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Market Wrap

Iraq vs. The Economy

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03-03-2003                  High    Low     Volume Advance/Decl
DJIA     7838.86 -  53.22  7981.46 7822.73   1392 mln  500/864
NASDAQ   1320.29 -  17.23  1353.31 1316.85   1216 mln  251/945
S&P 100   422.18 -   3.18   431.39  420.92    totals   751/1809
S&P 500   834.81 -   6.34   852.34  832.74
RUS 2000  359.31 -   1.21   364.63  358.28
DJ TRANS 2066.08 +  17.03  2084.65 2046.51
VIX        34.09 -   0.06    40.89   36.71
VIXN       45.83 +   0.17    46.02   44.62
Put/Call Ratio 1.02

Iraq vs. The Economy
By Steven Price

Is it all still about Iraq? It certainly was about the geo- political picture early on, but some conflicting economic data also proved that the economy is still playing a part in traders' minds.

We got a good snapshot today of reactions to both the geo- political landscape, as well as current economic conditions. The economic worries won out today, but it was only one chapter in a very long book. After a Friday afternoon that looked as though we had finally exhausted whatever bullishness was left in the broader indices, we got some news over the weekend that tipped the scales away from an Iraqi invasion. While it remains highly probable that the U.S. will still invade, there were a couple of items that made it a little more difficult. First was the expected destruction of missiles by Iraq. The U.N. weapons inspectors requested destruction of Iraq's Al-Samoud missiles, which they deemed to have a range beyond that allowed by the U.N. resolutions. Iraq agreed to do so last week, but said they did not know how and would require assistance, keeping alive the notion that they may just be wiggling. When the destruction began as planned, it was just one more factor that weighed against a U.S. invasions Iraq continues to throw bones to the U.N. every couple of weeks. The U.N. weapons inspectors also said that they had been allowed to interview more scientists. Iraq destroyed more missiles on Monday, but has said it would cease complying with the inspectors' request if it appears the U.S. will go to war anyway.

The second factor, and possibly an even more important one, was the vote by the Turkish parliament on allowing U.S. troops to base in its country. What appeared to be a victory for the U.S. with more members voting for than against the U.S. plan, quickly turned sour when the vote was declared "rejected" by the Prime Minister. The vote fell three votes shy of a majority due to 19 abstentions. Turkey's financial markets fell hard on the news, after they had rallied on the expectations that the country would be receiving U.S. aid that could help ease a $90 billion hole the country is facing and large IMF payments facing it. There has been talk of another vote, but that likely will not come until next week, after parliamentary elections this weekend. The rejection has a big effect on the U.S., which had planned on stationing troops in Turkey for an attack on Iraq from the North. While the U.S. has said the decision would not alter its overall plans, it will require some major re-positioning and could delay any military action. The U.S. has said it would be successful in an action against Iraq with or without Turkey's help. My guess is still that Turkey eventually takes the much needed infusion of aid and allows U.S. troops. However, just a few days before their elections, a topic that does not have popular support there may have simply had too much working against it. There were still more votes cast in favor of the U.S. plan than against it, so there is enough sentiment from those close to the problem to build on. I imagine the 11% decline in their stock market that followed the decision will only help the U.S. case.

The arrest of a high-level Al Qaeda operative also gave the markets a boost early on. Al Qaeda operations chief Khalid Shaikh Mohammed was arrested in Pakistan and U.S. officials seized computers, computer disks, paper documents and cell phones, which they will use to try and determine where other operatives might be hiding and what plans might be in the works.

The opening euphoria got another boost from a better than expected construction spending report. Construction spending rose 1.7% in January, to record levels, and also reflected an upwardly revised number for December.

On the negative side, however, was consumer spending. Analysts were expecting a 0.1% rise in nominal consumer spending and instead got a reduction of 0.1%. Overall, consumers reduced real spending by 0.3%. It was only the second time in the last 14 months that spending has declined. It would also seem to correlate to recent numbers from the housing market, which showed a big drop in new home sales for January. One of the biggest factors in keeping consumer spending alive, and supporting the economy, has been low interest rates. When we start to see a lesser effect in the housing market, it is a red flag for spending in general, as it indicates fewer consumers are taking advantage of those rates to either extract money from current homes or purchase a new one. While it is not a direct correlation, weakness in the housing sector can be used as a red flag for spending in general.

The drop in spending also portends more economic troubles for the country, as consumer spending has been one of the only positives we have seen in a climate where businesses have refused to spend. Consumer spending makes up 2/3 of GDP and a decline may have a serious impact on first quarter GDP. Real spending on durable goods dropped 5.4%, following a 7.2% increase in December. That was the largest decline in 13 years and reflected a drop in auto sales. As consumer debt has reached record levels, some of that previous spending is also making it back into savings accounts ahead of war concerns. The personal savings rate grew from 3.9% to 4.3%. Personal consumption was also flat, when excluding energy. One of the reasons for a drop in spending can also be linked to a smaller than expected gain in personal incomes. Personal income grew 0.3%, which was a touch lower than the already anemic 0.4% that was expected.

We got reports from several automakers, with GM showing the worst results. GM reported a 19% drop in February sales. Ford reported flat sales and Daimler Chrysler reported a drop of 4.5%. The total industry numbers came in below expectations.

The biggest report we were waiting on was the ISM manufacturing report. Last week's release of the Chicago PMI, which reflects manufacturing data in the region, came in better than expected. That was enough to get the bulls geared up for this morning's ISM release and we rallied into the data release. Oops. The ISM came in at 50.5% for February, well below the expectations for 52.0%. The internals of the report showed both employment and new orders down, while prices paid went up. While the 1.5% difference between the expected and actual levels may not seem like a big difference, its proximity to the 50% level is important. Anything over 50% shows expansion in the sector, while anything below that level shows contraction. The trend in both indices is down and now bordering on contraction. While the Chicago PMI was better than expected at 54.9, it was still a downtick from the previous reading of 56.0. The disappointing report led to a quick turnaround in the Dow, which had once again been on its way to testing 8000. It reached as high as 7981, before rolling over and dropping more than 100 points subsequently.

The chip stocks have been one of the hotter sectors over the past week. After bottoming around 260, just before we got a bounce in the broader markets from our recent lows, the Semiconductor Index (SOX) ran all the way up to a test of resistance at 300. This 15% gain outstripped the rest of the market and indicated that this sector may be leading us higher. While the SOX is only a sector index, it has a high correlation to the broader markets, as it measures spending and demand for the hard components that businesses invest in (or don't). The SOX finally hit the 300 mark this morning, topping out at 304, but that move apparently brought in the sellers that point to a continued lack of IT business spending. After hitting its morning high, it did a 180- degree turn and fell back to 285. It was the first indication that we might see a turnaround off the bottom a couple of weeks ago when it found support and started creeping higher and if today's rejection is any indication, the recent pop in equities may be running out of steam. The sector was not helped any by a report from UBS Warburg that said the Semiconductor Industry Association results for January were below expectations, despite some good data coming from Asian source around the Chinese New Year. UBS said most categories were down, with the exception of Flash and SRAM, but it expects a mild sequential increase in February. That report was out early and we got a morning rally, anyway, so the reversal is more likely due to valuation than that piece of news.

Chart of the SOX

While we did get a series of intraday lower highs after the initial morning spike, we also got a higher high in the Dow than we did on Friday. While the bullish percents remain in sinking columns of "O," indicating an uphill battle for any continued rally, we need to note that we have also maintained much of the bounce of recent lows in the broader indices. The Dow touched a relative low of 7628 on February 13, before bouncing 400 points. We have held onto much of those gains and have mostly moved sideways. The 50% mark of those gains is 7852 and that level has served as significant intraday support over the past couple of days. Today's drop through that level near the end of the day also led to a failed bounce just below it, indicating we may now be seeing resistance where we have seen recent support. That would certainly seem bearish. However, we are seeing a low volume market, with no real decisive trend. The point and figure charts continue to reverse from bullish "X" columns to bearish "O" columns every couple of days it seems. I highlighted a flag pattern forming in the Dow PnF chart last week and that pattern has remained as such, indicating indecision in progressively smaller trading ranges. The SPX and OEX had been in bullish columns of "X" and added another upside box this morning. Their subsequent rollovers would have turned them back down into columns of "O" at 835 and 422.50 (2.5 point box) if not for the earlier addition to the upside. If we trade the same lower levels tomorrow, they will reverse down. That can be seen as bearish confirmation, but with all of the sudden reversals, it is getting harder to simply conclude that we are heading in one direction or another. The main reason, of course, is the market sensitivity to world events.

60 min. Chart of the Dow

PnF Chart of the SPX

What happens if Iraq completes destruction of all of their Al- Samoud missiles? Or if the U.S. and Turley reach a new agreement? Or if Saddam heads into exile? We can certainly guess at the likely outcome, but we have no real idea what the next day will bring. After all, it seemed like a foregone conclusion that Turkey would allow U.S. troops.

We also got some contrarian indications today from the broader market movement. The Dow Transports, which had been testing October lows and underperforming even a sinking equity market, got a boost today, most likely from the continued slide in fuel prices. That slide has come as Iraq has begun to comply with U.N. requests and U.S. oil inventories have gotten a break from the passing of bad weather in the East. The Market Volatility Index also finished slightly down on the day, indicating a lack of downside fear. It usually rises on market drops and although it bounced from intraday lows, it still remained in the red at the close. It has tested the 34% level on two recent occasions, before equity drops took it back over 35%. Today it crept just over that level in the afternoon to close at 34.09.

It appears that for the moment the trend is down, and I will continue to trade that way. However, without a clear-cut pattern, and the possibility that the tide will change quickly on world events, I am sticking to risk capital and will likely do so until world events are sorted out.


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