FED STATEMENT HINTS AT HIGHER RATES SOONER -- BOND YIELDS JUMP -- OVERBOUGHT MARKET MAY BE STARTING CORRECTION

BOND YIELDS JUMP... The Fed took the bond and stock markets by surprise today by dropping their commitment to keeping short-rates low "for a considerable period of time". That was interpreted to mean that the Fed was a step closer to boosting rates. The result was predictable. Bond prices fell sharply and yields jumped. Chart 1 shows the 10-year T-note yield surging after the Fed's announcement. Last week we showed the yield testing its prior low formed at the start of last October. Today's jump also puts the yield back over its 200-day moving average. The prospect of higher rates caused selling in an overbought stock market. Not surprisingly, some of the biggest losses were in rate-sensitive financials and homebuilding stocks. It doesn't help that some of the major stock indexes are testing overhead resistance levels.

Chart 1

DOW BACKS OFF FROM RESISTANCE LEVEL... The Dow Jones Industrial Average has reached a potential resistance barrier at its early 2002 peak at 10673. It moved above it briefly on Monday. However, it's back below that barrier and is in danger of suffering a downside weekly reversal. [A downside weekly reversal occurs when prices trade higher during the week, but then close lower than the previous Friday]. If it happens at a prominent resistance barrier, the downside reversal is more serious. It's even more serious if the market is in an overbought condition. And it is. The 14-week RSI line has been in overbought territory over 70 since December, but is starting to turn down (red arrow). The last major signal in this indicator took place in October 2002 when it turned up from oversold territory under 30 (green arrow) which corresponded with a major bottom. The Nasdaq Composite has also slipped back below its early 2002 peak near 2100.

Chart 2

HOMEBUILDERS SLUMP... Homebuilders are very sensitive to the direction of interest rates. Last Friday we showed how a dip in interest rates had produced a bounce in the group. We showed Centex in the process of retesting its December peak and how several of the stocks had climbed back over their 50-day moving averages. Not after today. Centex suffered a nasty downside reversal day on rising volume. KBH has fallen back beneath its 50-day moving average -- also on rising volume. In my opinion, homebuilders are one of the most vulnerable groups to a rise in long-term rates. And they showed that today. Financial stocks in general were also among the weakest stock groups today.

Chart 3

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SEASONAL BULGE IS ENDING... Seasonal factors may also be playing a role in this week's stock market setback. We've pointed out many times that the three months from November through the end of January are historically the three strongest months of the year. That seasonal bulge is ending. February isn't historically a good month. To quote the Stock Traders Almanac "Sharp January moves usually correct or consolidate in February". That would fit with the idea that the market is putting in a short to intermediate term top. Some pockets of strength in the market today were in defensive groups like drugs and utiliities. Profit-taking in gold stocks continued. The AMEX Gold Bugs Index failed a test of its December high earlier this month and has been trading under its 50-day average for two weeks. Selling in gold stocks hint at a higher dollar. A higher dollar hints at higher interest rates. That's what's got the bond and stock markets worried.

Chart 5