Looking For Trouble

Daily State of the Markets 
Thursday Morning – December 31, 2009  

Good morning. As one of the most tumultuous years in market history draws to a close, it is time to look ahead. As such, we are in the process of drawing up our roadmap for 2010. While we expect to publish the report this weekend, we thought we would take a sneak peek at parts of the report this morning and talk about some of the warning signs that might signal a change in the current uptrend.

But before we look ahead, we should probably spend just a moment on the market action from Wednesday. In short, traders seemed content to sit on their hands and wait for the volume and the data flow to return next week. While this week has been exceptionally quiet, next week ought to pick up a bit as we’ll get the December Jobs report and some manufacturing data, as well as the holiday sales updates from retailers.

Yesterday’s session was once again very quiet. Traders initially followed the lead of the world markets and opened modestly lower. From there, the indices traded in a tight range below breakeven throughout much of the day, despite a report from the Chicago Purchasing Managers Index that was better than expected. As has been the case lately, the move during the last ten minutes of the day decided the outcome as a program or two pushed the indices into positive territory into the close.

In looking at the road ahead, while the 3 – 5% wiggles and giggles in the market are impossible to predict, we would not be surprised to see a continuation of the current rally as we head into the first quarter. Looking at the prior “mini bull” markets that have occurred within the context of secular bear markets, the pattern for the year suggests further upside for four or five months followed by a meaningful pullback, and then a rally phase into the end of the year.

The one fly in the ointment with using this type of analysis is that the current rally has been stronger than normal over the past 3 months. When looking at a chart of the DJIA plotted against a composite of prior “mini bull” moves, the Dow is currently more than 1,000 points ahead of where other bull markets have been at this stage. This doesn’t mean that stocks can’t go higher. However, it does reinforce the point that this bull has been one for the record books.

In light of the fact that the next big move of 10% or more in the market just might be down, we feel it is important to go into the New Year “looking for trouble.” While minor moves of 3 – 5% can occur at any time and for just about any reason, there are generally warning signs that a more substantial moves is in the offing.

Thus, we will be looking for the traditional telltale signs of trouble: (1) Breadth divergences, (2) Rising interest rates, (3) Extreme optimism in the sentiment gauges, and (4) Valuations becoming stretched. While we’ll go into more detail over the weekend, we’d suggest spacking a sticky note with these four items onto your computer screen.

While the four signs listed above generally occur before a substantial decline takes place, we should point out that this market remains fixated on the economic data and the state of the greenback. As we’ve discussed ad nauseam, should the dollar-carry trade begin to unwind in earnest, all bets could be off as traders will likely dump risk assets such as stocks, commodities and emerging markets.

Turning to this morning, things are incredibly quiet. However, we do have the weekly jobless claims numbers to review before the bell. The Labor Department reported that initial claims for unemployment insurance for the week ending December 26th fell by 22,000 to 432K, which was below the expectations for a reading of 460K and last week’s revised total of 454K. Continuing Claims for the week ending December 19th were below consensus at 4.981M vs. expectations for 5.1M and last week’s revised total of 5.038M. However, it is important to note that seasonal adjustments tend to wreak havoc with the numbers at this time of year. Thus, stock futures have not reacted positively to the report and have actually given up a few points.

Running through the rest of the pre-game indicators, the overseas markets that are open are modestly higher across the board. Crude futures are up a little with the latest quote showing oil trading higher by $0.16 to $79.44. On the interest rate front, we’ve got the yield on the 10-yr trading at 3.84%, while the yield on the 3-month T-Bill is at 0.06%. Next, gold is moving up by $13.20 and the dollar is unchanged against the Yen, but lower versus the Pound and the Euro. Finally, with about 60 minutes before the bell, stock futures in the U.S. are pointing to quiet open. The Dow futures are currently ahead by about 13 points; the S&P’s are up about 2 points, while the NASDAQ looks to be about 2 points above fair value at the moment.

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