Inflation Worries...

By: Mark McMillan | Tue, Feb 13, 2007
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Weekly Trader Alert #91
2/13/2007 8:44:32 AM

Buy shares of CLF at the open to cover the short position.


The previous weekly noted that the Fed policy statement noted that the economy was strengthening while inflationary pressures were subsiding. This allowed the markets to move up nicely on the day the policy statement was released. This last Wednesday, a Fed head began what became a concerted concern over inflation, and a clear possibility for the Fed to raise rates in response to signs that inflation doesn't continue moderating.

This process has taken awhile but both the equities and the bond markets appear to be concerned over when the Fed might raise rates, as opposed to when an easing might take place. Financial companies have been most effected by this and other concerns regarding mortgage loans. With that as a back drop, the focus continues to be on the strength of the economy and inflationary pressures. A day-by-day account of economic report releases follows:

Monday: The ISM Service report came in at 59.0 versus an expected 57.0. Last months reading was 56.7. Services are strengthening, even as last week's ISM Manufacturing number showed a contraction in manufacturing.

Tuesday: No economic reports released.

Wednesday: For the fourth quarter, the Labor Department reported non-farm productivity rose to a 3.0 percent annual rate, well above expectations of 2.0%. Unit labor costs grew by a lower-than-anticipated 1.7 percent. This eases the inflation outlook a bit, as the year-over-year gain dropped to 2.8%, from 2.9% in the prior quarter.

Philly Fed Reserve Bank President Charles Plosser, suggested that the current fed funds rate of 5.25 percent could be sufficient to keep inflation in check, but with the recently strengthening in the economy, this is "less likely." He even went so far as to suggest that "additional monetary policy action may be needed to keep us moving along the path to price stability."

Thursday: The weekly initial jobless claim number came in as expected at 311K (310K expected). Last week's number was revised to 308K from 307K. December wholesale inventories were expected to rise modestly, by 0.6%. Instead, they were reported to decline by 0.5%. Note, however that November's numbers were raised from -0.5% to 1.1%, so the inaccuracy may make the number somewhat meaningless.

HSBC holdings (NYSE:HBC), the world's third largest bank, indicated that reserves for bad-debt will be 20% higher than previously forecast. This pressured sub-prime lenders, the entire mortgage industry, and financials in general. Tol Brothers (NYSE:TOL), a leading luxury homebuilder, indicated Q1 orders dropped 33% and that full year write downs will "significantly exceed" forecasts. This contributed to more bearish concerns of a spillover of the housing market into the general market.

Friday: No economic reports released. However, Friday's concerted effort by Fed officials to jawbone investors into being concerned about inflation risk left the fixed income and stock markets reeling. There are a number of vacancies on the Fed, with both dovish and hawkish members leaving. This leaves investors wondering what tendencies replacements will bring to monetary policy going forward, with so many obviously leaning toward a tightening.

Three different Fed heads made speeches on Friday and all of them echoed a concerted theme began earlier in the week by Philly Fed President Charles Plosser. St. Louis Fed President Poole said inflation is still a concern; Cleveland Fed President Sandra Pianalto says the moderation in inflation is encouraging, but isn't yet convinced the trend is shifting down; Dallas Fed President Fisher has recently said he "wouldn't rule out" further rate increases and that he won't rest easier until core inflation is "well below 2%" on a sustained basis.

It is now obvious that the Fed wants the market to understand that there is more likelihood of a tightening than a loosening in the future. They are still concerned about inflation, and even though inflation most recently seems to be declining, the core rate is still above the 2% figure that the Fed is uncomfortable with.

Oil rose eighty-seven cents on the week closing at $59.89. Friday saw trading as high as $61.00, a level we have identified as potential resistance. Natural gas also rallied about thirty-five cents to close at $7.827. Both energy products continue to find support above their uptrend lines, and oil is very close to breaking above the psychological barrier of sixty dollars. We believe a close above this level would lead to a challenge as high as sixty-four dollars in the near future. This would likely adversely affect stocks in the short term.

We believe the Fed is prepared to raise rates yet again if the markets don't react to their jawboning on inflation concerns. The bond market and stock market have been quite complacent about prospects for a raise in the Fed rate until recently. In fact, until recently, they were pricing in a lowering of the Fed rate in the first half of 2007. They still don't seem to have priced in the possibility of the Fed raising rates this year, and we think the Fed will continue jawboning the market until they do so, or they may actually raise rates.

To understand more about our view on the markets, we will have to look at the charts.

Market Climate

The market began the week moving up but lost all those gains on Friday as worries of Fed rate hikes took their toll.

The market underwent further accumulation last week until Friday when there were signs of widespread distribution. One day doesn't make a trend but it is worthwhile to monitor accumulation or distribution for a divergent move to the market as it is an early warning sign that things are out of sync. At this time, there is a correlation to the price movement of the stock market and the signs of accumulation and distribution.

The U.S. stock market composite chart:

Friday's move lower seems significant, even though it wasn't a particularly large move. In fact, the daily trading lows from a week ago Friday, Monday, Tuesday and this past Friday define a support area that we believe will be broken shortly. This will signal the beginning of a new move downward for the markets, that may turn into the oft forecasted 10% correction.

The important things to note are the indicators we regularly monitor in relation to price. Note that RSI rose through the week, as did MACD as well as trading volume. The MACD histogram fell through the week. Friday, RSI and MACD abruptly reversed course, mimicking price. Volume actually continued to increase.

The last time the chart looked somewhat similar was around the Thanksgiving holiday. The market closed on the holiday shortened Friday, November 24th. Monday saw a large move downward on average volume, followed by three days of accumulation which put the market higher than the close the previous week. The difference in trading volume is significant as this Friday's volume is the highest since mid June 2006, which marked the initial bottoming of the market (recall that the market formed a double bottom a month later).

What does it mean? We believe that the market is getting ready to make a move lower. This will be confirmed by the MACD 12-day moving average crossing over its 26-day moving average. You will note when that occurred in mid-December, the market moved lower until early/mid January, even though this is the traditional Santa Claus rally period.

Note: The chart is through Friday's close. Monday, Feb 12th, the market continued to move down, so price, RSI, MACD, the MACD histogram, and volume all moved lower. MACD MAs haven't yet crossed and volume was below average, so we are still waiting for confirmation of the downtrend.

Fundamental Trends

The biggest change on the leaders is that the steel trade fell out of the leaders. That is specifically the alloys industry. Basic steel fell of the top screen (into the second screen of stocks). Steel Alloys continues to be a strong trade, but moved into seventh place.

Auto and Truck replacement parts moved into the number one spot, helped by the announcement of a deal to buy Lear Corp. We had been monitoring and discussing its move up in ranking.

There are still three building industries in the top screen, with four more in the second screen. Clearly, there is broad interest in owning stocks in these industries, which belies anything but a soft landing or better for the economy.

The US Integrated Oil industry is in tenth place and is the only petroleum industry in the top screen. Given the preponderance of petroleum industries in and near the laggards, there is clearly a bearish view on energy, even as the price threatened to move up through the sixty dollars per barrel price. Monday's collapse back below fifty-eight dollars (actually testing down to support) didn't help the case for oil related investments. Note the petroleum industry also includes natural gas plays, and natural gas fell sixty cents (more than seven percent) on Monday. Both oil and natural gas are still above short term trend lines.

The mining industry fell to the bottom of the top screen. There is a single healthcare industry in the top screen (nursing homes) and another in the second screen. There are no utilities in the top screen. There is talk of moves into defensive names, but not a lot of evidence of this yet. Clearly investors aren't yet concerned enough to rotate into defensive names.

The Industry leaders (ranked 1st-5th out of 190) are:

Leaders 2-09-2007

Leaders 2-02-2007

Leaders 1-26-2007

Auto & Truck (Repl Parts)

Machinery (Automation)

Machinery (Automation)

Container (Metal/Glass)

Container (Metal/Glass)

Steel (Alloy)

Food (Meat)

Steel (Alloy)

Container (Metal/Glass)

Retail (Department Stores)

Food (Meat)

Leisure (HtlsMtls)

Machinery (Automation)

Building (Residential/Com'l)

Food (Meat)

There are now two Petroleum industries in the cellar dwellers. In addition, in 181st and 185th places are two Petroleum industries, US Exploration/Production and the Drillers. That means four of the bottom ten industries are related to oil, and oil has been pressing at the psychological resistance level of $60/barrel. This discrepancy will get resolved soon.

Mortgage services were hit hard when HSBC announced they would have to raise their reserves for mortgage loans by 20%. Sub-prime lenders were hit particularly hard, but the financial sector took a hit across the board on these concerns.

A perennial cellar dweller, Control Instruments, is back on the list. We believe they have been the most unloved of all industries we monitor, logging more time in the cellar dwellers than any industry we can recall. Of course, this could eventually turn into a buying opportunity if Wall Street ever falls in love with them again.

We continue to monitor plastics. In fact, we are specifically looking for a long entry into a stock we have been monitoring under recommended trades. We suggested we might be able to enter at a double bottom formation, which hasn't yet occurred. We suggested that the Plastics industry had stared to rebound, but it is still in last place of all the industries we monitor.

The Industry laggards (ranked 186th-190th out of 190) are:

Laggards 2-09-2007

Laggards 2-02-2007

Laggards 1-26-2007

Petroleum (Intl Specialty)

Software (Educ/Entr)

Petroleum (Drilling)

Financial (Mortgage Svcs)

Electronic (Misc Prod)

Retail (Consumer Elect)

Instruments (Control)

Energy (Coal/Other)

Energy (Coal/Other)

Petroleum (Cdn Expl/Prod)

Petroleum (Cdn Expl/Prod)

Chemical (Plastics)

Chemical (Plastics)

Chemical (Plastics)

Petroleum (Cdn Expl/Prod)

Trade Recommendations

We continue to monitor BPT for an entry. It traded just shy of the 161.8 Fib level ($62.12) on Monday. The low was at $62.27 and it is likely a good entry point for the stock. We haven't yet had confirmation that the downtrend is completed so we have been cautious about issuing a recommendation for entry. We will monitor the trade and send out an intraday alert as necessary.

We recommend you take profits on CLF at the open.

Buy shares of CLF at the open to cover the short position.

Rogers continues to set-up nicely, and we are still waiting for it to form a double bottom, at which time we would recommend taking a long position. Wait for instructions on this trade.

Current Portfolio

FDG has tried for four days to get up and over the $23.87 level. It hasn't been successful, so we believe it will consolidate here, above its 100-day moving average, which is currently around $22.70 and moving gradually lower. If the stock holds the $23.00 level, through the consolidation, then it should rebound strongly higher. The company announced higher revenues, but missed analyst expectations by five cents. The stock moved three cents higher on the news so apparently investors had already priced in their expectations, as well as bucking headwinds from the market's latest downward pressure. With another dividend payment expected, this stock is a cash machine paying out double digit returns on dividends alone. FDG closed Monday at $23.14. We are long FDG.

We are short Cleveland Cliffs (NYSE:CLF), entered on Feb 9th at $54.70. The stock is currently trading at $52.85 and is showing signs that the downward move may be arrested. The stock touched its 20-day moving average on Friday and Monday closed on that same average, with the same closing price as Friday. The candlestick pattern was a Hirami star which indicates a braking of the downtrend, if it is confirmed.

* Initial stop prices are set to cause us to exit our positions if they close below these levels. You will note they are generally kept pretty tightly the opposite side of the trades we initiate. Historic volatility would imply that intraday price action may trade outside of these values, so that condition is insufficient to cause an exit from an existing position. On significant movement beyond our stop prices, we may issue an intraday message to exit the position or to maintain the position. You may chose to implement an absolute stop below these suggested stop values, but that stop should be wide enough to take care of the daily volatility for the stock in question. You can examine the candlesticks for an idea of intraday price fluctuations.

Entry prices are adjusted to account for dividends paid. The stock price was adjusted by your broker, to reflect the dividend taken out. The non-adjusted entry price reflects the actual entry price, without the adjustment for dividend values.

LVPB Concept: The concept is a Light Volume Pull Back, where a stock's price will pull back to a support level on light volume. Obviously, heavy selling is a sign of weakness, and we would not want to buy on a heavy volume pullback. However, we will occasionally place stocks on the LVPB (Light Volume Pullback List) to indicate a "re-entry" buying opportunity, when we have already entered a position. This should be used to add to existing positions, or to enter a position if you missed the initial entry.

LVPB Portfolio Stocks:


The Fed heads seem to be stepping up to a concerted effort to jawbone the markets to consider an interest rate hike and are getting the desired reaction (for a day anyway). If the markets remain convinced the Fed is serious about the possibility to raise rates, the market will likely become defensive here and perhaps even begin a sell-off. A sign of core inflation creeping up, with say a monthly report of core CPI reaching 0.3% would likely send the markets into a tailspin, as the Fed is likely to act on that sort of data. The Fed's favorite inflation gauge is the chain deflator, which has been looking somewhat benign of late. We will continue to monitor these reports to position for profitable trading.

Growth prospects for 2007 appear to be dropping down into single digits, at least for the first half of the year or more. This has already been seen in guidance provided by many companies and some warnings issued, such as Micron's warning of a semiconductor glut of memory chips.

We believe that growth will continue, albeit more slowly and that investors will weigh the risk of equities versus the returns of fixed equities going forward. With Fed rate hikes in the picture, it makes bonds less desirable as their value diminishes with rising rates. Still, if company earnings growth drops down toward the rates paid by fixed income, investors may flee equities for less risk. This represents quite a conundrum for investors in U.S. securities going forward, and we shall continue to provide analysis to position for profits going forward.

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Regards and Good Trading,



Mark McMillan

Author: Mark McMillan

Mark McMillan
Fundamental Trader Alert

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