Option Investor
Market Wrap

Rates Do Matter

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WE 03-24


WE 03-18

WE 03-11










-  16.73


-  33.81


-  29.01

S&P 100


-  10.23


-    5.61


-    9.68

S&P 500


-  18.23


-  10.43


-  22.04





-  91.78





+   1.75


-  13.75


-    5.50



-    7.31


-    4.27


-  18.11



-    5.91


-  81.51


+   1.12














Rates Do Matter

After a volatile week of conflicting economics and endless sound bites dissecting Fedspeak the markets failed to rebound much from their lows. Interest rates shared the spotlight with crude oil prices and both weighed on the markets. On Wednesday yield on the ten-year rose to a seven-month high at 4.69% while crude retreated from its all time high at $58. Unfortunately both are likely to head higher and fear of that eventuality kept the markets from rebounding into the weekend.

Dow Chart - Daily

Nasdaq Chart - Daily

The economic reports for Thursday followed the same pattern we have seen recently with mixed results. Jobless Claims rose +3000 to 324,000 and the prior week was revised up +3000 as well. With the current three week average around 325,000 it seems to have found a comfortable level above the 310 average it enjoyed for the prior four weeks. This is not a market mover at this level but it is also not producing any positive comments about potential gains in the Payroll report next Friday. Analysts are quiet and not stepping out of the crowd with any high profile whisper numbers. The current consensus estimate is for a gain of +215,000 jobs and down nearly -50K from February. A tame jobs report could be market friendly because a really strong report could stimulate the Fed to raise rates faster.

On the flip side the monthly mass layoffs for February fell to 1,128 down from 1,457 in January. This was the lowest level since October-2000. The number of workers impacted fell to 74,644 and the lowest level since May-2004. The manufacturing sector still led the list and accounted for 28% of all layoffs. Contrary to the lackluster jobless claims numbers the decrease in mass layoffs was positive for next Friday's jobs report.

Durable Goods Orders rose much less than expected at only +0.3% and well below estimates in the +1.0% range. Still this was a rebound from last months drop of -1.1%. Aircraft +3.5% and Computers +2.1% were the only components with decent gains and they kept the headline number from being much worse. Shipments declined -1.6% after four months of gains. I believe the slowdown in orders is due in part to the expiration of the end of year tax benefits for capex spending. There was a flurry of orders in Q4 but when the tax window slammed shut it cutoff further orders.

The most surprising report was a jump in February New Home Sales to an annualized rate of 1.226 million and substantially over the 1.15 estimate. Sales of new homes rose +9.4% and the largest monthly gain in more than four years. January sales were also revised up to 1.121 from 1.106 million units. The builders rebounded slightly but with mortgage rates now averaging 6% they fell far short of the news bounces we have been used to seeing. TOL for instance only gained +1.27 and failed to move off critical support at $76. The bloom is off the rose until we see how buyers react to the new interest rate range. The DHI CEO said previously that the best thing for the homebuilders would be a +250 basis point hike in rates by the Fed. He feels this would mean jobs and the economy were growing strongly and that creates additional demand for houses. I believe he will get his wish. Another analyst said demand was exceeding supply because of the +30 million immigrants over the last 30 years, 30 million baby boomers looking for their last house or a second house and 25 million boomer babies now around their 30s and looking for a new home for their growing families. Yet another analyst pointed to the divorce rate at an all time high which creates new demand for two residences instead of one.

Economics next week are clustered around Thursday and Friday with the GDP on Wednesday the only material early report. On Thursday we get Factory Orders, NAPM, PMI, Personal Income, Help Wanted Index, Monster Index and Jobless Claims. Friday has the Jobs Report, Construction Spending, ISM, Consumer Sentiment, ECRI Inflation and Weekly Leading Index and Semiconductor Billings. This is huge convergence of important reports clustered in a two-day period as the quarter changes. This could be a very pivotal two days for the markets. Funds could window dress right up to Thursday's close and then bail the next day if the reports don't measure up. Considering the weakness this week I would really hesitate to establish new long positions before next Friday.

There were plenty of stocks in the news on Friday with GE leading the list. GE raised earnings estimates to 37-38 cents from 36-37 cents. It was not a big jump but GE has nearly 11 billion shares outstanding. 11 billion pennies is still a lot of money. It was not the magnitude of the move but the market friendly sentiment generated by the announcement. GE is widely seen as a proxy for the economy and an upgrade by them indicates the economy is still growing albeit slowly.

Yahoo announced a $3 billion share buyback and saw a +$1 bounce on the news. The buyback is going to take place over the next five years with no immediate impact so the bounce should be brief. AMAT also announced a $4 billion buyback over the next three years and announced a dividend of three cents. Chip maker Lexar won a court victory over Toshiba and the stock jumped over +100% to $7.25 on the news. The court ordered Toshiba to pay more than $380 million in damages to Lexar as the first award. The jury will now consider the punitive damages and based on legal precedent it could be as high as $1.2 billion. Lexar proved that Toshiba stole secrets and then entered into a deal with SanDisk to make chips using the Lexar technology. Pixar saw a +$3 jump to $95 after announcing a 2:1 split but fell by days end to close back under $93. The market weakness weighed on all these stocks and they all closed well off their highs.

Tech stocks remained under pressure with Pacific Crest Securities cutting their outlook for the chip sector. They claim global chip demand is slowing and prices are at risk. They focused on the end user market and said demand was weakening in several sectors. They cut their global chip forecast to a decline of -4% for 2005. They estimated capex spending would decline by -6%. Jumping on this bandwagon IDC also cut their PC growth targets for 2005. Tech investors have not been waiting for these analysts to paint the dreary picture. The Nasdaq has been declining for three weeks and tech funds have seen negative outflows for 15 straight weeks.

Delta Airline continued to play the oil crisis card as the reason it may have to file bankruptcy. Delta said higher oil prices could produce an additional $1 billion loss for 2005. It takes a lot of seat miles to recover an additional $1 billion in fuel costs over a year. This is a symptom of a problem that will impact all airlines and it is only going to get worse. Regardless of the exact timetable for peak oil production to occur, it will occur soon. Once it is documented airlines will be wishing for $55 oil again. If Delta is going to lose an additional billion with oil over $50 how much are they going to lose at $75-$100? I would not own an airline on a bet because they are hostage to oil more than any other industry. Planes consume huge amounts of fuel and they simply do not run on any other alternative energy source.

Oil fell back to near term support at $53.50 on Thursday and well off its $58.20 high from last Thursday. The refinery fire in Texas sent gasoline futures to a new all time high but did nothing to the price of oil. The slight rise on Thursday was due mostly to traders not wanting to be short over the long weekend. Any new problem could easily send it back to its highs given the strong stand at support. The refinery in Texas is one of the largest in the world and one of the most complex. It is unclear how much the explosion will hamper gasoline output as we move into the high demand driving season. With some gas prices already over $3 in California a shortage of gasoline could be a critical problem. Before the explosion we barely had enough refining capacity to meet demand and taking out 450,000 barrels a day is not going to help. We have not had any new refineries built in 30 years for various reasons. It takes about ten years from permit application to production and between $3B-$10B dollars. Refineries have typically returned only about 5% and given the cost, liabilities and future of oil production it is not something oil companies have been interested in doing. This also highlights how fragile our gasoline supply is currently. Should another refinery be taken out by terrorists, gas could instantly jump to $5 instead of $3 and rationing occur. There will be no excess production available once summer demand begins. All eyes will be the Texas plant for news of how production will be impacted.

Oil Chart - Daily

SOX Chart - Daily

Next week will be the key for oil prices. We saw the beginning of a profit taking dip but it was cut short by the unknowns about the refinery explosion. Since the explosion should have no impact on the availability of oil we could see a resumption of the profit taking on Monday. We are treading on thin ice here as we approach the Q2 demand slump this close to the all time highs. It will be a battle by those trying to paint the tape and keep oil prices and oil stocks high through the end of the quarter and those who want to take profits and rotate back into equities before the quarter ends. Either way the first week of April would be my target for another dip as the artificial influences on prices ease. Funds will be free to bail and move to cash in anticipation of picking up some winners from the earnings hit parade. The pressure to pad the portfolio with big names will be over for another 90 days and it will turn into more of a stock pickers market once again. Once oil prices crack it should produce some serious cashflow into equities and offset the impact of higher rates. I emphasize once again that any Q2 dip in oil will be a buying opportunity in my opinion.

TrimTabs reported on Thursday that equities were seeing $3 billion a day in corporate buying based on the current buyback plans in place and the acquisitions in progress. $1.5B of that is replaced by insider selling, a rate not seen in many years. Mutual funds are seeing $.5B in positive cash flows each day and money market funds are surging. This combines to represent +$2 bil per day in inflows but you would be hard pressed to find out where they are putting it if not in the energy stocks. Payroll tax flows are rising at a very strong +8% indicating more people working and wages are growing. There is plenty of cash available but it is not going into the broad equity market. Energy, commodities and metals are the only constant winners and the broader market is languishing for lack of cash.

Ironically the semiconductor index was the only index to close the week with a gain. Support at 410 was defended by buyers despite the almost daily cautions by various analysts. I am encouraged that 410 did not break since 400 is much stronger support. This gives the chip stocks a potential floor as we move into earnings. We moved into the warnings cycle with hardly a noticeable increase in confessions. So far the Q2 earnings cycle appears to be right on target. Unfortunately Q3 and Q4 are starting to weaken as analysts take down their optimistic targets a notch or two.

The Dow rebounded back over 10500 from its Wednesday lows at 10430 but it could not hold the gains. The Dow closed at 10442 on Thursday and just a sound bite away from critical support at 10400 and the 200-day average at 10375. If there were ever a level that should be bought given our current calendar, sentiment and setup, this would be it. It gives the funds a comfort base heading into the month/quarter end and removes some of the risk in their minds. Once into April it will be up to earnings and guidance to hold that level.

The Nasdaq dipped back below the 2000 level and closed exactly on support at the 200-day average at 1992. This is the trigger switch that could void the Dow setup I mentioned above. Should the Nasdaq fall below the 200-day it is typically a sell signal for funds. The longer-term uptrend support is around 1965 but once under the 200-day it may not matter. Like the Dow, the 200-day at 1992 could provide a launching point for any end of quarter window dressing but I would be cautious about any bounce once we get to April.

Nasdaq Chart - Weekly

SPX Chart - Weekly

We are entering the "sell in May and go away" period where investors put their money on the shelf during the summer doldrums in anticipation of reentering the market on the October dip. With rates rising it puts additional pressure on those part time investors. I heard three separate analysts on Thursday comment about a rising concern that the Fed could jump to +50 points at the May meeting based on the rapid increase in inflation and still retain the measured pace profile. Whether they do or not is not the problem. The key is what the market thinks they might do. If this mindset gains acceptance and April guidance is flat then there could be a rush for the exits. Given the market weakness over the last several weeks we could be seeing the early adopters already taking an early exit.

The markets for March have been terrible despite testing new relative highs early in the months. The Nasdaq is down -8% for the month, Dow -2.6%, Russell -5.1%, S&P -2.9%, SOX -3%, TRAN -1.1%, Biotechs -7% and leading the losers list, Internets -14%. This is not what you would expect from stronger than expected earnings over the last five quarters and a growing economy. Thursday was the five-year anniversary of the all time high on the S&P at 1552. October 2002 was the cycle low at 768 and March 7th was the cycle high at 1229. That was a -48% drop from the highs and a +60% rebound from the lows. That rebound was a 29-month bull market that is showing some extreme volatility at the upper end of its range. Could it be that we have reached the end of this bull move? The long-term support from the March 2003 triple bottom low on the S&P is currently at 1160 and that is exactly where it converges with the horizontal support from Jan-2004.

There is another train of thought for the current market with buybacks and dividends hitting records each month. So far in March we have seen 111 dividend increases and an all time record for one month. Only three stocks cut their dividend. Multiple buybacks are being announced nearly every day. Most see this as market positive but there is another view. When this many companies announce buybacks it suggests we are at the end of this growth cycle. When companies like MSFT, YHOO and AMAT start giving their cash back to shareholders in large amounts instead of expanding their businesses through acquisitions, new products and capital expenditures it means they can't find anything to buy. Using this train of thought, the record buybacks could be a sign that we have reached a major market top. Add in the rising interest rates and the coming crisis in oil and there is definitely higher than normal market risk ahead.

The market is clearly setting up for a pivotal decision point over the next six weeks. Now more than ever investors need to ask themselves "why buy" and take extra pains not to let the perma-bulls impact their thinking. This may sound heretical but markets can decline on strong earnings. This may sound contrary to the current drivel you hear on stock TV but it is true. Stocks go up in ADVANCE of earnings not because of them. The age-old market axiom is still true. "Buy stocks when nobody else wants them and exit when everybody loves them." The perma-bulls are pounding the table on equities now for multiple reasons. They are trying so hard to get investors to buy that it should be a warning signal. Unless the picture changes I would be looking to buy more puts than calls on any end of quarter bounce. If SPX 1160 fails I would be 100% short instead of long, except for energy stocks. That level should be your key for the next quarter. A break there is confirmation the bull is headed for the butcher's case and the bears are lining up for a steak dinner. Definitely enter passively and exit aggressively.


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