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Market Wrap

A Series of Unfortunate Events

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On Friday traders were hit with a combination of news and events that pushed indexes to new six-week lows with the worst month of the year still ahead. Whether it was the news or the fear of worse news to come we will never know but the result was the same. The Dow closed under 10400, Nasdaq 2120 and the S&P very close to breaking the 1200 level. The talking heads on talk TV always find something to use as an excuse for major drops but seldom does it resemble reality. On Friday the excuses were Greenspan, Housing, Consumer Sentiment, Oil, Katrina, Yield curves and earnings.

Dow Chart - Daily

Nasdaq Chart - Daily

The opening salvo on Friday was the drop in Consumer Sentiment. The final reading of the August Sentiment came in at 89.1 compared to consensus estimates of 92.5. The 89.1 level was a substantial drop from July's 96.5 high. The -7 point drop was blamed on higher gas prices but a falling stock market and negative housing talk was also to blame. Consumers losing money on higher gas prices and in the market are being squeezed from all directions. The expectations component fell from 88.5 to 76.9 or -11.6 points. The present conditions component fell from 113.5 to 108.2 or -5.3 points. These are major moves for an index that tends to move in very low single digits or even fractional amounts from month to month. It represents a significant change in sentiment most notably towards the future. The gloom and doom surrounding the housing market is pressuring homeowners fearful that their equity will evaporate. Fears of lost equity in a housing crash puts those with high loan to value ratios at risk of not being able to sell at a time when interest rates are rising. All of these worries weighed on consumers. The corresponding drop in sentiment weighed on the market.

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When Wal-Mart warned that oil prices was pressuring consumers at the lowest and broadest level it was a strong warning signal of a coming problem. The flood of retail warnings by other companies over the last couple weeks has added to information base about that consumer cloud. The API said on Friday that every penny of increase in gasoline costs consumers an additional $1.4 billion a month. Just this past week gasoline prices rose +6 cents with an impact of -$8.4 billion. Over the last month gasoline has risen +37 cents for a monthly impact of -$51.8 billion, every week. Subtract an additional $51 billion from the economy every month and eventually you have a recession. OPEC does not have to attack us in retaliation for invading Iraq. They can just bleed us into a recession as a result of skillful management of oil expectations.

Greenspan has been a market mover for 18 years. In his retirement party speech on Friday he moved it again with his continued warning about the current housing bubble. The bottom line was a warning about the danger to the economy and the consumer and a warning that the Fed would continue to raise rates until it shrank. In the Fed's eyes the banking system is at risk much like the savings and loan problem in the 80s. In 2004 consumers added $1.75 trillion in new mortgage debt. This is more than seven times the annual average incurred during the 1990s. Consumers have the ability to borrow more than their house is worth and transfer short-term credit into long-term credit with the lure of an increased tax deduction. The problem with long-term credit is the difficulty in reducing it. Consumers find it too easy to re-use their zero balance credit cards and eventually those balances return to high levels as well. Consumers have to pay the credit cards to support their continued need to spend and there is no money left to pay down those high mortgages. As long as the economy is growing the consumer is able to make ends meet. Should we get another recession and the odds of that are very good, then these overburdened consumers will finally implode and foreclosures will surge. According to foreclosure.com that surge is already growing.

A reader alerted me to this info last week, thanks Joe. The June column was the foreclosures when an article was done on CNN Money at that point in 2004. CNN June 2004 Article The next column is the active foreclosures as shown by Foreclosure.com on August-23rd. If you take out Phoenix where retirees are seldom foreclosed and Las Vegas where an exploding market provides an easy out for those needing to sell, then the average for the other major areas is a +118% increase from 2004. A +118% increase and we are still in a growing economy and a strong housing market. Once the bubble bursts it could be a +1000% jump.

Foreclosure table

Another reader sent me an article last week about a For Sale sign installer in California. They had to hire new people to install signs because already record volume was increasing daily. Their latest record was 112 signs in one day. That is just one firm in one city.

The point to this is Greenspan's concerns that the banking system is not prepared to handle soaring defaults and rampant bankruptcies. The Fed warnings are falling on deaf ears and they are starting to become agitated that nobody is listening. It suggests they will continue to raise rates until the bubble becomes just a bulge. They definitely do not want to burst it because housing and banking are two pillars of the economy. They know that if it continues unchecked it will end badly.

As a result of the housing bubble the rental market has also risen. Rents in 85% of the U.S. markets have risen over the last year, some by obscene amounts. The rent index is currently at a 30-year high. This produces an additional burden for those consumers who do not own homes. Renters rarely have a large amount of disposable income and higher rents, higher electric bills and higher gasoline are going to squeeze them even harder. Another sign of a consumer stress is the recent warning by Petsmart. When times get tough consumers quit buying accessories for their pets. They still feed them but buying doghouses, new birdcages and cute play toys screeches to a halt. That is happening now according to PETM. A veterinarian friend of mine is seeing a sharp drop in patients because consumers can't afford to pay for grooming, shots, operations, etc. If the animals are sick they come in but only for the minimum treatment.

For me all the signs are pointing to a coming recession rather than good times ahead. There appears to be another soft patch developing and with higher interest rates and higher energy prices and it may not moderate as quickly as the March/April version. I believe the builders are reading the tealeaves and seeing the future. Lumber prices have fallen -25% in the last five months and that suggests to me that demand is slipping. Builders are erecting houses at a record rate but the selling season is about over. The building numbers for the next couple months will be very interesting and could show a sharp decline. On the flip side the price of copper has been rising with Friday's close only a couple cents off its all time highs. If a growing economy has a copper roof then copper prices are suggesting the current soft patch will be brief. Should copper begin to fall it could be a factor of higher oil prices reducing global demand.

Lumber Futures Chart - Daily

Copper Futures Chart - Daily

The main reason for a coming recession is oil prices. They soared to another new high this week at $68 on all the normal excuses. We had terrorist attacks, civil unrest, political hostility, fires, breakdowns and hurricanes. Oil was holding near $68 until 1:30 on Friday as all eyes were on the hurricane and forecasters tried to predict the eventual path. The outlook at the time was for the hurricane to turn north into the Florida panhandle on Sunday and miss the oil fields. Traders thought the danger was over and decided not to get caught in gap down open on Monday. Instead they bailed just before the close on Friday and oil prices fell -$2 in less than an hour. As I type this late Friday night the new storm track is aiming dead center for the big oil terminal off the coast of Louisiana. Five companies have announced evacuations from oil rigs in the gulf and more are probably scrambling to evacuate Saturday morning. Since storm track predictions leave a lot to be desired in the form of accuracy it could miss Louisiana entirely but it really does not matter. We are only in the beginning of the worst storm season in a decade and it will only take one direct hit to recreate last years shortage as a result of Ivan.

October Crude Chart - 30 min

October Crude Chart - Daily

I think the near double top at $68 on the October contract could provide a barrier to further advances unless a specific event occurs like significant damage from a hurricane. However, that does not mean I expect a major drop. We are only a week away from the end of the peak driving season and gasoline prices should moderate as that demand eases. Next traders will start focusing on heating oil, jet fuel and diesel, all of which see demand spikes in Q4. The Q4 demand typically increases by about 2 million bbls per day and given how tight supplies have been all summer there is serious doubt about supply in Q4. This means oil prices should remain high and I am told the floor traders expect $70 any day. Michael Economides, editor of the monthly World Energy Review, a petroleum engineer and a professor, said $75 oil before the year is out and $100 oil soon. He bases his prediction on the same story you have heard here numerous times.

This means the pain for the consumer will continue only more indirectly through higher prices for consumer goods, electricity and heating oil. There is no change in the natural gas picture with high demand also a Q4 problem.

I believe energy prices coupled with the rising Fed rates will bring about a recession in 2006. I believe the market is finally starting to see that vision. However, the current drop is simply the Q3 doldrums that we have been expecting for the last two months. The sell offs have been orderly and broad based as we head into what is typically the worst month for the markets. The true test of the market is not going to be the next six weeks but what happens around Halloween. If the market has not started a rebound by then we could be in serious trouble. That gives us two more months of economic data and the energy picture for Q4 should be a lot clearer.

Next week has a very heavy economic calendar. Tuesday has the sentiment twin in Consumer Confidence, Factory Orders and FOMC minutes of the June meeting. Wednesday it begins to intensify with the GDP, NAPM, PMI and Kansas City Fed Survey. Thursday we get the ISM, Construction Spending, Personal Income and Monster Employment. The ISM is the most critical of these with a consensus estimate for a rise in August to 58.0 from 56.6. Friday has the second most watched report in the August Jobs data. Current estimates are for a gain of +195,000. Remember last month the +207,000 gain was entirely from a quarterly seasonal adjustment, not evidence of real hiring. This sets up next Friday's report as a potential problem if non-adjusted jobs don't appear. We will also get the Challenger Employment Report on Friday.

With this strong of an economic calendar there is likely to be very little interest in buying. Fears of a soft patch return and memories of Friday's dip on the weak sentiment should keep most investors on the sideline. TrimTabs.com reported that only $1.8 billion flowed into funds last week but only about $400 million went into U.S. equity funds. International funds garnered about $1.4 billion. TrimTabs director of Fund Flow Research said "speculative appetite for domestic funds is completely dormant."

Also hampering the August close is its horrible history. The last five days of August typically see index declines averaging -2.5% according to the Stock Traders Almanac. Follow that with September being historically the worst month of the year for the markets and there is little to prompt investors to part with their money.

The lack of buyers was apparent as the week progressed and internals continued to shrink. The Dow closed under 10400 and is on its way to hit my initial support target of 10250. Even the addition of $4 billion in stock buybacks by HPQ failed to lift the index. Wal-Mart was the biggest gainer at +41 cents on a rebound from fresh new 52-week lows. The Dow has been declining for four weeks but the rate of decline has increased with a -161 point loss for the week.

The Nasdaq finally broke support at 2135 that had held with increasing difficulty for six days. Even a remarkable performance from the SOX in the face of extreme pessimism failed to support the Nasdaq. The Russell was the leading loser for the day with a -9 point, -1.37% drop. If anything this is a clear signal that the sentiment of funds has changed. The Russell had been trading in little more than a 10-point range since August 5th and the breakdown from that range on Friday came on very strong volume and it continued right into the close. When funds begin dumping the small caps they loved just a few weeks ago the sentiment has taken a turn for the worse.

Nasdaq Chart - Weekly

Nasdaq Chart - 90 min

I mentioned on Tuesday we had not seen any fund turnover and time was growing short ahead of the September weakness. I warned that once it began it could get ugly fast. I believe Friday's Russell rout was the leading indications of an impending flush.

The S&P-500 also accelerated its decline with a close at 1205 and is also on target to reach my initial support target of 1185-1190. This is where I expect the bulls to make a stand but the economics we see next week will determine the commitment level of that defense. Near record oil prices could not protect the energy stocks from also being sold on Friday. There is simply too much profit at risk and without the support of the energy stocks the S&P is a sinking ship. Financials, materials, homebuilders, etc are all floundering in their own pool of misery within the S&P. The SPX has multiple support lines converging in the 1185-1190 range. The 100/200-day averages, uptrend support and horizontal support are all coming together for a rebound party. We should at least get a decent pause at that level. Should 1185 break there is a distinct possibility we could see 1150. That would correspond with a Dow failure to 10,000.

SPX Chart - Daily

SPX Chart - Weekly

If you are bullish on stocks either short term or long term then your buying opportunity is just ahead. Even if economic disaster is going to strike in 2006 there will probably still be a Q4 rally. The strength and length will depend on evolving economic indicators and earnings expectations as we get closer to year-end. This means we need to start looking for a bottom to form after the third week in September. It might take 2-3 weeks but it will form somewhere in that September/October transition. Buying that dip would be the game plan for me. While I expect energy stocks to continue to be the strongest sector while we are waiting for that bottom to form I do not think they will escape the profit taking and portfolio rebalancing by the funds. If oil goes through the roof then all bets are off but I think we need to be very picky about which energy stocks to own over the next six weeks. Many analysts and fund managers believe the oil boom is over now that summer is over. They will be rotating out of oil and into other sectors. This is good for the general market and good for those of us who want new entry positions in energy stocks.

The only guarantee for the next six weeks is an increased level of volatility. That means for the uninitiated that there will be large swings in the market and probably a few strong short squeezes but the predominate direction should be down. Everyone has had ample opportunity to get short at SPX 1225 with four retests over the last two weeks once it broke. I have been warning everyone for weeks to be ready so there should be no excuses for missing the train. It is far too early to start predicting a September low but the near term support levels are still Dow 10250, Nasdaq 2050 and SPX 1185-1190. We should find traders willing to buy the dip at that level but I would only do it as a scalp trade. Be patient, our buying opportunity is coming but still too far away to be worried about it. Short/put any material bounce for the next couple weeks and then we will start making plans for the rebound. Just remember to enter passively and exit aggressively and definitely don't get married to your positions.
 

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