The market bounced back from a test of secondary trend support, putting up 2.5% gains on short covering. The appearance of such a powerful move points to a bear market rally for a number of reasons discussed below. The key point is that mid way through a decline is almost never the place where multiple power days show up, a signal of a trend change either way. We will be watching closely to see if today follows through, but also taking into account expiration and its ability to defer gravity until Monday mornings after options have been expunged. The decline so far has many attributes of a continuing decline and counts as a partially complete initial leg down of a bear market that could potentially test the ’02 lows.

The powerful run up in prices Thursday carried the senior averages back up to the key bullish support lines that were violated earlier in the month and now represent resistance. This is normal for the bulls to mount a buying campaign just as the bears over commit and have to pull back, hence the extreme speed and panicky nature of the buying. Should the next couple of days fail to follow through, yet another confirmation will be in place that the 2^nd leg of the Great Y2k Bear market is underway. The ST measurements of the rally conform to a corrective bounce and could hit resistance any time.

The interest rate picture is central to our LT view of the market and the economy, as we have mentioned in the past. The long bond yield returned to life after a swoon that brought it back below key breakout levels. With the negative inflation news coming from several sources, it seems clear to us that the Fed has little choice but to raise rates at least twice going forward barring significant new information of economic stalling. The importance of this change is manifold, forcing bulls to reconsider valuation parameters and giving new credibility to both inflation hawks and recession watchers. What we find most surprising is that consumers and investors that don’t believe government inflation data have reached overwhelming majorities. We have been in the inflation camp for 2+ yrs since we reworked CPI and found it to have been seriously distorted by Greenspan over his 18 yr term. The implications of this are troubling and range from cheating retirees of legitimate reimbursements to understating true cost pressures to most critically potentially overstating economic growth.

The risks associated with overstating economic growth due to inflation distortions are only overshadowed by the consequences if it did, as we believe, in fact occur under Greenspan. The problems begin with the state of denial only recently broken by the gov’t and the Fed. The next comes from potentially overstating actual economic growth since it comes net of inflation as measured by the BLS, the same folks that compile CPI. Last year in May we reworked CPI to put back in housing costs and to remove chain weighting and hedonic adjustments, using Fed estimates for the effects of each, and concluded that CPI was running at that time between 2% and 2.5% over the published rate. That suggests the economic growth reported for 4Q05 could in fact be flat or conceivably even negative. Since the Fed is convinced that GDP is growing nicely they could easily overshoot rate hikes as they belatedly wake up to inflation that has been brewing for years now. Even if the Fed doesn’t overshoot, the risk is quite real that bond market vigilantes that are reacting to one aspect of the inflation story might push rates above levels that the economy can tolerate without significant deterioration of activity levels. All this would be invisible to the marketplace because our tools to measure recessions are so crude and inaccurate that we won't know until 3-6 months after the fact whether GDP actually slipped into the red.

The market pattern is telling us that a major pillar of support for the economy and the bull market of ’03 has been removed. The sharp declines that have followed from the probable change in early May have punctuated the importance of global liquidity in driving stock prices higher. The Money Supply has been telling us that key changes in policy at the FOMC occurred but not clearly given the time lags. If MZM continues to slow or remain quiescent then liquidity will no longer be working for the markets as it has so reliably over the last 4+ years since 9/11. The implications are that the market will have to return to levels that are attractive to the only group of investors with both the money and the conviction required to put a bottom into a falling market: value players. In order to do that cash flow yields on stocks will have to increase substantially even from current levels, particularly so due to continuing deterioration in growth rates of earnings over the last couple of years. This weakness threatens to push valuations well below fair value until stocks become compelling once again.

Should recession become the consensus view of investors then P/E ratios would have to fall considerably further before discounting the harsh treatment that can be expected of tech stock sales and earnings into the onset of a downturn. The next useful data on earnings will come during pre-announcement season in 2 weeks. The 2Q06 earnings season will follow about 2 weeks after pre-season is over, usually completed by the 10^th calendar day of July. With currency now running in favor of the US dollar, a new and unexpected risk emerges that could upend the market leadership by eating away at sales and earnings due to FX losses. Should the dollar rally up to the same resistance levels that the market has now achieved, it would take away as much as 7% of earnings, a number that if realized would certainly cause widespread misses on expectations for 2Q sales and earnings.

The market pattern calls for another fast down leg that would be a movement born of new and credible information that shows investors that their valuation parameters have to be taken down significantly and therefore stock prices with them. The dollar rally may fit the bill all too well considering that the Fed has little choice but to continue talking down inflation and threatening (for real) to raise rates well beyond expectations in order to quell inflationary expectations. This of course supports the dollar against the euro and yen, making translation losses a growing and realistic possibility. The software stocks we cover would be hit hard should this scenario come to pass since guidance has been cut each time over the last 4 qtrs and now is slowing below zero for seasonally adjusted sequential growth rates. Investors have consistently punished stocks that inflect negatively on growth rates, particularly when it means estimate revision cycles on the Street.

The sentiment indicators show the market deeply oversold as do the trading range indicators like the A/D Oscillator and Wilder’s RSI, but may not be reliable in a transition from bull to bear conditions. In prior periods of economic deterioration and the concomitant bear markets the worst move a trader could make was to pay attention to either sentiment or to range indicators because they tend to go to extreme readings and then remain there for extended periods of time. The fact that sentiment has risen into the market highs to levels exceeding even the Y2K period fits exactly with historic precedent calling for an excess of enthusiasm just at the point that conditions begin to deteriorate into a deeper recession and bear market. We believe the odds are quite high that such a period is now occurring in the economy and global stock markets.

The logical conclusion of our work suggests that CPI will continue to rise even if inflation stalls, something we doubt will occur anytime soon. Further, that the market pattern has substantial downside potential yet to be revealed and 2Q earnings could well be the basis for another disappointment for bullish investors. Caution is indicated!

RTW

SPX may be correcting in a wave-4 bounce before turning lower

SPX has almost fully retested the broken support line at 1255

Wave  ‘C’ down could follow the Y2k wave ‘A’ bear market down in duration and in magnitude

Liquidity isn’t flowing to help the market – for the 1^st time since ’03 lows – a major policy change!

The Hourly Sell is extended and due to reverse

VAP is turning down and Moment is about to but from surprisingly strong heights!

Daily S/D is forming a potential Buy signal – if confirmed, it would be a big one!

But Momentum is saying that it is only a ST corrective bounce – more downside coming

Prices Paid are still moving higher – Inflation is getting worse not staying contained – rates likely to follow!

Bonds have now retested resistance at 108-16 – More downside coming soon!

Weekly sell signal became operative on the break below SPX 1245

Momentum is really weak here! This points to more bear market ahead…

Small and mid-caps have broken down badly – New bear market is increasingly likely !

Copper is a good proxy for economic activity – This chart says further downside is coming soon!

Jobs correlate surprisingly well with SPX over 25 years – if jobs continue to weaken it will mean trouble !

Certifications and Disclosures

© 2006 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
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