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Market Wrap

Sun Still Shining

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      09-28-2004           High     Low     Volume   Adv/Dcl
DJIA    10077.40 + 88.90 10099.52  9977.92 1.72 bln 2061/1058
NASDAQ   1869.87 + 10.00  1873.86  1852.59 1.56 bln 1906/1172
S&P 100   534.19 +  3.17   535.07   529.86   Totals 3967/2230
S&P 500  1110.06 +  6.54  1111.77  1101.29 
SOX       373.69 -  3.30   377.88   370.17
RUS 2000  565.66 +  7.30   565.73   558.36
DJ TRANS 3208.58 + 31.20  3214.81  3167.30
VIX        13.83 -  0.79    14.84    13.69
VXO (VIX-O)13.23 -  1.07    14.68    13.05
VXN        21.36 -  0.56    22.23    21.20 
Total Volume 3,577M
Total UpVol  2,199M
Total DnVol  1,324M
Total Adv  4461
Total Dcl  2532
52wk Highs  261
52wk Lows   161
TRIN       1.01
NAZTRIN    1.44
PUT/CALL   0.92

Oil crossed $50 and the world did not end. In fact the Dow ended with a +88 point gain and even more amazing the Transports closed with a +31 point gain. Feel like you are seeing the Twilight Zone come to life? You are not alone as millions of investors wonder how oil can double in price and the transports can soar.

Dow Chart

Nasdaq Chart

SPX Chart

The morning started off with a reaction dip after some disappointing economic news on top of $50 oil but it recovered on end of quarter window dressing. The morning reports started off with Chain Store Sales that fell -0.3% on top of the -1.1% for the prior week. Nothing new here with weak back to school buying and high gas prices. Year over year growth was actually up +3.5% and the best YOY growth since July.

The worst report for the day was Consumer Confidence and it dropped from 98.7 to 96.8 for September. This was the lowest level since May and most of the drop was due to the present conditions component that fell more than -5 points to 95.5 from 100.7. Consumers felt the jobs market had weakened significantly. Those who felt jobs were plentiful fell to their lowest level since May. Those consumers planning to buy homes and cars fell slightly as well. You can bet that the constant reporting on $50 oil is not going to improve confidence any time soon.

Let's dive right into the oil conversation since it is controlling the majority of air time. Oil broke $50 and the world did not come to an end and there was not an immediate sell off. Oil traded over $50 and closed at $49.90 an all time high. I use that term loosely because in inflation weighted dollars the 1970s oil crisis saw oil at levels that would equate to $80 today. The actual contract price today at $50 is the highest actual price on record and it may not get any better.

The high prices today were brought to you by Nigeria if you believe the talking heads on TV. Nigeria has a serious internal problem with militants. They kidnap and ransom hostages to achieve their demands and target oil production to emphasize those demands. They are currently warning they will declare all out war on oil on October 1st if their demands are not met. Various oil producers are evacuating workers from the country until the problem is resolved. Nigeria currently exports about 2.5 million barrels per day of which 1.6 million come to the U.S. That makes them our fifth largest importer. With the world currently in an oil crisis we don't need to lose 2.5 mil bbls of light sweet crude.

That brings us to the next topic. Saudi Arabia said today they were going to up production from 9.5M to 11M barrels per day. Almost immediately an entire army of oil experts hit the airwaves to dispute this increase. The general consensus is that Saudi could increase total output to 11 million but it would take weeks if not months for the production increase to occur. Secondly the additional oil would be "heavy" oil, not the light sweet crude that refiners want. According to several sources there is no refinery capacity available to refine any additional heavy oil. That is like pulling into a filling station for unleaded and the dealer saying he only has diesel. That may help somebody else but it will not help you.

Think $50 is high, stick around most analysts expect even higher levels soon. T. Boone Pickens said today that $60 oil was just around the corner and he was not alone. Cambridge Energy Research Associates said this years rate of demand growth has more than doubled the average for the last six years. They claim over the last decade there was always a 3-5 million bbl cushion between peak demand and average capacity. This cushion kept prices in check and smoothed out the peaks and valleys of seasonal demand. Currently this cushion has dropped to only 1.4 million bbls and less than the levels at the beginning of the 1973 crisis. Every time you hear about Iraq sabotage taking them offline for several days that eliminates the cushion. If Nigerian militants takes their production offline for a week that eliminates the cushion and puts us in a deficit. If Yukos stops production in some sector because they no longer have the cash to pay for transportation that puts us into a deficit. The bottom line is the world economy is careening down the highway with a gas tank running on empty. We are filling up at every filling station we pass but the first time we hit one that is dry the economic bus will stop.

I have preached several times about Hubbert's Peak and the coming global peak in production currently estimated for 2008. Once that peak has arrived we will be pumping less oil every day that passes than the day before. Critics claim that new technology will continue to improve drilling and pumping and let us recover more oil from new and existing fields than in the past. This is true but, picture the earth as a big sponge. When oil drilling first began you could literally find it oozing to the top on its own in many places. Wells were drilled in hundreds of feet. Current technology lets us drill wells that are miles deep in up to 10,000 feet of water in the roughest parts of the ocean. We are light years from our beginning but we are sucking oil out of the sponge at record rates. If you pickup a wet sponge out of the kitchen sink the first couple squeezes produce plenty of water. After the first couple squeezes it takes more and more effort to get any more water to flow. New technology may be able to milk a few more drops if you have the patience to wait. If you are using the sponge to put out a fire on the stove you don't have time to wait.

Currently the global oil demand is 82.5 million bbls per day according to recognized estimates. Some say this is absurdly low and the real demand is already near 88 million bbls because producing countries are keeping more and more for their own uses and it is not counted in the "official" quotes. Using the "quoted" demand levels our demand curve looks like this:

Millions of barrels per day
2004 2005 2006 2007 2008 2009
82.5 85.0 87.5 90.0 92.5 95.0

82.5 MBPD = 30.1 BILLION barrels per year
95.0 MBPD = 34.7 BILLION barrels per year

Remember, demand growth this year is DOUBLE the average growth rate of the prior six years. That means the chart above was probably outdated the day after it was produced. As we can see from the daily barrage of news stories current demand is pushing production levels to record twenty five year highs and to the breaking point. Every minor crisis puts us that much closer to more demand than production and when that happens $50 oil will look cheap. It will happen. The only question is when. How much longer can we continue finding, drilling and pumping an additional 30+ billion barrels per year?

The situation is becoming serious and there was a news story after the close that the Chinese military was said to be eying oil rich lands in Malaysia and Indonesia. While I doubt the veracity of this story it will not be long before there will be wars over the few remaining drops of oil in our global sponge. Peter Schiff of Euro Pacific Capital sees $100 oil by the end of the decade.

The problem for investors is not your next tank of gas but the eventual impact to corporate earnings. Currently only one of every ten companies claim the higher oil prices are impacting profits. I would also hasten to remind everyone that oil was trading at $25 this time last year. You and I understand that oil prices cannot double without a material impact to earnings for almost every company. Investors and corporations are still in denial. Everyone believes that this is just a spike and it will pass. A Saudi representative was interviewed again today and he quoted a future price target of $25. This jawboning is keeping the general public in the dark about the disaster ahead.

We know that there is a pre election event risk in oil because the analysts have told us there is. Right or wrong this is what everyone believes. Everyone also believes that once the election is over oil will return to more reasonable levels. While I agree there may be some event risk priced into the crude futures and we may decline after the election we will still face the rising demand and slowing production problem. Sell oil stocks the week before the election and buy the post election energy dip and hold for the long term.

Oil was not the only thing on the markets mind today but you would have to look hard to find anything else. One point of note was a positive guidance update from CAT. Caterpillar said sales were so strong that revenue will rise +25% to +30% for the full year. Before you rush out and buy CAT you should know their prior forecast was for a +25% increase. Always check your facts before pulling the trigger. CAT said earnings would rise +80% to +85% which was right inline with its previous forecast. Traders hearing the news rushed to buy the stock and Dow component CAT spiked nearly +$3 intraday. Not bad for a basically inline guidance update. To be fair there was some concern they would miss the prior estimates and Caterpillar comments like "unprecedented surge in orders" and "demand for heavy duty truck engines has skyrocketed" are always good for some knee jerk buying.

It was a good day for Google. The 40-day quiet period expired which prevents brokerage companies from issuing research about stocks they IPO. CSFB, Thomas Weisel Partners, JP Morgan, Morgan Stanley and WR Hambrecht all instituted coverage at an "outperform" but the comments were less than exciting. The price target of $145 was considered light in relation with its current gains. The companies made sure they expressed the risks as well as potential rewards and the risks were many. The main focus was increasing competition and a maturing market. Mary Meeker, Internet analyst for Morgan Stanely gave the following comment. "We believe IF Google continues to execute, the company SHOULD be well positioned to benefit from ongoing secular Internet user and usage growth." The keywords there were obviously IF and SHOULD. TWP analyst Christa Charles pointed out that Google has not been "overtly advertiser friendly" and it would have to correct that to be successful. She also said "We believe the likelihood that Google invests in negative projects is high." Still traders flocked to the stock and shorts were squeezed once again with a +$8.60 gain to $126.70.

On the downside Cypress Semiconductor warned for the second time in a month citing additional weakness across multiple markets. Share of CY fell to a 16-month low at $8.50. Earnings are now expected to be less than a nickel compared to their prior forecast of up to 15 cents per share. This sent the SOX into negative territory and shook it free from 380 support. Oddly the Nasdaq and Russell finished in positive territory with the Russell on fire with a +7.30 gain. After the bell MSPD warned and that should apply additional pressure to the SOX on Wednesday. The problem was a drop in orders from Asia and a "widespread buildup of inventory at key customers." Same song, 87th verse.

The Caterpillar bounce sent the Dow above 10040 resistance and short covering began. When a Dow stock like CAT jumps +$3 it impacts not only the Dow but the S&P. When the announcement was made the markets had been hovering near the highs and the spike just upset the balance of power. A buy program at 2:PM also kept the movement going. Dow 10100 appears to be current resistance and a level I would watch on Wednesday.

The Nasdaq was weak due to the SOX weakness but the end of day buy program pushed it back to yesterday's resistance highs. There was very little decline into the close and 1875 remains initial resistance.

The rebound off the day's lows gave all the appearances of weak end of quarter window dressing. The stocks bought were the recent winners and would make funds look a lot smarter to investors with those stocks in their statement. It was no surprise the energy sector found itself the recipient of late day cash flows.

For Wednesday we will start out with the GDP report with expectations for a +3.0% gain. This could be a challenge or a surprise but the risk is to the downside. At 10:30 we will get the weekly crude oil inventories and we have seen a drop in supplies for eight straight weeks. Last week inventories dropped -9.1 million bbls with -7 mil drop the week before. Traders are saying they expect another drop of -1.5 mil but a much larger drop could really explode prices higher. Economic reports increase on Thursday and Friday as we begin to get the September production data.

With two days left in the quarter the potential for another window dressing day is strong although the impact should be minimal. The coming economic reports should put a little fear into the market just as we enter October. Speaking of fear, the VXO is right back down and with the low today of 13.05 very close to retesting the eight year low set last Tuesday. Remember last Tuesday? That was when the Dow was at 10270 and the Nasdaq 1925, a two month high. Be very careful with the VXO this low.

Enter Passively, Exit Aggressively.

Jim Brown


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