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Market Wrap

Techs Sink Market

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Despite a rise in oil prices and energy stocks the markets failed to make any material gains in front of the FOMC minutes at 2:PM. The report provided strong confirmation of what the various Fed heads have been saying. Inflation is rising and interest rates have a long way to go before the Fed takes a breather in their rate hike cycle. The minor bloom in the market before 2:PM faded quickly as the facts dulled excitement for buying the October dip. There was nothing new in the report but news in black and white seems to trump random sound bites of various Fed speakers. The Nasdaq was the weakest link with tech stocks still in a steady decline as earnings approach.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The FOMC minutes was the only material economic news today and the markets were more focused on earnings and earnings warnings than economics. Monday's warning by Burlington Resources (BR) had knocked the energy stocks back to support once again as charges for damage and weakened production output loomed larger on the horizon. Numerous energy companies will post lower than expected earnings even if they suffered no damage in the gulf. Undamaged refineries will post lower earnings because of smaller amounts of oil to refine. Pipeline companies will post lower earnings because of lower volume of products through their lines. Drillers and production companies will suffer as shut in periods remove daily revenue and fees fall below expectations. This is nothing new to those who invest in the energy sector. We have been expecting the other shoe to drop since the BP warning two weeks ago. BR is only another domino to fall and the chain reaction could claim dozens more although the reactions will only be temporary. While there will be plenty of hurricane related charges in the energy sector we should not expect any major fall out. Earnings in the energy sector are still expected to exceed +70% for the quarter. The majority of energy earnings are due out the week of Oct-24th so the time for warnings is quickly coming to a close.

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The first major earnings for this cycle have begun to appear. DNA beat the street by a nickel on Monday and soared +3.25 today. Alcoa also announced earnings and beat the street by +4 cents and jumped nearly a buck in early trading. As of noon on Tuesday 26 of the 35 S&P companies already reported have beaten estimates. This is a very good ratio although early reporters typically beat estimates.

After the bell Apple Computer announced earnings and sales of 6.5 million iPods. This was well under the street expectations of 7.5 million units. Earnings were +38 cents compared to consensus estimates of 37 cents. The whisper number was 40 cents. The less than expected iPod sales number surprised investors and AAPL stock dropped sharply from $51.61 to $46 in after hours trading. This was a very sharp blow for tech stocks. Dan Niles was on CNBC after the announcement and he was very cautious about future tech earnings. He expects a very tough quarter and mentioned Dell by name as struggling to extract sales from a tough market. With gas at $3 a gallon and home heating bills expected to rise +50% to +70 percent this winter there is very little discretionary money available for toys. Apple did say it had shipped over a million Nano iPods in the 17 days after they were released. They said demand was very strong but components were in short supply and they could not say when the massive back orders on the Nano could be filled.

AApple Chart - 390min

However, I believe the lower than expected iPod sales could have been related to the constant rumor of a pending announcement for a Video iPod. This could have kept buyers on the sidelines in hopes of buying that device rather than settle for just an audio unit. Apple is going to make an announcement on Wednesday and rumor has it that it will be that video player. The announcement is in a concert hall where they could have a surprise special guest performer. Regardless of tomorrow's outcome the earnings surprise could be very detrimental to tech expectations in the weeks to come.

Sycamore Networks posted a surprise profit of a penny when analysts were expecting a loss of -2 cents. SCMR has traveled a rough road over the last several years and the surprise beat found few interested buyers with only a +50 cent jump.

AMD announced profits of +18 cents driven by all-time record sales of $1.523 billion. Third quarter sales were up +23% and gross margins climbed to 41%. They announced more than 20 new processors throughout the quarter. CPU sales increased +44% but memory products decreased -4% in a price challenged market.

Intel announced new dual-core Xeon chips for dual processor servers. These chips offer up to a +50% improvement over dual single processor systems. AMD had taken the speed edge and pushed their market share from 7.4% to 11.2% of the server market while Intel lagged behind. There are now rumors that Intel has another announcement ahead that could leap frog AMD into the next generation of processors. Using the chips announced today a dual processor, dual core system using hyper-threading will act like an eight processor system processing eight threads at once.

RealNetworks struck oil today with a $761 million settlement from Microsoft. $460 million was an upfront cash payment to settle the suit and another $301 million in cash was for an agreement to make RealNetworks products available to a wider market. Microsoft has written more than $5 billion in settlement checks to tech companies over the last four years in an effort to settle all outstanding problems. Gates and Glaser, CEO of RNWK, held a joint webcast to bury the hatchet and appear friends in front of investors. RNWK shares jumped +50% to three year high at $8.50 before startled traders rushed into take profits.

GM and bankruptcy continue to be mentioned in the same sentence after Delphi filed for bankruptcy. GM debt was cut to an even lower junk status as fears of a GM filing grew. While nobody expects it soon the bond traders are worried that the assumption of some Delphi debts could put GM even further behind the eight ball. SUV sales are falling faster than the temperature and losses continue to mount. Analysts feel that a bankruptcy for GM is the only way to shed its retirement and pension liabilities and "job security benefits". Those benefits translate into "knock the unions back into the 70s with lower wages and benefits." Labor now accounts for a very large portion of each vehicle made with health care costs alone well over $2500 per vehicle. GM could see $11 billion in pension liabilities flow back upstream to GM if Delphi is unable to pay them. There is a very strong indication that the Delphi bankruptcy could lead to a GM bankruptcy and a complete renegotiation of their union contracts to only a fraction of their current cost. This would lead other manufacturers to break their union contracts and the chokehold they have on the auto business. This could be heading towards a landmark event.

The FOMC minutes raised the inflation flag to a new level as it was almost the only topic other than Katrina. The hurricane was two weeks old at the time and the real damage was still not known. The Fed thought the impact would be out of the system by 2007. They lowered their GDP targets for the rest of 2005 and raised them for 2006. The most repeated comment was regarding the need for further hikes. "The upside risks to inflation appeared to have increased" and "further rate increases probably would be required." There was also a troubling comment on the progress of the economy. "Although real outlays for equipment and software increased solidly in Q2 available data on orders and shipments suggested some softness in Q3." These comments sent the market lower into the close despite a short buy program on the first post release dip.

The yield on the ten-year note continues to rise with a close today at 4.384%. As we approach the 4.5% to 5% level it becomes increasingly important that the equity markets thrive. When institutions are faced with a lackluster market, dim economic outlook and rising inflation they will shift funds from equities to treasuries once yields reach those levels. We don't need any asset allocation programs out of equities and into bonds at this critical level. Gold is also rising on fears of inflation with a new 18-year high reached on Monday just shy of $482. There was also some analysis in the news on OPEC gold levels. They typically hedge against the next economic downturn by investing oil profits in gold. The current levels of OPEC accumulation are well below previous cycle highs. This suggests OPEC may not feel oil prices are going lower any time soon.

November Crude Chart - Daily

December Natural Gas Chart - Daily

The International Energy Assn said today that it saw no lasting damage to oil demand as a result of the price hikes in the aftermath of the hurricanes. The IEA, adviser to 26 industrialized nations, forecast demand growth would rise by +1.75 million bbls per day in 2006. They said demand was already returning in the aftermath of the storms and demand from China was also accelerating again at a +4.8% growth rate after a dip in August. The IEA is now expecting shortages this winter and the demand destruction myth we have heard over the last four weeks is quickly being proven wrong.

The Minerals Management Service said today that 74% of oil and 60% of gas is still offline in the Gulf. More than 10% of our annual production of oil has been lost along with more than 7.4% of gas production. More than 3.0 billion cubic feet of daily gas production will be offline until MARCH! Even worse for drivers is the news today that 2.1 mbpd of refining capacity is still offline and much of that is still 60 days or more away from returning. Total said today they were beginning a restart of their refinery but it would be ten days before full production was achieved. The Explorer pipeline also said it was restarting but it could be a week before there is enough product to fill it.

Oil and Gasoline inventories to be released tomorrow should show a -1.5 mb drop in gasoline supplies. Strikes at refineries in France have also put a crimp in global gasoline supplies. Distillates are also expected to show a drop in supplies for the third straight week. Crude rebounded off support above $61 and rose +1.75 to close just under $64. Natural gas jumped nearly a buck from Monday's low at $12.70 to $13.70 after hours today. That magic $14 number is a target once again and energy stocks, especially natural gas stocks saw strong gains. The overall winner in the energy sector was not a refiner, driller or an oil/gas stock. It was Peabody Energy once again posting a strong +$3.64 gain. I mention this stock at least once a week as a must have in your energy portfolio and you need to act on that recommendation.

I would like to tell you that the markets rebounded off my support levels and the Q4 rally has begun. Unfortunately I can't. The Dow has retreated to rest on 10250 and although it posted a minimal gain today it was not encouraging. That 10250 level has come under increasing pressure as time passes and a breakdown there is going to get ugly. The S&P retreated to rest on support at 1185 and was kept from a complete breakdown by the rebound in energy stocks. Those +$2 and +$3 gains in the energy stocks kept the S&P above water but only barely.

Both indexes were dragged down by a dismal performance by the Nasdaq, which fell to 2060 and the low of the day at the close. There are many reasons making the rounds regarding the lack of tech buyers but none matter. It is enough to know that techs have fallen out of favor and the black hole in the tech sector is the SOX. The Nasdaq fell -.85% today but the SOX fell -1.66% to 438. The chip sector was so strong for the last three months that bulls were sure there would be no Fall disaster. Unfortunately today's close was a four-month low for the SOX. With rumors of weakness surrounding Dell it might have imploded even further except for the strong results from AMD. This suggests Intel could also post decent results although their midterm guidance was less than desirable.

My biggest sentiment indicator for fund direction is the Russell and it is just plain ugly. It closed today at 630, -7.89, -1.23%. It was the second weakest index after the SOX. This tells me fund managers are afraid of the coming earnings cycle and are lightening the load as October progresses. The next real support level for the Russell is 600 and I definitely hope we don't see it although it would be a great buying opportunity.

Another factor that could be weighing on the markets is the constant commentary on the potential pandemic of Avian Flu. The lack of protection against it and the number of potential deaths are damaging to sentiment for good reasons. It would cripple the world economy in ways that we can't begin to comprehend. It is entirely possible that a weak market is the result of many factors and one of those factors is the Avian Flu coverage. I guarantee I will be short that market with every dollar I can raise should we here news of a person-to-person breakout.

As I way the risks tonight I see the S&P and Dow valiantly trying to hold on to support but the indexes that count today, SOX and Russell, are looking very weak. Up until todays close I have been cautiously long from this same SPX level last week. Going into the close I reversed that with a small short on the Russell and I fear there is more pain ahead. I would love to be long but with all the indexes back at or below last weeks support I have to go with the trend. I am going to hedge that comment slightly. I mentioned on Sunday that tech buyers could be targeting the 2050 level on the Nasdaq as a buy signal. With the Nasdaq only 10 points away and Apple down -5 tonight there should be a sharp downdraft at the open. It appears almost a given that 2050 will be hit if not broken at the open. I also mentioned that funds could have been waiting for a second test of last weeks lows as one more flush attempt of weak holders. Therefore I am still looking at the possibility of a bounce. A sharp drop to new lows at the open could cause that capitulation event and see funds jump back into the market. IF IT DOES NOT play out like that then we are very likely going to see another leg down and one that could be steep. As Art Cashin said today, "if 10250 breaks 10000 is the next target." I completely agree. Since we are at a critical market level and one that could go either way I am going to continue to recommend choosing market direction based on the S&P. I raised my short/long trigger to SPX 1185, which had been a decent support level for a long time and reappeared this week. I will be long over 1185 and short below it.

I believe fund managers are afraid of earnings guidance. We already know from mid quarter updates that Q3 earnings should be strong but we have that unknown factor of hurricane impact and high gasoline prices. Maybe more than a few companies saw what they thought was just a blip in demand as the quarter closed and they thought it would pass. Now we are 45 days into Katrina and companies should have a better feel how that will impact their fourth quarter. This outlook should be translated into Q4 guidance that is released with earnings. That means we may need to see a strong earnings week before managers are going to be confident about their investment plans. Next week is the first week of strong earnings with over 300 companies reporting. We will know by the end of next week how the Q3 earnings quarter will pan out. That will also give us direction for year-end. Until then, 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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