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Leading Indicators Tell Us What to Expect in 2007

It has been several years since this many bullish technical and fundamental factors have conspired to point to a bull market for stocks as we approach the start of a new year. Just listing them all would fill up several reports. The diminishing supply of stocks, persistent bearish investor sentiment, increasing liquidity, record corporate cash, and record valuation are just some of the reasons why the months ahead should be bullish for stocks.

If we could begin with one major feature of the present stock market it would have to be a drastically improved supply/demand situation from the past few years. Mergers and acquisitions have helped to reduce the floating supply of shares, but so too have record stock buybacks. As veteran analyst Don Hays recently pointed out, "Corporations last year...made over $400 billion of cash take-overs of U.S. corporations. Besides that, they bought back $600 billion of their own stock. There has never been anything like this in the history of the U.S. stock market. We now have a 3% reduction of stock available for purchase today in relation to the supply one year ago." This situation has wound the stock market "coil" so tightly that it can only press higher in the months ahead.

Not only are valuation and other fundamental factors pointing to higher stock prices in the months ahead, but the price behavior of some economically sensitive and very important individual stocks have also given clues for us in the intermediate-to-longer-term. Take, for example, the bank stock sector. Bank stocks have been on a rip-and-tear lately and the Bank Index (BKX) is fresh of a new all-time high. The bank stocks are a major leading indicator and have been known to lead the way for the broad market. In this case that way is higher, as the chart for BKX emphatically shows.

Bank stocks have been bolstered by record earnings, as Lehman Brothers, Goldman Sachs and Bear Stearns have been among the latest of the major banks to report record annual earnings. Interestingly, in the same article on Dec. 15 that reported these record bank earnings, the Financial Times noted that "investors appear concerned that recent near-perfect capital market conditions will not continue." FT added that a slowdown in the housing market "could hurt" the leading banks even as they reap large profits from mortgage-related securities. Once again we see the specter of investor pessimism raising its head, underscoring the undercurrent of fear that has and will continue to bolster the stock market's "wall of worry" in the months ahead.

The stocks of some blue chip leading indicators look exceptional as we close out 2006 and head into 2007. Some of these are Dow 30 components and are worth reviewing:

IBM: Big Blue broke out of its 9-month trading range in October on extremely high volume and has gone on to make higher highs, closing out the year at a price of $97.15. Any worthwhile bull market should be led by IBM and it's comforting to know (from a bull's standpoint) that IBM is leading the way higher into 2007. IBM should be able to exceed the $100 benchmark sometime in early 2007 and eventually re-test its previous all-time highs between the $130-$135 area.

GE: Next up we have the super-bullish chart of another market "general," General Electric. GE recently made a high-volume breakout from a 2-year congestion range between roughly the $32-$36 levels. The chart pattern in GE is very promising and now that all that overhead resistance has been cleared away we should finally start to see some solid performance from GE, just like we did in the "glory days" of the late '90s.

MER: Merrill Lynch has supplanted GM as the ultimate broad market leading indicator and MER is currently flashing yet another bullish intermediate-term signal. Riding just below its all-time high at the $94 level, MER enters 2007 on a high note and has already signaled that the interim outlook is bullish for the broad market. As MER typically precedes the S&P at major turning points, it has already signaled higher prices for stocks in the coming months and will bear keeping a watch on for other important signals in the year ahead.

MSFT: Since bottoming this past June, Microsoft has risen to a 4-year high at $30. Will 2007 be the year MSFT finally exceeds its 4-year trading range high at $30 and goes on to make further headway to approach the previous all-time high? Price, volume, momentum and valuation factors all point to "yes!"

T: AT&T is an important leading indicator for the tech sector and economy and has performed extremely well in 2006, besting many of its fellow Dow 30 components in terms of the steadiness of its uptrend from its October 2005 low. A rising AT&T stock is always a bullish harbinger for the rest of the stock market, a fact which should be revealed for all to see in 2007.

The DRAM Index is another reason to expect that 2007 will be kind to tech stocks. Since bottoming a year ago, DRAM prices have climbed steadily and look to continue this trend into 2007. This is a bullish leading indicator for the SOXX and for the NASDAQ stocks in general.

We all know that the underlying monetary trends are needed to fuel a worthwhile bull market in stocks. We'e already examined some of the important money supply gauges in the past few weeks, such as the ones showing the percentage increase in M2 and MZM money supply as well as bank credit. But what many observers are now asking is how to tell if these recent and much-needed injections of liquidity in the banking system will actually serve to help the economy and stock market, or whether consumers and investor might shun this increased money supply? To answer that question we turn to the trend in adjusted reserves of commercial banks.

In the classic book by W.G. Bretz, "Juncture Recognition in the Stock Market" (out of print), the author writes, "The ability of the commercial banks to extend loans is affected by a variety of factors. One of these is the rate at which existing loans are repaid. When loans are being repaid more rapidly than they are being expanded, the ratio rises and the reserve position of the banks improves. A rising [adjusted reserves] index thus implies a change in the direction of easier credit conditions. Such a development should make the banking system eager to advance loans to the public and to the business community. It represents a background favorable for, but not necessarily producing, a stock market boom. The actual boom itself is the result of a complex [set] of factors that combine to create a condition of stress sufficiently powerful to reverse the existing trend."

What Bretz is saying here is that a rising adjusted reserves trend, when accompanied by an increase in money supply and bank credit, in most cases guarantees that a bull market in stocks will follow, not to mention a general economic improvement. And when we look at the recent trend of the adjusted reserves provided by the St. Louis Fed we see a *major* improvement in reserves in just the past few weeks. On an annualized percentage change basis, adjusted reserves have gone from negative numbers earlier this year to a growth of nearly 200% as of early December. Earlier this fall we pointed out that adjusted reserves were in sore need of recovery but now those reserves have risen of late to let us know that the process of re-liquification is well underway. Meanwhile, the MZM money supply statistics continue to show a healthy rate of growth as of late December. This is paving the way for a continued stock market boom and economic recovery in 2007.

While monetary liquidity is increasing, the supply of shares outstanding in the stock market has been shrinking steadily to form a potentially bullish combination. This has been mostly a consequence of share buybacks, M&A, the private equity trend, and Sarbanes-Oxley. The stock market liquidity analytical firm Trimtabs Investment Research recently observed that for 2006 the amount of oustanding shares has fallen by approximately $500 billion. Trimtabs observed, "U.S. equity fund inflows from 2001 through 2006 have been much lower than they were from 1995 through 2000. The bull run since 2003 has occurred even though indvidual investors have not been big buyers of U.S. equity funds."

Part of this has been reflected by the unusually large percentage of "neutral" investors in the AAII investor sentiment polls since 2003, a phenomenon we've commented on at length in the past. What happens when these sidelined investors, who have trillions parked in cash, decide to enter the stock market in 2007? Mark Dodson of Hays Advisory answers thusly: "When the public starts buying, it will be in a stock market with a smaller supply of stocks, causing an equity supply shock....a welcome change."

A welcome change indeed, and for that reason we welcome the many profitable opportunities the year 2007 is sure to bring the investors are willing to take advantage of them.


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