Calm Before The Storm
Finally the big day will dawn tomorrow. The Fed is huddled together to wring their hands, cuss the economy and argue semantics while the market churns in place. Antacid abounds as traders try to decide to buy or sell before the announcement. Pundits have taken up the challenge to verbally joust on every major TV station with views from no cut to major cut and the reasons why each is the right cut. Are we trading stocks or bond futures here?
Dow Chart - Daily
Nasdaq Chart - Daily
You would think the sun will not rise on Thursday if the Fed fails to cut 50 points if you listen to some analysts. Others claim a 50 point cut would shock the market and produce a terror filled sell off on worries about what the Fed knows that we don't. Regardless of your position in this debate the Fed announcement at 2:15 Tuesday afternoon will control your investing fate. More on this later.
The morning started off well economically with Chain Store Sales posting a strong +0.6% for the second consecutive week. The strong sales were due to the release of the Harry Potter book and continued rainy weather in the East which prompted shoppers to head into the malls instead of the beach.
The bigger report for the day was the Consumer Confidence for June. This report dropped a miniscule -.01 to 83.5 for the month. Estimates were for 82.8 but the whisper number was well over 85. The market rallied on the news for about five minutes then headed for the lows of the day. The problem was the present conditions component which FELL to 64.9 from 67.3. Every major component fell except for the expectations index which rose to 95.9 from 94.5. Everybody has bought the promise that the 4th quarter will be strong. Unfortunately the current conditions are still falling. Consumers planning to buy a home fell to a three year low at only 3.0. Those planning to buy autos fell to 5.9 from 7.7 and major appliances to 28.2 from 31.6. This was not a good report and should give the Fed even more problems to discuss.
AMD also shocked the market this morning with a drastic profit warning citing weak sales of computers and mobile phones in Asia due to the SARS outbreak. The stock dropped to a two month low after saying sales would fall to $615 million from the $715 million estimate. "The anticipated global sales improvement in June did not materialize as we had anticipated," said the AMD CFO. AMD would not comment further and would not give future guidance. Banc of America said AMD was also hurt by slowing sales of clone PCs and inventory buildup across the spectrum. We all know AMD is not the market leader here but could this be a leading indicator of other tech earnings coming out in the next couple weeks?
FedEx posted earnings that rose +17% but cautioned that June shipments were falling below management's expectations. They said the economy was poised for a recovery but volume trends were disturbing. CNF warned after the close that demand for freight shipments was VERY weak in North America and their earnings were going to suffer. They could drop as much as -47% below the forecast from April. Add the plastics warning from GE last week and there is cause from concern on a broader level. The FedEx, CNF and GE warnings are reflective of business in general not a specific company or a specific sector. Are you listening Mr. Greenspan?
The Fed is on center stage, the curtain is about to rise and the spotlights are focused. Not just U.S. traders but the eyes of the world are focused on 2:15 tomorrow. What they do/say will determine if foreign investors pull money out of the U.S. or put it back in. The Fed funds futures are showing a 100% chance of a 25 point cut and a 52% chance of a 50 point cut. That means the Fed cannot afford to not cut at all or a significant drop would occur. They have telegraphed a coming cut for a month and it is clearly priced into the market. The problem for us and the Fed is the 50-point cut potential. They have vowed to "do whatever it takes" to defeat deflation before it starts. 25 points is already a given and a purely psychological move at this point. A 50-point cut would take interest rates below 1.0% and while it could actually help in some areas it could be very bad in others. But would the negative result be worse than deflation? No chance. While it would hurt banks, brokerages, money funds and people that pay interest on deposits it would help insure one more refinance cycle.
Last week there were a couple news articles suggesting the Fed could cut 50 points and we actually got some selling instead of excitement. The problem is expectation. The market has been rising on the expectation of an economic recovery that the Fed has been promising for months. If the Fed decides to cut 50 points then they will have to say something in their guidance about why they see the economy as weaker than current expectations. It is the "kings X" statement. We "the Fed" were just kidding about the economy getting stronger. Or, we think the deflation monster is closer than we expected and we are going to bring out the big guns to defeat it. Most analysts expect a 50-point cut to contain a statement about being ready to use alternate means to continue the fight and that will also be seen as negative to the market. Yes, the Fed has a tough decision to make. Do they continue to dribble out reluctant 25 point cuts until they run out of ammo? Or, do they take it on the chin and blast out a 50 point cut and take a strong stance about protecting our future?
12 of the 22 primary treasury dealers expect a 50-point cut. The futures are showing a 52% chance of a 50 point cut. The more than $10 trillion in interest bearing accounts will cuss another rate cut, especially 50 points. Many banks and funds will have to change the way they do business with a 50 point cut. Many could actually cease paying any interest at all on accounts. The dollar would suffer and we could see the flight of foreign money back to countries with much higher rates. It is not just the stock market that will react to the news. Most analysts expect massive selling in the bond market after a 50 point cut if the guidance is not worded so specifically that there is the threat of even lower rates ahead OR at least no change in rates for a very long period of time. Being guaranteed a 3% return for the next couple of years would not be a bad thing for bond junkies. If the Fed reinforces a no hike posture for the next year or more as many expect then the bond market could remain stable. Many expect the Fed to not raise rates until after the election to insure a strong bounce out of this three year recessionary environment. They have seen Japan and the disaster deflation caused and they do not want to go there.
They are stuck between a rock and a hard place. 25 points is the political solution. Bonds will not tank because they will expect a potential further cut at the next meeting. The stock market will not tank (as bad) because the economy must be ok or the Fed would have taken stronger action. But, 25 points is only a psychological move now because the market has priced it in for over a month. A move that will have little on no impact on the economy and little or no impact on the next wave of refinancing. Remember, the Consumer Confidence today showed that new home prospects had sunk to a three year low. Another 25 points will not change that. The Fed is stuck. They needed a two-day meeting this month to puzzle their way out of this quandary.
I am split on the outcome just like the rest of the world. So, as a trader what do I think will happen to the market? I don't think there is but one outcome. It is not up. 25 points are priced in with hopes by retail traders for a 50 point pop. They do not realize what the 50 point decision could cause. A 25-point cut could produce trader depression and a sell the news drop. Do you really think the market will go up on old news? A 50-point cut would have to contain that negative guidance about the economic outlook and that would tank the market. Oh my gosh, you mean the recovery is not already in progress? Most traders are not stupid. They see the warnings by GE, THC, AMD, EK, CNF and FDX as the hand writing on the wall that may be leading indicators that all is not well. The Fed announcement is simply the focal point and the hoped for cure all.
The Dow struggled to hold on to 9100 this afternoon and this is significantly below the 9300 highs. The Nasdaq is struggling to hold 1600 and especially after the AMD warning this morning. The markets have not sold off and I believe it is due to the end of quarter window dressing and inflows of cash from retail traders who think the Fed is going to save the economy this week. TrimTabs said funds saw an inflow of $11 billion in cash over the last three weeks and that was the largest inflow since March 2002. Margin balances among the top brokers increased +7.7% in May and that was the largest increase since March 2000, the beginning of the current bear market. TrimTabs also said corporate and insider selling reached $20 billion in the last three weeks and that was the highest since March 2002. Ponder this thought. If insiders and institutions are normally on the right side of the market and retail traders normally buy the tops and sell the bottoms, there is an alarming trend here. The new retail cash along with huge first half retirement contributions is currently being put into the market and that retirement flood will end after the first week in July. There is also a good chance the window dressing from funds will be stripped back out once the quarter is over.
If we look at the March 2002 period where all those conditions existed before we will see the S&P was up over +24% after the bottom in September. Everyone was talking about the new bull market. The coming second half recovery was just over the hill. Instead July earnings came in less than expected and it was all down hill from there. Moving forward to June 2003 we are up between +22 to +31% depending on which bottom you use. Earnings are beginning to smell and the 25 point rate cut is already priced in. The second half recovery is just over the hill. Are we in any better shape than we were in 2002?
March 2002 SPX Daily
June 2003 SPX - Daily
If we move further backwards in time to a point before the bear market we may see a better picture of what July is likely to bring. We can go back to 1998 when we were coming out of a serious dip and had a strong rebound to new highs in July. That rebound was a +38% gain from the prior September lows. Unfortunately July earnings again came in less than expected and the S&P dropped -22% from the mid July top.
But, surely 1999 and 2000, the boom years were better, right? Yes they were. 1999 saw a gain of +53% from the prior lows and only sold off -13% from the July highs. Not bad but still -13% sell off in the middle of a vertical market.
July 2000 was less pronounced because there was only a +23% gain from the prior lows and the market was moving sideways as the big crash began. Still the July drop accounted for -7% of the S&P before one last gasp in August and the bear market began.
July 1998 SPX
July 1999 SPX
July 2000 SPX
The point I want to make tonight is not that we are doomed to hit new lows or the rally has failed. THE ONLY POINT I WANT TO MAKE is that July is not a friendly month. The first week of July is the best week and normally leads to new highs. Once the retirement cash ceases to flow around the 10th the summer doldrums begin. Just look at the charts, boom years and bust years are both the same.
Now, if you are a big money manager what would you do? If you have 20% gains in the market from the recent bottom, maybe more and a lot more if you were aggressive and bought the right stocks, would you hold them? Sure some might, some might feel like heroes and bail to lock in gains others are only hoping for. The bigger point traders should ponder is timing. How many years does a trend have to repeat itself before money managers begin front running it? Two? Three? Five? Eventually it becomes a flashing "sell me" sign that is begging to be hit. Will this be the year that the managers begin early AND will the Fed meeting trigger it? Nobody knows but as you can see from the charts above that even in the best of years the 10th-15th of July is a jumping off point. Using the 10th of July as the last target to be out of long positions there are only ten trading days left. With the retirement contributions providing lift in the first week of July there is plenty of incentive for the funds to wait until after the 4th as long as they have not decided to leave early and be safe. Or as long as the Fed does not scare them tomorrow. Or, I might mention that next week has PMI, ISM, NonFarm Payrolls, Factory Orders and ISM Services all packed into a holiday shortened week. The Fed is not the only pothole this week. We still have Durable Goods and Home Sales tomorrow, GDP, Jobless claims and Help Wanted Index on Thursday and Personal Income/Spending and Michigan Sentiment on Friday. Just how far do you think those funds want to stretch their luck before hitting an economic landmine?
The wildcard is still the bonds. If the Fed says something that makes bond holders think bonds have seen the highs then that flood of cash could break the July trend. I do not see this happening tomorrow. The Fed is more likely to say they are planning on buying bonds as plan B instead of cutting rates any further. They want the long-term interest rates to be low to support the economy. They have no more real cuts left and they have to avoid a spike in yields to keep the housing market liquid. Whether they actually plan on buying bonds or not they have to play that bluff in hopes of keeping that money in place. Are we having fun yet? Nobody ever said investing would be easy, at least not over the last three years.
I should think the game plan is clear. Remain long ONLY if you have stops in place and are prepared to honor them. We are approaching treacherous times over the next three weeks and we need to keep our seatbelts fastened and our eyes on the road.
Enter Very Passively, Exit Very Aggressively!