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2/03/01 Technical Traders Report
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Technical Traders Subscribers:

TONIGHT:
- Markets react negatively to some better economic news.
- What was the 'bad' economic news that caused the market to sell?
- What is the problem with the market?
- Subscriber Questions
- Team Trades

All three major indexes fell significantly Friday after receiving more mixed economic news that showed just perhaps the economy is not as bad as thought. Indeed, this continued the recent streak of good and bad economic news after a spate of very negative numbers for the economy. This has the economists making excuses about why things really are still very, very dire even in light of better than expected economic numbers. That has investors as confused as the economists, and thus they are still adopting the 'good news is bad news and bad news is good news' philosophy. Accordingly, they pushed the markets lower on Friday. Mercifully it was on lighter volume, but that is not a lot of solace with the size of the losses. How many nasty selling legs did we see last year that started with a bit of light selling? Too many.

There are significant differences at this juncture, however, that we believe will make the $4 trillion dollar difference. First, the Fed being ready to lavish first aid on the economy and market instead of ready to blindside them again. Second, we are seeing economic data start to swing the other way: when last summer's rally failed, we were seeing the formerly strong economic data peppered with weakness. Those weaker numbers were explained away by the popular economists as insignificant aberrations that in no way stood in the way of the 'white hot economy.' We knew better and ramped up the warnings about the coming economic slowdown. The market had tried to rally but could not hold the move; it was starting to discount the weaker economic news.

At this point bad is bad, good is good.

At this point investors need to get over the 'bad news is good news' mindset. We have a weak economy and the Fed fully recognizes this. It has slashed interest rates 100 basis points in less than 30 days when it took it over a year and a half to raise them 175 basis points. It has expressly stated it is standing ready to cut more if it sees further weakness. It has backed up that talk with action. We are no longer at that point where we should wish for bad news as a sign that the Fed will cut rates. The Fed is going to cut rates more: once it starts it cannot help itself until it sees the economy really starting to hum. Further, and critically, Greenspan does not want to let the economy lapse into recession if at all possible during the twilight of his career. He likes being called 'maestro' as much as that conductor on 'Seinfeld.' He wants to go out with his streak intact. That keeps those speaking engagement fees at the maximum levels. He pulled a 180 on tax cuts just months after he said he would prefer surpluses be used to pay down the debt. He is pulling out all stops to get things turned right back around.

There indeed appear to be robins on the yard.

Back when it was unpopular to do so we were writing that the economy was heading into rough water. In March 2000 the CPI jumped up and that had many economists saying it was a good thing the Fed was raising rates because here at last was a sign of inflation and proof that the economy was just too strong. We countered with a resounding 'No!' The economic numbers were already starting to come in erratic and the higher CPI was a sign of the supply side being choked off by the Fed's rate hikes. We had been saying since January 2000 that the Fed would have to stop cutting rates by the summer because the slowdown would be showing up. The Fed did put rate hikes on hold but maintained its pressure on the market and economy by keeping its 'inflation bias.' In the late summer we started warning of a bad retail sales season over the holidays. The 'white hot' consumer demand was waning by our take on the numbers. Moreover signs of the impending slowdown were popping up everywhere: lower production numbers, slower housing, erratic auto sales and durable good sales, continued creep in jobless claims, up and down housing market, and the apparent peaking of consumer confidence.

Each time the economic numbers came out showing what was clearly topping action, i.e., economic strength coming in below expectations, the popular economists explained it away as normal pullbacks in the cycle. The numbers kept missing expectations, but the lagging indicators were still strong. So they were ignored or explained away as 'seasonal' or 'special, one-time' aberrations. The problem: the economists were conditioned to 10 years of strength; they could not imagine that this great economy could actually start to fade. Their arrogance led them to miss the coming of the fastest slowdown in the last twenty or more years. Indeed, as late as October some were forecasting massive rate hikes in early 2001.

We know the rest of the story: they swung and missed the ball as cleanly as mighty Casey. Just as they are missing the ball now. We have seen some very nasty plunges in consumer sentiment and manufacturing. They have dived at levels not seen in quite some time. That finally dragged just about all of the forever bullish economists to the inescapable conclusion that we are going to have a recession. Indeed, on January 4, the day after the first rate cut, Merrill Lynch came out and officially declared that to be the case. More and more have piled onto the bandwagon.

Just as in the summer, however, we are seeing the economic reports starting to show mixed signals. They went from strong with pockets of weakness, to strong with a lot of weakness, to diving on almost all fronts. Now they are continuing to show areas of major weakness (e.g., manufacturing), but they are showing unexpected signs of strength just as the diehards are saying we are bound for recession. The housing market never gave up, and indeed new housing sales rose a huge 13% when they were expected to limp slightly higher. Retail sales for January were unexpectedly higher. Auto sales were weaker, but not nearly as weak as expected. Jobless claims were higher than expected on Thursday, but the four-week moving average, the true gauge of the trend, has been down for the third straight week to the lowest level in 14 months. Friday's data shows similar signs of surprising strength: Michigan Sentiment indicator was revised higher to 94.7 from the preliminary reading of 93.6. That is the worst reading since 1996, but we were not in recession in 1996. Factory orders came in at a 1.1% gain when they were supposed to be negative. The jobs numbers were impressive as well: unemployment hit 4.2%, a 16-month high, but as you know that is a horribly lagging indicator. Non-farm payrolls shot up to 268,000 when expected to rise just 80,000. Manufacturing lost 65,000 jobs, but construction gained 145,000 and services 183,000. This shows that even though people have been losing jobs as the weekly jobless claims reports show, fewer are now losing jobs over the past several weeks, and those that are still manage to find jobs in this economy. Indeed, average hourly wages were flat, and that is very positive as it shows there is no fear of wage-led inflation (though we feel this is always a red herring) that will keep the Fed thinking it has plenty of room for further rate cuts.

Economists as a contrarian indicator.

As you can see, we do not believe the data is as one-sided as everyone is saying. Just as it was popular to say the economy was super strong, it is now popular to say it is a disaster. Thanks for the heads-up guys and gals. The reversal in the economists is complete: where they used to explain away the weakness as seasonal or exceptions, they now are explaining away the pockets of strength as aberrations. For example, Friday the non-farm payrolls huge expansion was blamed on the weather, saying that December's bad weather had put off projects until it improved. Well, as we pointed out months ago when such explanations were put forth to explain away real weakness, the experts had factored all of that in when they came up with the 80,000 figure and they were still way off. That means there is real strength out there. Just as they were underestimating the weakness and overestimating the strength, from what we see they are now overestimating the weakness and underestimating the strength. They are a contrarian indicator of sorts: once the majority jumps ship, they can only see things one way. By the time that happens, change is in the air. We do see some robins on the yard.

Recession ahead? We are already in a relative recession.

As late as the popular economists were to come to the conclusion that the economy was hurting they have come to the conclusion that a recession is ahead of us. Again, they have missed the market on several points: we are already in a relative recession and are missing the signs of a coming recovery.

First, they are thinking inside of the box as always, a major shortcoming of most economists who were formally educated as such. Hence the nagging, lingering, annoying and dangerous continued existence of the Phillips Curve theorists. What is a recession? It is defined in their textbooks as two consecutive quarters of negative economic growth. As usual, they are applying that definition to every set of facts even if it collides with other 'immutable' economic rules they live by.

Over the past six quarters the quarterly GDP has grown 5.7%, 8.3%, 4.8%, 5.6%, 2.2% and 1.4%. Before the third quarter 2000 it averaged 6.1% for the previous year. Most economists say that a healthy economy grows at 2% to 3% per year as a maximum sustainable. The Phillips Curve economists who refuse to believe the expansion we have had was caused by the investment based on prior tax cuts and the death of the linkage between inflation and employment levels take this as gospel. For Greenspan to say that the economy could grow at 4% to 4.5% without inflation was heresy. In any event, despite their beliefs, the economy had been growing at over 6% without inflation. It is clear that the U.S. economy was humming along at a higher sustained clip than most thought it could before the Fed started hiking rates.

Using the 6% average growth rate the economy was experiencing, the drop from 6% to 2.2% in the third quarter was a 3.8% fall in GDP growth. If the economy had been growing at the 3% rate most economists believe is the safe maximum, that drop is the same result as sending GDP to -0.8% in the third quarter. In the fourth quarter it grew at only 1.4%, a 4.6% fall from the 6% level. That is the equivalent of a GDP growth rate at -1.6% for the fourth quarter. In relative terms based on the level of growth the U.S. had been experiencing, the economy has already been in recession. That accounts for the extremely sharp drops in consumer confidence and consumption. That accounts for the layoffs.

Here is something important to remember: the government and the majority of economists don't know we are in recession until it is either ending or it has gone on for a long enough period that the actual numbers come in negative and continue to worsen. As the numbers we pointed out above suggest, things are not worsening across the board. Sentiment is down because employees have been losing jobs. But they are finding jobs as well. If this continues, if the housing market continues, and retail sales improvement continues, we could be seeing the worst of this 'recession' right now. Manufacturing is in a recession now according to the 'real' numbers, but we have to remember, it was in recession in 1998 as well, and the entire economy never followed suit. We could be on the brink of a fast recovery to the most hyped 'recession' of all time. Lots of obstacles in the way, but the hype has reached monstrous proportions now, and that usually means the worst has already passed or is here.

Some caveats that could scare away the robins.

We hate to hedge what we say. We try to be as honest with the numbers and ourselves as we can and draw honest, common sense conclusions from the numbers. While we like what we are seeing in some key areas of the economy, there are a few things on the horizon that we mentioned last week that could really wreck things down the road.

First is the recent annoying persistence of the long bond to try and tick higher. Since November the 30 year note and the 10 year note yield curves have climbed higher with just a recent drop in early January before resuming the rise this past week. Friday the yield dropped a bit, but it is trying to resume the climb it started in late 2000. The long bond (and now some use the 10 year) is an indicator of future inflation. It is not at high levels, but it has reversed the slow meandering it was doing. Indeed, interest rates have been rising all during the past 6 years, just not dramatically. This persistence in trying to rise higher is a flag of potential inflationary pressure.

Commodities are another area to keep an eye on. The commodities index has been climbing higher recently and is trying to mount a breakout of sorts. Commodities are important as they are the raw goods that make up the products we buy. If they rise in price, our goods usually rise in price. Even with the U.S. economy slacking its pace the prices are still holding tough. That is another reason for us to believe that the U.S. slowdown may just be a temporary event.

Gold still remains in check. It has not done much of anything and is in fact well off of its even recent highs of late last year. Gold is a long-term hedge against inflation, and if there are not buyers that indicates there is not yet a lot of inflationary pressure. We are going to continue to keep an eye on it, however, given the long bond and the commodities index.

What do these figures mean? It means the U.S. economy could experience inflation if they break to the upside more. Markets are good hedgers of bad and good times as we have seen. Though on one on the financial stations is saying it, this is most likely one reason the market is having a bit of a hangover. The data is mixed with solid indicators both ways. Inflation means a changing Fed view toward rate cuts obviously, and that would be bad for stocks. For the near term, however, we have to see how the economy responds and the market as well. We do not believe that the weakness we saw Wednesday through Friday was based on this possibility because these indicators are still at very mild levels. If they persist it will become more widely discussed as another factor. If it becomes reality, that is bad for everyone on earth.

And the sad thing? It was caused by the Fed having shut down the supply side of the economy while demand was still raging ahead. That caused the 'imbalances' that may exist. Note that these prices did not start rising until right before the Fed quit hiking rates or late in 2000 after the economy was well on the decline (though no one seemed to notice). You CANNOT cut off supply and think you can control demand with interest rates. That failed for 200 years. In 1960 President Kennedy lowered tax rates and stimulated the economy from the supply side; the economy jumped and tax revenues jumped as well. Subsequent massive government spending and demand-side economics killed that boom. In 1980 the supply side was revived again with tax cuts that led to the 20-year boom we have had, a boom that survived several demand-side attacks by the Fed before this last round has again threatened our economic well-being. What a waste of potential, but, that is another story.

THE MARKETS

Friday had everyone we know, everyone, down in the dumps about the market. We were not pleased seeing the Nasdaq melt below support levels we wanted to hold or the Dow and S&P 500 fading from resistance. The Dow and S&P moves were not really surprising as they most likely needed another pause that refreshes before making an attempt at a breakout. The S&P dropped a sizable chunk, but it was on lighter volume and it landed on support. The Nasdaq sold on lighter volume too, but its pattern looks a bit more like a rollover as it is falling through the bottom of its recent consolidation range. We have seen lighter volume selling turn ugly before, and even with the positives we see for the economy and market we have to be ready in case it does decide to head back into the burrow. It has one last chance to make a stand right at 2620 to 2640 before it heads to 2500.

Remember after the first rate cut? The markets surged on the surprise. The closing bell that day was still echoing when the dogs were unleashed and speculation was rampant about why the Fed cut rates. Morgan Stanley officially proclaimed recession. Others speculated about some unseen disaster the Fed knew about that prompted the cut. The markets spent the next three days selling off. The Nasdaq fell 317 points on its low the third day after the cut. That had CNBC air a segment on how the financials were not responding as they should to a rate cut. As we discussed over the next few days, the financials shot up on the rate cut and were pulling back on low volume, forming some handles on their patterns and looked ready to rally from there. They did just that. Since last Wednesday's rate cut, they are doing the same thing: pulling back from recent gains on light volume. The techs don't look as good with more rollover patterns, but the point is the same: we may be seeing another pullback after the news became fact, preparing for another move up. Volume has been lower on the pullback and if it remains that way on some more selling early Monday, we could see the indexes hit support and mount another rally higher.

Overall market stats:

VIX: 24.75; +0.76. Volatility is going nowhere even as the markets sold down some pretty hefty percentages. This indicates continued complacency and that is not a good thing. That often leads to further selling once the averages tilt one way and pick up speed. That is how volatility ratchets back up. As long as the Nasdaq was consolidating we did not mind low volatility. If it sells we want to see it jump fast.

Put/Call ratio: 0.60; +0.07. Puts barely budged on Friday's selling, another indication that investors are complacent.

NASDAQ:

The doji on Thursday was not the portent of a climb back up off the bottom of the consolidation range. The employment report confused the issue and was read several ways. Investors were left with indecision and sold shares. It went on all day as the Nasdaq slipped lower and lower, falling through the bottom of the consolidation range.

Stats: Down 122.29 points (-3.8%) as the index closed at 2660.50, down over 4% for the week.
Volume: 1.706 billion (-3.8%). Down volume led up volume 1.395 billion to 227 million shares. Very lopsided selling even on a low volume day. The low volume is the silver lining, but we cannot afford to see it move higher on further selling.
A/D and Hi/Lo: Declining issues really took over Friday, 1.83 to 1 (1.07 to 1 Friday). New highs fell to 102 (-4) while new lows rose to 21 (+4).

End Part 1 of 3

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