Tough week for the markets but not as bad as it could have been. The Dow lost -2.3% and was the weakest link. Techs had one horrible day but held their ground for the rest of the week losing only -1.5%. The key was not how much the indexes lost but where they closed. All closed very near the lows for the week as September draws to a close with no major market events. Will October be as kind?
Crude Oil Chart
The markets attempted an oversold relief rally on Friday but conflicting economics and higher oil prices spoiled the rebound. The Durable Goods Orders headline number fell -0.5% and much worse than the +0.1% gain expected. However, don't believe all you see. The headline number was skewed significantly by a sharp drop in aircraft orders. Ex-aircraft, which is a highly volatile sector, the growth in durable goods orders was +2.3%. This is a very strong gain and was led by strong numbers in critical sectors. Computers saw a +4.1% jump and communications equipment rose +6.8%. Overall shipments are up +13.4% year over year and that represents the strongest sustained growth in the last ten years. The May/June dip has been erased and we appear to have growing order strength.
The Existing Home Sales fell slightly to 6.54 million units and this was inline with estimates. Analysts had expected this drop due to the higher mortgage rates in May/June, which created a shopping lull. With rates making a new attempt at five month lows we could see a fall bounce but the major buying trend has passed. Analysts want the levels to remain firm but nobody is expecting a new high any time soon.
The above economics were far less important to traders on Friday than the rising price of oil. Crude closed at another new high at $48.80 despite announcement of oil draw downs from the SPR. The coming hurricane was cited as a new event risk as well as new pipeline sabotage in Iraq. This may be the stated reasons for the continued push higher but we know it is really event risk speculation in front of the election. Bloomberg cited a survey showing a record number of analysts (59) expected oil to hit $50 next week. The real question is not will we hit it but what will happen when we do? Is this going to be some kind of electric fence that will repel prices back to $40 almost instantly? I seriously doubt it. I do believe we will see some profit taking but the key is really the conditions. Just hitting a $50 price does not change the hurricane status, IRAQ terror attacks, election risk or long term global demand. In the short term passing on $50 oil in the form of higher gas prices will slow consumer demand but a month from now that negativity will ease as we become immune to $2 gas and the demand will pick up again.
Several brokers are suggesting that oil stocks have reached extreme valuation levels and traders should lighten up. I miss the reasoning here. Yes oil stocks are high and some are nearly vertical but until the production/demand equation reverses there is still long term upside. Oil stocks tend to trade based on the price of the underlying commodity and that should not surprise anyone. I definitely think we will see some price dips ahead once the election is over but they will only be temporary. I view them as a buying opportunity for the next leg up. Ed Hyman the chairman of ISI Group, named top economist for 24 consecutive years, said oil was the only sector he was considering at present. His forecast for 2005 oil prices is $45 to $55. He claims the emerging economies currently are expanding rapidly and are very energy intensive. The top seven expanding countries are approaching a combined GDP of $7 trillion and together are about equal to the U.S. but growing much more rapidly at nearly a +13% pace. Thus a continued increase in demand for oil. He also predicted the risk of deflation would increase before year end.
Hyman also compared 2004 to 1994 as many others have also done. 1993/2003 were the beginning years of a recovery with a strong move higher ending in January. In 1994 the Fed raised rates six times for a whopping +2.50% jump in rates to 5.50% at year-end. Two of the increases were 50 points and the last one was 75 points. The markets refused to die although they did not move higher. In 1995 the economy caught fire and the market exploded. While Ed thinks the 93/03 94/04 comparison is very similar he does not think 2005 will follow the same pattern. His concern was due to the price of oil depressing the economy/market. With his expected price of oil at $45-$55 his economic projections are weak. At $55 oil he felt the GDP would run at only a +2% growth rate. At $45 oil he said a +4% growth rate was possible. This puts the focus right back on oil prices as the most critical piece of the 2005 picture. Remember Ed was voted the economist of the year for 24 consecutive years. We should assume he knows what he is doing.
Dow comparison chart 1993-1995 to 2003-2005
The major indexes changed sides on Friday with the Dow closing in positive territory and the Nasdaq losing ground. No surprise here with the Dow in oversold status from the -2.3% drop for the week. We should have seen some profit taking by the shorts. The Dow has been trending down since its recent 10363 high on Sept-7th and closed at 10046 on Friday. This is only 15 points above its low for the week and represents a low level of confidence that next week will be any better. Given the -320 point drop in the last two weeks you would have expected the bulls to put up a better fight this close to 10000. The challenge remains fear of earnings warnings from Dow components with next week the last week in the quarter.
The Nasdaq has dropped -2.3% in the last three days from the 1925 high set on the 21st. Friday's close at 1880 was the lowest close since Sept-10th and the low for the week. This definitely does not bode well for next week. The Nasdaq has seen four rallies of +9% or more since December and each was followed by a lower low. This appears to me to be the impact of earnings deceleration in front of the election. Funds are using each rally in the longer term decline to lighten up from the gains made in 2003. The 1880 close today represents the same support levels we saw in Oct/Nov of 2003. Nasdaq 1750-1785 represents very strong support from last September and from the August 04 dip. If we are going to see an October dip event that would be my worst case target.
The SOX has been a rock all week but on Friday it began to crumble. The SOX lost traction at 395 and dropped -2.85% back to the 380 support level we saw last week. Much of that loss came in a sell program that hit at 11:20 and knocked off -12 points in one swift drop. Should that 380 support level break it could be a quick return to 350.
Next week is the end of the quarter and funds may need to square positions and possibly mark up some stocks but September is not known as a big month for this trend. Funds want to be in cash for the normal October dip and they tend to not shuffle the portfolio much at the end of September. October is the typical portfolio reshuffle month and investors typically dig a little deeper and fire off an extra check to the funds in anticipation of the October dip/rebound. In this market managers are probably losing sleep and hair trying to make the right decision for the next three weeks.
On Friday the airwaves were full of speculation on bonds. Rumors abound of several hedge funds that bet on interest rates moving higher once the Fed began its current cycle. As you know they have done just the opposite and are currently just above five month lows. Those that bet rates will rise are in serious pain and the rumor is the current bond rally has been fueled by funds covering shorts. Must be tough to know rates will eventually rise because the Fed will guarantee it but not have enough money or guts to ride the trade to conclusion. I know from experience how painful that is on similar stock trades but with billions at stake in bonds and the outcome guaranteed it must be extremely frustrating. Word to the wise, if you have not refinanced to take advantage of the low rates now is the time.
The earnings cycle is nearly upon us. Two more weeks and Alcoa will kick off the reporting cycle on Oct-7th. This makes the coming week an active week for warnings as time before earnings expires. As of Friday we have seen 612 warnings for Q3 which is nearly twice the 356 for this time last year. Negative guidance is running 3:1 over positive guidance. 143 companies have warned in the last 17 days of trading. 54 of those have used the hurricane excuse. That should increase as it gives companies a free pass for some investors as a random event rather than a company problem. The current storm heading towards the east coast will only intensify this trend if it does as expected and moves up the coast line instead of moving inland. This will allow it to retain its strength and inconvenience the maximum number of people.
The tech sector has experienced the most warnings by far. 90% of the semiconductor sector has warned according to Thompson Financial. The major reason is a sudden drop in orders across the board that impacted almost every sub sector of the chip market. This is the result of a global IT slow down and while everybody is expecting it to pickup in 2005 there is currently no confirmation. The next 30-45 days is the order window for early 2005 and we should have that guidance soon. Thompson cited the various warnings this week and noted the outlook for Q3 earnings growth fell -0.5% to +14.3% from +14.8% the prior week. This is still strong growth historically but investors have grown accustomed to +20% to +25% or even more over the last year. The tech sector has seen outflows from tech funds for 30 of the last 31 weeks.
When evaluating the S&P earnings growth at +14.3% you need to realize that the energy sector is a major part of the S&P. Currently energy makes up about 8% of the S&P and earnings for the S&P energy stocks are up +33.6% for the year. Remember this when you see the talking heads continually listing the S&P estimates. Without energy it would be significantly lower and probably in single digits.
Next week it starts out slow economically but picks up beginning with Wednesday's GDP and a heavy schedule on Thursday and Friday. Earnings warnings will be the focus beginning on Monday and of course oil at $50 will attract attention. The terrorist countdown to the election stands at 37 days and counting. The Dow at Friday's 10040 close is nearing strong support at 9900 and a likely stopping point for any further weakness. The Nasdaq has risk to 1755-1785 and that would be my worst-case range unless we see a serious external event like an attack. It is the end of the quarter so volatility should increase. Other than that it should be a normal market week with long periods of boredom interspersed with periods of panic.
Enter Very Passively, Exit Very Aggressively!