British Pound Nearing Record

The dollar has weakened against several major currencies over the past week. One of the most important currencies the dollar has depreciated against is the British pound ($XBP). The US dollar - pound exchange rate is now approaching $2. Using technical analysis, is there any basis to conclude that the current high values will continue to move higher?

First, it is important to establish whether the value the pound is approaching, $2, is a resistance level. To do this, remember the basic rule: Look left. What I have done is to extend as far back as far as my subscription allows (to the late 1980s). When going this far back, it is necessary to use monthly data so the graph doesn't get very messy.

When doing this, first, clear off the moving averages that are on the StockCharts.com graphs (the 50 and 200 period). Experiment with values and find a period that fits the most recent upsurge very well. In the present context, the 48-month moving average does this, as the graph shows (click to enlarge).

Examination of the graph shows that $2/pound is a very long-term resistance level that dates all the way back to the early 1990s. So, I have drawn a horizontal line to designate this fact. Support is the 48-month Moving Average.

Is it likely that the pound will break above its long-term resistance? The answer is yes, in the near-term, though. Note that the RSI is not yet at or above the overbought reading of 70 yet, so this indicates there is more upside possible. Also, below the main graph I have added a graph that shows how far the actual values of the pound are from the 48-month Moving Average. Apparently, 20 is the resistance level for that divergence (note: this is 20 cents). At present, the divergence graph below is not yet at 20, so this also appears to confirm that there might be further upside for the pound.

Remember, this is a likely outcome, not guaranteed. And, if the pound does move beyond its long-term resistance at $2, it will become overbought fairly quickly thereafter, as the RSI is very close to 70. So, whether a move above $2 can be sustained after it occurs is open to question.

As I have stated in earlier posts, use economics to determine whether the move after $2 (if it does occur is up or down). To do this, you must essentially formulate a forecast of the pound. A key factor is US monetary policy. Also, will the European Central Bank raise rates for the Euro zone? If so, relative US interest rates will fall (as the Fed is on hold with rates for now), causing the pound to appreciate further. See if you can identify other factors that will determine likely future values of the pound.

Post Election Info

The election is now over (thank God!!). A sharp market sell off that some had feared failed to materialize. Interest rates have come down about half way from their gain after the employment report last Friday.

There is an excellent article I want you to read by Michael Kahn dealing with political cycles and the stock market. The interesting question he explores is whether the market will be strong for 2007 and 2008, or just 2007. In other words, will a historical pattern hold?

Today, we received the most recent balance of trade data. The September trade deficit fell sharply. Why? Because this is a nominal value, and the price of oil dropped sharply over the period covered by this report. So, while short-term fluctuations in the balance of trade often result from changes in relative US income change (as I noted in class), at times when oil prices rise or fall sharply, large changes occur. Read this article on the balance of trade figure.

Perhaps the most important implication of the balance of trade figure is that it indicates the likelihood of an upward revision to Q3 GDP growth. That's because the initial number we received (+1.6%) uses an approximation (i.e., guess) of the balance of trade deficit, which likely included an overestimate of the value of imports. Remember, imports get subtracted from GDP, so lower imports (due to a drop in oil prices) will add to GDP growth figure.

How Strong are Retail Sales

Retail sales data were released today. At first glance, the number seemed disappointing -- retail sales fell by 0.4% (read article). There is, however, a quirk you need to know about when analyzing this number: it is a nominal value. Why is that a problem? Gasoline prices fell dramatically in September, giving the impression of retail weakness, when in reality that was not the case. To see this, recall that:

nominal retail sales = price x quantity

When a critical price falls dramatically, as that of gasoline did, we have a large drop in the price term, which tends to make the growth rate in retail sales low or negative, as was the case this month. Similarly, in months where gasoline prices rise, this will tend to push up the value of nominal retail sales.

So, at the present time, or any time when gasoline prices change substantially, gauge retail sales strength by focusing on retail sales excluding gasoline (and retail sales at service stations). For September, retail sales excluding sales at service stations rose by a respectable 0.6%. What a different perspective this gives!!

An important part of macroeconomics is knowing how to "read the tea leaves." The Carnes and Slifer book is very good for this (you should read the material dealing with retail sales). This is one more example of why it is important not to examine only overall indicator values without delving into greater detail.

Now, as the more meaningful real trend of retail sales indicates economic strength, the bond market sold off again today, pushing the 10-year bond rate all the way up to 4.8%. Read this story to see the details. It's safe to say that the bond market has dramatically changed its perspective from just one week ago. The likelihood of a Fed rate cut early in 2007 is somewhere between slim and none. Don't forget that the Fed Chair and several members also need to establish their "cred." Erring on the side of ease would be a major error they would suffer from for years to come. So, for them, it is preferable to err on the side of causing weakness than to risk higher inflation.

Employment Report Implications

Today, the September employment report was released. There was a weaker-than-expected employment change of 51,000. If the market's focus were solely on this number, interest rates would have fallen (lower inflation expectations due to slower expected growth), and the stock market should have risen as this is consistent with the "soft landing" scenario.

As it turned out, the stock market dropped slightly. But, the biggest story was that the 10-year bond rose by 9 basis points, all the way up to 4.70%! How did that happen?

First, the bond market, which subscribes to the "hard landing" scenario, had not only priced in that the Fed is finished raising interest rates, they apparently also presumed that the Fed would begin easing early in 2007. Wow! While the 51,000 payroll change would normally have made them happy, there was a sizeable upward revision to August's payroll number (+60,000), the unemployment rate dropped to 4.6%, tied for its lowest value in a while, and the government released a statement indicating that payroll employment gains have been understated through March of this year, by about 800,000.

So, taken together, this information says the economy has more strength than the bond market had presumed, and the likelihood of the Fed lowering interest rates early next year is now remote. What is the outcome? You guessed it, a bond sell off, pushing interest rates higher. Go to StockCharts.com and plot the 10-year bond ($TNX) to see that action for yourself. The chart shows the 10-year (click to enlarge).

Note the large bar for today. Using the Raff Regression Tool (sixth icon from the top right), I made the blue price channel and have indicated three resistance levels (think of these as R1, R2, and R3 as technicans would). I have also located support.

The other story is the recent strength in the dollar. I discussed in class today that when we see the combination of rising stock prices, rising bond prices (declining r) and a rising dollar, this indicates that foreign investors are bringing money into US asset markets. This happened earlier in the week. What about today?

With the threat of a nuclear weapons test by North Korea, the dollar strengthened. Once upon a time (translation: when I was a student), gold was the "safe haven" when indicents like this occurred. Today, gold only rose $1.50. The US dollar has now become the safe haven. And when the US dollar strengthens, US asset markets also become relatively more attractive to foreign investors. This bodes well for stock indices not falling too far too fast. When the US dollar strengthens, this also puts downward pressure on commodity prices. Check out the CRB Index ($CRB) to see this.

Finally, to see the international fallout (sorry!) from the possible nuclear weapons test, check out the Japanese Yen index ($XJY). Not a pretty sight!

Dow Jones Record

The Dow-Jones Industrial Average ($INDU) set a new record today, closing at its highest level ever. You can read about today's performance or explore its history. The real question is whether this upward move has "legs." Will resistance hold, and today be part of a failed breakout, or will we move toward even higher levels?

Applying technical analysis, there is reason to think that today's record will be met with a pullback in the near term, even though the RSI doesn't indicate that $INDU is oversold (based on the weekly data used). The chart below (click to enlarge) illustrates that the record -- as resistance from early 2000 -- was broken today. Why do I think some pullback is coming? Using the RSI, there is a bearish divergence: the $INDU has moved higher (it has higher highs) but this has not been confirmed by the RSI (it has lower highs).

Where will the Dow-Jones go from here? To answer that question, economics is needed (see the prior post for an example of this).

stock prices = f(expected profit, interest rates)

Put these together and you get the present discounted value of expected future profits. Here are the types of questions that must be answered to arrive at an answer (which, bye the way, is a forecast):

(1) Has the Fed finished raising interest rates?
Will they actually lower rates next year (as the bond market presumes), or will inflation remain in the problematic range?
(2) Today, oil prices fell below $59/barrel. Will this continue? If so, this will moderate inflationary expectations and the inflation premium in nominal interest rates). What about declining gasoline prices? This will help consumers, but with a lag (it takes time to replenish the spending power lost over all these months with $3+ gasoline prices.
(3) How much damage to economic growth will be done by housing sector weakness? Have declining interest rates placed a bottom on the decline in housing, or is there quite a ways (down) to go yet? Look at a few home builder stocks. These appear to have bottomed. Is that a leading indicator of what is to come for the housing sector? Business construction (in the GDP accounts) have begun to rise. Will this be able to offset home construction weakness?
(4) Consumer debt has piled up -- largely through the use of home equity. What will power spending in the next several quarters if home equity can't? Job growth and income gains are critical here.
(5) Will business spending (Equipment and Software) be able to pick up the slack from weaker growth (or actual declines) in consumer spending? Judging from the most recent quarter's GDP report, no. But was the decline in this category an anomaly?
(6) Will growth in Europe continue to pick up and that of Asia remain strong? If so, this bodes well for export growth and profits to firms that have international sales.

This is not necessarily the entire list. But for a forecast of stock prices, like any forecast, you must identify what the relevant factors will be in the next 6 months or year, predict what each of these will do, then put all of this together to arrive at a conclusion.

Technical Analysis Applied to a Stock Pick

Today, Barron's Online had an article (subscribers only) with a strong recommendation to purchase Texas Instrucments (TXN), the maker of computer chips for computers and cell phones. While I have no doubt that just this recommendation led many to run out and purchase TXN, persons who know the tools we are using in class would have held off. Clearly, the "fundamentals" of TXN are very good, so the stock passes and important test. But should one buy it when a recommendation occurs? For persons who don't believe in technical anaylsis, the answer is a resounding "yes." They would likely point out that as a long-term investor, if the stock should fall in the near-term, it will surely rise later based on its strong fundamentals. Let's look at an annotated chart of TXN (click on it to get an enlarged version).

The first thing to determine is how close TXN is to resistance. It is apparent that resistance is at 34 (from April). It failed a breakout above 34 in late April and early May. That resistance recently held as well. Note from the Relative Strength graph (bottom) that TXN has failed to outperform the overall stock market since mid-August. So purchasing this stock now is a wonderful illlustration of my handouts in class -- how persons often tend to buy when a stock is close to resistance (i.e., price is high).

Why not wait until (or if) TXN clears resistance, then purchase it, or better yet, purchase at support? That is what I would recommend. Consider the "fundamental" investor. Should TXN drop to $30 from $34, assuming they purchased it at $34, they would need to recoup a 13.3% loss just to break even (=$4/$30). What they won't do, and that I recommended that you would do, is to consider purchasing at support -- this is the equivalent of "buying low."

The motto of the story: I often see buy recommendations for stocks given at a time when the technicals of those stocks are not "right." Use technical analysis with stop loss orders to manage gains and losses, and don't just "resign yourself to fate" in terms of whatever the stock price does, as the fundamental investors do.

Enter economic analysis: Is it likely that TXN will test resistance or fall to support? (As practice for you: Where do you see support here? Where would you think of buying this stock?) Since stock price is largely determined by expected profits (and interest rates), what is likely to be true of future profits for chip makers? Will electronics and computer purchases slow down as the year ends or will this get stronger? THIS WILL BE DETERMINED BY THE MACROECONOMIC OUTLOOK. What a coincidence, that's what ECN 327 is all about!!! The products TXN's chips go into are part of discretionary spending, which is highly cyclical. So, if the bond market is correct, that a sharp slowdown is coming, prospects for TXN's stock price are not very bright, in spite of its present fundamental strength. If the stock market is correct, that we are headed for a "soft landing," then the prospects for TXN are brighter, and this might be a stock to keep track of. So, look at the graphs of cyclical stocks ($CYC) and discretionary goods (XLY). What is the real-time information from these graphs telling us? Is the Fed done raising interest rates? Will housing's fall not be sharp (due to falling 10-year bond rates, etc.)? These are the questions to consider.

Bond Market

Today we discussed the bond market in class and how bond prices and interest rates move in opposite directions. This can be seen vividly in today's news. Existing (median) home prices declined relative to last year, a rare event. This is bullish for bonds since it implies that inflation should come down a bit, and the inflation measures we use (like the CPI) will likely drop as well. Remember: bullish for the bond market means higher demand and higher bond prices -- which causes lower interest rates. You can read about this in an article from MarketWatch.com.

To further understand what is happening, remember our basic model of nominal interest rates (r):

r = f(expected inflation, economic growth, monetary policy)

Today, the news caused expected inflation (and actually expected growth) to moderate, causing nominal interest rates to fall. Remember: you can also explore this by using the ratio TIP:TLT in StockCharts.com, or take a look at the TIPS spread from Bloomberg.com (the link is: http://www.bloomberg.com/markets/rates/index.html ). You should bookmark this link.

When at Bloomberg.com above, page down to the graph. This is today's yield curve. Then, click on the tabs for different countries. Compare the interest rates (say 10 year) for the different countries listed.

Finally, oil prices bounced off support at $60 today. Graph $WTIC in StockCharts.com. Look to the left from today's values to see where support lies. You will see a $60 support point from early March of this year. Had this support not held, the prior support of just under $58 that I mentionned in class would be the relevant level. There was a bullish divergence in effect which makes today's move not entirely surprising. Oil price was falling while the RSI was making higher lows.

The question now is how long this upward move will hold. How far might it go? Resistance, remember?

Bearish Divergence As A Leading Indicator of Price Change

Cyclical stocks ($CYC) move in the same direction as actual or expected economic growth. As a market, this is itself a leading indicator. And, its changes contain real-time information on market expectations concerning growth.

As you know, yesterday (9/21), two indicators were released that caused markets to change sentiment -- reflecting the belief that the economy would weaken farther and possibly faster than was previously expected. On yesterday's blog post, I detailed how this affected the 10-year bond rate. That rate fell again today (to 4.6%). With the expectation of slower growth, cyclicals should also weaken. And they did.

In the handouts on technical analysis, I detailed what is called a bearish divergence: price action moving higher but the RSI not experiencing higher highs. This is a leading indicator of a downward move in price in the near term. Note this is not 100% accurate, but it has a fairly good track record.

I have included a graph of cyclical stocks where such a bearish divergence is evident (and marked). Click on the chart to enlarge it.


Based on this bearish divergence, one should have expected some decline in cyclicals, and thus the perception of a weakening economy gaining traction. THIS DOESN'T MEAN THE ACTUAL ECONOMY WILL NECESSARILY WEAKEN -- JUST THAT THE EXPECTATION OF THE MARKET IS THAT IT WILL WEAKEN.

To earn extra credit, get the chart of cyclicals and using weekly data for the past two years, annotate the chart, drawing lines and adding comments. Determine if a bearish divergence occurred. Also, draw the support line for weekly data and a possible support line for the Relative Strength indicator. This will be accepted no later than the beginning of class on Monday. No pencil or pen lines will count.

The next test is to see if the support line (indicated in the graph) is broken next week. Note that cyclicals have been underperforming the overall market (based on a declining Relative Strength (below the graph) since early May. It is also possible to draw a support line for the Relative Strength indicator.

Soft Landing?

The economic indicators released today raised serious questions about how rapidly the overall economy is slowing. Prior to today, the consensus view was that economic growth would continue to slow, but not by enough to seriously crimp profits. Along with this, the Fed would be done raising rates, and might even begin rate cuts by the middle of 2007.

Two reports in particular, the Philadelphia Fed's Economic Activity Index was a negative value, well below the concensus (of around 13). Also, the Conference Board's Index of Leading Economic Indicators fell for the fourth time in the last five months. Hardly an endorsement for future economic strength. Read about these developments in an article.


















This percieved future loss of economic strength affected interest rates. The benchmark 10-year government bond fell by 8 basis points. Furthermore, by the end of the day, this rate had fallen to its support level from mid March. I have provided a chart using StockCharts.com (click on the graph to enlarge it). Note that at its present level, the 10-year is only slightly overbought and that short-term resistance is not the 200-day moving average. (NOTE: divide the right-side scale by 10 with this interest rate)

Is the Market Headed Higher?

We discussed technical analysis a bit in class today along with sector rotations. When the economy is slowing, you will observe a rotation from sectors that do well with a strong economy (like cyclicals ($CYC) and discretionary spending (XLY)) toward more defensive sectors like consumer staples (XLP), telecommunications (IYZ), and public utilities (XLU).

A good article dealing with this by Michael Kahn of Barron's discusses this. It provides more practice as you learn the material from the handouts today. He points to relative strength as an indicator (recall this is a symbol or index divided by the overal S&P 500). When the relative strength graph is upward sloping, that market is outpeforming the overall stock market. For XLP, that has been the case since mid April.

Finally, note how you can apply lines to other measures such as advancing issues versus declines, or as Kahn's article shows, advance volume vs. decliner volume.

CLASSROOM and Practice Exercise

Today our classroom permanently moved to CHAFEE 219. Please note this.

As you read your technical analysis material, go to StockCharts.com and practice by working with the graph for oil (symbol $WTIC). Where is the trend? As people ask where oil price is likely to go, you can use the chart and see the past levels of support. When a price graph is falling, LOOK TO THE LEFT and find a previous level of support. What price is it? Annotate the graph. My handout says how to print this if you want to keep a record of this.

Note that on StockCharts.com, you can use either daily or weekly time frames. Perform the above analysis on the daily chart, note past support, then switch the frequency to weekly. Do the same thing. Where is weekly support?

Technical Analysis Practice

You should be reading Stikki Stock Charts (finish it for class Wednesday). Let me refer you to a free article from Barron's Online by Michael Kahn -- someone I will be referring to throughout the semester.

His most recent article, Will September Be the Cruelest Month , contains several technical formations and tools that we will be discussing all semester. These are introduced in Stikki. Feel free to read though the archives of Mr. Kahn's column as well.

You should visit StockCharts.com. I have a set of downloadable notes on the online syllabus that detail how to use this site. Try it. It's actually quite easy, and you have the entire semester to gain proficiency with it.

Assigmnent #3

A number of persons had incorrect answers for the first two questions in Assignment #3.

1. As Md = f(r) but not a function of Y => Md is downward sloping but it does not shift for changes in Y. Thus, there is only one equilibrium r, no matter what the level of Y is. Therefore, the LM curve is horizontal.

2. You need to read the chapter on AD - AS for this. Yf is obtained when labor market equilibrium occurs (where labor demand = labor supply). This gives L*, which when plugged into the production function gives Y* (or Yf).

3. The data you obtained was for the nominal interest rate (the 10-year constant maturity rate) and the real interest rate (the Treasury-Inflation Indexed note). The basic formula to relate these is:

Real r = Nominal r - expected inflation

Solve this for expected inflation:

Expected inflation = Nominal r - Real r

The result is what is referred to as the "TIPS spread." It provides a real-time measure of the value of inflation expectations for the next 10 years (in this case). REFER TO THIS IN THE FUTURE AFTER YOU COMPLETE THIS COURSE -- IT IS VERY IMPORTANT AND OFTEN REFERRED TO.

THIS WEEK - WHAT TO WATCH

The big story, which we discussed in class this past week, is the rise of long-term interest rates. The 10-year ($TNX) has risen past two resistance lines over the past several weeks, and is now above the psychological 5% barrier. Next resistance is around 5.3% (I was kind in class when I used this, the preferable point is more like 5.45%). Note the recent trends surrounding this: mortgage rates rising; the dollar gaining strength; expectations for a slower pace of economic activity in the second half of this year are being reinforced.

This week, there are several critical reports to watch. There will be both a CPI report and a PPI report. Also, the minutes of the last Fed meeting will be released. All of these contain important and market-moving information. If you want a real-time indicator of inflationary expectations relevant to the 10-year bond, view the behavior of Treasury Inflation Protected Security prices (TIP) relative to bond prices for longer duration (TLT). To evaluate this, try viewing the ratio TIP:TLT on StockCharts.com. Switch from candlesticks or OHLC bars to lines, and add RSI(9) as usual. IN REAL-TIME, what are markets saying about expected inflation? How is this different from what the reports are saying? Also, check to see how this changes after each report is released.

Also view the yield curve. You can see this either from Bloomberg.com (under Market Data and rates) or Bondheads.com. If you use Bloomberg.com, click on the tabs to see the yield curves for other countries. Want to see a really strong positive yield curve? Try Japan. Interestingly, the British Pound has been appreciating relative to the US Dollar lately. Check out their yield curve. What does that say about their economy in the coming months? What about Pound strength relative to the US dollar going forward? Hmmmm.

We'll talk more about all this during class. But you should begin to follow trends like these and different variables to understand how the economy is performing now, or how things will likely change in the future. THIS IS ESPECIALLY USEFUL FOR YOUR FORECAST PAPERS!!

Dollar Strength

The strength of the US dollar is something that has been hotly debated of late. If you follow this measure each day, you see "ups" some days and "downs" on other days, but no dominant pattern (at least if you follow the financial press).

How should you follow the dollar? The dollar index ($USD) measures the strength of the US dollar against its major trading partners. It is not a bilateral exchange rate. Think of the dollar index as an equilibrium price -- in this case for the dollar. How is this price determined? Simply by supply and demand. So, you can use the supply and demand for dollars by the US and its major trading partners to model this variable. I will also refer you to my handout on Flexible Exchange Rates.

At the present time, it appears that relative US interest rates are the most important driving force for the Dollar Index. The Fed's indecision about whether it is done raising interest rates (at least in its post-meeting statements) has lead to recent market uncertainties and dollar "bounces." This is critical in light of recent slowing by the housing sector which has done much of the "heavy lifting" for our economy the past few years (an article about this).

In the last few days, the 10-year government bond ($TNX) has gained significant ground, breaking through resistance, finishing the day at 4.85%. This is NOT a good time to have money in bond mutual funds (see article).

How high will the 10-year go? To answer this, first examine a chart of $TNX and find support and resistance. Where is the next resistance? Are we close to that now? For extra credit (part 1), graph the 10-year bond using weekly data for three years in StockCharts.com. Change the moving averages to 10 and 40 periods (this makes them comparable to daily values of 50 and 200). Annotate this graph going back as close to the beginning of the three-year period as is necessary and draw relevant support and resistance lines. Print this out in a Word document. (do not hand draw the lines).

The other relevant question is how tied to interest rates the US Dollar is. According to economic theory, it is very tied, for reasons outlined in class and on the handout for Flexible Exchange Rates. For extra credit part 2, make a graph of the US Dollar Index ($USD) as a dotted line, remove the moving averages, and select Price as one of the indicators -- use $TNX -- and place this behind the dollar graph (this is done by changing the box from "below" to "behind price." Past this into the Word document and in one paragraph discuss how these two variables are related. Is it what theory leads us to believe? Bring this to our next class. It is due at the beginning of class on Tuesday.

In order to determine whether the 10-year bond might break beyond current resistance, you can use the model of interest rates we developed in class at the beginning of the semester. A forecast by you would allow you to make an "educated" guess as to whether we will break through the next resistance.

Rates Breakout

The big story this week is the rise of the ten year bond rate ($TNX) above resistance (both R1, as discussed in class, and now R2). This rate closed Friday at 4.684%, its highest level in more than a year. The main "fuel" for the breakout beyond R2 is a rate hike by the European Central Bank, a higher-than-expected inflation reading in Japan, implying they will begin raising rates, and several strong indicators in the US (read story about this).

There is great potential significance to this breakout, assuming it remains in tact. IF this turns out to be the bottom for bond prices, rising 10-year rates will translate into rising mortgage rates, bad news to a sector already weakening that has provided so much of the basis for economic advance. Second, bond prices tend to peak ahead of stock prices (historically), so the days of a bullish stock market might be numbered (REMEMBER my lecture on the signal given by declining year-over-year growth rates in real GDP and Real Personal Consumption Expenditures). Fortunately, though the yield curve had inverted in the most relevant way (3-month rate higher than the 10-year rate), this has reversed for now. Stay tuned!

There are "talking heads" saying that everything is well and stronger times are ahead. A good example is recent statements by Fed Vice Chairman Ferguson (read article). While I do believe we are not about to fall into the abyss of recession in the near term, I don't expect some surge in the level of economic activity that will be sustained for a number of years. That's what the persons who follow rates of change assume. As I stated in class, I am one of the rate of change in the rate of change crowd!

Finally, how does one find the new level of resistance for $TNX? I suggest switching the time frame in StockCharts.com from daily to weekly and extending the time period from the default of "Fill the Chart" to 3 Years. In other words, LOOK LEFT. WHEN USING WEEKLY DATA, CHANGE THE MOVING AVERAGE SETTINGS (divide the usual values by 5 due to 5 trading days per week). So, instead of 50-day and 200-day Moving Averages, change these to 10-week and 40-week values, respectively.

January PPI

This morning the government reported that for January, the Producer Price Index (PPI) rose by more than was expected. The overall PPI grew by 0.3% (compared to December), while the less volatile core rate, which excludes both food and energy, rose by 0.4%. This signals that for January, at least, "wholesale inflation" was worse than thought (read an article about this and compare it to another article).

What do you suppose the reaction was in the bond market? Normally, a "hot" inflation number will cause a bond sell off, pushing bond prices down and interest rates higher. Today, however, the opposite was the case -- rates actually fell. How could this happen?

Remember, when we analyze this market, we must, of necessity, consider "other things being equal." Today, that was not the case. First, the number itself might have been bad, but this is only the first bad number in a while for the PPI. And, never pay too much attention to the value of an indicator for a single time period. Second, the shocking rise was on a sequential rate of change, comparing December to January. When an alternative comparison is used, comparing this January to last January, called the year-over-year growth rate, that number was actually fairly good (1.5%), and below the year-over-year growth rate for December (of 1.7%).

As this was happening, oil prices continued their recent rise, moving from around $58 per barrel just a few days ago to $61.29 today. Again, this would normally be bad for bonds, which makes the PPI story even more interesting. For extra credit, due at the beginning of Tuesday's class, go to StockCharts.com and plot the price of oil ($WTIC) with the 9-day RSI and the Relative Strength compared to the S&P and annotate it with comments and lines that summarize the main aspects of its performance over the last week or two.

Finally, the University of Michigan's Consumer Sentiment Index fell more than expected today, further reinforcing the upward price movement in bonds.

S&P Breakdown -- Technical Analysis (click to enlarge)

January Employment Report

The jobs report yesterday had some surprises. The "headline" employment number rose by around 190,000, below expectations. But prior month totals were revised upwards. You should always view revisions to prior data when judging newly released data -- on anything.
To read a story about this click here. Look briefly at the overall report as well.

There is more to the employment report than just employment. It also contains data on the unemployment rate, hours worked, and the average hourly wage. It was these that triggered the ultimate reaction by the stock and bond markets. Average hourly earnings rose a greater-than-expected 0.4% for the month and 3.3 percent for the year. Along with the disappointing productivity number on Thursday, this further reinforced inflation fears. As a result, there was an initial rise in bond interest rates (remember this from class -- the inflation premium in interest rates increased, pushing up nominal rates). The stock market also reacted badly. Why? Two things. First, higher interest rates are bad for stocks. We will see in class this coming week that this entails a substitution of interest-earning assets for stocks, and it lowers the present discounted value of expected profits. Second, the acceleration of inflationary expectations means that the Fed will not be finished raising interest rates very soon as had been thought. In fact, the belief that the Fed was almost done raising rates is what led the Dow-Jones Industrial Average over the 11,000 mark earlier this year.


From a technical analysis point of view (read Stikki Stock Charts if it ever gets here), this means that the resistance encountered by the Dow-Jones average at 11,000 held, and that it will likely hold for a while. A similar argument pertains to both the NASDAQ and the S&P 500 (those doing this as your forecast paper topic should start to follow this). The pressing question from a technical point of view is therefore, where is support for each of these markets. For the S&P 500, prior resistance at 1,275 had been exceeded (i.e., a breakout occurred). And, as typically occurs, priror resistance became support during the breakout. Now, unfortunately, things have reversed once again -- 1,275 is once again resistance. Support (for now) is at 1,250.

In the blog entry above this one, I have provided a graph of the S&P 500 and the recent breakdown from a triangle formation. Not a very flattering picture. Why? Besides the obvious declines, I have added information about the RSI (I will distribute the handout for this soon). The bad news is that the RSI is not yet in oversold territory (RSI <30), so this decline might have a ways to go yet.

GDP Report

Friday's report on Q4 GDP growth was both surprising and disappointing. Yet the stock market posted a very strong day in spite of this number. Why?

First for the GDP number. The reported growth rate, 1.1 percent, is much smaller than what was expected (around a 2.6% rate). But examination "below the surface" of this number reveals some trends that are either one-time in nature or just plain incorrect. Government spending fell at a double-digit rate from Q3 to Q4. What's the probability of that repeating? Not much. Also, the amazing car sales prompted earlier in the year by major discounts essentially "stole" sales from the end of the year, making the Consumption growth rate much slower than is realistic to expect for this year. Then there is the fact that Friday's number is preliminary, using ESTIMATED values for Net Exports and Inventories. These may also be revised in the next two relases of Q4 data.

So, why the stock market response? Other things being equal (which we spoke about in class on Thursday), this should have hurt stock prices. But "other things" are seldom equal. Housing data released the same day were encouraging. Several large companies reported strong earnings. But, in a sense, the GDP number itself was a "win-win" for the stock market. IF it is correct, then the clear implication is that the Federal Reserve will have almost no further tightening to do. This is beneficial to stocks, since rising interest rates are bad for stocks (we will go over the reasons in class over the next two weeks). But assuming this growth rate is too low, which is a very safe bet, this implies profits, which are a fundamental driver of stock prices, have remained strong going into 2006. And the stronger are profits, the higher stock prices tend to move (other things being equal, of course).

We will cover this topic in detail on Tuesday. Make sure you bring the Online Notes for GDP to class with you.