Stocks Seek Silver Lining

Even housing is seen as a potential positive as the S&P hits a five-year high and the Comp jumps 1.4%.
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As the housing-market drama approaches a potential climax, benchmark highs for the major averages are upon us. Monday's decline in existing-home prices was not as deep as expected, and it may cleave a turning point in the housing slowdown. Traders think they see the bottom in view, which gives the bulls and the

Federal Reserve

more credibility in terms of the soft-landing scenario.

The stock market embraced this sentiment, along with some quarter-end buying, Monday afternoon. In reaction, traders pushed the

Dow Jones Industrial Average

toward an all-time high, while the

S&P 500

set a new five-year closing high. The bond market, too, is still on a bull run, as those investors drove the 10-year note up 10/32 to yield 4.55%, its lowest level in seven months.

"The stock market continues to back and fill, and most interestingly, not go down," writes John Bollinger, president of Bollinger Capital Management. "We've had a coup in Thailand, the meltdown of a major hedge fund, some really poor housing numbers and so forth, but stocks seem to be able to resist any significant downside response. That is quite bullish from a contrarian perspective."

The S&P 500 finished the day up 0.9% at 1326.37, the highest level since February 2001 but a high for the year by only 0.62 points. The S&P 500 remains 13.16% from its all-time high. The Dow gained 0.6% to close at 11,575 Monday, just 0.57% from its May high and 1.25% from its all-time high. The

Nasdaq Composite

gained 1.36% to close at 2249.07 Monday. This is 4.1% off of its May highs and still over 50% below its all-time highs.

Major averages benefited from advances in tech stocks such as

Broadcom

(BRCM)

and

Apple

(AAPL) - Get Report

, cyclicals such as

Caterpillar

(CAT) - Get Report

and telecoms like

AT&T

(T) - Get Report

.

Such strength helped overcome weakness in

Altria

(MO) - Get Report

, which tumbled 6.4% after a federal judge granted class-action status to a lawsuit that could include millions of smokers of light cigarettes, and renewed weakness in drug store chains, such as

Walgreens

(WAG)

, amid concerns about the competitive threat from

Wal-Mart

(WMT) - Get Report

.

Bollinger's comment about the market's resilience comes amid concern from other technicians about the lack of confirmation as the S&P and Dow hit major highs.

The Dow Jones Transportation Average, most notably, has diverged from the other indices' advances, falling 13.11% since reaching an all-time high in May. The average has failed to gain steam behind any advance back to those levels despite the decline in the price of oil. (Oil prices traded below $60 intraday Monday before rebounding to close up 90 cents to at $61.40.)

The Transports finished up only 0.4% Monday. Last Wednesday, when the Dow came within 109 points of its January 2000 all-time high of 11,722, the Transports were similarly lackluster and barely closed in the green, notes Jeffrey Saut, chief investment strategist at Raymond James. "These continuing upside non-confirmations by the

Dow Industrials and the

Dow Transports are worrisome, as are similar upside non-confirmations by the S&P Mid-Cap Index, and the operating companies only advance/decline line," he writes. (Saut incorporates an advance/decline measure that eliminates preferred stocks, closed-end funds and other non-operating entities that trade on the NYSE.)

Merrill Lynch's chief market analyst Mary Ann Bartels agrees the push to test the highs is suspect and October is a danger zone. "We do not believe this is a new leg of a bull market move and prefer to remain defensive into October," she writes, adding that the "recovery highs" would "not likely be confirmed by a broad array of technical indicators." Bartels expects a 15% to 20% correction in the major averages during the fourth quarter of this year, providing "an important buying opportunity."

The market keeps advancing in the face of all this mistrust, however, with the best recent performance coming from the growth sectors like housing and technology. In such an environment, is defense really the best offense?

Housing Matters

In economic news, the National Association of Realtors reported a 0.5% decline in home sales in August, to a pace of 6.3 million units -- higher than the 6.2 million units analysts expected. Home sales are down 12.6% year over year, and inventories of existing homes grew 1.5% to a seven-and-a-half-month supply.

Most importantly, the median price of new homes fell 1.7% from a year ago -- the first year-over-year decline since April 1995 and the largest since the 2.1% decline recorded in November 1990.

"There is a silver lining to this, where the decline is of a smaller magnitude than expected," says Art Hogan, chief market strategist at Jefferies & Co. "This is more bullish. We've been talking about the real estate bubble bursting for the last three years, and we haven't seen it, and we're not seeing that."

That said, "You'll probably see some more weakness" in housing, says John Lonski, chief economist at Moody's Investors Service. Those who bought a home in the second half of 2005 will feel the pain of price declines, he notes. Otherwise, home prices have risen an annualized 7% from the two years ended August 2006.

As for the bottom, Lonski says the late-August bottom in mortgage applications suggests that home sales will bottom by December of this year. Mortgage applications are a near-perfect indicator of near-term home sales, he claims, noting the four-week moving average of mortgage applications is up 2.7% since Aug. 25.

The market has been feeling around for a bottom in housing for a few weeks already. The chief executives of homebuilding companies have been crying out warnings about the horrid market, but their stocks have diverged from that bad news and gone up. The same was true Monday.

The

Philadelphia Homebuilders Sector Index

gained 2.4%, while homebuilders such as

Toll Brothers

(TOL) - Get Report

and

Lennar

(LEN) - Get Report

gained over 2%.

KB Home

(KBH) - Get Report

and

D.R. Horton

(DHI) - Get Report

added more than 3% on the day.

Indeed, with rates still low and prices coming down, now is the time for home buyers to flex their buying muscle, says Lonski.

The still relatively low mortgage rates are keeping the housing correction from an implosion. A soft landing in the housing market is a touchy accomplishment and arguably the Fed's chief focus when it comes to rates.

Dallas Federal Reserve President Richard Fisher said as much Monday. The Fed is watching the housing market closely, Fisher said, noting that "we have a serious correction taking place." But "we are fortunate that the rest of the economy is healthy and robust," he added.

The Fed is likely just paying lip service to its role as price stabilizer when Bernanke and FOMC members speak about the persistent threat of inflation.

The markets agree, as the fed funds futures market and the Treasury market are increasingly baking in a rate cut. The market is priced for 2% odds of a rate cut at the October FOMC meeting, 20% odds for a cut in December, up from 12% on Friday, and 50% odds of a cut in January, up from 40% on Friday, according to Miller Tabak. (That said, a soft-landing could just mean a stronger-than-expected economy later in 2007 and a resumption of Fed rate increases sooner rather than later, but that's for another day ...)

But even amid a potential end to the housing correction and a soft landing for the economy, many still don't trust the 2006 late-summer rally. Contrarian's delight, indeed.

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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