Fear of the Fed?
The lack of material economic reports on Friday left traders wondering which way to jump. Some decided to take profits as news of potential terrorist attacks jumped back into the news. KB Homes added to the negative sentiment with a new look at the future in the home builder segment. The Dow reversed roles with the Nasdaq and with the help of GM traded in the positive all day.
Dw Chart - Daily
Nasdaq Chart - Daily
The ECRI Weekly Leading Index was the only economic report and most traders would have a tough time finding the results without a roadmap. It rose slightly to 123.4 for an insignificant +0.2 gain. However, the six month growth rate, which is probably the most watched portion of this lightly regarded index, jumped to 6.1% from last weeks 5.5%. This is a vast improvement from the 0.2% growth rate from the April-25th report. If the economy comes even remotely close to that 6.1% growth rate by year end the Fed will be raising rates by 50 points a shot.
GM jumped +1.50 at the open after saying they were going to sell $13 billion in bonds to shore up its massive pension deficit. In the world of magic numbers GM derived about 50% of its 2002 net profit from its pension plan despite the plan being $25 billion underwater. How they can do that is anybody's guess. Actually 63 of the S&P companies reported net pension income as part of their earnings in 2002 despite their funds being in the a deficit. Let's see, if my pension fund liability is increasing $10 billion a year but assets are only increasing $100 million a year, is it right for me to claim a profit of that $100M? Other deficit winners include Ford -$16 billion and BA -$7 billion.
Lipper said fund flows for last week were +$4.3 billion and twice the +$2.0 billion from the week before. Considering the Dow had gained over +200 points for the prior two weeks I am not surprised. If you noticed the graphic at the top of the page the Dows gains for the last two weeks were only +54 and +83 points. That could indicate the money flow is weakening. Funds may be finding it a little harder to attract money this close to a top or at least this close to the Fed meeting and earnings.
The quadruple witching is history and the market was torn by opposing forces most of the day. The indexes gapped open Friday morning on S&P imbalances related to the expiration and the GM news. After drifting sideways most of the morning at just over 9250 the market was looking for an excuse to move. That excuse came from a terrorist threat in Kenya that closed the embassy there. The State Dept said there was a very real and credible threat that the new embassy was going to be attacked with an Al Queda truck bomb. The Dow dropped about -70 points in just a few minutes and failed to recover for the rest of the day. There was concentrated selling at the close but it is unknown if it was traders worried about a weekend attack or simply expiration volatility. After the close the U.S. said they had picked up Saddam's trail and could have him in custody by next week. Sure, and I assume they have a trail on the Easter bunny and tooth fairy as well. The report actually said that if they did not capture him next week they probably would not get him at all. And what is the reasoning behind that?
Helping the bounce this morning was an S&P rebalancing of sorts. IBM increased its shares outstanding by 2.2% by donating them to its pension fund. This increase in outstanding shares means every index fund must increase its outstanding position in IBM by +2.2%. Over the last week this has pushed IBM up to strong resistance at $85. Going the opposite direction CMCSA has bought back 60 million shares and fund managers have to reduce their stake. This rebalancing at the end of the half added to the quadruple witching confusion.
GE also helped keep the Dow positive after affirming their range of estimates for the quarter and the year despite the warning about their plastics business on Thursday. They said business gains in other areas had offset the plastic losses. They did say they would narrow the range of estimates when they announce earnings on July-11th. Most analysts think they will narrow the $1.55 to $1.70 range to the bottom of the range. Seven analysts lowered their estimates on GE on Thursday.
Weighing on the market was news that home foreclosures had soared to a record high of 1.20% in the first quarter. The previous record was 1.18%. Homes that started into foreclosure in the first quarter also increased. The rise in joblessness is being blamed for the high rates. This weighed on the market sentiment causing beliefs that the recovery may not come soon enough to stave off an even larger problem over the summer.
Unemployment was also given as the reason KB Homes failed to please investors on Friday. KBH beat the street by 30 cents and raised future estimates by 20 cents. Everything appears rosy on the surface but traders were expecting even better news from the home sector. The KBH CEO said they saw the market weakening due to unemployment and lack of job growth in some of their biggest markets. Despite the low interest rates they are having trouble selling homes in some areas and they see the problem growing. The CEO said, "it was a much more challenging market now than in the last couple years". This is not what investors wanted to hear. After months and months of worries about the real estate bubble it appears it may finally be coming to pass. KBH lost -5.70 after beating the street by 30 cents and raising estimates. Ok, but that is past tense, what are you going to do for us this quarter? CTX, PHM RYL and HOV all had similar drops. NVR dropped -$16 but then they are a $400 stock. (no options)
The biggest weight on the stock market was simply the market itself. After a +26% gain over the last 14 weeks in the S&P there is plenty of profit on the table. Next week is going to be a monster week in terms of news drivers. The FOMC meeting is a serious threat to the status quo. Next week is also the heaviest earnings warning week of the cycle. Add in the new terrorist threat and the urge to take profits was strong.
The Fed is still floating balloons about the amount of any potential rate cut. On Wednesday the Washington Post, claiming input from an unnamed Fed source said the Fed would cut 50 points. This was after several economic reports and analysts comments were seen reducing that possibility. Did the Fed want to telegraph to the market to hold on, help was coming? On Thursday night the WSJ ran a story, also reportedly using a Fed source for info, that leaned more to the 25 point cut scenario. Was the Fed again floating a balloon to see how the markets would react to the smaller cut? We may never know but the odds of the 50 point cut settled near 50% by Friday's close. They have been all over the board from 65% to 30% in just one week. It is not surprising that traders are taking profits with all the confusion. 50 points was priced into the market and now it is very unsure that we will have a cut at all much less 50 points. Personally I would be very surprised if the Fed did not cut at least 25 points since they have been saying they were going to cut for over a month. A complete retraction of those comments would be very negative to the market. Plus, there has not been any Fedspeak about a reduction in need for more stimulus. Again, this means that about a 37 point cut has been priced in (half way between 25-50) and a 25 cut will be disappointing and a 50 will be barely acceptable. Either way I see a sell the news event in our future.
The second threat comes from an expected flurry of earnings warnings next week. This is the heaviest week of the cycle and with some of the big confessors this week it makes you wonder who will don the scarlet E next week. With tech exports down to $166 billion in 2002 from $223 billion in 2000, a -26% drop and still falling, it is likely we will eventually see another wave of tech earnings problems. The key is whether the economic recovery will fill the gap first. Since the recovery has not yet appeared the odds are some more techs will confess next week. I would not be surprised to see more big caps warn as well. Remember, the beginning of this quarter was not exciting.
Offsetting the potential negatives is the end of the quarter and half window dressing. It is not over yet despite Friday's swoon. There is still a good chance the funds with cash to spend will buy Friday's dip or a post FOMC dip in hopes of getting some bargains and appeasing investors with a broad range of winners in their portfolio when statements come out.
I attended a conference last week where quite a bit of time was spent predicting the economic future. I have to say it was not bright. We are talking long term here, in years not months. The overall consensus of opinion was that 2003 would end well and the recovery would carry over into 2004. It is an election year and we know how politicians like to paint a rosy picture in their campaign speeches. Typically the 3rd year of a presidents term is the best year of the term. The problems come in year 2005. The tax cut just approved was said to be $350 billion. There are things in it that sunset in 2004. Get serious, are politicians going to raise taxes again in an election year? The consensus was a total cut before it could be rescinded of about $850 billion. The deficit for 2003 is already $292 billion as we saw this week. It is expected to be $400 billion by the end of September. Add another $450 billion in 2004 and the numbers start to be really ugly. What most people don't realize is this is in funded items like defense, security, etc. Unfunded items like social security, Medicare and military pensions are not accounted for in these totals. The estimates I am hearing are for a $1.5 trillion deficit by 2005.
Assuming Bush is reelected he will tackle this problem head on in order to clean up his legacy and prepare for the transition to the next republican president. He cannot get elected again so he has nothing to lose. He will take the first two years 2005-06 and force stringent changes in the economy including the tax code. He has to. He cannot let the deficit continue to climb. The current capital gains tax is the lowest it has been since the depression. This is the first place he is likely to act as it is the least painful to most taxpayers. Regardless of where he acts it will not be pleasant and the market is not going to like it. The next president is going to have it even tougher. In 2008 37 million baby boomers will begin hitting the social security/Medicare rolls. This massive influx of retirees will decimate the workforce and swamp the already overburdened social security system. This massive cash drain will have to be compensated for in some form. That means taxes on the rest of us in some fashion. Lots of taxes. The drain of 18% of workers from the workforce will be good for employment but that will raise wages significantly. Obviously all 37 million are not workers and not all are going to instantly quit working and move to Florida. Still the trend is there and 2008 is not that far away.
The number one field for investment to profit from this boom was healthcare and drugs. With that many people moving into the geriatric category there is going to be a huge demand for health services. Real estate in retirement locales was also mentioned as potential targets. Oddly enough the beef industry was mentioned as something likely to suffer as retirees ate less beef due to income and health reasons.
I am bringing this up as something to think about as you position your portfolios for the future. We get so preoccupied about the next day or the next week when the big money is really made over time in those retirement accounts. Next week is going to be tumultuous with opposing forces wielding large volume as each event transpires. The key is to balance your attack. Don't get so caught up that everything you have is riding on the outcome of the Fed meeting. They will cut, the market will spike up and down and life will go on. We are very overbought and I suspect earnings will not be exciting.
There is no such thing as a summer rally although we hear the term every summer. Odds are good we will move sideways to down until we get some more positive signs of economic improvement. Since this is the summer doldrums it could take a couple months before we really start to see some strong positive signs. Capacity utilization is at a ten year low (75%) which means there is no incentive for companies to spend money to buy more equipment. Until demand picks up and the excess capacity is absorbed there is not going to be a broad based recovery. This is not likely to happen over the summer. Until those numbers begin to pickup there is a 26% S&P gain at risk. Only one time in the last 50 years has the S&P gained more than 26% off a bottom. Can you say over bought?
The first week of July is the best week of the month as the retirement contributions for those 37 million baby boomers hits the market. After July 8th it begins to get grim for cash flow and that is when earnings ramp up to a fever pitch. For short term traders I would be cautious about being long around July 15th. I could only find one July in the last seven or so that actually went up after the 15th. The historical down trend for the second half of the month is very clear. For shorter term traders there is a lot of scuttlebutt about institutions loading up on shorts beginning on June-30th. Seems there are a lot of skeptics out there that also feel we have come a long way for the lack of visible earnings. Nobody knows what will happen in the market but the external short term stimulus is very strong regardless of what the Fed does. This will keep a floor under the market while we wait for the future. That floor could be significantly lower than we are now, maybe as far as 8500, but it is there. The most likely initial level is Dow 9000.
10-Year Treasury Index - Daily
The upside should be limited from here regardless of the Fed. Dow 9375-9500 is strong resistance and at this overextended level it may be tough to break. 50% of the S&P has warned for this quarter. That could also mean we have some upside surprises ahead. The wild card is still the bonds. They have started to sell off as worries over the Fed increase. If the Fed only cuts 25 points and then says the deflation threat was over stated then the bonds should sell off more and that money find its way into the stock market. We have hit a plateau on the ten year yield at about 3.4% and until that breaks the big sell off may not occur. At this point it all depends on the Fed not only in what they do but in what they say on Wednesday. The guidance will be the key as the cut is already baked into the cake.
Enter Very Passively, Exit Very Aggressively!