Option Investor
Market Wrap

Fourteen Days and Counting

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       WE 12-03        WE 11-26        WE 11-19        WE 11-12 
DOW    10592.21 + 69.98 10522.2 + 65.32 10456.9 - 82.10 +151.47 
Nasdaq  2147.96 + 45.99 2101.97 + 31.34 2070.63 - 14.71 + 46.40 
S&P-100  567.08 +  4.43  562.65 +  2.96  559.69 -  6.53 +  8.32 
S&P-500 1191.17 +  8.52 1182.65 + 12.31 1170.34 - 13.83 + 18.00 
W5000  11735.27 + 99.63 11635.6 +155.01 11480.6 -129.04 +200.13 
SOX      445.28 + 14.30  430.98 -  0.90  431.88 +  8.07 +  5.98 
RUT      642.21 + 11.05  631.16 + 17.71  613.44 -  8.54 + 17.69 
TRAN    3726.74 + 78.75 3647.99 + 80.34 3567.65 - 60.55 + 55.70 
VXO       13.61           13.35           14.60           14.05 
VXN       18.26           17.85           19.72           18.82

While the -49 Dow points for the week, -20 Nasdaq, may not look impressive on the surface we finished the week in much better position than many expected. With fourteen trading days left in 2004 the Dow covered nearly its entire range from 10600 to 10400 this week and then regained 75% of that drop by Friday's close. The bulls escaped disaster and gained needed breathing room as we head into the year end period where stocks typically move higher. A lot can happen in the next fourteen days and the outcome is far from certain.

Dow Chart

Nasdaq Chart

SPX Chart

Economic data surprised everyone on Friday with the PPI jumping +0.5% and well over the consensus of +0.1%. The component that had the most impact was of course energy prices with the gain ex-energy at only +0.2%. Inflation is rising rapidly at the producer level and eventually this will be passed on to the consumer. Finished energy goods rose +1.8% in November but was tame compared to the +6.2% jump in October. The price of energy has moderated significantly since this survey period and we can expect a downtick in gains for December. Finished goods prices have posted gains for the last four months so it appears limited pricing power is returning to manufacturers and that means higher prices ahead for consumers.

Consumer Sentiment jumped to 95.7 from 92.8 in November and this was a real surprise given the weakness in the various sentiment/confidence reports we have seen recently. The expectations component jumped to 88.8 from 85.2 and present conditions rose to 106.8 to 104.7. Given the massive drop in oil prices over the last couple weeks it should not be a surprise that consumers are breathing easier. Fears of $60 oil have been temporarily replaced by oil prices at $41 today. While this is only going to be a brief pause in the long term uptrend the average consumer is oblivious to the coming problems ahead. They live by the price at the pump and the sound bites on the 10:00 news.

Next week the main event is the FOMC meeting on Tuesday and there is unanimous agreement that they will raise rates by another 25 basis points. There is only a 10% chance as indicated by the Fed Funds Futures that the Fed would jump 50 basis points in reaction to the strong PPI. The Fed knows the gains have been energy related and will more than likely retain their measured pace scenario. There is a 91% chance that the Fed will again raise by 25 points in February and bring the rate back to 2.50%. There is a growing consensus that the Fed will pause after February and look for more signs the recovery is still in progress before starting the next hike cycle. Raising rates will create a stronger dollar and while everybody claims they want a strong dollar the truth is they are happy with the current slow decent. This helps U.S. companies compete better globally and slows imports. The only scenario where a falling dollar would be a disaster is one where it falls rapidly and disrupts the global currency balance. Greenspan warned several weeks ago that foreign banks would eventually discontinue buying U.S. debt and the comments rippled through the currency market with predictions of dire consequences for several weeks. This weeks five year treasury auction had a record 65% of the bids from foreigners. How quickly people forget once last weeks newspaper is lining the bird cage. Yields had soared last week to four month highs but the spike was very short lived.

The Fed cannot afford to raise rates much higher and risk knocking the stumbling economy off its path. Delphi reported on Friday that they were cutting 8500 jobs in a cost saving measure. The auto sector has cut -32,000 jobs this year in an effort to remain profitable on slowing sales. The Challenger layoff report last week was the third consecutive month with more than 100,000 announced layoffs. The economy is growing but it closely resembles the Wal-Mart economy. Manufacturers are putting heavy pressure on suppliers to cut costs to enable them to produce goods even cheaper and sell them cheaper just to remain competitive. Those that can't make the cuts are left on the roadside as the cheaper supplier signs up for their 15 min of fame. Employees are still the number one way to cut big dollars out of the equation and the signs are everywhere that employment is lagging.

There were several news stories this week about the global economy and the slow down in various countries. Some are nearing recession levels. That is far from true in China despite an attempt to slow their explosive growth. We need to be careful in what we wish for in hoping for a cooling off period for China. They have been the largest buyer of commodities for several years and supplying those commodities keeps numerous sectors in the black. Over the last year China consumed 1/2 the global supply of cement, 1/3 the worlds steel, 1/2 copper and 1/5th of the aluminum. Auto sales are doubling annually in China. Given the pre recession levels in some other countries a serious cutback in China could lead to even further challenges in the global economy. I understand the reasons for wanting slower growth but until other countries pick up the slack any growth is beneficial.

In stock news GE said they were so confident of returning to double digit earnings growth in 2005 they were raising their dividend +10% and announcing a $15 billion stock buyback over the next three years. Very strong news from the company which is a proxy for the U.S. economy. With the dividend jump to 22 cents a quarter GE is now paying 55% of earnings in the form of a dividend based on 2004 earnings of $1.60 per share. For comparison HON pays out 45% and UTX 25%. GE has bought back $75 billion in stock over the last ten years.

Next week Merck is going to host its annual analyst meeting on Tuesday and it is expected to provide some guidance about the financial impact of the Vioxx recall. Most brokers continue to rate MRK a hold because of its strong dividend but eventually Merck has to start building some reserves for payout to patients. There are several estimates making the rounds with the high end numbers between $38 billion and $55 billion for the potential liability. This is a huge number and to date Merck has not taken any charges for the expected resolution of the claims. Granted we are years from any payout but those numbers are so big it will take years to store up the cash. With an annual dividend of $1.50 and 2.2 billion shareholders that $3.3 billion annual payout will be on the chopping block eventually.

Fund flows for the week slowed to a trickle of only $500 million compared to a $2.5B weekly average for November. I doubt fund managers are worried because the next seven weeks should average over $4 billion a week in year end retirement deposits. This is the power behind the typical year end rally and we will be watching closely next week to see if the expected cash surge begins. The 15th is typically when the end of year cash begins to flow and it continues through January.

In anticipation of the year end surge or maybe in hopes of guaranteeing it the week was full of bullish analyst predictions. Ralph Acampora led the list with his Dow 13,264, Nasdaq 2796 prediction but he was not alone. Abby Joseph Cohen played cleanup hitter on Friday with a strong economy speech. She said that in spite of rising inflation and rising interest rates the economy should continue to grow through 2006. Her buzzwords for the day was "durability of profits" and she felt investors would see continued profit growth ahead. Profit growth even at a slower pace would still continue to provide attractive returns for investors according to Abby. The profits for the 4Q have yet to be determined but the deceleration trend is firmly in place. However, we should not jump to negative conclusions based solely on the headline numbers. Profits soared in Q1 at 37.38% and eased in Q2 to 27.88%. Q3 finally posted a quarter end bounce to finish at 18.95% and better than the 14% early reporters had averaged.

According to Thomson First Call the current estimates for Q4 are for growth of +15%. While this may seem weak compared to the prior quarters there is potential for a rare event. According to Thomson the current growth rate for the all of FY-2004 is projected to be +19.1% for the S&P-500. With only a small amount of upside surprises this could creep over 20% and it would be only the 8th time it will have happened since 1950. The last time was in 1993. Also according to Thomson the growth rate for the S&P for Q4-2003 was 28.3% and the highest growth rate in ten years. If we do achieve a +15% improvement over that rate in Q4-04 given the myriad of problems the economy has overcome it would be nothing short of spectacular. When you put everything in perspective the deceleration of earnings may not be as bad as most analysts would have us think. It will take another 12 months to see if Ralph and Abby are right but the stage is set for a bullish close for 2004 and positive earnings in January could go a long ways toward improving the 2005 outlook.

Next week the markets not only have to move higher on existing issues but there are 17 IPOs coming to market. This will suck a large quantity of investment cash out of funds and blunt the year end activity. One of the biggest will be the Sands Casino. Bankers have to get those deals priced and trading to earn those big bonus checks for 2004.

In the truth is stranger than fiction department OPEC met on Friday and decided to cut production on Jan-1st by one million barrels per day in order to push prices higher. Crude oil immediately dropped -$1.82 to close at $40.70 and a four-month low. No, that is not a misprint but a stunning event in light of the news. OPEC pumped 29.4 million bbls per day (mbpd) in November and the highest level in 25 years. 2.22 mbpd of that production came from Iraq. The current production ceiling is 27mbpd and the excess production came mostly from Iraq and Saudi Arabia and not from all OPEC member states. In fact several of the OPEC members cannot even reach the output levels assigned to them due to declining production.

The one-mbpd production cut was planned to remove excess oil from the pipeline before the heavy use winter period passed causing a rapid buildup in supplies among user nations. The International Energy Association (IEA) said a fall in 14 mb of distillate (heating oil and other products) had lowered the days in inventory to 52, the same level as September. This is trending below last years levels and at the bottom of their five year range. Officials worried that several weeks of cold weather could accelerate usage and create another shortage before the winter is over.

Crude Oil Chart

The bottom line is more speculation ahead and a guarantee that oil prices will go higher either by shortage, cutbacks in production or both. The OPEC officials clearly have abandoned their prior $22-$28 price range and the current intent is to hold oil at $40 or higher. If you had dreamed this scenario a year ago it would have been a nightmare. Now $40 oil is the baseline and after a brief taste at $55 OPEC is already addicted. Given their declining production capability it is only a matter of time before we see $75 and $100. Shock value? Definitely not! Just several months or research and I can't believe I am watching this play out so soon. The expectations for the price escalation on declining production was thought to be at least a year away. The problem is increasing world demand and it is not going away. The IEA said Q4 demand for oil had gone up +8% in China alone. I know the majority of everyone reading this article does not believe me but we are on the verge of a major problem. I explain exactly what is happening and what every investor needs to do about it in my "Coming Oil Crisis" report in the end of year special. You need to get it and make some serious investment decisions very soon. The link below is for the oil depletion chart I included in the market wrap on Thursday night for those who did not read that commentary. The numbers next to the country are the year production peaked and began declining in that country.

On Friday the markets traded sideways with only a very slight upward bias for the entire day. With oil falling to a four month low the best they could do was breakeven. While that sounds negative I was actually encouraged. The Dow managed to cling to 10550, the Nasdaq at 2127 and the SPX just below 1190. Remember this was on negative economic data and the worry that oil prices were going higher not that they were higher on Friday. Also there is the fear of the Fed coming back into the market with the Fed meeting next Tuesday. So why am I so positive?

If you remember my commentary from earlier this week the index leading us down was the Russell. The Russell had fallen nearly -4% over a five day period beginning on Monday. The Russell is the leading indicator for mutual fund activity and while a lot of the weakness was due to the SOX there was definite fund selling. On Friday afternoon that selling disappeared and the Russell rallied back over 630 and continued its rebound that began at 622 on Thursday. The Russell was the only index to close in positive territory and gained +.5% for the day. This may not sound like much but as a leading indicator for the broader market it was very positive. It suggests funds are already beginning to move back into small caps for the year end. There is plenty of incentive for the funds to prefer the Russell with profit growth for 2005 currently estimated at +27.5% compared to only +8% for the S&P.

Russell Chart

SOX Chart

I am not expecting any large gains on Monday with the Fed meeting looming but from my perspective the markets closed with a bullish outlook on Friday. All we have to do it hold our current levels until after the Fed meeting and wait for the end of year money to begin flowing. The Russell is my leading indicator but the SPX is the real yardstick. We rallied back to 1191 intraday and just below strong resistance at 1195. My outlook is still positive and I am still recommending buying any dip above SPX 1175. Add to those positions above 1195.

There is only three weeks left in 2004 and the clock is ticking on the End of Year Renewal Special. The potential profits from the "Coming Oil Crisis" report could pay your subscription for years to come. Don't wait, do it now.

Only 13 shopping days until Christmas

Jim Brown

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