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December 22, 2003

Closing Bell
by Adam Oliensis

Weekly Economic News Diffusion Index (WENDI)

We may have to change WENDI's name to JOE PALOOKA after last week's performance (If I could find a catchy phrase for which JOE PALOOKA is an acronym I'd do it. Any suggestions?)

After dipping down to 15% the Weekly WENDI bounced off the back of its head and up to just 2 points below its all-time high.

Bullish contributions were made by both the Empire State and Philly Fed manufacturing surveys, by the Housing Market, the CPI, by Industrial Production, Jobless Claims, the Chicago Fed's National Activity Index, and the SEMI Equipment Book-to-Bill Ratio.

On an average number of component reports (13) the Weekly WENDI hit 67%, the Cumulative WENDI rose to a new high at 58, and the 4-Week Weighted Moving Average bounced a point to 50%.

As far as the momentum of economic news goes, positive momentum remains at a high level and the strong uptrend continues apace with Industry, Production, and Hiring picking up the slack that may be developing in consumer spending.

The Fed has now been about as explicit as they get in stating what contingencies will cause them to raise rates. The release of the Fed's Oct. 28 minutes has persuaded many previously skeptical analysts that interest rates will remain low until slack in the economy (read: low Capacity Utilization and elevated Unemployment) has been worked off, and those two kinds of slack are, furthermore, unlikely to be worked off any time before late '04 or '05. This relative assurance that rates will remain low is good for the Recovery thesis.

The kinetics of Joe Palooka's bounce are as follows:

Empire State Manufacturing Survey: Dipped a smidge in December to a still-strong 37.4, above the consensus estimate of 35. (ZERO is neutral.) Internally strong throughought with New Orders at 31.2, Unfilled Orders accelerating by 10.6 points to 11.6, and both Employment (11.6) and Average Workweek(16) alos improving. Bullish (1).
NAHB Housing Index: Remained robust in December at 70, near peak levels. This one may dip in the future, but it's still strong. Bullish (1).
Current Account Deficit: Improved a bit during 3Q03 to -$135B, a decrease for 2Q03's -$139.4B. The deficit on goods declined and the surplus on services increased. However the quarterly run rate still projects for a $540B deficit, which is in the 5%-of-GDP range. That's just too high to be sustainable is a too-high drain on domestic wealth.. Bearish (-1)
Consumer Price Index (CPI): The headline number for November was -0.2%, which put the Y/Y consumer inflation rate at 1.8%. However the Core Rate was -0.1% for the month and a miniscule 1.1% Y/Y inflation rate, the lowest in 38 years. With GDP growth motoring along and interest rates at multi-decade lows this is all to the good and the market agreed this week. Galloping inflation is NOT at hand, the Fed has room to let the economy recover with low rates, and rates will remain low for longer than most pundits have been predicting (hence the bond market rally). Bullish (1).
New Residential Construction: Despite the Chicken Little predictions on the Housing Market November saw a 20-yr high in Starts. While Building Permits may have peaked November also saw the 4th highest level of permit-issuance ever. Once again, the upside explosion may be over but we have no real signs of a reversal...we do, however have many signs that a strong housing market will sustain. Bullish (1)
Industrial Proeudction: Jumped 0.9% in November, well ahead of expectations and the prior two months were revised upward. Capacity Utilization also popped up to 75.7%. The magic 80% area doesn't look quite as far up in the stratosphere as it did even a month ago when 75% looked like an anchor. Hard numbers are now confirming the strength seen in the various manufacturing surveys. Bullish (1).
MBA Mortgage Applications Survey: Jumped 12.6% for December 12, apparently reneging on breakdown signal we got last week. For the moment it appears that Applications, while well off their spike-highs, are in a highg-level plateau. Given the bond rally in the face of the low CPI, and the fact that many analysts are now pushing back their rate-hike time tables, I think we have to project this as slightly bullish for the future of the Mortgae Market. We're going to parse it a little more finely than usual and give this one a Very Qualified Bullish (0.25).
ABC News/Money Mag Consumer Comfort: Remained at -11 for the 3rd straight week. Neutral (0).
Jobless Claims: Initial Claims dropped to 353K, matching the lowest level of the recent decline. The prior week's claims were revised down (a positive change of character) and the 4-week moving average declined to 362K. The 4-week average of Continuing Claims continues to drift down as wee, now down about 200K from late October to 3.33M. Bullish (1).
Chicago Fed National Activity Index: Rose to 0.55, the highest level since March 2000. Output, Housing, and Consumption data are strong. Employment Data remains a slight negative. Overall this report is quite Bullish (1).
Conference Board Leading Economic Indicators: Rose by 0.3% in November, as expected. Of interest is a change of character in which Employment was accelerative while New Orders (while still positive) decelerated. Because there is some murkiness here, we'll give it a Qualified Bullish (0.5).
Philly Fed: Rose to its highest aggregate reading in a decade at 32.1. Acceleration was seen here in Shipments, New Orders, Unfilled Orders, Prices (both paid and received), Number of Employees, and Average Workweek. Bullish (1).
SEMI Book-to-Bill Ratio: The Book-to-Bill Ratio for North American-based semiconductor equipment manufacturers rose to 1.04, meaning that there are more New Orders for such equipment than there are shipments. The ratio improved on rises in both bookings and billings. Bullish (1).

Earnings

The Consensus Estimate for Forward 52-Week (F52W) Operating EPS on the SPX rose by $0.15 this past week to $61.33, up at a 15.3% annualized rate over the past 3 months. Meanwhile Trailing 52W Operating EPS rose $0.19 to $53.87.

The SPX PE on F52W Op. EPS is now 17.8.
The PE on T52W Op. EPS is 20.2.
The Fed's Fair Value PE is 24.2
(1/10yr Yield=Fair Value PE...or
1/.0424=24.2).
The market is now 26% undervalued according to the Fed model.

If we make the conservative assumption that interest rates should rise to 5% over the next year, then Fair Value on our "adjusted" Fed model ($61.33/.05=1227) is in the neighborhood of 1227 and the market is currently about 12% undervalued.

Risk Premium

The SPX's Risk Premium as we've discussed it in this space is at 1.5%
(F52W EPS / SPX) - 10yr Yield = Risk Prem
($61.33/1088.66) - 4.13% = 1.5%

That's above the 43-yr average but below the +1 Standard Deviation line, which is at about 2.17%. So, perceived risk remains high but not outrageous.

Notice that Risk Prem is inside the +1SD line, but still close to it, about 32%of the way down from 1SD to the mean.

The Corporate Bond Market is giving us a slightly different impression. The spread between the yield on the 10-yr Treasury and the yield on BAA-rated corporate bonds gives us an indication of just how much additional yield investors demand in order to take the risk of investing in Corporate America as opposed to investing in the "riskless" Treasury market.

The St. Louis Fed provides information on BAA bonds dating back to 1986, so we'll have to limit this study to the past 17 years. During that time frame the average spread has been 2.11%. The 1-SD range is between 2.65% and 1.57%. Right now the spread is at 2.32%. So the BAA-10yr spread is about 61% of the way back down to the mean. Almost twice as far in its trip back to "normal" as is the stock market.

What can we conclude from these two related but distinct analyses? There are 2 spreads we're looking at. 1) The difference between the stock market and the riskless Treasury market. 2) The difference between Corporate Bond Market and the riskless Treasury Market.

From our study it appears that the Corporate Bond Market has calmed down somewhat more than has the Stock Market in terms of returning to mean metrics of risk. Risk measures peaked in the bond market back in October '02 (yellow on the above 2 charts) while it required a "double top" in the stock market (green on those charts) that completed itself in March '03.

That only makes sense, if you think about it. Corporate bonds, while more risky than Treasuries are less risky than stocks. So, when money came out of hiding and began going back to work after Oct. '02 it went first into those corporate bonds and then, only later, into stocks. So, stocks are probably not quite as far along on their road to recovery. For that reason there may be additional upside in stocks going forward, that upside having already been more thoroughly played out in corporate bonds.

Seasonals

Lately the timing of seasonal strength has played out pretty much according to Hoyle. Last Monday the indices gapped up on the news that Saddam Hussein had been captured. However the indices closed down on the day, right in line with finishing up their early-mid December lull. Then on Tuesday, Dec. 16 they began moving higher, spending most of the week chewing through supply until they broke above Monday's high and then rocketed up on Thursday.

It wouldn't be surprising at all to see the now-overbought indices take a breather and/or a dip to work off last week's strength. As you can see above, however, there's more seasonal strength ahead. So it doesn't appear to be time to expect any smashingly bearish action.

A Look Down the Market's Throat

There's a dichotomy in our Baker's Dozen this week that brings to mind Bob Dylan's lyrics, "The first ones now will later be last, for the times, they are a changin'!"

The former leaders are laggards and the laggards are leading.

The Dow, SPX, and OEX have all broken above important horizontal support, up into their respective yellow zones, and are making for their upper channel lines. The Dow has reached the upper limit. The OEX is close. The SPX still has some room overhead.

The NYSE Cumulative Volume and Adv/Decl Lines are also at or near their upper channel lines and in overbought territory.

So much for the leaders.

The Dow Transports (DJ-20) are nominally up over 2985 and key horizontal resistance. However that's a trepid breakout and pretty suspect at the moment. We'd need to see more upside to believe it.

The SP-Midcap 400 (MID-X) and Russell 2000 (RUT-X) are both within their channels but are lagging lately. Both are in danger of putting in Head & Shoulders Tops. Breaks down and out of the blue channels would be bearish.

While 7 of the 8 charts above have to be considered bullish, all of them look vulnerable to pullbacks at the moment, even within their bullish contexts.

We expect these pullbacks to be benign. However, we'll watch for signs of trouble in the Transports, SP MidCaps, and Russell 2000 especially.

Our Tech-Heavy High-Beta charts look somewhat worse. And further weakness on numerous of these charts could put them into immediate danger.

The COMP is within a solid up channel. The index may, though, be finding some resistance at the bottom of its yellow zone. Stochastics have given a buy signal but have not broken out of their symmetrical wedge. Which way the Stochastics break will tell the tale. Obviously UP is bullish and DOWN is bearish. The blue zone is in some danger of breaking...which would be bearish.

The NDX is in a similar plight. Let's see which way the Stochastics break.

The SOX broke below 495, forming a Double Top that projected a target below 460, but with a "62% breakdown" target of 470ish. 468 held and the index rallied back up to the 495 area. Now it's crunch time. Up and over 495 would be bullish. Failure at to break and hold above that level suggests a return trip south below 460.

The NY High Beta (NHB) index has to be considered in a positive formation. However the rally on the 5-day Stochastic line has barely produced a new local high. If the bottom of the yellow zone fails, then watch for a hard test of the bottom of the blue zone. And if the blue zone breaks, this chart will look ursine.

The Nasdaq 100 Adv/Decl Line is mired in a horizontal range, and languishing at the lower end of that range. There's some pretty-imminent danger here.

The broad indices look essentially strong, with some minor signs of weakness. Tech looks ripe to suffer and may drag on the stronger charts. This coming week we'll see light holiday volume and an overbought market play out against seasonal strength. The wildcard, however, is the just-implemented Orange Alert issued by the Department of Homeland Security, which rouses visions of holiday cataclysms. (The futures are down this evening, I suspect on this announcement.)

Bottom Line

SHORT-TERM: Expecting a benign pullback early in the week.

MID-TERM: Looking for seasonal strength to hold sway through January 6.

LONGER-TERM: Anticipating that mid-January will be choppy-to higher (though we could get a bit more correction working in this time frame) with the end of January showing strength.

Beyond that I believe it's best to wait and see how earnings are doing and what companies have to say about '04 when they report during January. Right now earnings are expected to rise about 15% on the SPX. But of course those expectations are subject to revisions, which will begin in earnest next month.

It's a damnable shame to have to bring this up at all, and I hate to even discuss in a way that reduces it to market dynamics, but if there is some large scale terrorist activity, then my prognoses as discussed above are not worth much. Such activities could raise perceived risk in the markets and the particular paths such chaotic market oscillations might map out are not something I would have the hubris to try to forecast.

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Best regards, happy holidays, and good trading!

Adam Oliensis,
Editor The Agile Trader

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