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4/09/04 Investment House Daily
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MARKET ALERTS:
Target hit alerts issued Friday: RITA; DAB; ARTX; IVIL
Buy alerts issued: CPTV; XRIT; AWRE
Trailing stop alerts: None issued
Stop alerts: PLCE; BGFV

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SUMMARY:
- Stocks try a breakout but find no commitment ahead of a long weekend.
- Jobless claims tank, inventories surge but sales surge more.
- Raise taxes on the 'rich' and the 'poor' pay more.
- Action may have disappointed many, but we view it as good.

Market tries to rally on good news but is not ready just yet.

There was a lot of positive news to try and offset the concerns regarding Iraq violence and continued worries regarding further terrorist threats. The latter was further fanned by a CIA alert that Paris was a potential target this weekend. YHOO, DNA, GE all reported strong results. DELL said its unit shipments rose 25% as it was finally seeing a return to IT spending (recall how DELL, even when the economic numbers were showing solid capital investment, said it was seeing no improvement; DELL was so cautious, now that it is reporting improvement, you know sales are indeed strong). Jobless claims hit a 3 year low. Inventories were jumping. Investors' cups runneth over.

The market gapped up, but as we concluded Wednesday night, if volume was not there (and it would probably not due to the long weekend) the market risked a rollover. It started selling back after the initial surge. It took an unscheduled press conference by Defense Secretary Rumsfeld and the accompanying rumor that Bin Laden had been captured to provide the impetus for a respite from the selling. After it was clear that Rumsfeld was talking Iraq strategy as opposed to making capture announcements, the market started fading again. The indexes turned negative but for SOX. A last half hour bounce pushed NASDAQ positive on the close as well.

That was little consolation for most. The financial stations glumly reported NASDAQ closed down for yet another week (of course, NASDAQ was up the prior two weeks as it rose off the 200 day MVA). Others spoke of the problems for SP500 at 1150. Great. Bring it on. Right now the market needs a bit more gloom in order to give NASDAQ and SOX a bit more pullback to better set up the base. The market loves to climb over a wall of worry. It is very good indeed for economic data to continue its strong improvement in the face of doubt, for earnings guidance to continue to ramp higher just as expectations are for a decline, for worries about the ability for US forces to handle some insurrection in Iraq to cast doubt upon the entire Middle East, for others to predict that the US economy is ready to collapse once more later this year. That kind of negative sentiment that prefers to look for the worst and ignore the obvious is the kind of worry that catches the market by surprise when it does the opposite. In short, the negative views toward the future in so many areas only strengthens our belief that the market is setting up nicely just as it is showing.

THE ECONOMY

Jobless claims hit a 3 year low, Fed signals it is still on hold until job growth is a trend.

Many were referring to the 326K claims, the lowest since January 13, 2001, as confirmation of last Friday's March jobs report. More jobs, fewer layoffs (as seen also in the Challenger jobs report last week) led many to conclude a much better employment rate was coming. Maybe. The 4 week average fell to 336,750, the lowest since November 2000. Now that number is significant. Further, continuing claims fell to 3.01M from 3.01M, the lowest since July 2001. What did the Fed say? Vice chair Ferguson said the "most recent data suggest the labor market is improving gradually," noting however that it would take "some time to answer" whether the "improvement is fundamental and durable." Translated: the Fed is not going to raise rates until it sees a series of jobs reports that show strong job growth, not just job growth. That is what the Fed has broadcast for over a year, and despite the speculation otherwise, that is what Ferguson was telling those willing to listen on Thursday.

Wholesale inventories jump but sales rise faster as economy starts to feed on its own growth. Q1 GDP will be better than first reported.

Inventories jumped 1.2% in February, much stronger than the 0.3% anticipated, as companies ramped up production in order to meet current demand and build some cushion for a surging economy. Sales, however, rose 1.3%, indicating once again that companies are still not producing fast enough to keep up with demand. That pushed the inventory to sales ratio down to a record low at 1.17 months. That mans at current production and consumption rates it would take about 35 days to run producer's stocks dry.

That bodes well for continued expansion in business and investment in equipment and personnel. Moreover, it tells us that the first iteration of Q1 GDP was light. Inventories are considered as part of GDP. That is okay in the start of an economic recovery as it shows confidence by business that demand will remain solid. As we have discussed in the past, that supply helps foster demand as the economy improves. Later in the cycle excess inventory can mean a slowing economy. With strong sales that is not the case now, and once more it appears that the economic recovery has been underestimated.

It also gives off further hints of inflation. We noted back in 2002 that it was necessary for production, i.e., the supply side, to start expanding soon in order to be ready to meet the rising demand we were seeing. If it does not, then with the rising incomes due to tax cuts there is the definition of inflation: more dollars chasing too few goods. That has been occurring though manufacturing is now picking up steam. That is why we were saying there needed to be more and more substantial business incentives such as tax credits. As it turns out, the tax incentive finally started working, but supply has not has not yet caught demand. If there are any restrictions put on supply at this point such as higher interest rates or a reduction or elimination of incentives (e.g., raising tax rates and removing bonus expensing and depreciation), then we are guaranteeing inflation.

CEO confidence climbing as profits climb, and that means hiring in order to produce more.

For now this is really improving views for the future. CEO's remained cautious with their outlooks given shareholder lawsuits and the speed of the bust in 2000. Inventory rebuilding, fewer layoffs, and resumed hiring are signs of corporate confidence finally returning. Manufacturer confidence hit record levels in Q1 according to the Manufacturers Alliance survey that has been taken since 1972. This is simply further confirmation that the employment picture is really turning. We thought April would be the breakout month, and now the indicators we were looking for are showing that, but it just turned up a month earlier.

Raising taxes on the 'rich' raises the tax burden on the 'poor.'

It seems incongruous. If you raise the taxes on those that are deemed rich, surely the tax burden they share will rise and the tax burden on those deemed poor will fall. That is certainly the premise behind those championing raising taxes on the higher income levels to pay for budget deficits or otherwise promote 'fairness' (the Kerry chief economic advisor just recently stated that those in the top bracket "frankly, don't deserve" the tax reduction). That premise or assumption, however, is based on the belief that demand drives economic growth, i.e., that the consumer determines if the economy grows or shrinks based upon his or her buying.

Sure demand is important, but as the past four years have once again shown, demand can remain strong but the economy fall into recession because production levels drop as businesses abstain from investment in equipment and personnel that promotes research, innovation, production and, of course, job creation and an increased standard of living. Without this the economy stagnates at best. Typically it causes recession, and at the extremes, a boom to bust cycle or depression. Only now as businesses start to reinvest in business in America and start to hire does the economy really start to improve and tax revenues (business taxes, sales taxes, and personal income taxes) expand once more.

Thus when the supply side of the economy has incentives to invest and expand (tax incentives during recession, profit incentives during actual recovery), then the economy starts to grow and Treasury revenues rise. That is happening right now as state tax revenues are jumping dramatically from just a year ago when states bemoaned the tax cuts that did not provide a state bailout.

Now back to taxes. In the early 1980's President Reagan reduced the highest marginal bracket from 70% to 50% along with reductions in capital gains taxes that were astronomically high. That unleashed massive investment in the US, i.e., the supply side of the economy. Just prior to that reduction, those subject to the highest tax bracket, according the US government's own Budget Office statistics, paid 2.5 times the taxes of those at the lowest bracket. During the intervening 20 years tax rates have, in aggregate, dropped the highest bracket to 35%. They have also fallen on the lowest bracket as well. Surely the taxes paid by the 'rich' versus those paid by the poor fell. The Budget Office statistics, however, calculated the same way during that period by each administration, show that those in the highest bracket now pay 6.5 times the amount of taxes paid by those in the lowest bracket.

There are several reasons for this. The primary is that lower tax rates on all income levels leads to more investment in the economy and that has the synergistic effect of creating more production and jobs. There is more opportunity. More people become 'rich' in the sense they move up the socioeconomic ladder. The middle class swells. Yes, the poverty rate is said to still be high, but in the US poverty is measured by dollars alone and does not include possessions. Thus 35% of those in poverty own two cars, 40+% own their own homes, etc. The point is economic growth means more people in higher tax brackets paying more taxes. That includes the middle class and the wealthy, and that means more tax revenues. The 'rich' pay more as an aggregate over the 'poor' because there are more rich, and those that were already rich including the new rich are putting their money to work in the economy, making more dollars, and of course paying more taxes.

Higher tax rates mean less capital investment because the risk/reward relationship shifts. The more it costs to make the same or less profit, the less risk is taken. Less and less money is put into the economy but is instead sheltered in investments that don't produce the tax returns. Slowing economic investment and sheltered assets hurt tax revenues but federal spending, as always, remains. The burden shifts toward the lower brackets, those that just climbed higher because of economic success, that typically (i.e., historically) do not shelter the income. Thus the regression or shift occurs again as, in the aggregate, the lower brackets pay a higher and higher percentage of the taxes that are necessary to run the federal government. It is not dollar for dollar as deficits crop up, but as the Budget Office statistics show, it is very significant. This is exactly what Greenspan meant when he said taxes needed to be regularly cut to avoid bracket creep. When taxes are raised, the creeping effect turns into a galloping effect. It is a double hit: the economy slows so everyone makes less money, but the lower brackets have to pick up more of the burden.

Thus the incongruity is economic reality, but you have to understand what drives the economy. It is easy for those seeking popular support to play the 'tax the rich, help the poor' card because they as well as those they are appealing to believe that demand drives the economy and that if you raise taxes on the rich you will take in more revenues because they have more money. That is not economic reality. Raise taxes too much and you get reduced investment. It is the typical cycle: rates get too high and recession occurs. Rates are then cut and cut until economic prosperity returns. Spending goes up in proportion to tax revenues. Spending starts to outstrip revenues. Taxes are raised to make up the shortfall. As seen in the late 1990's, taxes continue to rise until there is surplus. That is the signal prosperity is ending because too much money is being taken out of the economy. Recession follows, and while all pay for a slow economy through lower profits, job losses, higher crime, etc., the lower brackets' share of the burden gets larger and larger.

That is the paradox of our bizarre tax system that has turned into an octopus of convoluted regulations that cost an estimated $500 billion per year in compliance, and have given rise to an unelected entity that is above the Constitution that our nation is founded upon. With respect to something so destructive as an income tax (that the original Constitution did not allow except in impossible to meet form) there is no constitutional protection. What better reason to go to a flat tax for everyone. Russia did it and tax revenues shot higher because there was much less incentive to try and avoid taxes. In other words, each dollar spent to avoid taxes returned less versus putting that dollar to work in the economy at the lower flat tax rate. That had a double positive impact: money was put into the economy, thereby increasing economic activity further, and dollars that were hiding came out in the open and were subject to the tax. That has the effect of lifting all boats as more money goes into the economy as opposed to being used to avoid taxes.

THE MARKET

We view the action overall positively even with the bearish intraday activity Thursday (gap then fade to close). As noted above, the disappointment and concern about the near future acts as some confirmation of our view that the overall action is still positive. Think of it as the sentiment paradox similar to the taxation paradox.

NASDAQ and SOX are still working on good looking patterns. Despite the gap higher and inability to hold gains on good news, the market sold back on lower volume while NASDAQ and SOX are still in decent patterns, continuing their work on a shakeout and then a breakout. The market needed a bit more rest, and the Friday action showed it.

Even putting the gap higher and fade aside, however, there were still some signs of potential trouble. Retail patterns have been forming up well and the same store sales were solid. WMT then said Thursday that April was going to be slower. Otherwise same store sales were solid. TGT 7.4%, JCP 11.4%, FD 6.8%, GPS 8%, TJX 9%, LTD 15%, SAKS 9.5%, NMGA +26%. Further, many stores raised guidance such as ANN, ARO, JWN, JOSB and BEBE. That is not chopped liver, but the retailers were under pressure because of WMT saying sales were softer in April and DDS and KSS posting slow sales and noting things were not that great. It appeared to be a case of the tail wagging the dog for the most part, but it is something we are watching as retailers sell. And, of course, WMT is pretty big to be considered part of the tail. We do not want to see them break key support and follow in the tracks of the interest rate sensitive stocks such as lenders, homebuilders, etc. Pullbacks by the retailers as NASDAQ completes its base are okay; breakdowns are not constructive by definition.

Mostly stocks took a rest Thursday on low trade as investors were unwilling to get too committed to new positions ahead of a long weekend when terror threats were present. On the other hand, there was not heavy selling, i.e., the 'lightening of positions' as some predicted. Certainly the early gains were sold into to an extent, but there was no dumping ongoing. That action is in keeping with the modest volume pullback on NASDAQ.

In addition to improving price/volume action we have noted the past few weeks, another key technical indication is again changing to the positive. In early March as NASDAQ moved into its sixth week of correction its 18 day MVA crossed below the 50 day MVA (late February if you use the simple 50 day). As noted at the time, that typically foretells more selling to come. Indeed, the selling pace increased as NASDAQ made its third leg lower, the longest of the three that took it down to the 200 day MVA. The action in the rebound has just started to move the 18 day MVA back through the exponential 50 day MVA. It has made the move on SP500 already. Now often they come back to test the crossover after it is made, and as noted, NASDAQ is just edging through; it is not a lock that the crossover will hold. It is an indication that the tide is turning, however, just as the improving price/volume action shows. Indeed, price/volume action on NASDAQ during the correction is now positive at 2 up weeks on rising volume to 1 down week on rising volume. No landslide, but overall money has still moved into the index even as it corrected. That is precisely what you want to see because it shows you that the institutions are still accumulating stocks, meaning they are still betting on the market rising further.

Market Sentiment

As noted above, sentiment remains pensive with Iraq, new terror concerns, and, most importantly, concerns voiced by those on the financial stations that the rebound is over as SP500 has returned to 1150 and will be hard-pressed to go further. Positive NASDAQ accumulation, good leadership, and strong economic data belie that position. This looks more and more like early 2003 where fears rose that the market had peaked on its bounce off the October 2002 low and that it was ready to collapse again. The fear is not that high; after all, the downtrend low is now a year and one-half removed. There is still concern about 'sustainability', however, as misguided talk about budget deficits and lack of jobs continues to dog both the consumer and professional money managers who should know better.

VIX: 16.26; +0.5
VXN: 21.38; -0.61
VXO: 15.83; +0.41

Put/Call Ratio (CBOE): 0.74; +0.04. Still at a high level despite the rally. Once the hint of selling turned up the put buying, either for edging or speculation or both, started right back up.

End part 1 of 3

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