The global economy sounds huge but it is really a small world with thousands of interconnecting flights across all countries on a daily basis. Unfortunately in that small world the SARS virus is spreading faster than chicken pox in a kindergarten class if you believe the hype in the news. The impact of this previously unknown disease is taking a toll on the already weak global economy.
Dow Chart - Daily
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The U.S. economy grew slower in the first quarter than analysts previously expected but we should be excited that it grew at all. The GDP rose +1.6% compared to estimates as high as +2.3%. The hero sector was residential investment at +12% with nonresidential investment dropping -4.2%, exports -3.2%, imports -7.9% and equipment/software -4.4%. Clearly without the residential sector the numbers would have been substantially different. The difference between imports/exports added about +0.9% to the headline number and was helped by the weaker dollar. The headline number may have been positive but there was nothing to cheer about. If you take out exports the headline number would have only been +0.7%. Consumer spending slowed, business investment was down and inventories continue to fall. Many analysts are discounting this report as "pre-war" and taking a wait and see approach for the 2Q. Now that the war is over there should not be anything holding back the economy but SARS and pessimism.
March Existing Home Sales dropped to their lowest level since last September with an annualized rate of 5.53 million units. Most analysts had expected a decline but the strong -6% drop caught everyone off guard. The drop was due to blizzards in the North East and colder than normal temperatures in the Midwest. The low mortgage interest rates are losing their luster as unemployment and job cutbacks are felt. This was the second monthly decline and inventory levels are rising, up +10% in the last month. Contradicting the Existing Home Sales was the New Home Sales, which rose substantially by +7.3% in March. The surge was attributed to home builders offering stronger incentives as inventory levels rose and mortgage rates started to climb. The statistical +7% jump is misleading since the Jan/Feb numbers had been artificially low due to the bad weather. Confused? Home builders simply have more incentive to dump inventory and resort to more freebies and gimmicks to sell homes than John Doe homeowner. With the Jan/Feb slump the incentives kicked into high gear. Also the bad weather delayed completion of homes in Jan/Feb resulting in a wave of houses coming to market all at once in March.
The biggest indication of post war relief came in the Michigan Sentiment which bounced from 77.6 in March to 86.0 in April. This was the final reading for April and slightly above the 83.2 preliminary number. Because the initial estimate had already telegraphed the change the market was not excited by the release.
Despite the economic reports on Friday investors were more interested in the impact of SARS and the increasing wave of downgrades now that the pattern of earnings results is clear. The SARS impact is increasing. The ACER Computer CEO said computer sales in Asia were down -20% last week and dropping. Companies are closing offices, airlines are refusing to fly to Asia and the convention and trade show business is coming to a halt. A third hospital was sealed off in Beijing due to a rapid spread of the disease and widespread contamination. Doctors, patients, workers and visitors are locked up until they get control of the contagion unless they hold a special pass. Over 4000 people are quarantined at home with nearly 1000 confirmed cases in Beijing alone. There are now confirmed cases in 26 countries.
The CDC in the U.S. said it was "very unrealistic" to think you can "magically" stop the spread of this disease. In an effort to stop the spread Beijing has announced that any building (office/hotel/factory/apt/store) that has a confirmed case of SARS will become a restricted area and subject to quarantine. Now that China has ratcheted up their activity level there is the assumption that control of the disease will eventually be achieved. However, officials warn that countries with a less developed medical system like Vietnam, Cambodia, Thailand or many of the African countries could become a breeding ground for the disease and infect hundreds of thousands before any medical cure can be produced.
I am explaining this completely because it is beginning to impact the global economy in a big way. Whether fear of the disease is truth or hype, chip companies are starting to see order cancellations and deferrals because of slowing sales in Asia. The already suffering airline industry is being crushed again by the lack of overseas travel. Some are reporting less than 20% passenger traffic on many flights. This not only depresses the airlines but the entire tourist industry and the lack of business travel will eventually depress profits. This problem has been exploding rapidly. Toronto, not an Asian city half a world away, was literally crippled by the "fear" of the disease more than by the disease itself. If an explosion of cases occurs in a U.S. city then the illusion we are somehow protected could evaporate in a week. As long as reported cases continues to climb the impact on the global economy from the perception of danger will continue to rise.
The other major factor impacting the markets on Friday was a high profile downgrade of the entire chip sector by Salomon Smith Barney. The company cut semiconductors to underweight citing increased customer inventories, evidence of end market deterioration, valuation and upcoming seasonal weakness in chip orders. The SOX dropped -5% and took the Nasdaq with it. Even the AMZN earnings win with the stock up nearly $4 failed to hold the Nasdaq in the green. The addition of the SARS concerns in Asia where most chip and fabrication companies have their plants is yet another factor. Several chip earnings announcements warned of the SARS impact. Motorola reported that they were seeing weakening end user demand and QCOM said channel inventories were relatively high and rising.
Factors impacting the Dow on Friday included the Intel reaction to the chip downgrade and the continued MSFT drop from CEO Ballmer's cautionary comments on Thursday. MO also dropped after RJR fell -$6 on a profit warning due to slowing sales, higher litigation costs and steep discounting. They also suspended share buybacks and said their credit status was in danger of being reduced to junk. They said higher state taxes required lower selling prices to remain competitive. Clearly the tobacco sector is not a safe haven any more. Dow component MO fell -$2 intraday on the news. MMM also dropped nearly $3 after a downgrade from Banc America which said the good news was already priced in and the stocks was overvalued based on the current economic picture. MMM has fallen from $136 to $122 in the last three weeks. Boeing continued to fall on fears the new crisis in the airline sector from SARS would cause more bankruptcies and cancellation of orders. GM dropped -$1 on a downgrade from UBS Warburg on valuation concerns. GM was cut to neutral and Ford to reduce (sell). IBM was down -1.32 on worries about a potential profit warning from falling sales in Asia and slowing orders in its chip business. MRK lost -1.55 on news that it had cancelled trials of a promising drug for lung disease due to dangerous complications. This was the second MRK experimental drug this year that MRK has had to stop trials.
The confusion in the markets is running contrary to the current S&P estimates for earnings growth for the rest of the year. According to S&P, with 330 S&P companies already reported for this quarter, the 1Q earnings growth will be around +5.3%. No problem there. However, their estimates for the rest of the year are producing some raised eyebrows. They are projecting earnings growth for the 2Q of +13%, 3Q +19% and 4Q +22%. Did I lose a couple of years while I slept last night? Did we revert back to a bull market just like we turn the clocks back for daylight savings time? I think S&P has a severe case of irrational exuberance.
We will see another 90 S&P companies announce earnings next week along with five more Dow components. (PG, DIS, XOM, MCD, DD) That brings to 27 the number of Dow components to report, (420 S&P) and brings to a close the majority of the material earnings reports. We still have HPQ, CSCO and Dell to report in May. Our challenge next week will be keeping investors focused on the market. The old adage of "sell in May before you go away" still applies. Investors planning family vacations and kids out of school typically go dormant during the summer and pick up the activity after kids go back to school in September. The next four months of summer doldrums in the tech sector also weigh on the market as sales slow to a crawl even during normal years. With SARS taking the place of Iraq as the global concern there is not likely to be a strong urge to invest.
On Friday the Dow broke its recent uptrend line and came to rest at 8300 support. This is right in the middle of its recent range but there was a noticeable lack of buyers. The volume was moderate but it was decidedly negative with declining volume beating advancing volume 3:1. This was a far cry from the 5:1 up volume on Tuesday. Current support is 8150.
The Nasdaq also pulled back from its weekly highs with a drop to 1434 at the close. The chip sector downgrade broke its recent uptrend as investors took profits. Initial support is in the 1420 range with stronger support at 1375.
Was this a change in trend? There are conflicting viewpoints with the majority thinking it was just a profit taking dip as traders took profits off the table from the huge pre earnings rally. The Nasdaq has risen +215 points since the March 12th lows. This is a huge amount of profit for investors to risk while thinking about a slow summer.
Did you follow my suggestion last Sunday? I suggested Dow 8500 would be a good place to close long plays on any weakness. Dow 8526 was the high for the week and +222 points above Friday's close. Friday's close is still +900 points above the March 12th lows. While I am not going to step in front of a bullet and proclaim the rally dead there are significant hurdles to overcome. The Dow/Nasdaq/S&P all failed exactly at strong and critical resistance points of 8522/1467/920. They failed on strong volume, 5:1 advancing over declining, 4 billion shares with 446 new 52-week highs to 68 new lows. Tuesday/Wednesday were very bullish and the bulls could not break the barrier. They were excited and motivated by the better than expected earnings reports. Now that earnings are drawing to a close the economic concerns and SARS will likely captivate investor attention.
There is also some scuttlebutt that the cash flowing into the market early last week was tax cash. Extra cash that had been held back to pay taxes and then not needed or cash moving into retirement accounts. This concept is possible because TrimTabs.com reported net outflows of $700 million for the week ending April 23rd. That includes the big gains on Tue/Wed. However there were cash inflows of $6.6 billion for the prior week that included April 15th. This would lend credence that it was some sort of tax cash that powered the gains since this week was negative. If that is true then the tax cash wave has passed and we could be left in calm seas with no wind at our back.
Without any new cash flowing into the markets, earnings coming to a close and the summer doldrums ahead of us there may not be enough excitement to break those resistance barriers in the coming weeks. There is very strong resistance at S&P 920 and it will take more than wishful thinking to penetrate that level.
For next week I would continue to advise caution should we retest those highs. With another 150+ companies reporting earnings the dip buyers could return but without cash flowing into funds it will be up to retail investors to hold up the market. May is not typically a positive month and according to the Stock Traders Almanac it is the fourth worst month of the year since 1950. The worst months being Feb, Aug and Sept with Sept being the worst. October is know for huge drops but it also is known for huge rebounds making it only the 6th worst month and even a better month than May.
The optimistic view is we are moving into a typically bullish week with Wed-Fri typically up days. With SARS being an uncharted external force we will have to wait to see if the historical uptrend comes true. The market is also reacting to the drop in oil to $26 and the prospects for a coming glut. Bulls claim the sluggish economy is priced in and now is the time to buy.
The pessimistic view is a week full of critical economic reports that could point to another weak quarter in progress. Monday has Personal Income/Spending, Tuesday Employment Cost Index and Consumer Confidence again. The confidence number is expected to be up around 71 from a prior disaster of 62.5. We could see a market reaction only if the number failed to recover and little impact if it exceeds estimates slightly. Wednesday we have the PMI, Thursday Jobless Claims, Productivity, Construction Spending and the worst report of all, the ISM. The ISM is the current gauge of the economy and it is expected to rise slightly to 47.1 from last months 46.2. Should this number drop again it would be taken as negative to the recovery. Conversely a sharp rise could bring out the bulls again.
Any bounce could be short as Friday reports include Factory Orders and the Nonfarm Payrolls again. We lost -357,000 jobs in February and -108,000 jobs in March. With the jobless claims rising well over 400,000 for the tenth consecutive week the odds are good we will see another large drop in the payroll number. How investors will take the 1-2 punch of the ISM and Payrolls remains to be seen. Since these numbers crossed the end of war boundary they may or may not be influenced by it. My guess is little or no influence since jobless claims are still rising and the ISM is not really a sentiment measure. This means we could continue to see negative numbers but investor reaction may still be muted.
As traders this could be a volatile week. The uptrend has paused and we could see another retest of the highs or a complete trend change which could be a directional change into the summer. It is a tossup but we do have stronger resistance above us than support below us. We can move up from here but it is not likely to be on the backs of huge triple digit gain days. We have yet to digest completely the gains since March and that should slow any future up moves now that earnings are over. Should investors decide those gains are in danger then we could see some backing and filling until the end of May when the post war economic reports begin appearing. Add in the threat of an expanded SARS epidemic and investors could start devoting more time to planning their summer than trading. Yes, the war is over, now what? Until the post war economic direction is known the market direction will remain confused as well.
Enter Very Passively, Exit Very Aggressively!