We knew it was coming eventually but nobody expected it to appear so soon. A little over a week ago Greenspan warned the G20 summit attendees that the U.S. deficit was unsustainable and they should reconsider their U.S. investments in our bonds and Treasury notes. There was a knee jerk reaction and the markets sold off on the news from their new highs just a day earlier. Traders withdrew into their shelters and started boarding up the doors to defend against the coming horde of dollar sellers. However, the lure of a Thanksgiving rally brought them back out into the light of day and the dip was bought. The rally appeared on schedule but was very weak and lacking in conviction. Traders were still leery of the impact from the Greenspan comments and waiting for the next shoe to drop. They did not have to wait long.
On Thursday a news item hit the wires quoting a Chinese central bank official saying they had reduced their holdings of U.S. dollar debt from $585 billion to only $185 billion over the last week. The futures markets had been wildly bullish from the overseas market action up to that point. The S&P futures dropped nearly -8 points on the news and the open for Friday looked to be in serious trouble. The run on the dollar had begun according to most overnight analysis.
After several hours had passed another news item appeared with a disclaimer from China that the official had been misquoted. A couple hours later another release said the official meant they had added to their dollar debt by a large amount. Numbers started to blur, accusations flew and damage control was in full swing. Before trading began at 9:30 the entire event had been discounted and buried under dozens of conflicting news releases. The market opened higher and the damage was contained. By the end of the day every original news item from the last 24 hours discussing the event had been removed from Yahoo news. The event never happened for anyone that did not watch it unfold in real time. 98% of traders never even knew it happened but the market was still skittish and was unable to shake off the worry cloud. The markets gave up all their intraday gains and closed flat on worries that the truth would surface over the weekend and it would not be pretty.
Just when the stars appeared to line up for an end of year rally there are clouds forming on the horizon and moving in our direction at a high rate of speed. The dollar has been falling for months or maybe I should say declining. If a run on the dollar began then the entire global economy could be at risk. Other countries currently hold between $1.8 and $3.2 trillion in U.S. debt depending on whose numbers you believe. The weak dollar is not good for these investments as their value has been dropping steadily every day. As long as the decline is orderly each country can manage the move and hedge against it. If a run on the bond bank began and countries the size of China at $200+ billion in U.S. debt and Japan at $1.2 trillion suddenly began dumping those bonds at the rate the Thursday report suggested then our interest rates would rocket higher causing severe damage to our economy in a short period of time. It also would eliminate these nations as buyers of our new debt. If they are liquidating then they would have no reason to buy more. We currently average over $2 billion in debt sales per day. If there were no buyers the rate at auction would rise dramatically. The U.S. debt has always had the privilege of being a sellers market with 2-3 times more bids than the amount of debt being sold. This enables the U.S. to achieve the lowest possible interest rate on its debt. If it changed to a buyers market where there was fewer bidders than the amount we need to sell then buyers could set the interest rate they want to receive, not what the U.S. wants to pay.
A weak dollar is actually beneficial to U.S. companies because it makes our products more affordable to export and makes products coming into the U.S. more expensive. That slows purchases and increases sales and narrows the trade deficit. It is bad for the nations selling to us because it depresses their economies due to the slower export sales to us. Without our dollars to fuel their growth everything slows down. On Friday it was announced that BMW and Daimler Chrysler were going to lose millions on their exports to the U.S. because of the existing dollar drop was already much more severe than anyone expected. This is the tip of the iceberg and the market is beginning to fear that it will grow rapidly.
I know most investors glaze over when analysts begin talking about the dollar, bond relationships, foreign currency fluctuations and their impact on our equity markets. Unfortunately these inter-market relationships are a fact of life. We have been fortunate not to have seen a real currency impact to the markets since the 1998 Russian default. Currency problems tend to appear rapidly and when least expected by the investing public. The U.S. has not been the currency in trouble for decades. Most commodities are denominated in dollars and most pegged currencies in the world are pegged to the dollar. If the dollar implodes the damage is global and it could be severe.
I believe the specificity of the initial story out of China on Thursday and the nearly complete eradication of all references before the end of the day suggests it was closer to the truth than we would care to admit. Damage control was immediate and thorough. Much more thorough than just an inaccurate story would have received. We constantly see inaccurate stories on other things that are rebutted and discussed in print and the story is just corrected not erased. The stories remaining on the web cast doubt on the original numbers quoted and almost all suggest China actually added to its U.S. debt reserves over the last week. Considering that the China Business News quoted a member of the Chinese central bank's monetary policy committee in the initial article the individual was in a position to know the real facts. The difference between liquidating billions in debt or adding billions in U.S. debt are not likely to be confused.
In reality it does not make any difference if the story was true or not. The threat is still real and potentially very damaging. Even if the story was not true the effects may be lasting. Other holders of U.S. debt may be ready to take the Greenspan warnings to heart and there may be real trouble ahead.
The markets never really shook off the worry cloud on Friday and that was just the kind of rumor that could weigh on institutional investors for weeks to come. The dollar reached a new all time low against the Euro at $1.32 on Friday and the $1.30 plateau many had suggested was a temporary bottom has now been broken. The dollar also hit a new four year low against the Yen. Metals and oil could be up strongly on Monday as trading resumes after the holiday. In short it could be a very volatile week.
On Wednesday the Dow rebounded to 10525 and within easy reach of the prior highs at 10600. On Friday the Dow managed to touch 10543 intraday but collapsed into the close right back to the 10525 level. It was a weak effort at best and the flat close suggests a strong fear of weekend darkness despite two potentially bullish weeks ahead.
The Nasdaq Composite was a mirror to the Dow. The Nasdaq managed to close over 2100 by a couple points on Wednesday and after the weak intraday bounce on Friday it pulled back to 2100 again at the close. This produced a mixed message of holding the high ground but unable to advance on a normally bullish day.
The SPX was not left out with a bounce to 1186 resistance once again but ended up less than a point for the day. The SOX was the weakest index and has pulled back to the 430 battle ground we have seen a lot lately. The Russell was the only index to set a new high and close at a new high but with less than a two point gain it was also weak.
The last two trading days are historically bullish. They fulfilled their historical trend but only barely and that could be troublesome. We still have a bullish setup ahead but the worries are building. Actually the magnitude of the worries is the real problem. Investors can shake off things like earnings because they impact individual stocks or at most several sectors. They can shake off economic problems because traders are always overly optimistic about the next economic report. It is easy for them to convince themselves that there was an external event like a hurricane or blizzard that impacted the last one and the next one will be better. The one thing they can't escape would be a global meltdown of the dollar. That would impact the economy, all businesses, all sectors and all indexes. While few actually expect a meltdown to occur the type of news I discussed above is exactly how it would begin. This brings the problem too close to reality for the big money players to ignore.
The second problem is the recent gains. We have moved substantially off the lows for the year that occurred in October to the highs of the year last week. Funds that moved from a loss for the year into a profit over the last four weeks could be worried about a sudden dollar problem erasing those gains and no fund manager wants to close out the year in the red.
Next week we also have a couple of serious hurdles to cross. Thursday is not only the Microsoft dividend date but it is also the Intel mid quarter update. Considering the almost daily chip sector downgrades this could be either confirmation of a continuing problem or a positive event if Intel were to raise guidance. The Intel CEO said twice last week that things were looking stronger for 2005 on general IT spending. If that translates into improved guidance on Thursday it could go a long way toward easing investor worries about buying the highs.
The economics heat up with the ISM, Personal Income, Construction Spending and the Fed Beige Book on Wednesday. Thursday has Monster Index and Factory Orders and Friday has the Jobs report and ISM Services. The ISM on Wed and the Jobs on Friday have the potential to ruin any further December gains. Nobody expects any trouble but that is when a bad number could do the most damage. The Jobs numbers for October blew away estimates at +337,000 but there is a lingering feeling that it was somehow related to the hurricane and will not be repeatable. Should the report disappoint it may not be a disaster for equities but it could help blunt any end of year run.
The saving grace for all of these problems is still the Microsoft dividend payout on December 2nd. Most estimates suggest that nearly $20+ billion of the $32 billion gift will find its way back into the stock market within two weeks of payment. When coupled with the current strong inflows it could be a substantial liquidity event that drowns investor worries in a sea of cash.
For next week I am not expecting any material gains early in the week and I think most funds getting the Microsoft cash will want to see the Intel update on Thursday night and the Jobs report Friday morning before making any big bets. That leaves the early part of the week in limbo and we could be directionally challenged. I would like to think that some funds will continue to position themselves in front of the Microsoft payout and that would lead to an underlying bid through Wed. Until we actually see that happening I would be more cautious about going long without a significant dip. The Chinese debt comments may have jinxed the bullish sentiment we had just a couple days ago and until that sentiment returns I would be more cautious.
We also saw a drop in cash inflows according to TrimTabs with only +$1.3B through the week ended on Wednesday and this was down from the +$5B from the prior week. Once the rally started to cool so did the money flows. My parting instructions would be to remain bullish until the trend clearly changes. Continue buying dips in the SPX above 1165 but consider closing long positions should that level fail. Don't be too eager to jump in on Monday and give the market a chance to confirm a continued up trend before committing to large positions.
Enter Passively, Exit Aggressively!