MASTERING
THE TRADE
ORIGINAL, INTERACTIVE SEMINAR ON TRADING USING
TECHNICAL ANALYSIS 

 SEC FILINGS

Overshadowed by Greenspan's speech yesterday was a 0.7% jump in import prices, the third consecutive monthly rise.  The forces of inflation have been held at bay, in part, over the past 1 1/2 years by a global economy in turmoil and its byproduct: falling import prices which took away the ability of American manufacturers to raise prices.  With the world on the mend and import prices once again creeping up, pricing power is returning to American manufacturers, and with the ability to raise prices comes the potential for inflation.  In short, yesterday's import price data added another entry to the FOMC's "Reasons to Raise Rates Soon" notebook.

Today's PPI and Retail Sales reports will determine the fate of the market over the next few days, but the figures will have to come in significantly below expectations to stave off a Fed rate hike.  A flat core PPI reading (estimates are for a rise of 0.1%) will not be enough to prevent rates from rising. Stocks will likely rally strongly on weak numbers, but this week's strong economic figures from Germany and Japan will likely force the Fed to take preemptive action.

With a rate hike seemingly a done deal at this point, the key question becomes whether the market has already factored in a rise in interest rates.   July Fed Funds Futures are already pricing in a move by the FOMC, and the jump in 30 year Treasury rates above 6% is signifying that the bond market has also factored in a move.  The stock market, however, remains significantly above the top end of its historical valuation range and has yet to adjust to the rise in rates.  While the major averages have corrected 5-7% from their highs,they remain significantly above their January 4th levels when rates hit an intraday high of 5.177%.

If the FOMC does raise rates, a scenario in which the long bond rallies and the stock market declines after an initial relief rally is entirely possible.

The medicine seemed to work wonders, as the patients quickly forgot the deafening din of "6%, the sky is falling, 6% where next", and turned their attention to the glistening report that Doctor chipmaker was holding in his outstretched hand.  The words in the report brought smiles to the  assembled mass, "12.1% growth in the worldwide semiconductor industry, the first double digit growth since the bottom fell out in 1995, 19% growth in memory chips, 16% growth in microprocessors, and on , and on".

After taking a moment to ponder the news, the CROWD quickly rushed with outstretched arms to greet their old flames, the tech stocks.   Now we like a happy ending as much as the next person, but we thought yesterday's wholesale plunge into tech stocks was a mite overdone.  The projections of future growth are better than expected, but not all  semiconductor makers will benefit equally.

To be specific, we're talking about the microprocessor market and Intel. Yesterday's report did not answer the key question of: which microprocessors will experience the growth. We have a sneaking suspicion that it will be the Intel Celerons and AMD K6's which receive the bulk of the growth, with the higher end Pentium lll Xeon's lagging behind--a scenario which is not bullish for Intel's profits or margins.

We also question the sustainability of yesterday's rise in the shares of the PC box makers.  A growing semiconductor industry does little to change the fact that, despite their recent drop, the stocks still sport high valuations and are essentially commodity producers operating in a business with falling product prices. Current forecasts call for the price of home PC's to slip below $500 by year's end, signaling more margin erosion for the PC makers.

And then there's yesterday's 5% rise in AMAT...Shares of Applied Materials, which stands to benefit the most from a chip rebound, are now valued at peak cycle valuation levels, leaving little room for further appreciation.   The large cap NASDAQ stocks in general, despite their correction, remain at valuation levels which are unsustainable in a rising interest rate environment....Which brings us to those bridges we mentioned earlier...

The odds of a Fed rate hike increased overnight after Japan reported that its economy grew a much stronger than expected 1.9% during the first 3 months of the year.  The rise in GDP was led by domestic components, capital spending and consumer spending, which increases the likelihood that the growth was not just a one quarter affair. The sharp GDP rise also raises the risks of a global reflation occurring and increases the chances of a Fed rate hike by removing the words "still fragile global economy" from the Fed's copy of "Reasons to Remain A Dove".   While we continue to believe that the Japanese government's bridge building program (in official-speak it is referred to as 'public works spending') is similar to a band-aid being given to a patient who really requires surgery (or in Japan's case structural change), the fact remains that in the short term the band-aid is helping to ease the pain. With the easing of the pain the deflationary forces that have kept inflation at bay are disappearing, raising the risks of inflation.

Hawkish comments from non voting FOMC members Broaddus and Poole sent the bond and stock   markets reeling. The yield on the long bond broke through resistance at 5.97% and finished at 5.99%, the highest in a year. The Dow Industrials lost 143.74 on the day and NASDAQ shed 49.70, but volume remained anemic on the NYSE, with only 685 million shares changing hands as trader's remain on the sidelines awaiting Friday's economic reports.

The day's losses were enough to change the intermediate term trends for the S&P 500 and NASDAQ to the downside once again, but the change in trend is not a signal for a wholesale shorting of the market.  While short term sentiment remains negative, longer term sentiment remains decidedly bullish and will act as a temporary cushion to any drop. [NOTE: For a quick and simplified way to measure underlying market sentiment you can look at the long term trend of the individual Dow stocks, where 26 of the 30 stocks are still in long term uptrends.  Think of the long term trend as a gauge of investors' belief that the market's long term outlook will be positive].

While sentiment remains overwhelmingly bullish long term, the chances of an external shock dealing a mortal blow to the belief that prices only go one way (up) were increased by 3 events yesterday which increased the chances of a Fed tightening.  The first event was of course the headline grabbing rise in long term rates to a one year high.  Rates are now at a level where stocks with excessive valuation levels will increasingly see selling pressure.  The second event that increased the odds of a rate hike at some point this year was the downward revision in first quarter productivity to 3.5%.  The economy's primary weapon against the onset of inflation is now showing cracks, with productivity showing a large decline from the fourth quarter's 4.3% gain.

The third event yesterday, and perhaps the most serious, was the announcement by a Japanese official that tomorrow's Japanese GDP numbers are expected to show positive first quarter growth, breaking a string of 6 down quarters.   The upside surprise will temporarily remove one of the primary defenses against a Fed tightening at its June meeting: fears of the repercussions a move would have on a still reeling global economy.

A case could be made that the past few weeks were merely a bad case of Fed induced indigestion and that the patient has now fully recovered, ready to participate in the next chapter of the Goldilocks saga.   The 3 day rally has resulted in the market doing an about face, with the short and intermediate term trends for the Dow, NASDAQ, and S&P 500 once again pointing skyward.

On a purely technical basis, the Dow's short term chart supports the case for higher prices, with the index successfully holding support and bouncing off of its 55 day moving average which has acted as a support trampoline over the past 5 months (see today's Market Chart section for further analysis).

There is another explanation for the market's bounce however, one that is not conducive to the start of a sustainable rally, namely, the market's rally has been primarily due to A Paucity Of Sellers.  Around here, we're not about to place long term bets against the gathering storm of an unfavorable interest rate environment until a ray of sunlight appears between the storm clouds, and we have a sneaking suspicion many market players are also taking this course of action, as evidenced by yesterday's scant 654 million shares traded on the NYSE.

The nature of the recent rally, with volume doing a swift disappearing act as the sellers await further economic data, points to a short lived rally with heartbreak the end result for those who have eagerly returned to pick up perceived bargains in their favorite speculative hunting grounds.  The reemergence of the large cap techs and Internet stocks as market leaders points to market weakness rather than strength.  A market that is led by those who have yet to learn that there is a strong inverse relationship between valuation levels and interest rates is a market that is swiftly marching to the edge of a cliff without a parachute.

Finally, in an unrelated note, many of you will remember the belief trumpeted around these parts throughout last Summer and last Fall, at the depths of the emerging markets exodus, that a buying opportunity was at hand and the Asian markets would recover from their near death experience. Since that time we have seen South Korea and the Philippines turn in impressive economic turnarounds, with other Asian markets showing signs of emerging from last year's depression. Today the Indonesian stock market joined the recovery parade following yesterday's Indonesian parliamentary elections, with the market gaining 12.1% to finish at its highest level since before last year's rupiah devaluation.

The question that was to be answered last Friday, alas, was not.   Friday's mixed employment numbers were released in two versions: a relief inducing copy for the stock market, and a fear expanding copy for bond traders.  Neither camp fully understood what they were given to read.

The bond market had a clearer understanding of Friday's piece of the puzzle, but its sense of timing remains off.  The larger than expected jump in average hourly earnings and dip in the unemployment rate to a 29 year low added to the already visible signs that the consumer debt financed wealth effect is finally causing the inflationary beast to stir.  The inflationary menace remains contained at this stage of its reawakening, however, and the Fed will not act without further proof that the doors of its decade old cage are about to spring open.  The bond market was correct in sensing the danger lurking over the horizon, but it was wrong in believing that Friday's data was the final piece needed to ensure a rate hike at the next FOMC.

The bond market's premature assessment of the damage done led to a decline of 11 ticks on the long bond, with yields rising within a hair of resistance at 5.97%.  Watch this level closely this week, a failure to hold below 5.97% will likely lead to a rise in rates to the next resistance level at 6.11%, a level at which the stock market will be forced to dust off the V(aluations) word.

While the bond market partially understood Friday's mixed numbers, the stock market rallied without a clue. The number upon which the stock market fixed its eyes, 11,000, is likely to prove to be merely a transient blip.  We expect the non farm payrolls number to be revised higher next month.

Friday's stock market rally is unlikely to be sustained for the duration of this week.  The rally once again occurred on thin volume (692 million), and the last in to the bull market were once again the first stepping forward to pick up stocks perceived as bargains, with the crowd pleasing favorites: the large cap techs and Internet stocks at the top of many a New Era bargain shopper's list.   Classic topping signs continue to unfold, and the ability of money new to the market to sustain the rally continues to weaken with each successive basis point rise in bond yields.

After an early week continuation of Friday's "value" buying, we expect fear to once again dominate stock market sentiment as the release of this Friday's Retail Sales and PPI numbers draws near.