holds some semblance of the breakout. The 18 day EMA is at 408, and holding that keeps it on top of the December highs and thus holding the breakout.

DJ30

DJ30 sold to the 18 day EMA (12,585) as well, falling on rising though still below average volume. Once again DJ30 rallied off of the lows in the narrow channel, moved to the highs and is now fading once more within that range. Volume was still below average so this initially has the look of a routine pullback in its not so routine 7 month uptrend. Every pullback is questioned given the length of that run. For now it looks as if DJ30 is heading back for another wave at the 50 day EMA (12,448) as it did twice in January.

Stats: -56.8 points (-0.45%) to close at 12580.83
Volume: 220M shares Friday versus 193.8M shares Thursday. Strongest volume of the week but still below average.

The Chart: (Click to view the chart)

MONDAY

After a quiet week of economic data the floodgates open again with regional PMI reports, retail sales, housing starts, and PPI to hit the high points. Bernanke addresses Congress as well in his son of Humphrey-Hawkins. He is likely not to get into monetary policy details too much but the interesting aspect will be how much he can be drawn into the political fray. He was doing a pretty good job of it but then opened the door last week with his comments on social issues and entitlements.

That economic overlay adds spice to a market that got roiled late in the week with the mortgage and chip issues. Add expiration to the mix and the likelihood of some further downside increases.

A continued pullback will further set up some leaders that ran higher in the last rally and are now testing the move. Many stocks are pulling back in this test and the issue is which ones hold at near support and which ones need s deeper test. There is no economic meltdown despite the sub-prime mortgage problems; we discussed Thursday why they in and of themselves will not present the boogeyman some are predicting. They could be a sign of further mortgage problems down the road, but the economic data, consumer confidence, and the leading indicators do not suggest that is the case.

Thus outside of the sectors directly impacted by the housing issues we can look for continued advances and use the overall market pullback to our advantage. When solid leaders rebound off of their pullbacks we can accumulate some positions and play the next run higher. We want to see the distribution subside and see some good rebounds on decent volume, however, to show us it is more than just a relief bounce. After all the market is still extended and NASDAQ has shown three occasions where a strong, higher volume upside move was tossed back. As of Friday the market is still struggling with some systematic selling in techs with some of the selling branching out.

Accordingly, we are going to selectively look at some strong upside leaders that are in the right sectors and are in the right position to rebound and continue their runs. We are also looking at some more potential downside plays in the event the selling spreads out and continues. Expiration week has suffered a downside bias the past several months only to recover later. We want to be positioned, however, in the event the distribution wins out and the market heads into an overdue correction. The distribution is undermining NASDAQ’s 3-month lateral move; sellers are using the rebounds to unload shares. If it keeps up eventually the foundation gives.

As we said, we want to be ready for some potential downside. The distribution is not good but the market to this juncture has shaken off every selling attempt. Each time it appears the market has had it, the indices find the means to rally again. With the economy still in solid shape there are many strong leaders still in position to rally, and this pullback, even if it takes all next week and turns into a short correction, will leave the strong ones in position to rebound. We want to be very patient in this environment and move in when we see good moves starting. In addition, we don’t need to take a full position at once; even if a move is solid, in a volatile expiration week a strong stock can still show some up and down action. Thus we are going to be patient, pick our shots, and take what the market gives during what could be a transition week.

Support and Resistance

NASDAQ: Closed at 2459.82
Resistance:
2468.42 is the November 2006 high
2471 is the December 2006 high
2509 is the January 2007 high
2493 is an interim peak from February 1999
2523 is price resistance November 2000

Support:
2450 is minor support
The 50 day EMA at 2439
2412 from June 1999 low
2384 is an interim peak from January 1999
2379 is the October high.
2376 is the April high, the former post-2002 high
2368 is the early October handle high.
2333 is the top of the Q1 2006 trading range (the January and mid-March 2006 highs)
2316 from interim tops in January and March 2006 trading range

S&P 500: Closed at 1438.06
Resistance:
1440 is the mid-January high
1447 is the July up trendline
1475 from peaks in December 1999 and January 2000
1444 from February 2000

Support:
The 18 day EMA at 1436.81
1432 is the December 2006 high
1425 is an interim high from November 1999
The 50 day EMA at 1420
1408 is the November high
1401 is a low from April 2000
1390 is the October high.

Dow: Closed at 12,580.83
Resistance:
About 8.5% above the 200 day SMA. Still going strong, overcoming the chop as it pushes to a series of new highs once more.

Support:
The 18 day EMA at 12,585
12,499 is the December intraday high.
The 50 day EMA at 12,448
12,361 is the November 2006 high
October high is 12,167
11,986 is price support from mid-October and the early November low.
11,865 from the early October consolidation
11,750.28 is the pre-2000 all-time high

Economic Calendar

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

February 12
- Treasury Budget, January (2:00): $40.0B expected, $21.0B prior

February 13
- Trade balance, December (8:30): -$59.5B expected, -$58.2B prior

February 14
- Retail sales, January (8:30): 0.3% expected, 0.9% prior
- Retail ex-auto (8:30): 0.3% expected, 1.0% prior
- Business inventories, December (10:00): 0.4% expected, 0.4% prior
- Crude oil inventories (9:30): -449K prior

February 15
- Initial jobless claims (8:30): 311K prior
- NY Empire PMI, February (8:30): 11.0 expected, 9.1 prior
- Net foreign purchases, December (9:00): $60.0B expected, $68.0B prior
- Industrial production, January (9:15): 0.0% expected, 0.4% prior
- Capacity utilization, January (9:15): 81.7% expected, 81.8% prior
- Philly Fed, February (12:00): 5.0 expected, 8.3 prior

February 16
- Housing starts, February (8:30): 1.61M expected, 1.642M prior
- Building permits, February (8:30): 1.59M expected, 1.613M prior
- PPI, January (8:30): -0.6% expected, 0.9% prior
- Core PPI, January (8:30): 0.2% expected, 0.2% prior
- Michigan sentiment prelim, February (10:00): 97.0 expected, 96.9 prior.