It has been a fascinating week in the financial markets as the investment community is fully engaged in open debate of the future direction for the economy and the stock market. Are we at the early stages of a new bull market or is this the tail-end of a counter-trend rally within the confines of a primary bear market? The stock market is considered a leading indicator for the economy, and right now stocks are saying that the economy is on the mend. Over the past decade the Federal Reserve has come to the rescue on many occasions with an easing of monetary policy. We have witnessed unprecedented rate cuts by the Fed resulting in half-century low interest rates, along with massive injections of liquidity via Fed repurchases in the open market. I believe that investors are looking at the situation and saying, “It’s going to work; it has every time in the past!” Investor optimism has pushed stocks prices higher once again.
For the week, the Dow Industrials added 212 points to close at 9062, the NASDAQ gained 32 points or 2.0% to close at 1627, and the S&P 500 said goodbye 965 and added 24 points for the week to close at 987. My WrapUp from Tuesday regarding the proper placement of the neckline of the S&P 500 brought a rousing response to my email in-box. I have not returned all of the emails, but I openly thank all of you for your constructive feedback. It’s great to see that investors have such varying opinions, because that’s what makes a market. Every trade is two-sided. For every buyer there is a seller. Why would one investor want to buy something that another investor doesn’t want any more? Simply put, one person thinks the asset is going to go up while the other believes it is headed down.
From all of my emails and the research I have done the last few days, I have drawn some conclusions. Overall, I sense that investors are very much on edge. This has been a rally driven by momentum, excess liquidity, and hope. The great hope is that the economy will improve. Stock investors are still trying to decide if this rally will continue. My conclusion on the neckline of the S&P 500 is that the neckline is now positioned at 970, but should be viewed as a band or zone. Following are two excerpts from the emails I received. “…The bigger question right now is where is the top of the band? The only indicator I can find is the double top at 983.12 on 10/7/97 and 983.79 on 12/5/97. This would give a top for the band of about 990 for today and should set an upper limit on the ‘neckline.’ This is about a 2% difference, which is not out of line for technical analysis.” Another reader emailed, “…the truer value would be ~970 +/- 3%. That essentially allows the S&P to kiss 1000 before significantly breaking above the neckline, in my estimation. I find the current market action very strange and wonder how much the massive injection of liquidity is buoying prices.”
Another email pointed out that the Nikkei Average broke above its neckline five times between 1993 and 2000 before the drop of the last three years from 20,000 to 8,000. In my mind all of the evidence still points to near term weakness for the stock market. In the next couple of weeks we should start hearing the warnings from companies that won’t make their second quarter numbers. In the past few quarters I have noticed that stocks tend to take their fall during “warning season” and by the time we get to actual earnings in July, companies will meet and beat expectations. Jim Puplava has been watching the developments for second quarter earnings very closely, and points out that earnings’ expectations have been slashed throughout the quarter. Between the heavy resistance of the S&P neckline, upcoming earnings warnings, overbought momentum indicators, and fundamental valuations (P/E’s) at two times the historical norm, stock prices should be coming down over the next few weeks. Another observation that tells me stocks will go lower is the fact that the NASDAQ has been front-running the Dow Industrials and the S&P. Today at the opening bell the NASDAQ gapped-up by 24 points and ran another 14 points within the first hour for a total gain of 38 points. Within two and a half hours the index was in the red and closed at the lows for the day at minus 18 points. That is not a very good lead going into the trading day on Monday.
Bonds and Interest Rates
With all the spin that the economy is getting better, bonds are taking a hit. The shorter end is selling-off today, but money is moving into the longer dated 30-year maturities. The two, five and ten-year notes are being sold because with the anticipation of economic improvement, the Federal Reserve will not need to cut interest rates at their next meeting on June 25th. The bond market has priced-in a 25 basis point cut, and for a time was speculating that it could go to a half point cut. Earlier this week the two-year note posted a yield of 1.2% which is lower than the current Fed Funds Rate of 1.25%. In the past when two-year yields have fallen below Fed Funds, the Feds have been forced to cut. In the past 14 years the rate on the two-year note has gone below the Fed Funds rate six times, and every time the Feds cut the discount rate within six months. With the yield on the two-year note now creeping back up, it could give the Feds enough breathing room to avoid a rate cut.
To that same point, this one really caught me today. Moody’s Investors Service believes the May employment figures were “not weak enough to strengthen the case for a Fed Funds rate cut” at the June 25th meeting. According to Moody’s, “Another rate cut may not necessarily be risk free. A decline in mortgage yields following a rate cut very much runs the danger of pushing residential real estate prices up to levels that are unsustainable longer term. (Read that as concern over a real estate bubble.) By no means is the U.S. economy suffering from a dearth of liquidity that otherwise would practically mandate a rate cut.” They are saying that at this point, a rate cut could cause more damage than good. Stocks aren’t going to like it and bonds will surely go down with a cut.
Economy
As far as the economy goes, where’s the beef? The employment numbers were bad again this week, but here we go again with, “better than expected.” I’ll bet that all of the people waiting in line for a job would like to see better than expected results from their job search. Millions of Americans are out of work with rising debt levels and bills that have to be paid. This week the ISM report that showed that the index for retailing, financial services, and other non-manufacturing companies rose more than expected to 54.5, its largest jump in a year. The third piece of economic news this week showed that orders placed with U.S. factories in April declined 2.9%, the biggest drop in 18 months. The lower dollar is supposed to be helping our export businesses, but it hasn’t kicked in yet.
Spin of the Week - Euro Rate Cut
Yesterday was probably the most fun for the week when the ECB announced their widely anticipated half-point rate cut. Normally when a country lowers their interest rates it weakens the currency. Yesterday when the cut was announced, the Euro took off against the dollar. This Bloomberg headline will have to go down as the Spin of the Week! Yesterday as the dollar was tanking, the headline read, “Dollar Falls Amid Speculation Fed to Match ECB’s Rate Cut.” They were actually saying that the dollar was falling because the ECB half-point cut would cause our policy makers to cut a half point. I don’t think so. Seems to me it was a no-brainer to sell dollars and buy the euro to chase rising bond prices. It’s the old momentum game but on the other shore. The hot money chased the returns in Europe. Actually, our euro holdings have done exceptionally well. We are getting the interest payments (higher than US bonds), the appreciation of bond prices with yesterday’s rate cut, and the profits from currency conversion when we go back to dollars. We’ve had a three-way-winner with our euro holdings. Note that yesterday there were rumors of a half-point cut coming from the Fed and today the word is that there might not be any cut at all. Tends to keep you on your toes, doesn’t it?
I tend to think that if we do get a cut, it will only be a quarter point. If they use all of the rate-cut ammo now, they won’t have anything left in the event of an emergency. A major default on Wall Street or a terrorist attack could warrant the need for emergency measures. The other problem that exists with a rate cut of a half percent is that it will take the rate down to 0.75%. When you have your money “on the sidelines” it is sitting in a money market fund that has managerial overhead in the area of 0.5% to 0.75%. If interest rates go to 0.75%, it will only be enough to cover the overhead of the fund managers, leaving no interest available for the investor. If rates go lower again, they will be charging us to keep our money in a money market fund. That is the oversimplified version, but suffice it to say that interest rates below one percent creates some problems of its own.
Big Picture – Stocks, Bonds, and the Dollar
As I take a few steps back mentally, I try to visualize where this is all headed. The dollar has taken a real beating over the last year and a half. Since January 2002 the US Dollar Index has fallen 22%. In the very near future I expect the dollar to plateau and stay in a range of possibly 90 to 95 on the USD Index and in the range of $1.15 to $1.25 versus the euro. As the dollar was declining rapidly, both stock and bond prices were going up nicely. Asset prices rose as the dollar fell. As the dollar begins to find an area of support, it could leave room for asset prices to come down without seeing huge capital flight from dollar denominated assets. I believe this is the way our policy makers are trying to bring the dollar down in a controlled fashion. To allow asset prices to fall along with the dollar would be suicidal. Foreigners would be compelled to sell dollars and convert to another currency.
Somewhere in the near term, I expect the dollar to gain some stability and consolidate in range bound territory for six months or so. Stocks would also go range bound with the Dow Industrials holding in a pattern around 7500 to 9000. During this time bond prices should remain high. We are nearing the end of a 20-year bull market for bonds. Bonds should flip-flop at these high levels until something happens for interest rates to move higher, either true economic strength or some kind of interest rate increase to support a falling dollar. I firmly believe our leaders would like to see some stability going into the elections next year. I can’t know the timing for sure, but soon enough the markets will need to slow down and consolidate near the current levels, especially in the currency markets. In the very near term, I expect stocks to come down, bond prices to remain high, and the dollar to consolidate. We could see one more rush from bonds to stocks for a final pop in stock prices, but that should do it for now.
One of these weeks I’ll try to type faster (or start earlier) to cover all of the developments in the commodities arena. Oil went over $31 today, so it’s getting interesting in the commodity pits once again. Gold and silver are always fun to comment on, and natural gas is getting some play lately. For now, it’s time to head out for the weekend. I hope you enjoy yours, and best of luck to you in all of your investment decisions.
So far the major averages have held up despite the extreme level of Bullishness and Complacency that now exist in the market. The % difference between the Bullish and Bearish Investment Advisors now stands at 42.4% which is the largest % difference between the two since April of 1987. With this extreme amount of Bullishness now present in the market it's hard to imagine that some type of multi week correction isn't going to occur before much longer.
Now this correction can end up going two possible ways. The best case scenario would be for something similar to what occurred in the early part of 1999 when the major averages basically traded sideways for 8 weeks (point A) before heading higher as the % difference between the Bullish and Bearish Investment Advisors reached an extreme level around 36%. On the other hand the worst case scenario would be for a prolonged sell off to occur lasting several weeks similar to what transpired in the late Summer and early Fall of 1999 (points B to C) although the market was still able to rally strongly after it bottomed in October of 1999 (points C to D).
If some type of correction does take place there are some key support levels to watch in the major averages. So far the Dow has remained above its Neckline (red line) in association with its previous Inverted Head and Shoulders pattern. If the Dow drops below its Neckline the first key level to watch would be near 8800 as this is where the Dow's upward sloping tend line (black line) originating from the March low comes into play. Also as I pointed out last weekend the 23.6% Retracement Level calculated from the March low to the Dow's most recent high is near 8800 as well. Thus the 8800 area appears to be a key support area to watch if a correction does develop.
As for the Nasdaq the areas to watch for possible support if a correction develops is between 1560 (upward sloping trend line originating from the March low) and 1590 (20 Day Exponential Moving Average). In addition the 23.6% Retracement Level calculated from the March low to the high made on June 6th is near 1582. Thus the 1560-1590 range appears to be a key area to watch for support in the Nasdaq.
Meanwhile if a correction develops in the S&P 500 the 960 area appears to be a significant support area as three separate things come together near this level. First the Neckline associated with the S&P 500's Inverted Head and Shoulders pattern is around 960. Secondly the S&P 500's upward sloping trend line originating from the March low also comes into play near 960 and thirdly the 23.6% Retracement Level calculated from the March low to the high made on June 6th is at 956. If the S&P 500 does enter a correction phase the 960 area appears to be the first key support area to watch.
Last weekend I talked about Elliot Wave Theory and mentioned that it looked like in the short term the Nasdaq may have completed a 5 Wave pattern with 3 separate upward moves (E to 1, 2 to 3 and 4 to 5) and 2 separate downward moves (1 to 2 and 3 to 4) after making a bottom in March (point E).
Although some type of correction is likely to develop before much longer it appears from a longer term perspective that the Nasdaq has just completed the 3rd Wave of a potential longer term Elliot 5 Wave pattern. Notice how the 1st Wave (upward move) was associated with the rally from the October 2002 low to the early December 2002 high. This was then followed by the 2nd Wave (downward move) as the Nasdaq corrected from December of 2002 until the low was made in March of 2003. Meanwhile the potential 3rd Wave (upward move) began in March and was completed on June 6th. If you believe in Elliot Wave Theory then the 4th Wave should be another downward move followed by the 5th Wave (upward move) which would complete the Elliot 5 Wave pattern sometime late this year or in the early part of 2004.
Finally when you are looking for stocks to invest in a lot of times you may miss the 1st breakout attempt unless you watch the market on a daily basis. However the strongest performing stocks will always give you a 2nd opportunity to get into them if you monitor them closely.
For example TRAD which has appreciated over 400% since early March first broke out of a 4 week Handle (H) in early March after forming a Cup and went from $2.00 to $6.75 over the next 9 weeks.
TRAD then formed another Cup and Handle pattern and broke out of its 3 week Handle (H) in mid May and has risen from $6.50 to $10.50 over the past 4 weeks.
Thus even if you had missed the 1st breakout in early March there still was an opportunity to catch the 2nd move in mid May.
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