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TECHNICAL ANALYSIS 

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If you look in all the right places, its turning out to be a beautiful day: inflows into equity funds are strong, the Dow, NASDAQ, and S&P 500  enjoyed solid rallies, an apparent break in OPEC's resolve has sent oil prices plummeting, and this morning's non farm payroll numbers showed surprising weakness. All in all, it would seem, a good day, and one that speaks of better days to come.

A glance at the broader landscape, however, shows that things are a little less serene than they seemed at first glance, and behind each of the bright spots there is a darker story waiting to be told, a story that could make the outlook for the coming days and weeks a little less sanguine.

In this morning's early commentary, we said "We are looking for non-farm payrolls to come in below consensus due to the impact of Hurricane Floyd. While a much lower than expected non farm payroll figure would likely provide the necessary fuel for a market rally.... we would be inclined to regard any such reading as a storm skewed aberration that is unlikely to decrease the odds of further Fed tightening."  Our expectations for a weak number were met, with non farm payrolls showing a surprising drop of 8,000 during September, much weaker than the consensus expectation of a gain of 220,000.

While Hurricane Floyd's impact played a large part in the weaker than expected payrolls numbers, we would not be so quick to regard the remainder of the drop, or the downward revision in August numbers, as a sign that the economy is slowing.

 Rather than a sign of slowing economic activity, the deceleration in non farm payroll gains over the past 2 months, when combined with September's stronger than expected 0.5% surge in average hourly earnings, is more likely a sign that employers are having a hard time finding qualified workers in the shrinking pool of available applicants and are being forced to raise wages to fill positions.

 On Tuesday the Fed said, "...the growth of demand has continued to outpace that of supply, as evidenced by a decreasing pool of available workers willing to take jobs. In these circumstances, the Federal Open Market Committee will need to be especially alert in the months ahead to the potential for costs to increase significantly in excess of productivity in a manner that could contribute to inflation pressures and undermine the impressive performance of the economy."

Today's non farm payroll numbers, rather than being a positive that will decrease the threat of a move by the Fed, are instead the exact type of numbers that the Fed warned could trigger inflation and force it to hike rates at a future meeting.

While today's employment data increases the odds that the Fed will be forced to act before year's end to quell developing inflationary pressures, today's numbers should not be regarded as the definitive answer to the question "will they raise rates before year end".  The Fed will need to see further evidence of inflationary pressures in upcoming data  before making a final decision.  The October employment report now takes on added importance.  If the wage pressures shown by the September numbers make a repeat appearance next month, look for a November rate hike to be a done deal.

Aside from the employment report, today's other bright spots also appear a bit dimmer, and grayer, on second glance.

The strong inflows into equity mutual funds during the past week were largely channeled into large cap equity funds, which enjoyed their strongest inflows in 5 months, according to the latest figures from AMG Data.

The public's preference for the largest of large caps is evident in today's market, as the large cap averages (along with the oil sensitive transports) surge, while the midcap and smallcap averages are left behind.  While the S&P 500 and Dow finished the day with better than 1% gains, the S&P midcap 400 lost nearly 1%, and the Russell 2000 ended the day with a marginal loss.

The narrowness of today's rally is also apparent in today's advance/decline numbers, with decliners leading advancers by 70 issues on the NYSE, and up/down volume in a dead heat.  In short, the divergence between the haves (narrow basket of large cap crowd pleasers) and the have nots (broader market) continues to grow.

With the bond market taking a much needed day off on Monday, today's big cap rally will be given a free rein to continue for another day, but don't expect it to last.

The divergent reactions shown thus far when earnings surpass expectations mirrors the steadily widening divergence in sentiment that has become unmistakable in recent months.  The broader market is keenly aware that the winds have shifted, that the once perfect set of circumstances is rapidly departing, and with its departure, the environment has turned inhospitable.  There exists a tiny segment of the market, however, where complacency still reigns despite the deterioration that has taken place in the outside world.

The market's reaction to better than expected earnings from General Electric and Yahoo illustrates the rapidly growing sentiment chasm that is developing, with Yahoo riding a euphoria driven wave to a 14 point gain, while GE dips a point as the 'sell on the news' camp that thrashed Dow component Alcoa into submission yesterday returns for a second engagement.

Divergences, whether intramarket or intermarket, whether they show their face in the advance/decline line or in market sentiment, are never a positive force, and they always have a way of working themselves out, and more times than not they are resolved by the minority rejoining the majority.  When the divergences are kept alive by euphoric sentiment alone, and when the very  circumstances that initially allowed euphoria to flourish no longer exist, the eventual shakeout process can be brutal, sparing no prisoners in its wake.

Now, we're not saying that the NASDAQ is about to crash immediately, far from it, for with the NASDAQ composite within 4 points of its old highs a sneeze will be enough to carry it to a new high, and euphoria could be enough to carry it the rest of the way to 3000.

Sawed-off euphoria, that dangerous variety of excessive feel-good sentiment that remains even after the favorable environmental supports that initially gave birth to it have been removed (or sawed off), is the most dangerous variety of euphoria because it forces its adherents to live in a vacuum, one that blinds them to the negative changes that have occurred in the broader world around them, a blindness that act to accentuate the pain on the downside when the limits of euphoria have been reached.

NASDAQ's current run at its old highs, driven by a narrow group of stocks that have anointed the most bubblesque of the group as their chosen leaders, is not a sign of renewed market strength, unconfirmed highs never are, but rather it is another in the series of warning bells that have been sounding with increasing regularity that the market has topped out, that only the weak hands remain to steer the ship through the waters of a suddenly inhospitable environment (a ship that many insiders at crowd pleasing NASDAQ Internet and technology companies have been jumping off of at an accelerating pace as the year has progressed).

One day after the wrecking ball swung in a wide arc across the landscape, one day after uncertainty and trepidation ruled the town, the pieces are being picked up and composure has been regained, but the pace of rebuilding is an uneven one, with some neighborhoods recovering faster than others, and the bright skies a little less bright on second glance.

Call it relief, call it complacency, or call it the return of earnings anticipation fever, but the market is making a valiant attempt to put the past behind it and emerge from the no man's land, the whipsaw zone that it found itself mired in at the close of trading on Tuesday.

It is a bright day on the street as the market races upward, but the day's rally is indistinguishable from many rallies that have preceded it in recent months, with the brightness dissipating as one surveys the broader market landscape.  The percentage gains gradually decrease as one moves away from the market leaders, with the usual suspects bringing up the rear: the utilities, the Russell 2000, the transports, the U.S. Dollar Index, and the long bond.

In short, it is more of the same, a top heavy rally skewed towards the new Nifty 50 and the crowd pleasing .coms, in short, a market where divergences continue to grow.  Despite a 2% gain in the NASDAQ and a better than 160 point runup in the Dow, advancing issues are barely leading declining issues, with the margin just 250 on the NYSE and 270 on the NASDAQ.

It is unlikely that today's rally is the start of anything new.  In order for the market to mount a sustainable new leg up we will need to see the laggards pickup the pace, with their percentage gains equaling or surpassing those of the current narrow basket of crowd pleasing leaders.

The factors that have led to today's rally, relief and pre-earnings anticipation fervor, are unlikely to remain around long enough to spark a fire under the broader market.

When hopes build in anticipation of an outcome that is at the top end of the possible spectrum, the actual attainment of the best possible outcome is more times than not an emotional letdown.  Translation: with expectations running high, expect selling on the news to dominate this earnings season as expectations are met.  We have already seen this as Alcoa, the first of the Dow 30 stocks to report, was summarily taken out and shot after meeting analysts estimates this morning.  Earnings season is likely to bring more pain than joy, as only the stocks that exceed their "whisper number" are left to rally.

Relief, the second factor in today's rally, is also likely to be short-lived.  A belief has developed that uncertainty will end when the Fed makes its anticipated third move, that 3 is somehow a magic cure-all.  In reality, the Fed's job will not be done until the underlying economic imbalances and inflationary pressures that have been slowly building beneath the surface are alleviated, and the extent of the move necessary to ease the pressures remains up in the air at this point.

It is not just the Fed, however, that investors in the  U.S. stock market must fear. While all eyes are on Greenspan & Co, the European  Central Bank also poses a direct threat to the U.S. stock and bond markets.  While we do not foresee a move to hike rates at tomorrow's ECB meeting, the accelerating pace of European growth is increasing the likelihood of a move in the not too distant future.  A move by the ECB would exert a strong downward pressure on the dollar, pressure that would be felt in short order in other U.S. financial markets.

Enjoy today's rally while it lasts.

The party wrecker and his 11 cohorts arrived on schedule shortly after 2 p.m., and quickly brought an end to the day's pre-victory celebration, stunning the gathered crowd with an announcement that while nothing had changed, things might change in the future.

The crowd, who had been under the misguided impression that the passing of Summer and arrival of Fall signaled the downfall of their arch nemesis Mr. Uncertainty von Ratejitter, quickly panicked, fleeing the gathering en masse.  The panicked departure continued for an hour but quickly ebbed after the the Cheerleaders of Panic, Mr. & Mrs. Bondmarketti, had made their final exit.

The remaining partygoers were left standing around, jaws agape, to ponder the aftermath of the unexpected monkey wrench that had been thrown into their festivities.  The question, "whither from here?", that echoed throughout the air, resonating off the walls and floors, was a simple one, but one without a clear-cut immediate answer.

The participants were left adrift in a sea of uncertainty, a place that they had become all too familiar with over the past few five months, and a place from which the euphoria of Spring and early Summer is unlikely to sprout anew.  It is a place where rallies are quick and unsustainable, their growth quickly stunted when contact is made with the emotion draining flyswatter wielded by their nemesis Uncertainty von Ratejitter.

Little has changed with today's adoption of a bias towards tightening by the Fed.  The numbing game of living economic report to economic report will continue, with the market continuing to swing wildly from complacency to despondency, the tenure of each emotion lasting only as long as the time span between the release of the bits of economic data.

As today's market chart shows, the stock market ended the day in a virtual no go zone, a no man's land, it's upper bounds marked by today's high of 10509 on the Dow, its lower bounds marked by the afternoon's panic low of Dow 10277.  The area in between today's highs and lows should be considered a no go zone where whipsaws rather than profits will result.

In the short term, on a move beyond either boundary of today's range, we would expect a powerful, but short-lived and unsustainable, movement to development.

In the longer term, the uncertainty will continue until the rate hike cycle is at an end, an end which will only come about when the current torrid pace of above trend consumer demand eases.  At this point, continued strong demand and Greenspan era Fed history point (with rate hikes following 8 out of 11 moves to a tighter bias during Greenspan's era) to a third rate hike.

The market will receive its first real dose of post FOMC economic data, and direction, on Friday with the release of September's Hurricane Floyd skewed employment numbers.

The real danger to the stock market at this point is that the anticipated rate hike number three will be followed by numbers four, or five, an event which the majority of market participants have yet to consider. With consumer spending undeterred by this year's rise in interest rates, and with the global economy on the mend and signs of inflation emerging at the producer level, the possibility cannot be ruled out that the action required by the Fed will last longer, and be far more severe, than presently anticipated.

Earnings season anticipation, mergers and rumored mergers, slipping oil prices, a declining yen for yen, and a near unanimous belief that the Fed will stand pat tomorrow combined to send stocks and bonds higher this morning, a rally broad enough to entice even the downtrodden transports and utilities.

On a purely technical level, the pieces for this morning's rally began to fall into place about 40 minutes before Friday's close when one of our favorite indicators gave a (very short term) buy signal on the 5-minute chart (and only on the 5-minute chart) of the Dow Industrials.  On a purely fundamental level, the release of Japan's Tankan survey (which showed confidence at a 21 month high, but capital spending plans still in the doldrums) set the wheels in motion for a rally.  Add to the mix telecom giant Sprint in play, falling oil prices, a strong dollar (against the yen), and a belief that third quarter earnings will be strong, and the market had nowhere to go but up this morning.

The key question now is, "will it remain up ?".  Not likely.

Third quarter earnings will be stellar, but everyone has known that they will be for months, and the majority of players have already placed their bets.  The upcoming earnings season is likely to prove to be a disappointment, just as the eagerly anticipated second quarter earnings period fizzled when it finally came.  Selling on the news will likely be the norm,  with only those companies that comfortably exceed their whisper number escaping unharmed.

While we expect selling on the news to dominate, we expect to see it occur at a lower intensity than it did in July--the market enters this earnings period leaning to the overconfident side, but emotions are running far below the euphoria of early July.  All in all, we expect the upcoming earnings season to be a relative nonevent for the market, an event which is likely to be overshadowed by the continuing presence of the market's arch enemy: uncertainty.

After today's brief respite, we expect to see uncertainty return with a vengeance in the not too distant future as the crowds of bird watchers who have gathered in Washington D.C. return home disappointed that the expected sighting of the flock of 12 benevolent doves never materialized, disappointed that the 'all's clear' signal was not sounded.

Today a rally and a touch of complacency, tomorrow a change in bias and a bit of despondency.  On the fundamental side, strong consumer demand powering the economy at full steam will continue to make rallies like today's unsustainable until demand eases.

On the technical front, Friday's short term buy signal just turned into a sell signal, and after making a brief foray above the 10402 resistance level and falling back, the Dow's second run at the morning highs has failure written all over it, with divergences abounding...and that's only on the 5-minute chart.