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December 28, 2006

2006 in Review December 28, 2006
by Bruce Zaro

In part 1 of this 3-part series on market technicals, Bruce Zaro takes a look back at 2006 and tries to put it into perspective. Subsequent essays will deal with the outlook for 2007.

Looking back at 2006, the break out of the Dow on January 6th at 11,000 may have ushered in a new era for the US markets. With that move, the market's 6-year recovery seemed complete and the subsequent follow-through breakout in May at 11,500 has been impressive. Nightmares about the post-1990's collapse finally faded as the realization sunk in that corporate profits have been piling up at double digits rates for years now. Finally, equities were waiting for one event that had been so illusive -- a pause from the Fed. Since the middle of 2005, investors had been bidding up stocks prior to each Fed meeting in hopes that this time the spell of higher interested rates would be broken; most times, the market sold off as those hopes went unrealized.

I wrote on June 13th of 2006 in Delta Global's Morning Meeting notes titled "Market Reversals Imminent" that it appeared the ugly market sell-off that had started on May 10th was about to come to an end. Deeply oversold conditions and wildly bearish sentiment led to this earlier than normal mid-term election bottom (truth be known, I had expected a mid-term election bottom later in the year. While the timing is always difficult to pinpoint, I have strong convictions that the rapid 8% sell-off we saw this year, which bottomed in July, was a very significant bottom, possibly the second such major inflection point -- October 2002 being the other -- in the post -911 market).

I believe chart based analysis is valuable in confirming one's fundamental outlook. Personally, I developed a very positive fundamental outlook to the markets late in 2005 and had written on January 11, 2006 ("Will the Strong Start to '06 Last?") that these positive fundamentals would unfold during 2006. In retrospect, the November 2005 bottom may have been foretelling that the Fed's rate increases would cease 9 month hence, the top choice on the wish list of most investors. Front and center in this article was a prediction of Dow 12,400, some 1, 400 points above the current closing price. Meanwhile, the NASDAQ has so far fallen short of my 2,700 price objective, but more on that later.

Outlook for 2007

Dow Jones Industrial Average - (DJIA 12,423)
What we have experienced over the last few weeks has been predictable volatility in uncharted territory for the Dow. I had thought a perverse mood might surface as the Fed abandoned its rate increase campaign, and it has. Are we facing recession? Plunging corporate profit growth? Now what?! It's just so predictable...classic fretting as a result of the Fed's change in policy direction.

I happen to expect the market to make additional progress in 2007 as profits remain strong, although it remains a good possibility the string of consective quarters of double digit growth will be broken. Inflation may shrink a bit, contrary to what yields on the inflation sensitive TIPS bonds are telling us, and while some consolidation is in order and could hit at any time, it's unwise to be bearish on stocks at this time of year. As we get to the end of the seasonally favorable period - April - then I will likely take more defensive capital preservation strategies. As of today, however, my target on the Dow now stands at 16,500.

Nasdaq Composite - (COMP 2,418)
The one crowd that has not been made whole yet is the tech-crazed, post-'90's bubble herd. Investors who were heavily invested here saw their fortunes play out like Cabbage Patch doll collectors, yet they've gotten some relief in 2006. So, what's the outlook from here?

An encouraging sign that the market rally has further to go is the growing appetite for risk. Indeed, from the July bottom the NASDAQ is up 22% versus the Dow's 16% rise. Year-end tax trading and lack of liquidity has resulted in a bit of lost momentum for the NAZ, but with the January effect around the corner, NASDAQ out-performance is likely to widen in the coming weeks. I would caution that the index and its components are exhibiting some pretty brutal volatility right now. Furthermore, additional short-term indicators I follow have reversed down to signal more consolidation is near. Still, investors should generally look to use pullbacks as opportunities to initiate positions, albeit in technically healthy stocks which also have well-defined stop points. This remains a time one should want to be pretty fully invested. My own NASDAQ target is 3,360, but bear in mind that in the types of analysis I employ it often tends to be timing that is most difficult to gauge, with my 2006 NASDAQ target standing as one overly-optimistic example (although the direction was surely correct).

US Treasury 10 year Yield Index - (TNX 4.59%)
The peak in rates was clearly signaled with the TNX unable to push yields higher than 5.22% in July. In fact, multiple lower bottoms on this chart preceded the Fed's August pause by almost a month and that downward trend in yields continues, refreshed by each subsequent reaffirmation of the change in Fed trend at later policy meetings. With a bit of recession worry and the hope of numerous rate reductions coming, the yield worked its way down to 4.42% in early December. However, rates have gone about as low, technically, as can be expected for a while. While rates could consolidate and back up all the way into the 4.82% range, 2007 could be quite boring on the interest rate front, with the 10-year ranging generally between 4.5 - 5%.

More on specific sectors, including commodities, in part II...

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Bruce Zaro
Chief Technical Strategist
Delta Global Advisors, Inc.
877-746-4228
bzaro@deltaequity.com

Over his 20-year investment career, Mr. Zaro has become a highly-regarded technical analyst who runs private client portfolios at Delta Global. For the last 3 years, he served as Managing Director of Granite Wealth Management outside of Boston and spent nearly 15 years prior as a Vice President at Gage Wiley & Co. His current firm is full-service, but specializes in providing international market access as well as alternative investment strategies.

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