Becoming a nervous bull

The financial community generally interprets the "extended period" verbiage to imply a time frame of at least six months into the future. Under this assumption, the U.S. Federal Reserve, at a minimum, is unlikely to make any policy changes until at least early 2011.

Housing. In last week's edition of the Weekly Viewpoint, we pointed out that the foundation of the housing market was beginning to show some signs of cracks. Well, last week, the roof fell in. The Commerce Department reported that the purchase of new home sales in the U.S. collapsed in May. Sales fell by 33% to an annualized rate of 300,000 units, and now stand at the lowest level since 1963.

	Index	Closing Price 6/25/2010	Week Ending 6/25/2010	Year to date through 6/25/2010
	Dow Jones Industrial Average	10143.81	-2.94%	-2.73%
	Wilshire 5000 Total Market	11144.86	-3.61%	-2.42%
	S&P 500	1076.76	-3.65%	-3.44%
	NASDAQ Composite	2223.48	-3.74%	-2.01%
	S&P/TSX Composite	11707.85	-1.84%	-0.33%

While new home sales account for only a small percent of total home sales and the plunge can be attributed to the ending of the new homebuyer tax credit, the rate of decline was very worrisome. In addition, the National Association of Realtors reported that sales of previously owned homes unexpectedly fell by 2.2% in May to an annualized rate of 5.66 million units. The report appears to be another indication that housing demand was pulled forward by the homebuyer tax credit.

In a sign that things are likely to stay depressed in the near future, the Mortgage Bankers Association reported that mortgage applications during the week ended June 18 fell by 5.9%. Both the Purchase Index (-1.2%) and the Refinancing component (-7.3%) contributed to the decline. During the period the average 30-year fixed-rate mortgage rate fell to 4.75% from 4.82%, the lowest rate observed in the survey since the week ending May 15, 2009. Bottom line, the recent batch of housing data paints a grim picture for the near-term housing market outlook.

More signs of an economic soft patch. In addition to the weak housing data, the recent plunge in the Economic Cycle Research Institute (ECRI) Weekly Leading Indicator (WLI) is raising some eyebrows. The weekly index, published by the ECRI, is just off its lowest level in 45 weeks. Investors appear to be paying close attention to the index as it was fairly accurate in alerting economists to the economic peak in late-2007 and catching the economic trough near mid-2009 (although over longer periods of time the accuracy has been spotty).

The data appears to be raising fears of a developing double-dip in the economy. While we believe the odds of a double-dip remain low and a return to contraction is not likely to occur by the end of the year, there is no arguing that the overall economic recovery remains subpar.

Encouraging developments. On the economic front, the Labor Department reported that initial jobless claims during the week ended June 19 fell by 19,000 to 457,000, the largest decline in two months. Expectations were for a smaller decline of 7,000 to 465,000. The four-week moving average, which helps smooth the week-to-week volatility, fell for the first time in seven weeks.

Separately, the ASA Staffing Index picked up one point to 90 in the week ending June 13. On a year-over-year basis, the index is up 25%, as demand for temporary and contract workers continues to strengthen. Temporary help is considered a leading indicator, as it usually is a precursor to actual hiring. Elsewhere, the Commerce Department reported that durable goods orders during the month of May fell 1.1%. This was the first decline in six months. The weakness in May was led by a sharp drop in the volatile transportation orders component, however, when transports were excluded durable goods rebounded 0.9%, the third gain in four months.

Bond yields fall. During times of uncertainty investors tend to gravitate to what are referred to as safe-haven investments. These generally include Treasury notes and bonds from counties like the United States, Germany and Japan. The recent flight to safety has ignited a strong rally in the bonds of the aforementioned countries and pushed yields to near record lows (Note: Bond prices and bond yields move in opposite directions).

The action may be an indication that investors are positioning for a global double-dip recession and/or starting to discount a highly deflationary environment. At this juncture neither outcome would be very desirable as most Central Banks have run out of monetary bullets to help jumpstart economic growth and/or battle deflation.

Europe back in the news. After a brief respite and what looked to be a firming in the fiscal situation in Europe, the fear of default became front page news once again. Fears were reignited last week after rating agency Standard & Poor's made negative comments on the eurozone and opined that Greece has a 14% chance of defaulting. These comments were preceded by the credit downgrade of France's largest bank, BNP Paribas.

Adding to the negative sentiment was a statement in a draft document for the G20 meeting. According to the report, leaders are expected to warn that the economic recovery should not be taken for granted and that the huge amounts of stimulus afforded to the global economy could hurt long-term growth. Top all this with the Fed's statement that U.S. growth may be dented due to the problems abroad, and it becomes apparent why investors around the globe have become more skittish.

Technicals in focus. While we ultimately believe that fundamentals (earnings, valuations, etc.) matter, right now they are being pushed to the backburner. Traders appear to be more and more focused on technical analysis to help define and shape risk in the marketplace. This means moving averages, trend lines, as well as support and resistance areas are becoming a bigger part of investors' toolboxes and are being watched very closely.

Currently, the three major U.S. stock Indices (S&P 500, NASDAQ and Dow) are all trading below their 200-day moving averages, a potential sign that a change in the market's trend is occurring. In addition, other indicators are beginning to show that the near-term technical picture is beginning to deteriorate and may be signalling the potential for another down leg in the market. While we're not saying that it will ultimately come to fruition, we do believe the recent actions are worthy of raising a yellow caution flag -- hence the title of this report.

On a positive note (at least from a contrarian point of view) sentiment indicators have turned very bearish, the market is very oversold, and the VIX Index (fear index) is back to 30. These indicators suggest that a good portion of the downside may have already occurred. In trying to handicap downside risk, technicians focus on prior areas of "support." The next major support level for the S&P 500 appears to be in the 1040/44 area. This represents a level where selling pressure dried up three times in the past (early February, late May and early June) and buyers re-emerged. A violation of the 1040 level could lead to a retest of the 1000 area (round numbers tend to act as a psychological support level) and then the 943/45 area, which represents a 50% retracement of the March 2009 through April 2010 rally.

Financial reform. On Friday, the Senate and House reached an agreement on financial regulation with final approval expected by July 4. On the surface, the bill is expected to curb the level of risk taking by banks, put additional consumer protection measures in place, and give regulators additional oversight powers in an attempt to avoid future meltdowns. While specific details weren't readily available as of mid-day Friday, the financials sector staged a relief rally (+2.8%) on word of the deal.

As pointed out in last week's Weekly Viewpoint: "While the need to impose stricter standards on some parts of the capital markets is inevitable, the government's inability to clarify the regulatory process appears to be hampering investors' ability to evaluate the impact and therefore determine the eventual winners and losers. This indecision is likely partially responsible for the recent bout of volatility in the market place. It is well known that Wall Street dislikes uncertainty. While the regulatory bill may ultimately prove to be a negative for some financial institutions, Wall Street will likely figure out how to work within the new rule structure, however they must know what the rules are before that can happen. With the financials sector accounting for a 16% weighting in the S&P 500, let's hope clarity emerges soon…"

China's currency action: Lip service? Last week China announced it would adopt a flexible exchange rate policy, implying that the yuan would be de-pegged from the U.S. dollar. The initial reaction was favourable; however, investors may have jumped the gun in handicapping the near-term positive impact of the change. While specific details of the change are still hazy, the general feeling is that the action will result in a gradual appreciation of the yuan over time.

This should ultimately allow exporting-oriented countries to compete on a more level playing field with China and be viewed as a strong vote of confidence for China's economic outlook. The announcement may also help ease political tensions that have risen between China and the U.S. since last year, including accusations that China was deliberately undervaluing its currency to boost exports.