Last Sunday cracks were beginning to show in the October rally and today it would take more than Visine to get the red out. October has lived up to its reputation for red numbers for the indexes but good news may lie ahead. October is half over and hopefully it was the bad half.
Economically Friday was a not exciting for the bulls with conflicting numbers once again. The bad news began with the NY Empire State Manufacturing Survey. The headline number fell sharply to 17.4 from 27.3 and almost completely reversed the September gains. Since topping in July at 35.8 the index has been trending lower and suggests the economic boom for manufacturers in New York could be coming to an end. Shipments fell from 32.1 to 19.1, new orders fell from 26.2 to 21.2. Back orders turned negative at -2.7 from 11.7. Employment fell to 17.6 from 20.3 and prices paid soared to 59.2 from 52.0. A positive headline number still indicates growth but the internal components paint the real picture.
The PPI showed rapidly rising inflation is still with us. The prices for finished goods rose +0.1% in September and +0.3% for the quarter. However, the headline number does not give the true picture. Core intermediate goods rose by +9.0% for the quarter and September was the 14th month of consecutive gains. Non-durable goods rose +19.4% for the 3Q. Core crude goods rose +50.3% for the quarter. Any questions now about why the Fed is not backing off its rate hike policy?
Retail Sales soared much higher than expected in September with a +1.5% headline number but in reality it was not as good as it appeared. Automakers dumping inventory accounted for two-thirds of the number leaving all other retailers struggling at +0.6% and inline with the consensus estimates. Auto dealers saw sales jump +4.2% for the month in an effort to dump 2004 model inventory. Building supply stores saw a +1.4% gain mostly due to hurricane related buying. Ironically sales at gas stations only rose +0.1% as angry consumers cutback on driving to save money.
Industrial Production rose only a very minor +0.1% and well under expectations and the August number was revised down to -0.1%. Production gains have been trending down since Nov-2003. Manufacturing fell -0.3% and August was revised down to only a gain of +0.2% from a previously reported +0.5% gain. Capacity Utilization fell across the board with Durable Goods slipping to only 73.2%. This means more than 25% of capacity is idle due to lack of demand. Low utilization means no pricing power as companies fight for market share just to keep plants running rather than increase profits.
Business Inventories rose +0.7% but slowed from their pace from the prior month. Sales rose to match the inventory and the balance appears to be holding. The low rate of inventory build may be beneficial to manufacturers who are avoiding buildups where possible but it is detrimental to the GDP. In Q2 the inventory gains added +78 basis points to the GDP but for Q3 it could be a negative number as the rate of growth slows.
You may recall I cautioned about the Consumer Sentiment on Thursday night. Friday's report showed sentiment falling sharply to 87.5 from last months 94.2. This is the lowest level since March-2003 and not a good sign for the future. This was the sharpest one-month decline since February. Consumer outlook for the future fell from 88.0 to 79.6 and the first time under 80 since April-2003. The reasons given for this sudden drop in sentiment were higher gas prices, negative economic comments from the Kerry campaign, falling markets, slow job growth and earnings guidance for 2005. This is amazing since the survey was done before the high profile company specific guidance began to appear. Consumers are beginning to believe analysts that growth for all of 2005 could be only +2-3%.
The markets on Friday opened up slightly but hesitantly and walked the flat line until the text of the Greenspan speech on oil hit the wires. The speech went into great historical depth explaining why current oil prices did not worry him and there was an immediate spike in equities and drop in bonds. Clearly an asset allocation program triggered on the positive comments but the impact was not lasting and the bonds and equities returned to the prior levels before the day was out.
Ten-year yield chart
Crude Oil Chart
The main point of the Greenspan speech was a lack of worry about oil prices based on historical trends. Oil dipped slightly as the speech was delivered live but promptly rebounded to trade at $55 and close at another new high at $54.93. Why do you think this happened? Mr. financial himself just said oil was not a problem and not to worry.
After reading the entire text of the Greenspan speech I was struck by the complete divergence from present day reality that appears to be evident in his thinking. He suggests that new technology, cheaper fuels and better oil recovery methods will delay the depletion of all oil reserves until 2050. While that may be true the oil crisis will reach epic proportions well before the last drop of oil is extracted from the ground in 2050.
Currently emerging economies like India and China only use a fraction of the oil consumed by the U.S. The U.S. has a population of 290 million and we consume about 22 million barrels of oil per day. China has a population of 1.3 billion, four times the size of the U.S. China only consumes 6 million barrels per day but that rate of consumption is expanding rapidly. It is a well known fact that emerging economies consume more oil per capita during their growth phase than fully developed countries. China is currently exploding from its agrarian society and rapidly improving the life style of its population. However China is still well behind the industrialization levels of Korea and Japan. Both Japan and Korea currently consume 16 bbl per person per year. If China only brought the coastal 1/3 of its population to the current economic and technological levels of Japan/Korea it would increase China's consumption to more than 20 MBpd. That is the equivalent of adding the production of two Saudi Arabia's operating at full capacity to the daily global production. It is just not going to happen. Add in the explosion in India and other emerging economies and global demand could increase by 30 Mbpd over the next 10 years.
Greenspan made a big deal about the 100 billion barrel increase in reserves over the last decade while at the same time 250 billion barrels were consumed. What is wrong with this picture? It is a sure bet that the current decade will NOT add 100 billion barrels to known reserves. If that additional consumption of that 30 Mbpd projection above came to pass it would increase annual consumption by over 11 billion barrels and that does not include increases in consumption by already developed countries.
In other words reserves increased at only 40% of the rate of consumption over the decade of 1990-2000 with the advent of deeper drilling, monster offshore wells, and a vast improvement in recovery technologies. Consumption increased over 50% during the same period. Current annual consumption is 31 billion barrels. Add in the 11 billion in expected new consumption from just the emerging economies and increases in existing economies and consumption in the current decade could spike to 500 billion barrels. If we only found 100 BB of new reserves from 1990-2000 with the worldwide race to locate those reserves then it should be clear to everyone that we are not going to find another 500 BB between 2000-2010.
The outlook is clear to anyone that wants to take the time to think it through. The easy oil has been found and the major fields are already drying up. New technology and additional discoveries will add to known reserves but at a far smaller pace than current reserves are being consumed. If we did find another 100BB over this decade it would be less than a three year supply at current demand levels.
I believe the Greenspan speech was crafted to DOWNPLAY the current crisis and attempt to TALK DOWN PRICES. The Fed is famous for this in multiple markets over the years. When the Fed finds itself being pushed aside by current events they will always try to talk the problem away. When David confronts problems of Goliath proportions the first weapon of choice for Greenspan is a word barrage. By the time the current scenario plays out Greenspan will be retired and new presidents in power. This attempt to talk down oil prices is a stop gap measure to stop the bleeding. The U.S. economy is currently experiencing a $20 billion per month undeclared tax on consumers from the increase in oil over the last six months. $20 billion of valuable purchasing power evaporating each month. You do the math. Greenspan is simply trying to apply a tourniquet to the wound to stop the economic bleeding. If he could talk down prices, a feat OPEC and Saudi Arabia have been unable to do, then the pressure would ease on the administration and on the economy. Unfortunately those who understand the problem and have no vested interest in Greenspan's economic game plan considered his statements for all of an hour and then pushed prices to another new high. Greenspan is firing blanks in this battle. Back in July he called high-energy prices as a "transitory uptick". Friday he warned that further increases in oil prices could continue and cause more long term damage to the economy and had already subtracted -0.75 off the 2004 GDP. Of course these negative points were glossed over by the media.
Every day we are coming closer to the day when oil production peaks forever and begins the downhill slide to that last drop in 2050. That day is currently expected in 2007-2008 depending on how fast China grows. Once demand exceeds production and that could come over the next three years, the price of oil will explode higher. Once orders exceed capacity the bidding war for available production will skyrocket. The crisis will not be when oil is gone in 2050 but when the demand exceeds production on a daily basis. $55 oil will quickly become $100 oil or even higher. Demand and production are balanced very precariously today and the prices are at all time highs. What if demand only exceeded production by a million barrels per day? That is less than a 1% increase in demand at current levels. One million bbls per day, 7 mil per week, 21 mil per month. Get the picture? Oil sales will become a bidding war and price will become less of a concern than actually getting delivery. $5 gas by 2010? I would NOT bet against it.
The chief economist for Conoco Phillips told a business audience on Thursday that oil prices would remain high due to a "permanent structural change" in the industry. The economist said the cost of finding new oil reserves is over $30 a barrel and rising sharply due to the difficulty of prospecting and drilling in remote locations. They cited unrest in oil-rich areas, constraints on global production capacity and rapidly increasing worldwide demand. I would assume the chief economist for Conoco probably knows what they are talking about.
I do believe oil prices will moderate after the election but it should be considered a long term buying opportunity for those stocks that have large proven reserves. The longer that oil stays in the ground the more valuable it becomes. Five years from now I believe we will look back at $50 oil just like we look back at 99 cent gas today. If this scenario comes to pass then a global recession will eventually appear. When countries can't get or afford oil their economic expansion will slow. I reported last week that Goldman Sachs Commodity Index had risen +103% over the last 33 months. A recession has never failed to appear when the index rose over +55% in any 30-month period. Bulls will always claim this time is different until they are run over by reality. Need proof? Oil hit an all time high of $55 today and the Dow transports are nearing a four year high. Delta is losing $6.78 million per day and will eventually follow the other carriers into bankruptcy. All airlines are reportedly losing more than $1 billion per month on fuel costs. Fuel is the largest expense for the transportation sector. Compare these charts and tell me there is not something drastically wrong with this picture.
Transport/Crude comparison charts
The markets struggled all week and the insurance implosion on Thursday stifled any chance of a recovery. $40 billion in market cap was wiped out in a matter of minutes. Spitzer managed in one fell swoop to punish stockholders of those companies to the tune of a 30% to 40% loss in their retirement holdings. Millions of investors suffered irreparable harm for the sins of the few. Did he really have to go public in such a visible manner? Could he have worked with them in private to achieve a settlement that would have left their market cap relatively intact? Absolutely! I believe we have a prosecutor gone wild and living for that next jolt of adrenaline that the public limelight brings regardless of how many investors are hurt. Shame on you Spitzer. Lose the ego and get a conscience.
On Friday the Dow rebounded off its two month lows and struggled in vain to hold its intraday Greenspan gains. By the close it retreated back to within 30 points of the 9900 level and appeared tired from the effort. The Dow will start off on Monday with two major earnings hurdles with MMM and IBM both reporting. MMM before the open and IBM after the close. Those are just two of the over 500 companies to report next week.
There is a very heated discussion underway on the potential for a retest of the lows for the year at 9783 and the potential for that retest to hold. Should the Friday rebound from 9900 hold and we move higher from here it would be a higher low and a bullish event. There is a growing group of technical analysts that think it will not hold and a lower low is in the cards. Technicians feel future events such as the election are already priced into the market and the potential for a lasting post election rebound is slim. The sentiment traders feel the current October dip was a normal event as will be a coming pre/post election rally. Those keeping statistics point to the election trends for the last 100 years and suggest the growing Kerry lead predicts an incumbent defeat and the potential for the Dow to retest 9000 rather than 9800.
The bottom line is the market is very confused. Historical trends are failing. Oil is at all time highs and showing no indications of falling. Bulls are in denial of the earnings deceleration ahead and mutual funds are piling up cash while waiting for a sign of normalcy to return. Buffett has 38% of his assets in cash and many funds are adding to cash instead of equities. Bonds are continuing to rise and long term rates are falling despite an aggressive rate hike program by the Fed. Times are very confusing and traders do not know where to jump.
When all else fails we always have to drop back to the technicals for directional hints baring an external event. The Dow must hold 9800 or all bullish bets are off and a new game plan will have to be drawn up. Resistance on any continued Monday bounce is 10000 with 10100 a close backup. The Nasdaq returned to support at 1900 on Friday and managed to rebound to 1925 resistance on the midday asset allocation program. Overall the Nasdaq is clinging to the relatively higher ground although still in a long term downtrend. 1850 would be dip support and 1965 strong resistance.
When the Dow/Nasdaq are giving conflicting signals we need to look at a broader market indicator. The Wilshire 5000 has gravitated around the 10750 level since January and that is right where it started the year. The Wilshire has held up remarkably well compared to the Dow and looks more like the Nasdaq in performance. When determining broad market support level the 50dma on the Wilshire has been both support and resistance on many occasions all year. The current horizontal support is 10750 and the 50dma is 10785. I believe this 10750-10785 is the crucial market level to watch next week. As long as we remain above it I will remain bullish but a break below would turn me bearish in a flash. If the Wilshire decided to return to the downtrend support since January it could easily project back to 10000 and a -800 point drop. I do not expect that but it would be the worst case. By watching the Wilshire ($DWC) it removes the weighting impact of individual stocks like AIG in the Dow. AIG was responsible for nearly two thirds of the Dow loss on Thursday.
ilshire 5000 Chart - Support/Resistance
Wilshire 5000 Chart - overview
Other considerations include the SOX where 380 support is beginning to look weak and a break there could easily drop quickly to 350. The Russell is holding above support at 560 and doing well considering this is small cap shuffle month. The 100dma is trending up at the 560 level and time is expiring on the October calendar.
Taken together the best picture of the market can best be seen by watching the Wilshire at 10750, Russell at 560 and the SOX at 380. The weakest being the SOX at 380 with short-term risk to 350.
Everybody always wants me to boil down the analysis to a sentence or two. If it was that simple I would not need to write the complete wrap. In my opinion there is a huge pile of cash on the sidelines. Indecision is rampant and over the last nine months we have been moving in the tightest trading range (SPX) in decades. Hedge funds are losing money, mutual funds are breaking even and nobody in the fund management business is making any money. Everyone has a vested interest in pushing the market higher once the election is over regardless of the winner. With the abundance of cash available the potential for an end of year jam job is tremendous. I believe that despite bad earnings and the fear of ever increasing oil the fund managers will try to produce an end of year rally in hopes of getting to January with a profit and then pop the parachutes. Obviously if oil continues to break new levels it will be difficult but some of the current speculation in oil is based on election risk and the potential for a terrorist event.
Once the election is over the speculation will ease and oil should revert to a lower level. Those analysts not on crack expect something in the mid $40 range. This will give fund managers something to base their buying on and the end of year rally becomes a self fulfilling prophecy. We are already seeing profit taking in the energy stocks despite new all time highs in oil. Funds are trying to raise more cash while slipping quietly out of the energy door. I also believe there is enough disbelief in the market that should a rally actually appear the majority of traders will either wait on the sidelines or continue to try and short it. Both groups will end up chasing prices higher and contributing to its success.
This is of course just my humble opinion and by printing this commentary it will make a suitable substitute for newspaper on the bottom of your birdcage or as a starter stuffing for your next fireplace fire. No one can predict exactly what will happen over the next twelve trading days until the election but hopefully the scenario I laid out above will bear some resemblance to the actual events. The alternate bearish scenario of a Wilshire retest of support at 9300 is more than we want to imagine tonight. The negative ramifications would be enormous and best left to my Halloween commentary two Sunday's from now. Nightmare on Wall Street? Let's hope I don't have to write it.
Enter Very Passively, Exit Very Aggressively!
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