Navarroâ�,��"�s Big Economic Picture

This was a good week for my January prediction that weâ�,��"�ve hit a market top for the year and a bad week for the market.  The only thing missing from the bearish party was volatility â�,�“ which at least some pundits see as a bullish sign that the market was merely resting rather than turning over.

Fundamentally, however, it was hardly a good week.  Not only did oil prices firm and the Fed hike interest rates again.  The Fed funds future now point to at least two more rate hikes through June that will push us to 5% -- a nice round number that is likely to make the market flat, at the very best.

In fact, the marketâ�,��"�s action closely mirrored the concerns I had expressed last week regarding the economic news.  The big deal was the fall in productivity â�,�“ an ominous sign of wage inflation, which was indeed revealed on Friday by a robust wage cost number.  Most disturbing is an unemployment rate of 4.7%, which is below potential output and therefore boomishly inflationary â�,�“ unless you believe that the fall in the rate was driven by folks leaving the work force.

So the short story is one that looks more and more like a replay of 2000 â�,�“ a late stage expansion that suddenly vanished in a puff of market smoke.  While it may be too early yet to put Rest in Peace on the 06 bulls, the risk/reward is tipping to the shorts.

Navarro's Macroeconomic Calendar & Market Movers

Itâ�,��"�s a very, very light calendar this week, with the one hope for market volatility riding on the trade report on Friday.   Itâ�,��"�s difficult to see the trade deficit going down so the risk is more towards the bearish side of the market..  This isnâ�,��"�t even worth talking about so look to other news to fuel the markets.

Hedging Your Bets With Matt Davio: As the Russell 2000 Goes, So Goes (Down) the Market

Weâ�,��"�ve had three years of bull market activity on the Russell 2000 (RUT) index since the war in Iraq started in the Spring of 03.  The mighty mouse RUSSELL went from 343 to 736 most recently last week.  So the smallest stocks have led this rally from the onset with an over 112% run up.  The way I see this move is that the smallest and most volatile names have been the easiest place for the reflationary efforts of the Fed to be put to work. Note that we have not had the same type of action in the â�,��"realâ�,� solid stalwarts of the American economy, the Dow 30 and the S&P 500 stocks.

Now letâ�,��"�s look at this from a technical analysis perspective:  If you look at the first power move of this index from 343 to the intratrend high of 606.42, then take a look at the next low from that power move of 515, and subtract the latest high of 736, you get almost a mirrored move in the index.  This still projects a move possibly up to 778 or so.   Technically, I have found that over time many moves â�,�“ whether it be that of individual stocks or indices -- move in two steps that mirror the first original move.  Over the last 3 years, those moves have now been completed for the RUSSELL.   Hereâ�,��"�s what I think that might mean:

I first make the guess that the broader market, which has been led up by the Russell, will follow it as we continue into the future. The question is whether money will continue to pour into the smallest of small cap companies or will we begin to roll over on the downside?   I think not â�,�“ at least not for much longer.  The index is at around 735 but my projected top is around 775, which is merely another 5%.

The reason I think this is that the final parabolic piece of this move may have just occurred in January.  January saw the RUSSELL increase by 9.2% alone in January of 06. This is the biggest one month move the Russell index has seen since this rally began over three years ago.

Now it may take some time for this momentum to wane, but the earnings period we recently finished was mediocre at best in my eyes overall. I would anticipate a trend change in small cap stocks leading the rest of the markets down as we proceed through 2006.

I still anticipate a major move down in the broader US indices led by the RUSSELL due to what may turn out to be the final parabolic move we just witnessed.  Letâ�,��"�s see how this develops, but I can say that my money will be betting against small cap stocks from this point on and although I may be early, I feel they will lead the markets through an extremely volatile and exciting 2006.

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.

DISCLAIMER: This newsletter is written for educational purposes only.  By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.  Trading and investing involves high levels of risk.  The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader.  The authors may or may not have positions in the financial instruments discussed in this newsletter.  Future results can be dramatically different from the opinions expressed herein.  Past performance does not guarantee future performance.