The market has run up to a post-2/27 high and the media is saying telling us that all that was lost has been recovered. The Fed is telling us that it is guarding against inflation as its top priority, ‘really’! Meanwhile our Conversity theory of Fed interpretation is saying something altogether different: recall the basis of Conversity is that after mapping Fed-speak to market action, it turns out that exactly the opposite of what the Fed tells us over the last few years has in fact been the operative event. So when the Fed warns about deflation, inflation was heating up fast. When it told us that ‘inflation is well contained’ prices were in fact soaring higher, beyond its own ill-advised ‘comfort levels’. So if Conversity is a more effective way to interpret the Fed, then the translation of yesterday’s statement might be: ‘We don’t really care about inflation in the short- to intermediate term timeframes. We are nervous about sub-prime bleed over into mainstream loans and then by extension into the banking system. To protect against a down market and a banking crisis we may need to pump up the Money Supply like crazy to try and save the situation like Greenspan managed to do, regardless of the eventual consequences which may be really serious down the road.’ This scenario may be the most likely outcome.

The marketplace reacted to the news with its own aggregate views which we interpret to mean that bond market vigilantes suspect that in effect the Fed is trying to head-fake investors by telling us one thing and doing the opposite. If the Fed was taken at its word, why would the TYX index of long bond yields jump up after a brief spike lower? Bad news in the economy is usually good news for bonds but the reaction is one that expects either a better economy which seems to fly in the face of the evidence or more likely … Inflation. If price erosion is the worst thing for bonds then naturally any hint of inflation would make holders sell, which is exactly what the considered response to the Fed seems to be. Likewise if the Fed can be taken at face value, then the stock market should take off in a new spiral to new highs on confidence that housing will be bailed out by the Bernanke-Put. Instead we are getting a distinct impression that this rally that started so robustly and euphorically right after the 2:15 announcement is petering out from a lack of conviction. Perhaps the bulls are fully committed…

As we have often observed, the fast moves are caused by wrong-side traders panicking and scrambling to get out of the fire before they get too burnt. Yesterday’s rally had many similarities with previous short-covering squeezes, but the key difference may be that today there is a conspicuously absent follow through by the bulls adding to long positions. If they are unable or unwilling to put more money to work on the long side, then the entire balance of bulls and bears could shift away from the recovery bounce back from the surprise 2/27 market break. The Street wisdom calls for a ‘dead cat bounce’ after a big drop in prices. The structure of a dead cat is usually a corrective ABC where the A- and C-legs are up while the intermediate B-leg is a partial pull back. The significance is twofold: first it would confirm that the selloff from late February was a bearish 5-wave count which by definition requires further declines ahead; secondly it would set up a nice exit or selling point for traders to make a good profit as the market peaks and then recedes lower. The big question is whether the bounce off 3/14 lows represents a wave-2 bounce which is usually in a 3 like an ABC corrective bounce, or whether the recent rally is the counterpart to the sharp bounce in mid-to-late June, in effect a 5^th wave up from mid-June lows. Either case could be argued with good support from the evidence. Our suspicion is that post-Fed upside is a bull trap that is decorated with the perfect bait, technical signs that make it look too strong to be the end of a wave-2. 

The alternate case to our corrective ABC bounce (wave-2 up) theory is that the SPX may be in a final leg up of a wave-5 from mid-June that could conceivably make it to new highs, particularly on the back of Greenspan-style liquidity pumping by the Fed in an attempt to rescue the mortgage market from serious trouble. Our view is that should this attempt be operative and the market run to higher highs, it may only worsen the eventual comeuppance that is required to clear away the many, many excesses that have accumulated since the recovery began. Even if we date that recovery to 2001 which seems doubtful to us because we use employment data to track trends and correlations with the economy and the market over decades, there have been more than enough excesses just since sub-prime became a force in the lending circles in early ’02. Since then sub-prime mtgs have grown by over $2 trillion with a high proportion coming in the form of hybrid loans with teaser rates and reset clauses that are now causing all kinds of financial havoc in kitchens around the US. But we could just as easily date it back to ’91 and then the excesses grow to really formidable levels that could require a major recession to clean up. Either way the market looks sick to us in the near term; whether the medicine makes it feel well enough to score another series of higher highs or turns sour doesn’t seem to alter the LT trajectory. It only makes for better exits.

The rise of vacancies demonstrates further weakness in housing prices to come

Our early channel checks support the notion that business has not materially improved in Enterprise Software spaces that we cover. There may be pockets of relative strength but bell weather stocks showed us surprisingly weak guidance and margin erosion even as they blew away consensus estimates for the quarter, something that just doesn’t add up for us. This is odd given the License sales surge reported by one of the largest software vendors in the world this week. One reason for the sharply lower guidance during this vendor’s strongest quarter could be the same IT spending weakness that surveys have been showing for the last few months among C-level executives. A slowing economy clearly argues for weaker IT spending, but negative CEO sentiment can accelerate the downturn. There have been plenty of negative news items that could have legs in the recent past so the softness in channel checks may carry more weight going into 1Q07 earnings. The pre-announcement season begins in 10 days and traders appear more nervous than usual. 

The dollar is one of our critical indicators for the near term. After the Fed news yesterday, DXY fell hard down to just above key support at 82.25. Should the buck fail to hold support, then the next partial support hits around 81 but the last gasp before a freefall comes at 80. below that the dollar would fall into uncharted territory with all the commensurate issues. Clearly the Fed will have to react to a falling dollar in the ST by raising rates, the antithesis of its announcement yesterday. To be forced into a highly visible retreat so quickly after a major statement of policy would only highlight how weak the Fed’s position is now that huge deficits have significantly diminished its firepower. That is why the dollar is so important in our opinion. The fact that most of the buyers of sub-prime securitized loans have been foreigners, who are also size buyers of all types of derivatives associated with CDOs. Should sub-primes or housing worsen as we fully expect they will, then investors abroad could quickly elect to exit, precipitating an exodu of foreign money. With Japan closing its yearly books on 3/31 and repatriating funds abroad as they always do, there is a sense of heightened risks in the marketplace. 

Each trough in jobs seems to lead recessions by about 9-12 months – this would put the next onset in late spring/early summer ‘07

Interest Rates will play an important role in the developing market pattern. As we discussed above the Fed actions have prompted an interesting response by the bond market. After a brief spike higher, rates fell hard intra-day only to rebound today back inside what turns out to be a wedge pattern with solid measurements on our Dilemma of the 4^th (DOTF) metric for identifying potential wedge patterns and associated trading opportunities. The DOTF comes in at .618, a key Fibonacci ratio that indicates that the wedge has high probability of behaving along certain lines. The TYX shows the wedge pattern once we remove some of the Fed-induced noise from the chart. With TYX back inside the formation the implication is that rates could run higher in the near term. The fact that TYX at the time of this writing is already above the upper wedge resistance suggests that rates are likely to target 5.5%-6% in the next few weeks to months as bond vigilantes move to demand compensation for rising inflation risks. It also suggests that consumers beset by mortgage woes will only find increasing pressure rather than relief. Prospective home buyers into the crucial spring selling season are already finding that mortgage lenders are loath to give even the most credit worthy borrowers more than the time of day. This pattern of behavior is exactly what caused the recession of 1980-81 as banks recoiled from bad loans relating to real estate, buying Treasuries instead of making loans. The result is a spiraling failure rate of troubled home owners with few choices.

The SPX is just above a critical level where retracements become rallies to higher highs if not new highs. The fact that the market ran above the normal bearish retracement limits suggests to us one of two things: the Fed will aggressively pump liquidity to try and rescue troubled mtg borrowers and the banks behind them or the always clever Wall Street financial engineers and trading pros are setting up the bulls for a nasty trap. While both scenarios make sense, the fact that the market didn’t follow through at the open after yesterday’s Fed-induced rally points to the possibilities of a bull trap that uses all the hot buttons that have been working of late to entice everyone into the long side of the market; just before the bottom falls out and forces a fast breakaway move where bulls and bears scramble to sell as fast as they can. From these sustained power movements come the trend changing shifts in the market mind. We have been watching for signs that the 2/27 break was just such a shift in sentiment but until we get the confirmation of a wave-2 bounce turning into a wave-3 decline, the risks remain at an unusually heightened state. Just as the retest of lows in a nascent bull market bring out maximum fears of a meltdown, so too should the upper end tests of resistance evoke all the chest pounding the bulls can manage. The key tell if this is a turning point of significance will be the volume, momentum and speed of the market.

SPX has rebounded in an ABC ‘dead cat’ bounce – now A-up measures to C-up at 1.618x

SPX has retraced more than the normal 50%-62% in a bear move – now the question whether that is just Fed-induced ‘noise’

If SPX is finishing a B-up of a bearish ABC correction, it has run further than normal

Hourly S/D has reached extremes on the ST Buy from 3/14 – time for a turn?

VAP is back at highs as is RSI – at extremes Hourly S/D usually signals reversals

Daily charts show a massive potential Buy signal…

VAP is just below highs, but RSI is markedly lower – now all depends on how high RSI can go

Weekly S/D is turning positive but magnitude is quite small

VAP is rolling over from highs, Momentum has halted its freefall – now the key will be RSI bounce potential

Hours worked indicate a downturn that is similar to the Y2k experience around 3/00 timeframe

Claims show a similar pattern to jobs – troughs precede recessions by roughly 9-12 months

Rates appear to be moving higher once again – Fed ‘noise’ may be spurious 

March Retail Sales could be extremely important – weather hasn’t been a factor so weakness will be telling!

March Retail Sales could be extremely important – weather hasn’t been a factor so weakness will be telling!

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© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
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