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Market Wrap

Waiting To Exhale

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The market weakness continued this week to bring pain to traders still in long positions and confusion to those trying to buy the dips. Friday provided a ray of hope as the reversal, which began on Thursday continued to move higher. A morning decline in oil and gas prices reversed late in the day and allowed a rebound in energy stocks to provide added support to the tech led rally. Is the rally real or simply a head fake from oversold conditions? Traders will have to hold their breath until Monday to know for sure.

Dow Chart - Weekly

Nasdaq Chart - Weekly

SPX Chart - Weekly

Friday was chock full of economic reports led by the Consumer Price Index. The CPI rose +1.2% and more than double last month's +0.5% reading. Energy prices rose +12% driven by a +17.9% jump in gasoline and +4.6% jump in electricity and natural gas. The 12-month rate rose to +4.7% and the fastest inflation rate since 1991. Core prices excluding food and energy rose only +0.1% for the fifth consecutive month. If you don't eat or use energy your inflation rate is nearly flat for the year. The rest of us are faced with paying ever-increasing prices for everything we buy due to higher energy costs. With inflation at 14-year highs it is practically impossible to expect the Fed to pause anytime soon. This report almost guarantees rate hikes at the next four meetings if not longer.


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Industrial Production fell -1.3% in September and much larger than the expected -0.2% drop. Much of the drop was related to a -9.1% decline in mining output which includes oil and natural gas. The production outage after Katrina was obviously the biggest factor in the drop including the drop in refinery output. Capacity Utilization fell -1.2% to only 78.6% overall. This indicator of industrial output was impacted strongly by the hurricanes and should not be seen as a true reading of industrial strength. The most troubling component was a -3.7% drop in business equipment, a component not directly related to the hurricanes. There was also a -15.1% decline in aerospace and transportation equipment. However, general consumer goods were largely unaffected and lends credibility to the tame core inflation numbers in the CPI. Overall this report contains nothing that should impact the Fed's decision process.

August Business Inventories rose +0.4% and more than consensus estimates of +0.35 and a complete reversal of last months -0.4% decline. Despite a large decline of -2.1% in auto sales retail inventories rose strongly in August. This data is pre hurricane and could fluctuate wildly next month as September data becomes available. Inventories destined for the Gulf would have been put on hold when those destination businesses were damaged or destroyed. Post hurricane orders to replenish damaged or destroyed inventory levels should also see a boost but it could be over several months and related to the pace of the recovery cycle. The inventory to sales ratio remained at 1.3 as it has since January. This is a cycle low and still points to a lack of confidence by manufacturers about future economic strength. Nobody wants to be caught holding lots of inventory when the next recession appears so they are keeping inventory risk very low.

Retail Sales rose only slightly at +0.2% in September and less than estimates of +0.5%. I would have thought sales would have a tough uphill climb with more than four million displaced by hurricanes during the month. Sales at gasoline stations rose +4.0% due to higher gasoline prices. Year over year sales growth fell to only +6.5% due to a drop in auto sales once the special deals ended. Growth ex-autos rose +9.6%. Considering the special circumstances and the negative impact of autos this was actually a very strong report.

Consumer Sentiment slipped again, falling to 75.4 in October from 76.9 in September and slightly below expectations. Present conditions fell to 95.7 from 98.1 and expectations fell to 62.4 from 63.6. Neither component saw an earthshaking drop but just another decline in a four-month trend. Considering the constant news chatter about a coming pandemic, constant warnings about a +50% jump in utility bills and a -450 point drop in the Dow I am amazed we did not see a -10 point drop in sentiment.

This weekend marks a generational change in bankruptcy laws and there is a rush on to file before the deadline. In Q1 there were 294,520 filings followed by 362,481 in Q2. The numbers for Q3 are said to be off the scale. Many areas are reporting hundreds of filings per day with one report claiming 9,000 per day. There were several reports of block long lines as Friday approached. Alaska, Minnesota and Colorado have reported a +25% increase in filings for September. The problem is the new restrictions on eliminating debts. If you have assets or income you may have to pay out debts over a five-year period rather than erase them. According to most analysts only 15% of filers would fall into the restriction group but that did not stop the uneducated from rushing to the court house. If bankruptcies are up +25% or more then how strong can we expect consumer sentiment to be? Warnings of a -40% drop in housing prices coupled with a +50% increase in utilities has got to be weighing on the outlook for consumers.

A greater sign of investor sentiment for me was the marked decrease in the stock market internals last week. On Thursday we saw only 22 new 52-week highs and 598 new 52-week lows. This is a remarkable change in market sentiment and it came on a day when the Dow ended flat and the Nasdaq up +9. On the bright side this could be seen as something akin to a capitulation event. It came the day after a 4:1 imbalance with declining volume over advancing volume and more than five billion shares traded. The SPX traded as low as 1168, Dow 10156 and Nasdaq 2025 on that Thursday imbalance. Over the last week the Nasdaq had been the lead weight dragging the other markets lower and the Nasdaq was the first index to mount a rebound. The Russell also rebounded sharply from 615 to 632 from Thursday's bottom. This is very positive for sentiment as it indicates fund managers are again putting money into small caps. This suggests they are less fearful about a liquidity crunch or another major dip. October is now half over and we have seen a decent drop and five month lows on all the major indexes. Could this be the bottom we are looking for?

Refco Chart - 180 min

Refco was the main topic of conversation on Friday as it continues to unwind positions and close different businesses. The SEC got a court order that put restrictions on the various Refco companies to prevent last gasp attempts to trade their way out of a financial crisis or use customer funds to offset cash drains elsewhere. Refco closed its offshore securities and foreign exchange business, Refco Capital Markets, a hedge fund brokerage service after a surge in customers trying to take their money out. The entire Refco collapse was a major disaster for the markets but they appear to be handling it well. Refco is a major clearing broker on the futures exchanges as well as a major player in the introducing broker arena. There were billions of dollars in trades being unwound over the last week and many analysts believe the drop in gold and energy futures late in the week was due to dumping of those Refco positions. Customers with accounts at Refco were faced with the potential of a pending collapse and loss of their funds. While that may or may not be possible there is always the fear and closing positions and fleeing with cash to another firm was the number one priority this week. Refco stock fell from $28 to $8 before trading was halted and should trading resume it will likely go to near zero. The premeditated fraud prior to the IPO will likely unwind the entire IPO process but it will not be resolved until after the many class action suits wind their way through the courts. The main focus now is by regulators into what positions the company itself currently holds as well as the safety of customer funds. Once remaining customer funds are safe and released for disbursement we will see a mass exodus to other companies and those positions reinstated. Unless Refco itself or one of its subsidiaries has monster derivative positions still in force the impact to the market should be over. In fact, the market impact of the Refco news may have created the bottom we were looking for. If you remember the Refco news broke when the indexes were just above the critical support levels I had been watching, Dow 10250, Nasdaq 2100 and SPX 1190. The news sent shivers through the market and we broke that support with a new drop to the new lows. While a thank you is probably not in order for Refco I would be perfectly happy if those Refco lows were the lows for the rest of the year.

After the bell on Friday the Wall Street Journal said The Commodity Futures Trading Commission and the CME had asked Goldman Sachs to step into the gap left by Refco and take over at least some of the Refco liabilities and duties. Goldman would definitely have sufficient resources but the question remains if they would want to take on any of the liabilities of Refco without a guarantee by some agency that those liabilities would be limited. Goldman was hired by Refco this week as a financial advisor and rumor on the street late Friday was that GS was trying to sell the futures portion of the business not take it over.

The Refco problem started when trading losses of $335 million surfaced as a debt that had been shuffled from company to company to avoid being carried on Refco's books during the IPO. The debt, which has grown to $430 million over the years is said to be related to trading losses incurred when the hedge fund controlled by Victor Niederhoffer collapsed in 1997. Refco claimed at the time they suffered no losses but Niederhoffer claimed in a later suit that the broker, Refco, suffered substantial losses. Those losses appear to have been hidden to save face and reputation and Refco could never find a way to flush them through the books prior to the IPO. "Oh what a tangled web we weave when first we practice to deceive." (Sir Walter Scott)

Bennett, the CEO now on leave and indicted for fraud, still owns 34% of Refco post IPO. Thomas H. Lee Partners owned 49% of Refco pre-IPO but that was cut to 40% post IPO. Bennett also received a "special" $140 million dividend after the IPO. The money Bennett transferred to Refco reportedly to make Refco whole once the debt surfaced last week was in the form of 350,000 million in euros wired from an unnamed foreign bank to an account in the name of Bennett and Refco Group Holdings. It is said to be a loan against his remaining shares in the company. Considering the very good chance of a bankruptcy and shareholder suit that collateral may not be worth much.

AOL has suddenly become a hot property once again. I mentioned on Tuesday that MSN was in talks with Time Warner about some deal that included the possible merger of AOL and MSN. On Wednesday we heard a rumor that Google and Comcast were also in acquisition talks. The CEO of Time Warner refuted that as just a market rumor but on Friday Yahoo threw its hat into the ring as interested in acquiring all or at least part of AOL. When the Yahoo news hit the wires at 2:15 on Friday TWX stock shot up immediately. The company is trying to fight off an attack by Carl Icahn to produce higher investor returns by divesting non-core assets and buying back stock. Selling its AOL division could pacify Carl for at least the short term. We could actually see a strange deal emerge if the various non-Google parties decide to combine resources and take out the entire AOL division. It is not that they specifically have a burning desire to own AOL but mount a defensive play to keep Google from taking over a major Internet property.

The drop in oil prices back to a three-month low was all Occidental Petroleum needed to add to its proven reserves by purchasing Vintage Petroleum for $3.52 billion. OXY wanted to expand its reserves in Latin America and California. It will sell Vintage assets in East Texas, the Gulf and the Midwest. Those assets consist of 19,000 mbpd of oil production. Vintage produced 76,000 boe per day in Q2 and has 437 mb of proven reserves. OXY said it would double Vintage's production in Argentina within 5 years and output in California by 20%. The Vintage (VPI) deal is expected to add to OXY earnings and cash flow immediately once closed in Q1-2006. With oil companies accumulating cash as oil prices continue to rise we can expect to see many more acquisitions as companies find it is cheaper to buy reserves than find them.

Refiners are coming back online with all the Houston refineries running with the exception of the 437,000 mbpd owned by BP. In Lake Charles only the XOM 348,000 mbpd and Motiva 285,000 are still offline. Three refineries in New Orleans representing 534,00 mbpd are also still offline. That means only 10% of our total capacity is still offline. Oil production in the Gulf is slowly coming back online with the offline number falling to 67% for oil and 56% for natural gas. While the numbers are improving we need to remember that much of the remaining production will NOT be back online until March or even later. 3 bcf of natural gas will not be back online until March and after the winter heating season.

The oil and gas inventories on Thursday showed a decline in gasoline, heating oil and jet fuel for the fourth consecutive week. Oil imports rose +500,000 bbls to 8.619 mbpd but this was still the lowest weekly number since March 2003 and -7.9% below last years levels. U.S. production rose to 3.9 mbpd but that is -18.5% below last years levels. Bottom line we are far from back to normal levels and there are still shortages ahead. It does appear that we are going to dodge a serious bullet if we can get back to 50% production in the Gulf before Nov-1st when the traditional cold weather begins. It will still result in higher prices for utilities simply due to the demand/supply equation.

Several analysts were speculating that the Wed/Thr drop in oil/gas futures was related to the Refco positions being unwound to raise cash. We had a nice rebound underway from Monday's lows when lightning struck and knocked us back to $61. Late in the afternoon on Friday we saw a sharp spike in natural gas, which took it back into positive territory for the day at 13.21. We saw the same rebound in oil from the $61.15 low for the day to close at $62.75. There was definitely a sudden end to the selling and buyers returned. If in fact the selling was due to Refco position clearing and that clearing is complete then we could see a continued bounce next week. However, there is resistance at $65. I have been recommending buying the dips in oil stocks and this would be the last week before I would change that practice. Earnings for most oil stocks will be announced the week of Oct-24th and I expect lots of damage claims and lower earnings from lost production. I do not want to be in energy stocks over the week of the 24th. Once that week passes I would again favor buying the dip as we move into the winter heating season.

Natural Gas Futures Chart - 5 min

November Crude Futures Chart - Daily

Natural Gas Futures Chart - Daily

I have noticed a lot of TV advertisements for Conoco Phillips (COP) over the last two weeks. While they are my favorite oil stock for a long-term investment it does make me wonder if they are trying to increase investor comfort ahead of a nasty earnings surprise. Why else would they spend millions to run hundreds of costly high profile ads when the stock is only $9 from an all time high? That was the thought that occurred to me as I watched the charts this week. Conoco's 247,000 bpd Alliance refinery is not expected to restart until December or even January. The Lake Charles refinery just restarted this week. Several platforms were damaged and suffered production losses. 20,000 boe of daily production was lost for the entire quarter. The Ursa field remains shut in pending restoration of infrastructure in that area. These are just a few of the problems for COP that could help generate a negative surprise. I would not hold COP over earnings but I would buy any surprise dip. This also illustrates why I would not want to hold any oil stock with Gulf exposure over earnings.

Friday's rally was also seen in yields on the Ten-year treasury, which rose to 4.528% intraday and closed at 4.49%. This is eventually going to cause trouble in the equity market as it closes in on 5%. This is typically where institutions decide a safe 5% is better than a risky stock market. However, if last weeks low really starts looking like the low for Q4 then stocks could remain in favor until January. If the Fed does continue raising rates as expected and analysts are now talking about an end rate beginning with a 5, then ten year rates will definitely be in nose bleed territory by January. That means any equity weakness in January will immediately see an equity flush and asset allocations into bonds and away from stocks until the Fed is done raising rates. But, that is months away and we have a lot of fun ahead of us between now and January.

Next week there are quite a few economic reports but none are particularly exciting and none should be market movers. The highlights next week will be earnings as the calendar is weighted heavily with the major names through Thursday. Leading the list are these companies of note with those most watched in bold.

Friday: T, CAT, MYG, SLB, WY

The tech giant missing from the list is Microsoft, which reports on the 27th. There are nearly 500 companies reporting in the week of the 24th but after this coming Thursday closes we will already know what the future holds. If guidance is good then investors will probably rush in for the historical Q4 rally.

The bears will be screaming foul if a real rally breaks out but the stage is definitely set. The bullish sentiment in the market has declined substantially from levels seen just last month. The bears have ratcheted up their whining about the various reasons they see a new bear market just ahead. Short interest is high and the dip over the last three weeks has struck fear into the hearts of many investors. The stage is set for a surprise rebound on any run of good guidance.

Those following my suggestion to maintain a short bias under SPX 1185 had a nice run to 1168 before the rebound began. The rebound took us back to 1186 at Friday's close and based on Friday's action I am cautiously long again over that 1185 level. Friday's internals swapped sides with the negative divergence on Wednesday with a 3:1 edge of advancing volume to declining and advancers beat decliners 2:1. New 52-week lows were cut nearly in half at 345 from the 606 average of Wed/Thr. Clearly buyers were slipping back into the market BUT the market was also very oversold. Friday's rebound could have been just short covering before the weekend. Given the -450 Dow points lost in the prior drop a +70 point bounce was lackluster at best. Every rally has to start somewhere but I would have wished for about +125 points and 4:1 advancers to decliners for confirmation it was broad based. As traders we don't always get what we wish for and I will be content to see the SPX move back over 1200 and out of the congestive resistance formed over the last two weeks. If you are ultra cautious that move over 1200 would be real confirmation for me that the October lows are in.

Should the rally not continue then we have a clear line in the sand at 1168 and the five-month low. A successful retest of that level would be the desired result of any new dip. It also establishes clearly the level at which market sentiment would change 180 degrees almost instantly if broken. With a five month low already in place a failure of that low in October would be a disaster and a sign of serious market problems. Overhead resistance on the Nasdaq is just under 2100. Resistance on the Dow is much closer at 10300-10325 and just over Friday's close. With nearly a third of the Dow components reporting next week it faces an uphill challenge. While I would like to assume the bottom is in we all know what ass-u-me really means. I am going to maintain a bullish bias as long as the SPX is over 1180 but be ready to dump everything if it appears that level will fail. That gives me a five-point cushion for my longs I established at the 1185 level on Friday. Energy prices are right in the middle between their lows and overhead resistance so we could see some support from the energy sector. If energy loses traction ahead of earnings then it will fall to the tech stocks to save the day. Techs managed to post a +17 point gain on Friday without the help of the SOX, which lost -3.64 for the day. With IBM, RMBS, NVLS and PHG earnings on Monday and INTC, MOT and several lesser chip stocks on Tuesday there could be considerable uneasiness in chips and therefore techs. For the rally to continue it may have to overcome a chip deficit and it remains to be seen if we have that kind of tech traction at this stage of the rebound. We are also facing option expiration and traders will have to make an early week decision about holding expiring October positions. All of this makes next week very difficult to forecast and makes it even more important to enter passively, exit aggressively and definitely don't get married to your positions or your bias.

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