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Market Wrap

October Surprise

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October is known for surprising eager investors and today was definitely a surprise. Investors trying to beat the herd into long positions for an expected fourth quarter rally were beaten back to the sidelines by a rash of negative economics, earnings warnings and Fedspeak. At least that was the excuses given by the talking heads on stock TV. We have always found that when the market is ready to move the reasons seldom matter although those responsible for reporting the news find plenty of events to blame. Today was one of those days. After a rally on three end of quarter buy programs on Thursday the SPX tried unsuccessfully for four days to break the 1230 resistance level. After four days of trying the bulls gave up and the bears attacked stragglers and punished those holding on until the close. Even a strong drop in oil prices failed to reverse the action.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The morning started off positive with falling oil prices and a strong jump in Factory Orders. The orders for August spiked +2.5% compared to a drop of -2.5% in July. Consensus estimates were for a gain of +2.0%. Durable Goods were revised up to a +3.4% gain with non-durable goods rising less at +1.6%. There was no appreciable drop in the manufacturing sector and there was a burst of orders attributable to Katrina. We just saw on Monday that the ISM rose sharply from 53.6 to 59.4 as orders for hurricane replacement products appeared more quickly than initially expected. Despite all the negativity in the Gulf regarding closed businesses, blocked rivers and ports and lack of electricity to more than a million residents the orders for durable goods exploded. This is only a trickle of what is to come but the markets failed to get excited.

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The market was more concerned with a major earnings warning from Lexmark. LXK shares fell nearly -30% (-$17.44) after cutting its profit forecast in half for Q3 and said the same factors would impact Q4 as well. LXK said slower sales of printers and ink was to blame. Apparently Hewlett Packard, absent Carly Fiorina, is waging war in the printer market and Lexmark was the loser. Canon printers are also taking market share from Lexmark. Dell has partnered with Lexmark on the inkjet side but it was not enough to rescue them. Dell sells another brand of laser printers leaving Lexmark out in the cold. There were many analysts interviewed today and most feel the damage is not yet over.

Clorox (CLX) warned that higher energy costs and higher commodity prices were too strong to be offset by recent price increases. While they plan on raising prices again they claim the dramatic increase in natural gas prices is too strong to be offset quickly. They also tried to play the get out of trouble card and blamed the hurricanes for slowing demand of their products. This failed to erase the stock drop but may have eased it slightly.

Crude Chart - 120min

Natural Gas Chart - 120min

Oil prices were also in the news with a -$2.50 drop to $63 by midmorning. This did not help the broader market as hundreds of energy stocks lost traction. The major problem with the energy stocks was not the drop in the price of oil but the first signs of damage amounts from oil companies. BP said they would miss their profit projections for Q3 by more than $700 million due to lost production and damages related to Katrina and Rita. BP said its 470,000 bbl Texas City refinery could be closed until Thanksgiving. BP said it was also losing 300,000 bbls per day of production. BP also said it would take $100 million to repair the Thunder Horse platform that was damaged by Katrina. Plus it will be the second half of 2006 before the platform can be placed into production rather than late 2005 as previously projected. This represents another loss of 250,000 bbls of production per day that was expected to come online this year. BP will still make a tidy sum as each $1 rise in oil equates to $500 million in profit for the year. Each 10-cent increase in natural gas lifts profit by $100 million. So don't cry for BP they will still be ringing the register. However their admission served to undercut the entire sector. Investors suddenly put 2+2 together and realized that there were likely to be other companies in the same boat. Chevron has multiple refineries in trouble and said there was no time frame for returning the Henry Hub to full capacity. Other firms with problems and losses mounting daily include Conoco, Marathon, Valero, Shell, Sunoco and dozens of others. Conoco said their Lake Charles refinery would not be back online until late Oct and the Alliance refinery would partially restart in December but not be up to full production until 2006. Unfortunately the average investor does not know how each player is impacted by the other and where the next profit warning will appear. They dumped the entire sector but in fairness it was due for a dumping.

BP Thunder Horse Platform

Funds had loaded up on energy stocks going into month end and there were plenty of profits at risk. The BP profit warning combined with the -$2.50 drop in oil was simply too much for the sector to bear. The losses were substantial with many losing several dollars. Some samples include APC -4.76, AHC -4.41, MRO -4.35, BR, -4.22, PBR -4.08, OXY -3.98, UPL (no Gulf exposure at all) -3.97, KMG -3.75, VLO -3.54, SWN -3.50. Of course SWN was up +18 over the last five days so -3.50 is only a wrist slap. Gas producers UPL, SWN, STR, CNX, EOG, DVN, ECA and even CHK were all knocked for strong losses despite natural gas prices closing at a new high for the week. It was simply a knee jerk reaction to the BP warning that triggered profit taking and once stop losses began to be hit there was no end in sight. Natural gas was trading at $14.31 in after hours and any continued move higher tomorrow should resurrect the gas stocks.

In late news last night Chesapeake (CHK) announced it was buying Columbia Natural Resources for $2.2 billion in cash. They are adding between 2.5-3.9 trillion cubic feet of natural gas or tcfe with half of it at $1.45 per mcfe and the other half at $2.48 per mcfe. MCFE = thousands of cubic feet equivalent. 1 bbl oil = 6 mcfe. This is a way for gas producers to account for the oil/gas liquids also produced to be discussed in one CF number. Considering that gas is now trading at $14.31 per mcfe this is a very profitable deal for Chesapeake. They picked up as many as 14,000 drilling locations that independent engineers have identified. Columbia currently produces 125 million cfe per day. Chesapeake will hedge 50% of Columbia's production through 2008 to pay for the deal and the aggressive drilling program planned for the 4.1 million acres of leases acquired. That means they will pre sell 50% of the gas in the futures market at today's historic levels. The other 50% will be profit when produced. They also acquired 6,500 miles of gas pipeline. The only two companies with more gas reserves than Chesapeake are XOM and COP in that order. Chesapeake is now the number three gas producer and nobody else is even close. This is a very positive transaction and one they have been working on for three years.

Interior Secretary Gail Norton said today that it will take months to return offshore gas production to normal. Many late life production facilities will not even be replaced due to the expense of bringing them up to the current 1988 hurricane standards. 109 older platforms and 5 rigs were destroyed and would not be rebuilt. She said the Gulf produces 20% of the gas used by industry and for home heating but despite the lingering damage she does not expect shortages. (Famous last words) She said it could take up to a year to repair some rigs/platforms. The Interior Dept said only 10% of the oil production and 28% of gas production has been brought back online. Norton said damages to rigs and platforms will be in the billions of dollars and there has been no clear assessment of the damage to the underwater pipelines. Her damage assessment to date showed 63 platforms destroyed and 30 severely damaged. Nineteen rigs were blown off their locations and set adrift dragging their anchors through the complicated maze of undersea pipelines. The take away point from her briefing was the time it would take to repair the damage and return production could be over a year. 342 platforms or roughly 40% of the manned sites in the Gulf remain evacuated more than a month after Katrina. Onshore 12 refineries and 21 gas processing plants are still offline. Norton said it would take several more weeks before the full extent of the damage to the gas infrastructure is known and months to fix.

Oil prices fell today but it is only temporary. According to the government as of Friday more than 100 million bbls of oil/oil equivalent production/refining has been lost. More than 55 million bbls of that loss would have been refined into gasoline. Wednesday is oil inventory day and the picture is not likely to be pretty. 18% of refining capacity is still offline and as much as 10% will be offline until late December or early 2006. Gasoline prices will remain high and heating oil will be under pressure. The administration said today that they would consider releasing two million bbls from the heating oil reserve in the first release ever. Of course that is a drop in the proverbial bucket in overall heating oil demand.

The challenge is still that 1.5 mbpd of lost oil production and the loss of 75% of gas production. The only thing between us and very high prices is the lingering Indian summer. A serious cold front would ratchet up the problem significantly. It is only a matter of time and we still have eight more weeks of potential hurricanes ahead. I am still advocating buying energy stocks on dips and especially stocks in the gas and coal sector. Coal is an alternate fuel for natural gas. Recommendations would be CHK, ECA, EOG, UPL, SWN, BR, BTU and CNX.

I reported on Sunday that several airlines had started cutting flights due to the cost of jet fuel. That fuel hit a record high of $3.03 per gallon today and Delta joined the others in reducing flights due to the cost of fuel. Delta said it was not sure how many flights would be cut other than they would be the routes with low bookings. Delta said it could contact passengers impacted and offer them alternate arrangements.

Google and SunMicro made a joint announcement today but there was only flash and little substance. In what had been a long awaited event Google announced it was going to start offering SUNW software as it continues its attack on Microsoft's dominance. Google will offer Sun's office suite that performs the same tasks as Microsoft's Office product. SUNW will include the Google Java toolbar when users download Java programs. Google will pay SUNW an unspecified fee each time a user downloads the toolbar. 700 million computers worldwide run Java programs but SUNW has been unsuccessful in reaping an economic bonanza from the free software. Google CEO Eric Schmidt worked at SUNW more than a decade ago and was an early supporter of Java then.

Another challenge to the markets today came from Fedspeak from Fisher, the Dallas Fed head. Fisher said in a speech "the inflation rate is near the upper end of the Fed's tolerance zone and it shows little inclination to go in the other direction." This suggests the Fed is not through raising rates and inflation is approaching a point where the Fed may have to accelerate its rate hike cycle. Fisher is the same person that said a couple months ago that the Fed was in the 8th inning of its hikes, suggesting there was only one hike to go. The markets exploded when that comment was made and other Fed speakers rushed to water down that comment. Today St. Louis President Poole and Philly Fed President Santomero both spoke after Fisher and did not contradict his remarks.

Whatever the reason for the market drop it was a very direct move. Once started with the repeated failure of SPX 1230 it was one long red candle to the close at 1214. There was no end of day rebound and no bargain hunting. The futures continued to drop after regular trading ended and as of 8:PM have yet to show any signs of buying. The SPX is only a handful of points away from its recent lows at 1205 set on Sept-22nd. Notice the green buy programs on the 29th and the red sell programs today. Clearly window dressing and undressing.

SPX Chart - 30 min

The Dow was under pressure from the open after the Lexmark, Clorox and BP warnings. While none are Dow components they are all blue chip stocks and blue chips were being sold. XOM, CAT, MMM, PG and UTX were the biggest Dow losers but it was a broad based drop. The Dow had tried for four days to break the 10565 resistance and after a valiant try this morning in the face of the warnings it simply gave up. Traders ran for the exits after Fisher's comments and Norton's damage assessment and the Dow closed -117 points off its high and at the low of the day at 10440. This is right in the middle of its congestion support range from the prior week and only 90 points away from its recent low at 10350.

The Nasdaq took an even more direct route to the basement after setting a new three week high at 2167 at 1:15Pm before dropping -28 points to close at 2139. The Nasdaq shows far more promise than the Dow and SPX with a close above its congestive support of 2110-2130 from last week. The SOX gave up -10 points into the close but still maintained its dominance as the strongest index followed by the Russell-2000. The Russell had been very strong out of last weeks lows and was giving the impression that funds had forgotten about the potential for an October surprise and were buying like crazy. The Russell and the SOX are normally the first indexes to perk up when mutual funds go shopping for fall bargains. Both were clearly showing bullish signs and supported the Nasdaq by default.

Was today's drop just a knee jerk reaction to Lexmark, Clorox and BP? I think it started out that way and was greased by the comments from Fisher. However, if the bulls really wanted to buy we would have seen an entirely different ending. Dip buying has been turned into an art form and today's performance was no Rembrandt. There was definitely a buyers boycott once the selling began. Actually there has been a buyers boycott for the last three days. The bears seemed content to wait at SPX 1230 until the last of the bulls exhausted their funds trying to breakout. With the calendar on their side they waited for the mutual funds to shift into window undressing mode and dump those positions they added just last week to make them seem smart to their customers. When the undressing began the bears piled on while the talking heads tried to pin the blame on all the high profile events they could find. Last Thursday we saw buy programs cap off the window dressing with Friday's market held in place with bubble gum and a prayer as the quarter closed. The last five days have seen better than average volume with today the strongest of the bunch at 4.8B shares across all exchanges. Strong volume on a down day is never a good sign but the internals were surprisingly tame. Decliners did beat advancers but it was not as lopsided as the closing indexes would have you believe.

With the market already slipping we did not have the oil sector to provide support after the BP warning and the -$2.50 drop in oil. That took out 12% of the market and turned those stocks into red-hot streaks as they plunged into the depths like falling stars. Energy buyers tried to catch them around 1:30 when oil/gas prices firmed but the profit taking stops were already self fulfilling at that point. Fisher's comments just after 1:PM may not have helped but I believe they were not the driving force. It was a window undressing day and BP removed the exemption from the energy sector and Norton's comments just added to the fear of damages impacting earnings for the sector.

For Wednesday we have oil inventories at 10:AM and with communication restored in most cases the EIA and API numbers should be more realistic. The past weeks have been educated guesses based on what few bits of data they could retrieve. Two weeks of sunlight has allowed most reporting companies to get the lights back on and restore some semblance of order. There has got to be some serious shortages coming down the report pipeline because petroleum products are not flowing through the various Gulf pipelines. Wednesday could be even worse as natural gas inventories are reported. With 75% or more of production shut in for the last five weeks there has to be inventory reductions there as well.

While I would hope for energy stocks to stop their slide and provide support to the market there is no guarantee firming oil/gas prices will produce that result. If today's dip scared other funds into thinking the oil rally is over then we will see even more profit taking ahead. Personally I see it as a buying opportunity with oil bouncing off strong support at $63 today. We have bounced off that level four times in the last month with a decent rally on three of those occasions. We do however have down trend resistance at $66 from two lower highs over that same period. Since past results are no guarantee of future performance as broker ads are so fond of saying there is no guarantee that $63 level will hold. However, natural gas is holding at its highs overnight at $14.30 and that could be our ace in the hole. Gas stocks tend to follow oil stocks as they are painted with the same broad brush but a new high for natural gas could break that relationship or at least blunt any further drop for oils.

Since the SPX failed to move over 1230 I am still short the broader market from just under that level. I will continue to short any bounces as long as the SPX is under 1225 unless my downside targets are reached. I have been saying that Dow 10250, Nasdaq 2050 and SPX 1190 were my targets for late September early October and I am still holding to that for the Dow and SPX. The Nasdaq has benefited from the late buying in the SOX and RUT and I doubt we will see 2050 now. I am changing that target to a retest of 2100. I will be a buyer of the broader market on any dip under SPX 1200 just in case 1190 is too much of a stretch for over eager bulls hoping for an October buying opportunity.

A word to the wise. I am sure nobody ever does this but me but I tend to anticipate bottoms before they actually appear. This results in some positions being entered before they should. Please wait for the rebound to begin and confirmation to appear before buying the dip. Catching falling knives is only for those with too much money or too little experience. Once my stitches heal I promise to never do it again. That would be the umpteenth time I have made that promise. Be patient! If there really is a Q4 rally ahead there will be plenty of profit for everyone even if we miss the actual bottom. October has been known for some really big drops and I guarantee you none were expected. As always, enter any position passively, long or short, and only when the price comes to you. Be ready to exit aggressively if the trend you expected changes suddenly.
 

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