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Market Wrap

Don't Worry, Be Happy

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That was the mood on the floor of the NYSE today as traders brushed off Friday's early weakness after four days of strong gains. It was a good week with the major averages pushing higher on decreasing volatility. The current rally leaves a lot to be desired in the conviction category but we are not going to complain as long as the trend higher continues. Economic reports continue to pose more questions than they answer but traders are turning a blind eye to the numbers. Declines in energy prices helped trader sentiment but declines in energy stocks helped feed the market weakness. Sometimes you just can't have your cake and eat it too.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The big report for Friday was of course the non-farm payrolls. There was a gain of +56,000 jobs in October and September was revised higher to a loss of only -8,000 jobs. Previously the job loss for September was estimated to be -35,000. August job gains were revised down by -63,000 to +148,000. The +56K job gains for October was only about half of what analysts expected. The separate household survey showed that employment rose +214,000 in October following a drop of -17,000 in September.

The slower than expected jobs growth cast some doubts on the strength of the Q3 economic rebound. It had been thought that the rebound out of both the Q2 slump and then the hurricane slump was stronger and this was not the needed proof. The Commissioner of the Bureau of Labor Standards, Kathleen Utgoff, said jobs growth outside of the hurricane region appeared to have been below trend. Why? Was it just a ripple of uncertainty as the impact from the hurricanes was felt in the economy? Or was it a reaction to higher costs from higher energy prices that caused a pause in hiring? These are the questions analysts were posing with no answers available. Another jobs component was also causing concern. Average hourly earnings jumped +0.5% and the biggest one month jump in years. A sharp rise in wage growth is a prelude to inflation and a component the Fed watches closely. The Economic Cycle Research Institute said on Friday that inflation was rising sharply and currently at a five year high.

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The ECRI Future Inflation Gauge rose for the fifth straight month. This months gain of only +0.2 to 124 was substantially less than the gains for the prior four months of +2.4, +1.4, +1.7, +0.8. The 124 headline number is also a five-year high. High commodity prices, energy prices and higher interest rates were the major components of the increase. The FIG for other countries rose across the board with the exception of Canada and the UK.

The Weekly Leading Index fell for the second consecutive week. The index was pushed lower by rising interest rates and a sharp decline in mortgage applications. The smoothed annualized growth rate dipped to +1.9% according to this index. The economic growth rate topped in August according to the WLI at +3.2% and has been declining steadily ever since. The NYSE composite is also linked to the WLI and declines in the market until mid October had influenced declines in the WLI. This week's rebound plus the drop in natural gas prices should have a positive impact on the WLI for next week.

Other releases this week produced conflicting reports of economic health. On Thursday there was a sharper than expected drop in Factory Orders of -1.7% in September compared to a gain of +2.9% in August. This could be directly attributed to the hurricane disruption. At the same time Q3 Productivity jumped to 4.1% and well over estimates of 2.5% and Q2 levels at 2.1%. ISM Services reported on Thursday also jumped to 60.0 from only 53.3 in September while the manufacturing ISM on Monday fell -0.3 from 59.4 to 59.1.

While the reports conflict the general consensus of opinion is that the economy is continuing to grow and is rebounding out of the Katrina/Rita dip. The Fed said they continued to see growth sufficient to support continued rate hikes. Earnings for Q3 are basically over with 90% of S&P companies reporting and growth has been in the 15% range with 65% of companies giving positive guidance. That guidance level is right at the low end of normal levels but still suggests future growth. Any further deterioration of that guidance could push the viewpoint back towards a possible recession.

What everyone should derive from this boring economic discussion is that the economy is growing but the pace has slowed. We did rebound from the Q2 dip but that rebound may be running out of steam. Earnings are positive but earnings momentum is slowing. In the short term it will allow the markets to continue this moderate rally pace but the growth is not strong enough to generate any acceleration. The first look at Q3 GDP showed growth rose to +3.8% from the Q2 level at +3.3%. This was mainly credited to a sharp increase in auto sales during the employee incentive program. I fear that Q4 could be a challenge. October is now history and auto sales fell off a cliff with GM and Ford both seeing more than a -22% drop in sales. They will come up with some new program to sell cars before the quarter is out but we are already nearly half way through the quarter and the auto lots are still a graveyard.

There was an interview on CNBC on Friday with several economists and all were projecting a drop to 2.5% GDP in 2006 give or take half a point. Earnings were projected to fall into single digits in Q3. The Fed was expected to continue its rate hikes past March. Conventional wisdom suggests Bernanke will have to continue the hike cycle at least two more meetings to prove he has the guts to take hard action if needed. Since the Fed typically goes too far this seems to guarantee that any Bernanke hikes will push us over 5% and into high risk of a recession. This is the risk institutional investors are facing and probably the reason the rebound from the October lows has been so choppy and lethargic.

Historically the second year of a second presidential term produces a bear market. Promises and mistakes made in the first term have to be fulfilled or corrected to set the stage for the next election. Outgoing presidents not up for reelection are more concerned about making changes and protecting their legacy than being nice. They tend to take the hard line because they have nothing to lose. The exception was 1998 and Clinton's second term. Buying ahead of Y2K and the Internet bubble negated that historical dip. Greenspan gave Bush a little push this week by warning again that uncontrolled deficits would eventually produce a disaster. He used his face time on camera to warn that now was not the time to be passing tax cuts that were not paid for with revenue from other areas. Since there are no other areas available to generate that kind of income he was warning the administration not to take the plunge. Voters are on the edge of their seat from this week's news about a new, simplified tax code and lower rates. Greenspan's warning was an attempt to head off that move. Greenspan's continued attack on administration policies are an example of how lame duck politicians tend to become more vocal and take unpopular actions. If Greenspan had the power he would be taking decisive action now to clean up deficits as his days wind down. He does not have the power but Bush does. 2006 is that second year of a second term and all the factors are lining up for a rocky market year. That leave us with two months in 2005, which are normally bullish and conditions are still positive for that trend to remain intact.

One problem we face is the continued rise in yield on the ten-year note. Friday's close at 4.66% was the highest close since June-2004. Given the potential for a rocky 2006 this has got to be attracting the eyes of institutional investors. The closer we get to Dec-31st the more likely we will be over 5% and those institutions will begin moving funds from equities and into treasuries. It is only a matter of time before we start seeing asset allocation programs in the market if yields continue to rise. It is only a question of which comes first, 5% or Dec-31st. Both will likely produce selling in equities.

There is no selling in Google despite multiple lawsuits about its proposed scanning of copyrighted books. Google has been rising almost vertically since earnings on Oct-20th. GOOG has risen +$87 since that Oct-20th pre-earnings close at $303 to close at $390 on Friday. It appears to be immune to any criticism, legal action, threats or legislative attacks. With multiple brokers calling for $450 as a price target the gains just keep coming. The +4.50 gain today added $160 million to the net worth of each of its founders. They must have been feeling prosperous because they bought a Boeing 767 for their personal use. The used wide body cost $15 million and will be refitted to seat 50 with a large galley, multiple showers and other creature comforts. Only 18 of those seats will be considered first class. To put it in perspective they could have bought ten of those with Friday's gains.

Google Chart - 90 min

Apple Computer has a similar chart with nearly vertical gains since its Q2 earnings in July at $38.35. Friday's close at $61 represents the latest dip in its upward path. The dip was courtesy of a Prudential downgrade to neutral based on price. This may be a buying opportunity given the new market opening up for the iPod. Vivid.com has already started releasing video clips from its vast inventory of porn. The porn industry is more than $11 billion a year and the opportunity presented by the iPod video player is too good to pass up despite Steve Jobs attempts to keep them off the iPod. The Vivid CEO said on Friday they would have dozens of titles available soon and they were converting titles to the iPod format as fast as they could. Jobs may not like his device used for porn but there is little he can do to stop it. Apple is selling two million songs a day for their devices and the video market is still young but is expected to explode as well. The initial offering, movie clips of Desperate Housewives, will quickly be surpassed by tens of thousands of other offerings from sports clips, news events, music videos and yes, porn. Personally I would like to see a dip back to $57 for an entry point but that may be wishful thinking.

Friday's Jobs report may have provided an excuse for profit taking but the most serious selling was in energy stocks. On Thursday oil jumped more than $2 a bbl as demand expectations for the winter were raised. This capped a four-day run for oil stocks after earnings produced some strong gains. Gas stocks continued to be weak but selected oil stocks had been recovering. On Friday the CEO of BP said oil above $60 was unsustainable and prices could return to $40. Right or wrong he rocked the market. Crude retreated from its Thursday high of $62.15 to close at 60.50 on Friday. In retrospect this was not that bad given the comments. However, there was some serious carnage in those stocks that had seen the most gains for the week. TSO -5.43, VLO -4.75, SUN -4.14 etc. Refiners were hit the worst as warm weather continued to postpone the winter demand cycle.

Mr. Browne related that OPEC needed a price above $40 to keep their economies afloat and they were pumping at the highest level in 25 years. Given the ability of OPEC to set the price and the general acceptance of oil in the $60 range I seriously doubt we will see $40 again. If the market has grown used to paying $60 why would OPEC let it decline to $40? It is a declining resource and there is no reason to give back those price gains. Would you take a -33% cut in revenue if you did not have to? Prices could still retreat some as the Gulf production comes back online but end user demand will continue to grow as long as the price of gasoline moves up slowly. Sticker shock will ease until a new level of acceptance is found. Oil production still offline in the Gulf has fallen to 52% and natural gas to 47%. These are still very high numbers for two months after Katrina. We are lucky demand has also been offline or prices could be much higher. On December 9th a movie called Syriana will open staring George Clooney and Matt Damon. The movie is a thriller loosely based on declining global oil production and its consequences. I suspect it is very loosely based and more fiction than reality but it is interesting that the topic is appearing more and more in print and the media. Next weekend I will have more input from the front line after I attend the Peak Oil Conference this coming week.

December Crude Oil Chart - Daily

Selling in the broader market was also weak as investors held their positions afraid to miss the next leg up while traders took some profits ahead of the weekend. This was proven out late in the day as the indexes recovered from the morning weakness and rallied to close back in the green. The Nasdaq closed at 2168 and only -4 points off a two month high. The NYSE Composite ($NYA) was the only major index to finish in negative territory at -27. I am not counting the -0.61 on the Russell after a strong finish. That is close enough for me.

Unfortunately I am not seeing much confirmation among the indexes. The Nasdaq is the most bullish with a close right at its highs and right at resistance from Oct-3rd at 2168. The Nasdaq is only one good day away from a real breakout possibility at 2188. Once that level is broken the remaining psychological resistance at 2200 and the spike high at 2219 are the only bumps in the road before resistance at 2250 dating back to April 2001 is tested. Bad economic news or not there should be a race to jump on the train as each of those mileposts are passed. That may be wishful thinking but I doubt I am the only one with that thought this weekend.

The other indexes exhibit lesser stages of bullishness with several formations taking on what could be considered risky attributes. This is not unusual in situations like this where there is still some doubt about the outcome. There are still some institutions taking advantage of the rallies to lighten up as we saw in the strong selling on Thursday afternoon when the Dow dropped -70 from its intraday high. On Friday the NYSE Composite fell -65 points at the open and only managed to recover half of that amount. However the NYSE Composite has a large number of energy stocks, which could have accounted for the Friday weakness.

The Dow continues to zigzag slowly higher with two weak days for every strong one but still maintains its positive trend. Current Dow resistance is 10565 with much stronger resistance at 10700-10725. I believe we will test that level next week. The S&P is also creeping higher mostly propelled by two strong buy programs that triggered short covering on the 28th and the 2nd. Without active buy programs the index is having trouble moving forward. Strong resistance is just ahead at 1230.

I believe the internals are showing us the true strength with strong volume on Wednesday and Thursday of more than five billion shares each. Up volume was 4:1 on Wednesday and 2:1 on Thursday. Friday's choppy session was barely over 4B shares and advancing volume was only slightly better than declining. Still the indexes battled back to positive territory to end with strong gains for the second consecutive week. Profit taking was light and provided entry points for those bargain hunting.

With a little over two weeks remaining before Thanksgiving the bullish sentiment should continue to grow with every upward tick. Converts will grudgingly abandon the short side and start following the herd. Next week is light economically and there are only a few bellwether companies left to report earnings. Those of note for next week are PIXR and TOL on Tuesday, CSCO Wednesday and Dell on Thursday. Dell already warned so that leaves Cisco as the focus of attention and the next indicator of health for the tech sector. There are plenty of smaller companies still to report and that should keep the newsrooms busy but there should not be any real market movers.

This should be a pivotal week. The rebound from the October lows is nearing four weeks old and it has definitely been light on conviction except for those two days last week. With major resistance just ahead on the Dow and Nasdaq this will be a critical test of that conviction. Can the rebound stretch into the normally bullish Thanksgiving week? Will Santa reach down from test flying his new sleigh and pull it into December? Nobody knows for sure but I was encouraged by the lack of real selling and the recovery on Friday. I am growing increasingly wary of our chances once we get past Thanksgiving but a solid performance next week could go a long way toward easing those concerns. I would continue to maintain a long posture and I would add to those longs over SPX 1230. I would look to reduce positions under 1200. That is going to be the key directional indicator for the rest of November. A failure back below 1200 would increase sentiment worries and that bond yield nearing 5% would look increasingly attractive for institutions.

NYSE Composite Chart - Weekly

Fund managers faced with a mostly range bound market under 1245 for the entire year are no doubt looking at that level with longing as the year draws to a close. As long as it looks like a breakout is possible they will likely stick with their longs with hopes of larger bonuses on a breakout. If we stagnate at 1245 there would likely be a mass exodus as they try to capture as much profit as possible, move to cash and lock in what bonuses they can from the October rebound. 2006 is not looking good and hedge funds may want to switch sides as soon as possible once the bullish trend fades. Bear in mind this is only my long term musings and my outlook into Thanksgiving is still bullish. I just don't want everybody to bet the farm and then get married to their positions thinking there are still a good seven weeks remaining in the rally. Historically that is the trend but I believe this is one trend we should not count on this year.
 

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