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InvestmentHouse Weekend Update:

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

- Impressive comeback from intraday shakeout sets up market for a recovery but it has to find some strength.
- Treasury starts selling the 30 year bond again. Time for rates to rise?
- Does the trade gap need to be fixed?
- Market shows the ability to come back but will have to show ability to rally once more.

Market finds a bit of character, rebounds after downside follow through.

You are not going to hear us say the market is out of hot water or any other rather ridiculous characterization, but we will say the market showed something we did not expect, i.e. a rebound after morning downside follow through to Thursday’s failed rally attempt. The week was not going well before the Friday morning selling; it started lower from the prior Friday, sold some more, attempted a narrow relief move Wednesday, and then rolled over Thursday after a strong morning that saw stocks gap higher only to collapse.

The early selling pushed SP600 down to its 50 day EMA, a support level it had not seen in 6 weeks. NASDAQ and SP500 were extending their losses further below their 50 day EMA after closing below those levels once more on Thursday. SOX, the clear leader in the rally, even tested its 18 day EMA. Breadth was overwhelmingly downside early with NASDAQ posting almost 3 to 1 declines. The market leaders were even starting to crack with financials breaking below their 18 day EMA and chip leaders doing the same. It was at the point where it looked as if the leaders were going to finally give up and join in the breakdown. Indeed, on the week they were down more than the overall market.

The session was just over an hour old and the downside move accelerated sharply. Then it bounced, what at the time we thought a relief bounce that would take it up to the 15 minute moving average. It broke through, tested, and then kept moving higher. We were waiting for a stall that would send it back down, but it held through lunch and accelerated in the last two hours and into the close. There was not much volume and breadth was mediocre (not bad, however, given the early session hammering), so the rebound was not a clear reversal from the prior selling. It could have been a shakeout of the sellers that sets up the next rebound; as noted, the leaders were selling through near support and then recovered. That shows some of the weaker holders sold out, and that always helps harden a stock for more upside.

Thus the continued run lower following the Thursday lower no doubt shook out some sellers and the recovery shows buyers stepped in. That sets up the possibility of a return to the rally next week, but the market will have to show some serious upside volume to be believable. The technical patterns for NASDAQ and SP500 remain weak. SOX looks solid, but its leadership partners SP600 and SP400 are showing some strain in their patterns. They both tested the 50 day EMA intraday and rebounded; maybe they too have shaken out their sellers. The market needs that to be the case if it is going to pull off a return to the rally.

THE ECONOMY

Thirty year bond not taking any heat off the 10 year.

It was not the reason for the re-emergence of the long bond, but many were thinking that another treasury on the long end would attract some money and maybe allow the 10 year a chance to rise a bit and mitigate the gradually steeper negative yield curve. Recall that it is widely believed that the 10 year yield is so low because a lot of foreign money is piling into that note because of the trade deficit as our trading partners put their excess back into US treasuries.

Thus far it has not worked. The 10 year is now 10 basis points less than the 2 year (4.58% versus 4.68%), the spread having widened over the past week. Indeed, the 30 year is the lowest of all at 4.55%. There is a lot of buying in the 30 year, but it is not enough to take away from the 10 year at this point, at least not enough to allow that bond to rise vis-à-vis the 2 year.

Again, taking pressure off the 10 year was not the primary reason for reissuing the long bond. The government originally eliminated the long bond because it felt that surplus was here to stay and it could use the short term interest rates to finance any debt required. Then things flipped and long rates have fallen relative to the short end of the curve. It is now more expensive to fund through shorter term treasuries than longer term. With the recognition that deficits are here to stay for some time to come, lower long term rates, and pension funds desiring a long maturity instrument to match up to their longer maturity liabilities, the return of the long bond was necessary.

Of course, the federal government waited a long time to come to this decision. Long end rates have been low and falling for a few years and the long bond is being issued even as longer rates have started to creep higher. Indeed, now that the Feds have acted you would almost expect that the decline in rates is over. That sounds a bit facetious, but markets tend to work that way.

Some suggest the trade gap could be the catalyst.

There is an idea, somewhat widely accepted, that a large trade gap and large budget deficit could ultimately lead to higher interest rates. The trade gap figures were released Friday and they were worse than expected, putting the 2005 gap at an all-time high at $725.9B, topping the $617B in 2004. Higher 9 out of 10 years. Oil imports made up $229B of the gap, up 40% from 2004. That makes it 31% of the overall deficit versus 26% in 2004.

The theory is that eventually a large trade gap and federal deficit will cause foreign investors to lose confidence in the US as a store for their excess wealth, and they will sell dollar denominated assets in favor of others. Those dollars will have to come home, but not as treasury buys. That will put more dollars in circulation here and likely jump inflation as more dollars are in the economy to chase the same amount of goods.

Former Treasury secretary Ruben spoke at the Houston energy conference on Thursday, putting the theory into familiar and unconvincing terms. Ruben said that at some point in the future, and he was not sure when, the large trade deficit “may” result in decreased foreign investment in the US. Now I suppose you could get more vague than that, but I am not sure how. At some unbeknownst point in the future a large trade gap may cause foreigners to stop investing in the US. Yes and at some point a spaceship may land on the White House lawn.

Vague theories are one thing, and Ruben tried to use this one in the last presidential election to stir up concern over current economic policy. There are realities as opposed to theory, however, that mitigate against such a scenario, at least anytime in the near future.

First, over the past twenty years many producing countries have geared their economies to supply US consumption. At this juncture they are not prepared to jeopardize that relationship by significantly reducing their purchases of US treasuries. They need a strong US consumer, and if they stopped buying treasuries and sent dollars home to the US they might risk higher US interest rates and thus less buying power for their products.

Second, as long as the US has a strong economy we will have a trade gap. We consume lots of goods, foreign and US, when the economy is strong. Specifically, we consume a lot of oil to drive our cars, manufacturing, etc. With oil on the rise and our appetite for oil on the rise as well, oil makes up more and more of our deficit. Thus as long as oil remains high priced and as long as our demand holds, the trade gap will be large.

We can get rid of the trade gap or at least seriously reduce it. We can have a recession; that reduces consumer and business demand and buying power. It means we need less oil. Voila, a reduced trade deficit. That, however, is a very draconian method of rectifying a potential problem that ‘may’ at some unknown point in the future lead to higher interest rates. A much better method is to foster technology whereby we can wean ourselves off so much oil for our vehicle fleet.

Indeed we need to get the gap under control, but not necessarily for the reasoning usually given. The Chinese and Indian populations are huge and their economies are on the technology and industrial rise. That means their citizens are becoming wealthier. That means they are at some point going to start consuming on their own. They will consume imports but they will also start consuming their own domestic production. Their populace will realize they have wealth and start to spend it. The Chinese are ready to import their own cars to the US. Never mind that they gained most of their knowledge taken from US automaker trade secrets, the fact is they are going to be producing goods that their own people will at some point realize they can afford and desire what they make. That means less need to purchase US treasuries to support a US consumer with low interest rates. The flow of unwanted dollars in foreign hands will begin in earnest at that point. As with the Ruben theory, no one knows when that will happen, but with more and more wealthy Chinese and Indians, the time horizon is not 50 years out but more like in the next 15 to 20 years.

THE MARKET

MARKET SENTIMENT

VIX: 12.87; -0.25
VXN: 16.88; -0.26
VXO: 12.21; -0.15
Put/Call Ratio (CBOE): 0.68; -0.08

Bulls versus Bears:

Bulls: 51.6%. Bulls did not rally to end January despite the market bounce off the 50 day EMA, but last week’s drop and choppy trade did push bulls lower from 52.6%. That continues the drop from 60.4% hit in January on the high for this cycle. It is a positive to see bullishness fade during the rebound to end January; finally some of the bullish sentiment has cracked. It still, however, has a way to go to reach a level that will produce enough negative sentiment to spark a rally if this one should fail. It hit 44.8% on the low on the last leg, just above the 43.5% low in May.

Bears: 25.3%. Bears did not rally as bulls faded, instead dropping modestly from 25.8%. We expect that to change after this week, but really wanted to see bears start to ratchet higher now that bulls are cracking. Bears have held above 20% on this last rally. It hit 29.2% on the high this cycle, just below the 30% level hit in May when the market bottomed at that time as well.

NASDAQ

Stats: +6.01 points (+0.27%) to close at 2261.88
Volume: 2.081B (-12.45%). Significant drop in volume Friday. That was somewhat okay on the early test lower, but you like to see volume rebound as the market makes a strong price rebound as it did Friday. The lack of trade shows buyers, while they did take control after the morning selling, were not pouring back in stronger than the recent selling. It was Friday so that was part of the reason for the decline, but it leaves open the question of whether any upside conviction remains.

Up Volume: 1.142B (-75M)
Down Volume: 822M (-310M)

A/D and Hi/Lo: Decliners led 1.19 to 1. It was really ugly intraday with a -3:1 reading on the early selling. Many leaders were under pressure as well for the first time in a while, and thus breadth was ugly. A respectable recovery given how bad it was intraday. NASDAQ 100 led the techs, so the rebound was once again rather narrow as on Wednesday.
Previous Session: Decliners led 1.2 to 1

New Highs: 66 (-93)
New Lows: 35 (+5)

The Chart: (Click to view the chart)

NASDAQ made a lower low last week, undercutting the 50 day EMA (2257) as well as the late January closing low (2248). That gives it a lower high and a lower low after the trend higher through January, not technically good action. It fought back Wednesday with that narrow rally, reversed Thursday on volume, but then reversed again Friday after an early sharp drop lower that took NASDAQ to a new low for the month. The rebound was good to see as some leaders were under pressure but recovered with the index. NASDAQ recovered the 50 day EMA on the close but it remains below the December highs (2278 intraday) and has to fight through the overhead supply it has made for itself with that January high and the lower high that followed. Over the past two weeks the sellers have strengthened their hand and have taken control from the buyers. Friday did not change that but it gives the buyers an entrée after that shakeout of some sellers on the test lower.

SOX (-1.18%) led the downside as usual (it tends to lead both up and down), but as noted all week, it has a superior technical position, and the selling pushed it down only to the 10 day EMA (540) on the close. Intraday it slightly undercut the 18 day EMA (534.75) and rebounded. That moving average has acted as support on this run since a 50 day EMA (514.70) test that ended December. Thus the chips remain in excellent shape and will be the litmus test this coming week for the market.

SP500/NYSE

Stats: +3.21 points (+0.25%) to close at 1266.99
NYSE Volume: 1.705B (-3.91%). Volume remained above average but was lower than the prior three session that saw a distribution session Tuesday. As with NASDAQ that shows the buyers were not taking control with the force of the sellers earlier in the week. They won the day, but will have to show some strong volume upside if it continues the recovery.

A/D and Hi/Lo: Advancers led 1.06 to 1. Breadth managed to eke out a win Friday on the comeback. It was never as bad as NASDAQ on the downside selling, hitting near -2:1 at the lows.
Previous Session: Advancers led 1.07 to 1

New Highs: 84 (-48)
New Lows: 35 (+19)

The Chart: (Click to view the chart)

SP500 reached lower Friday as well, furthering the move below the 50 day EMA (1264) after undercutting that level again on the Thursday low. On the intraday low (1255) it held above the Tuesday and Wednesday lows. It then rebounded, recovered the 50 day EMA on the close, keeping it hovering around that key level. SP500 has suffered some distribution the past two weeks and that has pushed it to this support level. It has come close to failing but has managed to recover. The upside strength has not matched the downside, but as with NASDAQ, it has given buyers a point to enter if they want it. The large caps have lagged since the mid-January peak, and they have not shown much strength since, yet are still in position to rebound. There has not been a catalyst to give them incentive to do it, however, and not much has changed in the market to turn the tide.

SP600 (-0.03%) struggled last week and indeed has struggled since the start of February. Of course, it has enjoyed a stellar run, and even with its struggles it is in much better position than the large cap indices. It undercut the 18 day EMA (371.57) mid-week and then Friday reached all the way down to the 50 day EMA (364.45) intraday before rebounding to a basically flat close. Good shakeout action to say the least though not a big reversal session as NYSE came in lower. Likely not done with this testing; if the large caps indices fall hard again the small caps are going to be hard-pressed to hold the line.

DJ30

DJ30 was again one of the leaders, posting a higher percentage gain. Lower volume as with the other indices showed a lack of conviction, however, and the pattern remains less than thrilling. DJ30 did managed to rise Wednesday through Friday, something the other indices could not muster, but volume lagged all the way. DJ30 is still trying to shake off the formation of a head and shoulders top. Clearing 10,968 on volume is the key to breaking up this toppish pattern.

Stats: +35.7 points (+0.33%) to close at 10919.05
Volume: 303M shares Friday versus 314M shares Thursday.

The Chart: (Click to view the chart)

MONDAY

Earnings have just about wound down but a big economic week ahead topped with Bernanke’s first official comments when he addresses Congress with the semiannual Monetary Policy Report. For a market suffering from renewed fears of too much Fed intervention, Bernanke’s first comments will be picked apart and likely cause some overreaction, particularly with Greenspan’s comments last week to private groups about how the economy was stronger than he thought and that many more rate hikes would be necessary.

That re-opens some comments we made Thursday about Greenspan’s rapid transition into the money circuit. He purportedly received $125K for that appearance. No problem with that; after 18.5 years of public service, let him get some gravy. The issue a lot of people have is that one so important to monetary policy and just a week out from office is making such sensitive comments. Now some are saying he is a private citizen now so he can say what he wants. Well, would we like a CIA operative quit the service and then go out a week later and start talking about how things are done? Do we not put limits on what special ops troops can reveal? Does the president reveal all of the thoughts and inner workings of the white house a week after leaving office? Some will say monetary policy and covert operations are not related, but in the real world of today we know that economic strength is as much a national defense issue as military and political operations. Sure Greenspan can talk, but an appropriate time period, at least letting the new Fed chairman get his feet under him and gain some of the same credibility Greenspan had to earn when he took over, would be appropriate. To have one of the most powerful men in the world, yes the world, reveal his thoughts to a private group one week after he leaves his post is irresponsible and patently unfair to all of the public he supposedly served for years.

Aside from Bernanke losing his congressional virginity (though the confirmation process likely accomplished that already), there is a passel of economic data starting Tuesday: retail sales, New York and Philadelphia regional PMI (key because they have been slipping the past three months), production and capacity, housing starts, PPI and Michigan sentiment. The market is worried about economic strength and jobs leading to inflation. This data will provide more insight, but we still see a weakening economy as opposed to strengthening. It may be just a cyclical downturn in an otherwise upward cycle. ECRI’s weekly leading index continues to weaken from high levels. This shows slowing, but nothing that indicates a recession. It will still take a few more weeks of this reading to determine if a peak has been hit. The data this week won’t answer the question because much of it is lagging; thus the inflation fears will likely remain elevated unless there are some downside surprises, and that is unlikely this early in a slowdown.

That leaves the market still on the edge of the knife, i.e. struggling and at a key support with leaders showing some cracks. Friday was better intraday action, a really weak open and a stronger finish, but not a lot of internal strength. Leaders tested and rebounded, but many were down on the week for the first time in a month. When a market finally cracks the leaders are the last to go, but they can have off weeks while the market appears flat. That was somewhat of the case last week: SP500 was flat but many of the stronger stocks finished lower.

We liked the Friday recovery because that showed investors still ready to step in. There simply were not enough of them to make it convincing. It was Friday so that was part of the issue, but it didn’t answer any questions. The market will have to show some upside volume and a solid leadership resurgence, basically the opposite of what it has done the past few weeks. Not sure it can pull it off with the heightened concern about more rate hikes from the Fed. It was the lure of just another rate hike or two that renewed the rally in January, and the market is now pricing in not just those two but a third. Strong employment data has erroneously whipped up fears about inflation and a tougher Fed, but since the former Fed believed that and Bernanke has not distinguished himself in that vein the market’s reaction is rather logical. When the Fed gets in these inflation watch modes the Fed typically overreacts.

That leaves us watching for a rebound from the leaders, SOX and SP600, but it does not leave us with much conviction it will happen this week. We are thus going to look at stocks in weak position for downside opportunity while we will also look for strong moves in strong stocks making rebounds from support tests. If the overall market can move up with the leaders on some volume then we will have more conviction in what we buy upside. If not we will be cautious, looking for good moves and not loading up on any position we take, just nibbling. Another downside session on strong volume and the market will likely be in for a test of the next strong support level, and we will play that with some put options. We will also look at selling some calls on our leaders that are still strong but simply in need of a deeper test.

Support and Resistance

NASDAQ: Closed at 2261.88
Resistance:
The 10 day EMA at 2268.50
The 18 day EMA at 2272.62
2273 is December 2005 closing high.
2278 is December 2005 intraday high.
2288 is the October/December up trendline.
2288 from December 2000 low.
2328 from the May 2001 peak
The January high at 2333
3015 is the December 2000 peak and the October 2000 low

Support:
The 50 day EMA at 2257
The October 2005 up trendline at 2224
2220 (2218 intraday) is the August high
2216 is the August 2005 high
2178 to 2182 from the December 2004 high and the September 2005 high; these roughly mark the breakout from the 2 year base.

S&P 500: Closed at 1266.99
Resistance:
The 10 day EMA at 1268
The 18 day EMA at 1270
The December highs at 1275 (intraday) and 1273 (closing)
The January high at 1295
1315 is the May and May 2001 peaks
1324 to 1329 from the October 2000 lows.

Support:
1264 from the December 2000 lows
The 50 day EMA at 1264.48
The bottom of the November/December 2005 range at 1248
The August 2005 high at 1246
The September 2005 high at 1243
March 2005 closing high at 1225 and intraday high at 1229.11
The 200 day SMA at 1225

Dow: Closed at 10,919.05
Resistance:
10,965 from Q4 2000 and November/December 2005
10,985 is the March intraday high
11044 is the January high.
11,176 – 11,186 from April 2000
11,248 from the May 2001 peak.
11,238 from the September 2000 peak.

Support:
10,868 is the December 2004 high
The 10 day EMA at 10,843
The 18 day EMA at 10,848
The 50 day EMA at 10,814
10,754 is the February high
10,720 is the high in the recent lateral move
The June highs at 10,646 to 10,656
Price consolidation at 10,600

Economic Calendar

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

February 14
- Retail sales, January (8:30): 0.8% expected, 0.7% prior.
- Retail sales, ex-autos (8:30): 0.8% expected, 0.2% prior.
- Business inventories, December (10:00): 0.3% expected, 0.5% prior.

February 15
- New York Empire Index, February (8:30): 18.0 expected, 20.1 prior.
- Capacity utilization, January (9:15): 80.8% expected, 80.7% prior.
- Industrial production, January (9:15): 0.2% expected, 0.6% prior.
- Crude oil inventories (10:30): -318K prior

February 16
- Building permits, January (8:30): 2.062M expected, 2.075M prior
- Housing starts, January (8:30): 2.005M expected, 1.933M prior
- Philly Fed, February (12:00): 10.0 expected, 3.3 prior

February 17
- PPI, January (8:30): 0.2% expected, 0.9% prior
- Core PPI, January (8:30): 0.2% expected, 0.1% prior.
- Michigan sentiment, prelim, February: 92.0 expected, 91.2 prior.