Road to Dow 12,000 Hits Some Potholes

Core CPI and signs of extreme optimism give pause.
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The

Dow Jones Industrial Average

may have hit another all-time high Wednesday, but bearish divergences and core inflation data are calling investors' bullish certainty into question.

The headline consumer price index increased 0.2% in September. While that was in line with expectations, the increase brought core inflation to 2.9% on a year-over-year basis -- its highest level since July 1996. This came in as housing starts surprised to the upside, but building permits remained weak.

In the stock market, a quick burst past the Dow 12,000 threshold early Wednesday morning drew a bout of serious selling pressure. While the market rebounded somewhat in the afternoon, several indicators point to a possible pullback and disappointing results and/or guidance after the bell from

eBay

(EBAY) - Get Report

,

AMD

(AMD) - Get Report

and

Washington Mutual

(WM) - Get Report

that could portend more weakness Thursday, although

Apple

(AAPL) - Get Report

did surprise to the upside. (Apple and eBay shares were up in after-hours trading, Washington Mutual and AMD were down, the latter by over 13%.)

Housing has been the key to many forecasts of slowing growth, but Wednesday's housing starts fuel the argument that the residential-real estate slowdown has bottomed. September housing starts jumped 5.9% in September, marking an 18% year-over-year decline. But the more forward-looking measure of building permits fell 6.3%, their lowest level since 2001.

"The rise in September starts, if maintained, points to a dissipating but continuing rate of decline in residential investment over the remainder of the year," writes Gary Bigg, economist at Banc of America Securities. "With a high level of units completed and a decline in building permits, housing construction will remain weak into the new year."

When looking at inflation, the headline number for both the producer price index and the CPI came in lower than expected due to the huge decline in the price of energy. While the 2.9% year-over-year core CPI is a scary number, many will argue that just as higher headline inflation feeds into core measures with a lag, so will lower headline measures flow into core readings down the road. By the same token, how long can the

Federal Reserve

let inflation run at these levels without losing its credibility?

The Fed has been slightly more hawkish of late, dampening the expectations for a rate cut that were priced into the Treasury and fed funds futures markets. The message has been clear -- growth has not slowed as quickly as we expected, and inflation remains a threat. Wednesday's data had a little bit of everything in the growth vs. inflation debate.

"Ultimately, the Fed will have to meet the inflation threat with higher rates," says Michael Darda, chief economist at MKM Partners. "For now, the data is too mixed."

The fed funds futures market eked out slightly higher odds of a rate hike on the heels of these data points. The market prices in 6% odds of a rate hike at the January FOMC meeting, up from 2% last week, according to Miller Tabak. The new odds may be slim, but they reflect a major shift, sentiment-wise. At the start of September, the market priced in 50% odds of a rate cut in January.

Thus far, inflation fears haven't crept into the stock market. But if odds of a rate hike continue to climb, eventually the Fed and the stock market will stand up and take notice.

Instead, the Dow set its sights on 12,000 and made it there Wednesday, but it didn't stick. The Dow reached an intraday high of 12,049.51 early in the day behind strength in

IBM

(IBM) - Get Report

. But the index struggled thereafter and ended the day up 0.4% at 11,992.68. The

S&P 500

gained 0.14% to close at 1365.96, while the

Nasdaq Composite

ended the day in the red, down 0.3% to close at 2337.15.

Even amid the new Dow high, some traders say the market feels shaky.

"It is a textbook top for the short-term," says Alex Grace, hedge fund consultant and trader, who noted the textbook bottom

back in June. He says the morning began with the TRIN, which measures strength in the market as measured by the ratios of advances to decliners divided by the ratio of up volume to down volume, at an extreme level. The 55-day moving average for the TRIN on the Wilshire 5000 was at 0.97 Wednesday, compared with 1.19 in mid-July when the market was near its bottom, Grance notes.

Combined with a four-year high of 73% bullish reading from MarketVane on the S&P 500 futures, optimistic sentiment seemed at a peak, which is often a sign of a market top, according to contrarians.

Grace also noted so-called bearish divergences, including the relative-strength index, or RSI, which did not confirm the Dow's move higher. The index made a new high, but the RSI did not. Lastly, the Dow Jones Transportation Average, which many believe needs to participate in any sustainable market rally, experienced a 0.9% loss on the day.

Meanwhile, semiconductor stocks weakened in the wake of

Intel's

(INTC) - Get Report

capex cut and disappointing guidance from

Linear Technology

(LLTC)

and

Novellus

(NVLS)

. While Intel did rise 1%, the Philadelphia Stock Exchange Semiconductor Index slid 2.8%, as Novellus and Linear each lost more than 7%.

The market hates uncertainty, so while incoming data is engendering some raised eyebrows, earnings are not. All balances out to new highs, but perhaps more cautious ones.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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