Option Investor
Market Wrap

Where's The Bull

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It appears our market direction will continue to be dominated by days of sheer boredom interspersed with a few event driven triple digit moves. The normal post October trend has yet to appear and the bulls are notably absent. Inflation fears and fears of a tech slowdown are weighing heavily on the market. The consumer has been the backbone of the economy and purse strings are slowly drawing tighter despite a sharp drop in the price of gasoline. This may be a November to remember but things will have to pick up substantially or those memories are going to resemble more of a nightmare than fond recollections.

Dow Chart - Daily

Nasdaq Chart - Daily

Russell 2000 Chart - Daily

The morning started off with a better than expected ISM at 59.1 compared to estimates of only 58.0. Both numbers were below last months 59.4 headline number. While investors are not going to get excited over a headline number that was basically flat there were some challenges in the internal components that bear discussing. The Prices Paid component jumped +6 points to 84.0 from 78.0 in September. This is a substantial move from the cycle low of 50.5 seen just four months ago in June and the highest level since May of 2004. There is no way that the picture can be spun to claim inflation is not filtering through the economy. Of course this number does include energy so the core rate as monitored by the Fed has barely budged. We have a real conflict of views depending on which number you use as your benchmark. I favor the one that includes energy since my energy bills including gasoline account for more than 20% of my monthly expenses. Saying inflation is only up +2% for the year is ignoring reality. Other components worth a mention include a small drop in new orders from 63.8 to 61.7 and flat order backlog at 55.5. Imports rose +5 points and exports fell -2 points. This is the wrong direction with our dependence on foreign goods increasing and our exports declining. Despite the negative components the ISM remains in positive territory with an only slight bump in a positive trend.


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Construction Spending rose inline with expectations at +0.5% buoyed by private spending with public construction flat after seven months of increases. This index has remained mostly unchanged for three months but should tick upwards as the rebuilding in the Gulf gains speed.

The most negative piece of economic news was a sharp drop in auto sales especially for American companies. The rate of sales fell to only 14.7 million units on an annualized basis and well below the 16-17 million rate we saw over the summer when incentives were in place. Today's number was the lowest since 1998. Granted there was substantial "pull ahead" buying during the incentives as those planning on buying a car this fall were induced to move that decision forward to take advantage of the employee incentive program. Sales fell sharply for American manufacturers with GM sales dropping -23% and Ford -22%. Gainers included Toyota +5% and Chrysler +1%. The major sales drops were in the SUV category with Ford Explorers dropping -59% and Dodge Durangos -29%. Luxury cars also fell off the cliff with Jaguars dropping -22% and Porsche -50%. Toyota is very close to taking over the second position in U.S. market share with 15.1% share compared to 16.1% held by Ford. The biggest sales category was the CUV market, those new SUV models that are smaller, lighter and get better gas mileage. Automakers are expected to reinstate some large incentive program later this year to jump start sales again.

The elephant in the economic closet today was the FOMC meeting. It was mostly ignored and after a little early morning volatility the markets took a siesta until the expected results were announced. The required post meeting volatility was tame and the markets closed at about the same premeeting level. The Fed statement contained no surprises despite the elevated concerns about inflation. They raised the rate by +25 points to 4.0%, which was no surprise to anyone. They said energy prices and hurricane related disruptions in economic activity have temporarily depressed output and employment. However, they expect that rebuilding effort to support and add to current economic progress. They did agree that energy and commodity costs had the POTENTIAL to add to inflation pressures BUT core rates remain low and longer-term expectations remain contained. Take off the rose-colored glasses guys! They kept the measured pace language which guarantees only a +25 point hike at the December meeting. Current perceptions are for a top somewhere in the 4.75% range. This suggests another quarter point hike in December, January and March. Fed funds futures are currently showing an implied rate of 4.45% in Feb, 4.48% in March and 4.61% in April. Since the futures are never wrong that confirms the 4.75% rate after the March meeting. Bernanke will be in control from that point forward if not before and it is assumed he will raise rates at least once more to show he is not afraid of pushing the envelope. That suggests 5% will be the ending rate unless inflation continues to ramp higher requiring a stronger attack by the Fed. Currently they view the risks between growth and inflation as roughly equal and will be kept that way with continued removal of policy accommodation until inflation pressures ease.

A revised tax plan was making the rounds today with a simplified tax form and streamlined deductions. While I think that is a great idea it will cause problems for one sector of the economy. One plan proposes four tax brackets for individuals (15,25,30,33%) with a fixed rate for business at 31.5%. This plan exempts 75% of capital gains from taxation and 100% of dividend earnings. The other plan has three tax brackets (15,25,30%) and would tax dividends and capital gains at 15% and set the business tax rate at 30%. A major plus for both plans is the abolishment of the Alternative Minimum Tax. A major detriment for those who live in states with income taxes is the abolishment of that deduction on Federal taxes. The major problem for individual investors is the elimination or reduction of the mortgage interest deduction. Suggestions are for a home credit of 15% of interest paid but limited to a mortgage of not more than the regional price of homes. In other words if the average price of a home in Texas was $225,000 then mortgage interest on 225K is all that would qualify for the 15% credit. Someone living in California where homes could be 5 to 10 times the price of that Texas home would be limited to a $425,000 cap. Remember these are just suggestions made by the tax panel and everything is subject to change. The problem as I see it is the removal of the mortgage interest deduction as it exists now. Not only would primary homes be capped but there would be no deduction for second homes. This will eliminate a lot of demand for higher priced homes due to the added expense of ownership and will destroy the second home market. Currently the laws reward you for buying the most expensive home you can afford by giving you a deduction of all the interest. A $5,000 payment would be $4,500 in interest and basically a tax subsidy of your large home. Once that deduction is limited to $1500 a month or less the cost of owning a large home will go up dramatically since you will have to pay taxes on a much larger amount of income. The large home market will implode for those living on the edge of their means and that means all but the rich in America. Secondly the removal of the deduction for second homes means those vacation retreats just got more expensive to own and cheaper to sell. That segment of the economy would take a large hit and see lots of for sale signs spring up overnight.

In stock news tech stocks struggled all day after Dell warned that earnings would come in at the low end of expectations. Dell cited price competition and excess inventory. There was also a problem with a component used in millions of their PCs that was failing and needed to be replaced. Analysts seized on the price and inventory portion of statement and Dell dropped to $29 or -$2.64 on the news. Intel, married to Dell due to Dell's Intel only processor stance, also fell to $22.50 and a new six-month low. To add insult to injury HPQ is rumored to be readying an announcement of a $398 laptop and a $398 desktop with a flat screen monitor that will be sold at Wal-Mart and other discount stores over the holidays. Very tough to make sales targets much less profit targets with prices hitting new lows. I have mentioned several times in the past that Dell's low price strategy was eventually going to be a serious problem for profits. If Dell sold 5 million computers in Q4-2004 for $1500 then they have to sell 10 million in Q4-2005 at $750 just to break even on revenue. With computer prices falling off a cliff the manufacturers are faced with having to sell millions more each quarter than they did in the prior quarter just to keep analysts happy with an increasing revenue trend. Eventually the lower prices will find a bottom where component prices cannot be squeezed any further and the wheels will come off the ever-increasing revenue model. $398 for a laptop/desktop hits Dell right where they live. Those computers are built with a cheaper chip from AMD and puts the squeeze on the Intel/Dell relationship. Secondly it hurts their attempt to squeeze profits out of the higher priced laptop market. Their $6000 laptop special from last month appeals to very few people. Is that a sign of desperation with attempts to milk the very high-end market? I hope it was successful because a mass-market laptop for $398 could really hurt Dell's entry-level models.

With Dell warning the Nasdaq was never able to mount a successful rebound with the post Fed bounce quickly sold. Conversely the sellers were just as unsuccessful in breaking support at 2110 as buyers were unable to break resistance at 2120. I think that is a very positive factor when two of the top five Nasdaq stocks were in the tank together and the Nasdaq managed to hold to only a -6 point loss. However it is hard to get excited about being long when the Dow gains from Friday are slowly eroding on an hourly basis. The SPX has managed to hold most of its gains and remains over 1200 but like the Nasdaq it showed no life today and no trend.

We are finally out of October and we should be in that historical rebound period that comes in early November. Maybe the flurry of ghosts and goblins kept traders busy on Monday and an overdose of sweet treats kept them away today. BUT, the lack of a positive trend at this point on the calendar is scarier than anything that came to my door last night. I want to be bullish since we are well over SPX 1185 and holding over 1200 but there are no signs of buying. Monday's afternoon bounce had me thinking we were off to the races but the sell program at the close deflated that balloon rather quickly. The Dell warning cemented that drop we are left levitating just above SPX 1200 and waiting for the next event to produce a triple digit day. There are no economic reports capable of moving the market on Wednesday with Thursday the next spate of releases. Oil and Gas inventories on Wednesday could send the energy sector flying but the numbers will dictate the direction.

December Crude Futures Chart - Daily

Natural Gas Chart - Daily

Now that the energy sector has produced earnings that revived the overall S&P results we are back with a headline number of +16% earnings growth and a 16 PE for the S&P. This should be a honeymoon for value players with the PE at levels not seen in years. The Fed thinks the economy is growing just fine and strong enough to endure a continued rate hike cycle. Recent economics have shown a rebound out of the Q2 slump and rebuilding in the Gulf should continue to raise the numbers. Oil prices have fallen to below $60 and gasoline is under $2.50. Everything appears to be right with the world but the markets are flat lining between triple digit shocks in a period where they typically are bullish. What is wrong with this picture?

Personally I believe it is a long-term problem that will become more apparent in 2006. Investors were slapped upside the head with skyrocketing oil prices and they refuse to believe that the crisis is over. Energy inflation is still spiking all the internal components of the various economic reports. Investors are not stupid enough to believe that inflation is contained as claimed by the Fed's core rate view. They are patiently waiting to see if the beginning of the winter demand cycle is going to revive those energy prices and further pressure the economy. Guidance from S&P companies has also been a problem with lukewarm outlooks. There were very few cases of abundant optimism and quite a few warnings. This has dulled expectations and a 4.5% yield in the bond market is starting to look pretty good.

That leaves us with a listless market in a bullish calendar period. Unless a real rally appears soon the remaining bulls will begin to fear an impending slaughter and head for the hills. The markets are living on borrowed time at these levels and without a new spark to light a fire under the indexes they could become a dead weight.

NYSE Composite Chart - 90 min

SPX Chart - 180 min

Russell Chart - 120 min

The Nasdaq could retrace to 2080 filling the gap at 2088 and still retain its upward trend from the Oct-13th low. It needs to break the 2120 resistance for more than a few minutes to attract new money. Downtrend resistance on the Dow is 10485 and a level that held twice on Monday. It is also the convergence of the 100 and 200-day averages. The resistance level to break on the SPX is 1210. The chart on the NYSE composite is the one that most clearly shows the existing market resistance, which must be broken at 7450. I still believe that retail traders will jump on the train if a clearly recognizable up trend appears but it needs to appear soon before hopes of a Q4 rally fade into thoughts of ski trips and turkey dinners. I am still cautiously long and will add to positions over 1210. I suggest you keep your stops tight and look to reenter positions if another retest of the lows appears. This is definitely a time for caution and restrained bullishness until further confirmation appears. Continue to enter any position passively and be ready to exit aggressively if the trend you expected changes suddenly.

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