October 2003 will go down in the record books as one of the least volatile Octobers on record. As if to punctuate this fact the VXO closed at 17.15 on Friday after reaching a five year intraday low of 17.02. More than a few professional traders are scratching their heads over the combination of factors that produced these numbers. The good news remains that October went out with a strong gain with a Dow close over 9800 and the Nasdaq at 1932. The biggest drop for the month was a meager -2.5% in three days and far from the monster dips that dot prior Octobers.
What economics? One day after the GDP blew out estimates the reports were positive but less than exciting. The NY-NAPM came in at 226.4 and slightly more than the 222.2 in September. Not a blowout but it was the second consecutive monthly gain. The expectations component was not showing that much excitement. For the fourth time in five months the expectation component registered 62.5 and only slightly higher than the prior months. Current conditions is where the big gains were made with the component jumping from 51.1 to 58.2. This is the first time since Q2-2002 that the current conditions has been over 50 for two consecutive months. 62% of the respondents said they thought the recession in the NY area was not caused by the 9/11 attacks but by a longer term problem of general economic weakness. Manufacturing in the area slowed only slightly and still remained strong at 90. Employment grew for the month despite the high 9% unemployment rate in the city of NY.
Shifting geography the Chicago PMI report was inline with expectations at 55.0 and was a jump from 51.2 last month. This would indicate that manufacturing activity accelerated rapidly in October. This is a strong supporting factor in believing that the Q3 GDP may be the start of something big. September had seen a sharp drop to 51.2 from 58.9 and the rebound to 55.0 may be a good indication that the dip was an anomaly. Prices paid did jump +19% to a seven-month high and that could be the first signs of the inflation monster returning. The Fed would be eager to shift their focus from unwanted disinflation to unwanted inflation. It is a much easier battle to fight. Also, inflation produces tax revenue and deflation subtracts it. Inventories continued to fall and the case for a huge buildup cycle is still improving. New orders jumped to 59.2 from 53.2 but backlogs fell due to a spike in production. It was still a good report.
Personal Income rose +0.3% for September but personal spending fell -0.3%. This was the largest drop in spending since Sept. 2002. This was not a good sign. We already know that retail sales fell off a cliff in October and this spending number was for September. This would suggest that October could be down even further. In real dollars the drop in spending was close to -0.6% and that is a significant drop. The slowdown in personal income would suggest the wage cycle is weakening again with less overtime and more competition for jobs impacting income. The exporting of high paying jobs overseas is forcing workers to retrain and accept lower paying entry level positions in other professions. This type of report is seen as more long term negative than short term because most investors are only looking 3-6 months ahead. Should this trend continue for the next year it would draw significantly more attention.
Contrary to the Personal Income/Spending news the Michigan Consumer Sentiment rose to 89.6 for the final October reading. This was two points above September but only slightly above the 89.4 preliminary reading. The sentiment has been flat since May and if the GDP numbers are real then the good news should have been flowing through to the consumer. We just saw that the consumer cut spending drastically in September and despite the growing list of good economic news it does not seem to be translating into higher sentiment. Analysts point to the more than nine million workers still unemployed, rising interest rates, oil prices and the worsening war in Iraq. The daily litany of several dead soldiers each day is continuing to drag on the overall feeling of well being. Almost everyone knows several families with members overseas and the daily attacks are killing soldiers with such randomness that nobody feels safe.
Ok, everybody exhale. October is over and it was a good month. The Dow was up +2.5%, Nasdaq +8.2% and SOX +18%. Very good numbers for a month that is known for drops. The Nasdaq has only had 2 down months this year, Jan and Sept. The most bullish event for the week was a +4.3% gain for the Russell this WEEK! This is clearly mutual funds putting money to work at month end. Mutual fund selling was nonexistent and most funds should have booked very good returns. ICI reported Friday that cash inflows for September were in excess of $17 billion and TrimTabs is estimating those inflows rose to $30 billion for October. This is consumer sentiment in its purest form.
As we move into November there will be outflows in at least one major fund. Putman, owned by Marsh Mclennan, is under direct attack by pension funds with huge amounts of money invested in Putman. Since Monday organizations with nearly $5 billion in pension deposits at Putman have said they will be withdrawing those funds due to the illegal trade practices currently under investigation. $5 billion in only a week and the snowball is just beginning to gain speed. Massachusetts is pulling out $1.7B, Rhode Island $69 million, Vermont $91 million, NY $395 million and the list continues too far to print. Numerous other states and pension organizations have expressed concern and will make decisions next week. One analyst was speculating the outflows could exceed $20 billion or more. Add to that the individual mom and pop accounts and it could turn into a flood. According to Morningstar, Putman's New Opportunities Fund top 5 holdings are ... PFE, QLGC, INTC, AZO, MSFT. Janus was accused of far less and they lost nearly $5 billion in Sept according to some estimates. Strong funds are also on the hit list and the ball is just starting to roll in their direction.
This money is not all in U.S. equities but by far the majority. The current withdrawal amount for Putman at $5B is less than 2% of their assets. It is far from a life threatening event for Putman but is will impact the markets on a short term basis. If the withdrawals continue to grow at the same pace and do reach $20 billion over the next two weeks then the funds under attack will have to sell stocks to raise cash. $20 billion in sales is more than 60% of the estimated inflows from October and more than all of Sept. Most of this money will be reinvested back into the markets but there should be a 2-3 week lag time between selling to raise cash, transferring that cash, new funds being chosen and then reinvesting the received cash. This scenario should play out over the next couple weeks and there is always the potential for a workout period between the funds and the agencies to allow them to distribute funds over time to avoid impacting the market for the rest of the investors.
Next week we should get a feeling for how November should go. Is it going to be a November to remember or a month of consolidation from seven months of gains? The caution comes from the market action the last two days. Art Cashin commented on Friday that floor traders were concerned about the lack of advancement after the excellent economic results. The Dow has not advanced more than a handful of points since Wednesday and traders are unsure why. The general consensus is that the good news was already baked into the cake. Most are very happy that there has been no sell off and almost all expect some profit taking next week.
The stock traders almanac suggests that the first three days of November are bullish as new retirement cash is put to work and funds reinvest cash received from October sales. Without any October sell off to speak of there may or may not be any excess cash floating around. Any funds hoarding money for the "drop" may still be holding some cash. The incoming deposits could be offset by the withdrawals from funds like Putman mentioned above. This makes for a cautious atmosphere for next week. There is still a train of thought that has some funds adjusting their portfolios now that the October year end is over. They were able to close their year within 50 points of the Dows highs and fully invested. Many of those investments have increased +30, +50, even +100% over the last year and could easily stand to be rebalanced.
This leaves investors with many decisions for next week. Do they put new money to work now with the market only a few points from new highs or do they wait for a pull back that may never come? Those that expected a bigger drop in Oct and held off making purchases are now cussing themselves as the markets pulled back to the highs. This problem is being faced by more than a few traders and I am sure more than a few funds that expected a dip as well.
If I was a fund holding a lot of money and trying to get into the market I would be looking at the economic reports for next week and hoping for an upset. Hoping for anything to take the edge off and let me sleep better after making my entry. Those reports include some majors with the ISM at 10:AM on Monday, the ISM Services on Wednesday and the Nonfarm Payrolls on Friday. If I had to key on one it would be the ISM on Monday.
Monday is the key day. If there is going to be any fund selling or window undressing it should be on Monday. If the ISM report is the slightest bit below expectations then we could see an acceleration of that selling. However, I doubt it will be serious in the overall context. There is simply too much good news and too much money flowing into the markets. Everybody has their eyes on a typical 4Q rally and it could turn into a self-fulfilling prophecy.
Any continued rally into the 4Q would have a steeper road to climb. The earnings comparisons for 4Q-2003 will be a lot tougher and unless the economy catches fire we may see a cycle where the number of companies beating estimates drops substantially. Success breeds optimism and analysts fall all over themselves trying to up their estimates for the next cycle. Eventually they get ahead of reality and the whole things grinds to a halt. While I am not making any dire predictions for the 4Q there are already rumblings that earnings may not be as positive.
The market is a forward-looking mechanism that typically focuses 3-6 months ahead. It has been focused on the 3Q expected GDP for the last three months. Now that it has passed the focus is on the current ISM numbers and any GDP revisions ahead. The 4Q advance GDP is not until Jan 27th and there is still plenty of time for it to be revised many times. Don't forget that tax cuts, tax rebates and a refinancing boom from rates at historic lows helped to power the 3Q GDP. Only a very little of that will carry forward into the 4Q. The major boost to the 4Q should be the beginning of the inventory rebuild as it appears the demand is beginning to accelerate faster than businesses anticipated. With inventories already extremely low any real demand should drive that rebuilding phase.
The current estimates of 4Q GDP are between 4-5% depending on who you ask and what day of the week you ask. There is no credible estimate and that is part of the problem. What do you do with a +4% 4Q GDP estimate when the 3Q blew out at +7.2%. How do you relate it to the estimate for +4% GDP growth for the entire year? While economists and analysts are crunching numbers to come up with the "new" 4Q estimate for investors everyone is in a holding pattern. If the current estimate does not grow substantially then sentiment could fade. If economic reports begin to cool from the current positive trend then the Q3 GDP could start to look like a blip instead of a boom. All of these factors will weigh on stocks over the next couple weeks.
I am going to try really hard to reduce the paragraphs above to as simple an outlook as possible. Sunshine with scattered clouds and intermittent showers. The overall trend should remain up. We are an optimistic bunch and until a series of bad economic reports spoil the party we will continue drinking from the Fed punchbowl. The month of November begins the best three months of the year for the S&P on a historic basis and this fact is not going to be lost on many traders. Add in a rebounding economy and a Fed on hold until May of 2004 and you have the fuel for a fire that could put California to shame. Is that bullish enough for you?
The problems of the past are not gone but once investors have $ signs in their eyes they are going to overlook all but the most dire economic numbers. Assuming the ISM on Monday does not implode the stage should be set for the month. Even a negative jobs report on Friday should not spoil investor sentiment if the ISM was positive. We have heard jobless recovery so many times it has been completely discounted. If we happened to tack on more than 50,000 jobs in Oct we could really see some momentum build.
At the risk of seeming too bullish I will close with the obligatory warning. For the first time in months the bulls really have something to cheer about and they were unable to mount a charge. Chalk it up to October uneasiness. One thing you cannot ignore is the VXO. It printed a 17.02 low and closed at 17.15 on Friday. It is showing exactly what I explained above, extreme bullishness. Traders are seeing the potential for another leg up in the current bull market and they have completely lost all fear. This is exactly when unexpected lightning normally strikes.
To use another analogy everybody is standing in the front of the boat and that boat is struggling to make headway without dipping under the waves. Visualize waves breaking over the bow while the engine is sitting out of the water in the rear. We can't get any forward motion because the bullish sentiment in the front is too heavy. There needs to be balance in the boat to move forward and that means any rough water ahead could cause sudden and unexpected dips. Those dips should just be a balance adjustment that allows us to pick up speed. Grab a life jacket and keep your eyes open for rough water and maybe we can get through November without the seasick pills.
Enter Very Passively, Exit Very Aggressively!