Betting On The Fed
After dropping to 8309 on terrible economic news the Dow rebounded on numerous buy programs to close just below key resistance at 8550. They say bull markets are created by bulls trampling over bears. There was some serious road kill on Friday with bewildered bears running about in utter confusion.
The morning reports and end of year unwinding by some funds knocked the markets back to support at the open. Leading those reports was a benign Jobs report which showed another loss of jobs in October as expected but was revised up from a -43,000 loss in September to only a -13,000 loss. When most were expecting whisper numbers in the -30,000 range for this month this report, while still negative, was not the end of the world. Manufacturing losses increased to -49,000 from -39,000 for Sept. There were several areas including short term employment where October showed declines that predict worse numbers in the November report. Business services lost -44,000 jobs in October. This entire report shows an economy that is on hold and suggests that it is clinging to the edge of the cliff but may not fall over. The unemployment rate did increase to 5.7% from 5.6%.
Construction Spending rose an unexpected +0.6% in September but the prior month was revised down to -0.8% from -0.4%. These are hindsight numbers and therefore are not as compelling but the unexpected gain in September was appreciated. Most analysts claim the economy came to a halt in late September so the October numbers may tell a different tale.
Personal Income rose less than expected at +0.4% but Personal Spending fell by -0.4%. We made less money and spent even less. The consumer is definitely pulling back and conserving but that could be simply a lull before the holiday spending begins. Add the falling consumer confidence and you get worry by retailers that they will have to come up with new and expensive promotions to get shoppers into the stores for that holiday season.
Automobile sellers have their backs against the wall after seeing record sales in prior months. The numbers released today showed that all the major manufacturers saw huge decreases in sales. GM -32%, Ford -35%, Chrysler -31%, Toyota -20%. The total vehicles sold fell to 15.4 million. This is down from huge numbers over 18 million in July and August. According to reports the sales have dropped significantly but they have also flattened. GM said they thought they would hold their October levels for November and added a new $2000 cash back component to the Zero, Zero, Zero program as an added incentive. While autos have held up the economy for two quarters they are not going to be a player going forward. Nearly everyone who can afford a new car has already bought one.
The biggest number on Friday was the ISM Manufacturing Index which fell to 48.5 and below consensus of 49.5. Any number below 50 is considered a contracting economy. This is the single component that could tip the scales in favor of a rate cut next week. This was the second month of contraction and indicated that inventories were continuing to shrink. Nobody is confident enough of the 4Q to invest money to create goods or inventory them if there are no sales ahead. The new orders component rose slightly but not enough to signify a new trend. The ISM has now posted four months of no growth and an increasing rate of decline.
A positive sign in some respects was a slight increase in semiconductor billings. They increased +3% in September and were powered by sales of application chips and wireless phones. While this growth is good it is not coming in the PC sector. The reduced capital spending in the sector is still warning of further concerns by the chip makers themselves. The breadth of chips is growing but not the depth. There are chips in almost everything now sold which builds volume but the quantity needed to see high profits is lacking. Everything points to a reduced demand of chips for computers and that means a real recovery is yet to be seen.
The economy may not be dropping at the same rate as it was over the last few weeks but the momentum is still slowing. Productivity continues to increase at a meager 4% but that is enough for an eventual recovery. It is just not low enough to build a case for huge rate cuts. The GDP is growing at a +3.0% rate and while not exciting it is growing. The 4Q GDP is expected to be in the +2.0% range or less but the year will still be respectable. Since the rally on Friday was a clear bet on a rate cut next week we should analyze that chance one more time.
Over the last two years we have had massive stimulus and are now enjoying an interest rate at decade lows. The economy is growing at a +3.0% annual rate as a result of this stimulus. Any new stimulus would not have a material impact to the current economy. It would be June of next year before any of it filtered down to the business level and the impact would be minimal. Cutting rates adds liquidity into the banking system. With money flowing freely the idea is to loan it out to businesses for capital equipment, construction, home improvements, home loans, etc. Cheaper rates are supposed to influence businesses to buy/spend on projects they would not have done at higher rates. It is hoped they will buy more, produce more inventory, create more value and inject activity into the economy. The problem today is not lack of money. There is plenty of money. The system is awash with it. The only people who want to borrow it are the ones without credit. Nobody wants to build buildings today so they can sit vacant for a couple years until the economy catches fire. Nobody wants to build inventory to fill warehouses and then have to write it down for a loss when customers don't buy it. Ask Cisco, Intel or Lucent if another 25 point cut would make their excess inventory age slower.
The only reason for a rate cut next week is because the market needs reassurance from Uncle Alan that they are still on the job and they care about our well being. It has been eleven months since they cut rates and even though they have done the trick the market is begging for more. How many times have we seen the market stuck in some trend that just seems to go on forever and suddenly something comes out of left field to break the trance? Analysts think another rate cut is that event. The market "should" continue to grow. There are signs that it has stopped falling in most cases but it just has not started growing. The conventional wisdom is that a rate cut next week will be an "insurance" cut that will guarantee no further slippage in the economy. We all know there are no guarantees. The economy will improve when it improves. The economy has the flu and just like there is no cure for the flu in people there is no instant cure for the economic flu. Everything has been done that can be done and now we just have to wait for it to pass.
The bullish contingent are convinced there is at least a 25 point cut in the wings and maybe even a 50 point cut. If 25 is good then 50 could be better according to the analysts. A 25-point cut is already priced in and therefore will have no real impact to the markets. (their words not mine) If the Fed really wants to make a statement they "have" to cut 50 points. They view the current conditions as similar to Japan which spiraled down over years to its current conditions. They feel a continued diet of 25 point cuts as conditions worsen will only set the Fed up to be in the same shape as the Bank of Japan with zero interest and no cuts left.
The bearish view is that there will be no cut. There has been zero Fedspeak that would imply there is a possibility. The only line is the party line of "more than adequate stimulus has already been injected". The Fed needs to retain all the ammo it has left to counter any future terrorist attacks and the possibility of a long war with Iraq. Why give the patient another antibiotic shot when he is already showing signs of improvement? The more antibiotics someone receives the more immune they become to future treatments. Another factor is the European Central Bank. They have been reluctant to cut rates and I am sure the Fed would rather not cut again until they do. If the Fed holds the line this week then the ECB may feel pressured to pick up the pace.
The wild card in the rate cut scenario is the election. I think the Fed has not come out to talk down the possibility of a rate cut to keep from negatively influencing the election for the administration. If you think about it the election outcome can influence the Fed's decision. A Republican victory that gives them control would probably lessen the possibility of a rate cut substantially. More items would get approved in Congress in a smaller amount of time. This would be implied stimulus. If the Democrats maintain control then gridlock might prevail and a rate cut might be needed to get the markets mind off the political outcome. The markets normally like gridlock because it means restrictive new laws take forever to pass and can get mired down for years. Currently they would love for gridlock to disappear so that new stimulus programs could be passed and spending increased.
Despite analysts comments to the contrary there is no sure answer to the rate cut question for Wednesday just like there is no answer to the election with so many races up for grabs. As investors the side we take depends on our bias. The bulls are buying stocks with the clear assumption that the Fed will cut rates and the markets will soar off into the clouds. Bears are closing shorts just in case the bulls are right. Nobody wants to be short if the Fed pulls a rabbit out of their hat. The difference in opinion sent the market back to resistance one more time and they appear poised to rally again on Monday.
As investors we need to be careful in putting too much faith in the rate cut scenario of our choice. A 25-point cut will probably result in an eventual sell off since this size of cut is already priced into the market. A 50-point cut could give the market an initial pop but there is still the possibility of a sell the news event after the remaining shorts cover. No cut at all would generate an immediate drop until the cut expectations were removed. The bottom line is that we have already had a strong run over the last four weeks and it will take a lot more to move it higher. There should be profit taking after the Fed meeting regardless of the outcome. With the Nasdaq up +13% in October and the Dow up +10.6% there is always the risk that new investors will want to wait before joining the crowd. Even if the Fed did cut rates 50 points Cisco announces earnings two hours later. How much is the market going to run with the CSCO axe hanging over their head?
What I think is more important this weekend is fundamental events occurring in stocks. Friday after the close the Microsoft antitrust case was decided in the favor of the current penalty settlement. This is very bullish and the stock was up strongly in after hours. This will buoy all the markets simply because MSFT is a major component in the indexes. (Ironically the Microsoft news could actually be detrimental to the rate cut possibilities. If the Fed sees the markets in strong rally mode sparked by Microsoft then they may not feel the urge to cut rates quite as strongly.)
Additionally the dockworkers reached an agreement on the west coast and the slowdown should end Monday. Supply lines will fill up promptly and the holiday season may not be hampered. The semiconductor sales numbers I mentioned above will continue to attract investors to the chip sector. There were also some rumors on Friday that there were about to be some large orders released in the networking sector. JNPR soared +18% on the expectation that the dry spell could be over. Cisco could be a bigger key than the Fed next week. With the Microsoft led rally on Monday, a favorable outcome in the elections and any cut from the Fed on Wednesday a positive Cisco earnings event could blow the lid off the market. The reverse is of course true if the rate cut is 25 points or less and Cisco warns then the bears will roar out of hiding.
October is over and November started out with a bang. Monday morning is going to look like a stampede as the bulls trip over themselves trying to dive into the new bull market. Explosive rallies breed more explosive rallies as shorts race to cover and the flashing green numbers attract more investors like moths to a flame. For whatever reason the Dow has put together four positive weeks in a row. It will have a head start next week with a Microsoft Monday but the finish could be a struggle. Don't count the bears out just yet there could still be some serious potholes in our future.
I apologize for the long winded commentary this weekend but the many emails I received on Friday were begging for an explanation of factors affecting the coming week. There is no simple answer and I hope this helped rather than confused you.
Enter Very Passively, Exit Very Aggressively!
"If all the economists in the world were laid end to end, they still would not reach a conclusion" - George Bernard Shaw
Revised version: "If all the economists in the world agreed a 50-point rate cut was needed the Fed would still ignore them"