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Market Wrap

Dead Cat Flop

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The weak rebound on Friday could not be called a dead cat bounce. This term has been in use by Wall Street for ages to describe a sharp rebound for a seriously oversold market. There was nothing sharp about Friday's rebound and it would be more aptly called only a pause to reload on the part of the bears. Advances and declines returned to mostly equal and volume dropped sharply from the very high levels seen earlier in the week. The markets hit my posted targets for the decline I had been expecting but the lack of a meaningful rebound suggests there may be more weakness ahead. The only real sector back from the dead was energy and without some help from the broader market that bounce could also fail.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

Friday started off well with the Jobs Report showing a loss of only -35,000 jobs when estimates were for a much higher loss of -175,000 jobs. When you consider we saw a jump of 360,000 unemployment claims directly attributable to Katrina it was thought that this would translate into a very strong job loss. There are two suggestions that were tossed around on Friday as to why the number was relatively light. The first suggests that job gains in the rest of the country offset those losses. This has some validity since September is historically a high jobs month as seasonal employment trends have workers going back to work when summer vacations are over. Many companies are beginning to staff up for the holiday season. If this was the reason for the lower than expected number then the economy is stronger than previously thought. Giving credence to this explanation was a corresponding increase in the number of jobs previously reported for the last two months. August was revised up +42,000 to +211,000 and July +35,000 to +277,000. According to the CBO about 400,000 jobs were lost due to Katrina resulting in 360,000 jobless claims. The second excuse discussed for the smaller number was an error in the reporting methods. The jobs survey is taken from a sampling of data in the week of September 12th. This was only two weeks after Katrina. The BLS assumes workers on the job in August are still on the job in September unless the sampling reports otherwise. Two weeks after Katrina there was nobody at work in the hurricane area with no power and no phones. There was no way for the BLS to sample the area so workers on the rolls stayed on the rolls. This was rather ridiculous reasoning but then it is a government agency. Regardless of the reason the lower than expected number gave the markets an opening boost that it was unable to maintain.

The sectors with the largest job losses in September were Retail -88,000, leisure/hospitality -80,000 and manufacturing -27,000. The major gains were profession/business services +52,000, education/healthcare +49,000, construction +23,000 and financial services +11,000. Hurricane Rita struck after the Sept 12th survey and job losses there are not reflected in this report. The partial counting of Katrina and all of the Rita impact will be reflected in the October report and the numbers could be significantly distorted. Elaine Chao said after the close on Friday that they were switching their methodology for the October report to assuming the company is either out of business or wiped out if they don't answer their phone. All employees for that business will be assumed unemployed for October. Obviously this will have the effect of pushing the numbers in the opposite direction. It makes no adjustment for those areas still without power and phones and will undoubtedly wrong but at least closer than the September numbers.


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Jobs openings are reported to be going unfilled in New Orleans with thousands of openings but nobody to fill them. With 600,000 homes destroyed or severely damaged and most uninhabitable the work force has moved to higher ground and away from New Orleans. As an example Burger King is offering a $6,000 signing bonus for anyone committing to work for a year. They have 900 positions currently unfilled. The Sheraton Hotel is offering free room and board in the hotel and a $5 an hour premium for new hires. Signing bonuses for flipping hamburgers and free room and board for working the minimum wage jobs? There is definitely a shortage of workers.

The other economic report making waves on Friday was the Future Inflation Gauge. The headline number rose to 122.7 for a +1.7% increase and is now at a five year high. This was the fourth month of substantial gains indicating a sharp uptick in the risk of inflation. Annualized growth projections also rose sharply to +6.6%. Rising commodity prices including increases in energy are pushing the index to new highs. This is not lost on the Fed. At least not lost on Fed President Richard Fisher. He continued his prolific speaking schedule and continued to rock the market. On Tuesday he riled investors with the following comment. "Readings on core inflation have been within the acceptable range of 1 to 2 percent, but they are edging closer to the upper end of the Fed's tolerance zone, with little inclination to go in the other direction." This suggested the Fed may have to accelerate its hike cycle in order to get ahead of the accelerating data. On Thursday he fired another verbal volley with this comment. "Money flows are an economy's lifeblood, and the Federal Reserve's great responsibility lies in maintaining the cardiovascular system of American capitalism. We cannot let the equivalent of sclerosis block the arteries and disrupt the workings of the economy, nor can we let the inflation virus infect the blood supply and poison the system." Investors are not used to having a Fed president speak so bluntly or figuratively and the reactions are quick to the perceived increase in fear over rising inflation. If inflation is rising so rapidly that Fisher and the nine other FOMC members are girding for the coming battle then maybe we should be more concerned as well. Prices paid rose by the most in 15 years according to the ISM released this week. Fed President William Poole said this week that it was "reasonable for futures markets to bet on two more increases before year-end." Fed President Santomero said "the central bank will have to continue shifting rates higher to curb inflation."

The Fed has raised rates 11 straight meetings and based on the recent Fedspeak it appears at least two more are scheduled for this year. Fed Funds futures are also pricing in a rate hike in January at the last meeting Greenspan will govern taking the rate to 4.50%. Analysts are now suggesting at least two more hikes will come after that meeting. The market is taking all this inflation talk seriously and that is one reason we may not have seen a material bounce on Friday.

Other problems giving the markets indigestion included an increase in the number and severity of earnings warnings. Most are using either the energy excuse or the hurricane excuse or both. Companies warning are seeing the obligatory decline although not as severe as the Lexmark drop earlier in the week. The excuses are becoming routine and the damage is decreasing but still impacting market sentiment. Apria (AHG) was the scapegoat on Friday with a drop of -5.46 (-12%) after warning that earnings would be $1.68-$1.72 when analysts were expecting $1.90. Apria did not use the twin excuses and but simply said a slowdown of several business lines had extended from prior periods. Word to future confessors, use the excuses and escape the pain.

RIMM suffered a defeat on Friday after a federal court denied their request to rehear its appeal of a patent suit with NTP. NTP owns a critical patent on the BlackBerry and RIMM has repeatedly failed in its efforts to get the patent rescinded. RIMM stock was held for several hours after the ruling was announced but only declined -2.42 once trading resumed. The talking heads tried to spin it as a doomsday verdict for RIMM but they are wrong. RIMM has been escrowing a percentage of sales as payment to NTP while the court case was in progress and should suffer no permanent damage. Now that the case appears doomed there is a very good chance they will settle with NTP and continue business as usual with NTP getting a small fee for each device sold. RIMM has bigger problems than NTP with the copycat devices taking market share from the BlackBerry.

Last week Microsoft applied the old saying of "the enemy of my enemy is my friend" and entered into talks with Time Warner/AOL about merging MSN/AOL in some manner. Both are afraid of the growing Google threat and are looking at how to diffuse its impact. The thought is that MSN would take over the AOL website/search functions. AOL would drop Google as their search engine and use MSN search. MSN would shift its advertising to AOL and away from Yahoo. The instant messaging components could be merged and handled by MSN and improved. MSN has significant technology that could benefit AOL and together they could resist the Google wave. After the recent Microsoft reorganization there are significant rumors circulating that Microsoft will spin off MSN. MSN has 2.6 million dialup accounts but just a distant second from the AOL millions. Together a dual spin off of MSN and AOL could solve problems for both Microsoft and Time Warner. Both are tied into the online Internet space where dialup is a shrinking resource. Longtime competitors AOL and MSN spun off into a merged company? Stranger things have happened.

The Q3 earnings cycle starts on Monday with earnings from Alcoa and Genentech leading the list. Earnings really do not develop any real momentum until the following week when the avalanche of reporting companies begins. The current First Call earnings estimate for the S&P-500 is for +16% growth but some other estimates are as low as +10.8%. Energy earnings are currently projected at +71% but that is without any material deductions for hurricane damage. As we saw last week BP was going to take a $700 million charge for damage and not meet their projections. The majority of energy earnings will be released the week of October 24th. Energy stocks account for about 11% of the S&P and without their monster earnings the S&P would be hard pressed to produce high single digit growth. This will be the 14th straight quarter of double-digit earnings for the S&P and a string never before accomplished.

The energy stocks took a beating over the last week but awakened on Friday to provide enough support to the S&P and the Russell to push the broader indexes back into the green. The pure refiners led the sector higher with strong gains. VLO +4.66, SUN +2.98, TSO +2.92 with the integrated giants, XOM, COP and CVX posting smaller gains due to their exposure to refinery damage and the price of oil. An new refinery friendly energy bill passed the House on Friday by a very slim margin. The Barton bill makes it easier to get permits for new refineries or expansions to existing refineries and eases restrictions for pipelines to get oil to the refineries and refined products to the nation. This is a long way from being a law and the Senate version could be very different. The Senate version should contain some provision for the gasification and liquidation of coal. The recent hurricanes highlighted our dependence on oil for gasoline, diesel, jet fuel and heating oil. With available technology coal can be converted into gas and diesel but up until now there was not enough economic justification to make the process justifiable. Peabody Energy (BTU) is still my best bet for coal and it is on sale after last weeks sell off. BTU announced on Thursday they were buying a 30% stake in Econo-Power. This is a company that has technology to convert coal to natural gas. 50,000 tons of coal converts to one billion cubic feet of natural gas for less than the current price of gas. Sounds like a deal to me!

BTU Chart - Daily

November Crude Chart - Daily

December Natural Gas Chart - Daily

The energy sell off was way overdone and was strictly related to the October surprise. Energy was only a piece of the broad market sell off despite the claims by the talking heads that it was influenced by falling oil prices. Oil did decline to its 100-day average at $61 before finding buyers again but this was not the problem. This drop came despite a -4.2 million bbl drop in inventory on Wednesday according to API. Gasoline fell -4.9mb and distillates fell -4.9mb. Does it seem strange to you that oil fell off the table with inventories falling? I will give you a clue. It was just the same profit taking that was killing the broader market. Funds, especially hedge funds can play the energy sector with crude and natural gas futures as well as stocks. The leverage is extreme and a little money can produce larger profits than you can get with stocks. When a broad market sell off appears it impacts these positions as well. Falling markets and falling oil and gas futures produce double damage for energy stocks. That damage was severe BUT there was no change in the outlook or the current situation. Oil is still soft because 14% of our refining capacity is still offline. That takes 3.1 mbpd of oil demand off the market with most of that demand for light sweet crude. 1.5 mbpd will be offline for 2-3 months. This also affected the price but only negligibly. It was not enough of a demand slump to solve the global problem. If you remember the IEA put 60 million bbls of oil and products on the market to offset the drop in production in the Gulf. That was a 30-day program that has now run its course. However, Japan announced on Friday they were drawing down another two million bbls of product from their strategic reserve to offset a lack of supply. This is a key point! It illustrates that global production is still insufficient to fill the demand even with our 14% of refineries offline. On Thursday the IEA recanted on its 30 day, 60 mb disbursement. They initially said it would only last 30 days and would not be extended. Now they are saying "maybe" they could decide to extend it. Based on the Japan move it appears the IEA might have to extend. On Friday the energy sector found buyers despite continued weakness in the futures ahead of the weekend. Given the numbers below I am very surprised oil prices are so calm.

The refinery outages will keep oil prices soft with 14% of our total capacity offline for up to two-three more months. U.S. total crude oil production was 3.81 mbpd in the week ended 9/30. That was the lowest recorded number since 1949. As of 10/5 there were still 3,114,700 bbls per day of refining capacity still offline. Those running only managed to operate at 70% of capacity due to lingering problems and lack of oil supply. This was the lowest level of capacity utilization since March 6th, 1987. Gasoline will remain high but oil prices should drift until those refineries come back online.

Refineries saw inputs of crude oil of only 11.715 mbpd last week. That was the lowest volume of crude refined since March 13th 1987. Crude oil imports fell -1.574 mbpd to 8.119 mbpd due to ports or facilities still closed for Rita. This is the lowest level imported since March 7th, 2003. Mexico announced on Thursday that Pemex was suspending shipment of 45 mb of crude to the U.S. in the wake of the hurricanes. Production in the Pemex fields has been suspended until the oil can be delivered to the U.S. and storage capacity freed up. Pemex was also hit by hurricane Stan and is in the process of cleaning up now
For the last two weeks I have told you I would be a buyer of the broader market with a pullback to my targets of Dow 10250, Nasdaq 2100 and SPX 1190. Those targets were hit on Thursday at the close. Heck, I just revised my Nasdaq target upwards to 2100 from 2050 last week but the Nasdaq nearly hit my original target as well. Amazing how a real sell off nearly always overshoots once the momentum builds. I did go cautiously long at the close on Thursday but I am not comfortable this weekend. The rebound on Friday was listless and on much reduced volume. Volume on Thursday was 5.56 billion shares and only 3.92 billion on Friday. That is a substantial difference and the internals were simply lackluster. Considering the magnitude and velocity of the selling, -350 Dow points and -98 Nasdaq points in only three days I would have expected a bull stampede into the market at those levels. The stampede was a no show and that flashes a caution signal to me. I keep telling myself it was because of the semi-holiday on Monday but that is probably grasping at straws.

What is bothering me is a lingering feeling that there is more to come. I don't see the reason for it given the recent underlying economic improvement. With earnings starting next week we should be seeing some speculation on those earnings reports. The lack of speculation suggests investors are worried that there will be some negative surprises. The hurricanes have put a cloud over the earnings picture despite the estimate of +16% growth. I hope I am mistaken and we see a new rebound begin next week as earnings begin to flow but the wimpy tape on Friday is not confirming that.

If we do move lower it could be just another flush attempt to retest those support levels we hit on Thursday. If that is the case it should occur on Monday/Tuesday with a Tuesday afternoon rebound a likely conclusion. If we break those Thursday lows it sets up a potential test of much lower levels. Those levels could hinge on my original 2050 support target on the Nasdaq. If that level was broken it sets up a test of 10050 on the Dow and something in the 1150 range on the SPX. While I am not expecting to see those Thursday lows break we always have to be aware of that potential. October is known for market bottoms and the dip on the SPX to 1181 was already a five month low, three month lows for the Dow and Nasdaq. That is a good place to start if a rally were to break out. Historically if the first week of October is ugly the rest of the month typically sees strong gains. I would not base any trading decisions on that piece of trivia. For the time being the trade is to be long only until proven otherwise.

The damage last week was severe and the internals were the worst I have seen in quite a while. In the table below I have highlighted the new 52-week highs for the last three days. They dropped from over 400 per day on Tuesday to only 62 on Friday. Also note the increasing volume over the last two weeks as we built up to the sell off climax over five billion shares.

Market Internals Table

Annotated SPX Chart - 30 min

It was a textbook event with end of quarter window dressing building up to a new high at resistance on the last day of the quarter. The Monday open saw another new high on a gap open break above resistance as retail traders bought the weekend news and the hype at the high. When the rally failed to continue the funds that had dressed up positions the prior week bailed along with those wishing to lock in profit ahead of an October surprise. Remember, we saw a stronger than expected end to September and plenty of confusion from the hurricanes. October brought us into a new week without any storms monopolizing the news and a week before earnings were scheduled to start. Oil was neutral with the refineries down and energy stocks were sitting at 52-week highs. It was a perfect chance to scrape the profit off the table and raise some cash for new positions in advance of the historical year-end bounce. The selling was very strong and the internals on Wednesday showed nearly a 10:1 imbalance between up volume and down volume. Decliners were better than 4:1 over advancers. This was a textbook sell off event. Wednesday's drop triggered stop losses and Thursday's open was followed by a large amount of margin call selling when no rebound appeared. That pressured weak holders even further and Thursday turned into a cleanup day with the majority of volume starting at 1:PM with the final flush of weak and margined positions. Like I said, it was textbook with the only exception the lack of a significant rebound and that is the most crucial part. Without that confirmation of big money returning to the market it means funds are still looking for something. It may be another successful support test or the first few earnings reports to reassure them the earnings are really there. Or it could be they just wanted to get past Monday and the three day weekend. Monday is Columbus Day and while the equity markets are open banks and the bond market will be closed and equity volume will be very light with many trading offices either closed or lightly staffed. Monday might as well be a holiday for stocks making it an unofficial three-day weekend. Monday could either be a throwaway day where nothing happens or highly volatile given the light volume. Either way funds probably did not want to commit large sums of money until conditions return to normal on Tuesday.

I suspect we will see the recovery in the energy sector continue next week especially after the cold weather this weekend. Natural gas supplies should be dwindling after the sudden surge in demand from the cold weather. Besides my core positions in energy I am cautiously long the broader market from my target levels and will stay that way until those levels are broken. The low on Thursday was 1181 on the S&P and that now becomes my focus number for trade direction. I will continue to buy dips above that level and go short again should that level break. As always, remember to enter passively and exit aggressively and definitely don't get married to your positions or your bias.

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