There is never a dull moment when markets are trading near resistance highs. Volatility increases and daily reversals are common with indecision rampant. Just because December is normally the best month of the year for the market it does not mean the indexes will always go straight up. This year daily analyst duels between bulls and bears are providing conflicting advice and traders can't decide whether to buy or sell. Profit taking from the November rally is still occurring as funds lock in profits ahead of year-end. Fear not, we are nearing the end of that market indecision and the directional trend from November should reappear soon.
Dow Chart - Daily
Nasdaq Chart - Daily
SPX Chart - Weekly
The economic picture continues to be mixed with consumer indicators mixed while manufacturing reports showed improvement. Chain store sales fell -3.1% for the week ended 12/3 to 440 and knocking the index back to a new post hurricane low. The week of Sept-17th was the post hurricane low for the index at 445 until the week after thanksgiving fell to 440. The week before Thanksgiving was the post hurricane high at 458. The week after Thanksgiving typically shows a drop in buying as the initial holiday surge passes and early shoppers rest from their buying binge. The rest of us are still thinking about shopping and waiting for the calendar to wind down to provide urgency to push us into the malls. The post Thanksgiving lull this year was the second largest weekly decline on record at -4.2 dating back to 1996. According to the ICSC tracking survey only 9% of households have completed their holiday shopping. I would like to know how many have not started. Stores complained that cold snowy weather kept buyers home during the week. Had it not snowed they could have complained that the lack of cold weather had not provided any incentive to buy winter apparel. There is always an excuse somewhere. ICSC lowered their holiday forecast to growth of +3.0% to +3.5% a drop of -0.5%. ICSC still has high hopes based on a drop in gasoline prices, strong jobs and a strong bonus season. Gasoline has fallen under $2 in many areas and S&P companies flush with billions in excess cash are set to pay record bonuses to employees.
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Factory Orders rebounded by +2.2% for the October period and erased the -1.4% hurricane drop in September. This was inline with consensus estimates. Durable goods estimates were revised up to +3.7% from the advance estimate of +3.4%. Aircraft orders were still the major driver with orders ex-aircraft rising only +0.9%. Auto inventories rose +11.4% after a monster decline of -16.7% in September. The employee discount program was a huge success in moving those inventories in Aug/Sep but once that promotion ended those levels rocketed higher again. No promotion equals no sales in the auto sector. On a broader basis inventory to sales fell to 1.17 matching the lowest level ever recorded back in August of this year. This suggests production will have to increase soon IF consumer buying continues. I believe it represents hesitancy by manufacturers to invest in inventory ahead of an uncertain future. There are still quite a few analysts expressing concern that 2006 could be rocky for the economy and the consumer.
Q3 Productivity was revised to +4.7% from the initial estimate of 4.1%. This is well above the average for the last ten years. This change pushed unit labor costs lower by -1.0%. The output component rose to +4.8% from the initial estimate of +4.2%. This is slightly higher than the +4.3% GDP reading we got last week. This suggests the economy is still growing strongly and keeps the Fed on track for at least two more hikes. Strong growth will support higher rates and the Fed is counting on this to offset their next two hikes.
Reports due out on Wednesday are not likely to move the markets or give them any reasons for concern. Mortgage Applications and the Challenger Employment Report are likely to tell us nothing we don't already know. The oil and gas inventories should show a decline in crude and a build in distillates with gasoline neutral. The rise in distillates is the key component. Traders will want to see if the increase in refining capacity from continuing repairs is able to offset the draws in heating oil produced from the colder weather. The cold really did not hit the Northeastern heating oil dependent areas until the weekend and should not show a major impact to the levels reported tomorrow. Next week is the key level to watch after sub zero temperatures moved across most of the Midwest to the northeast. It is -2 in Denver as I type this and the high tomorrow is expected to be 8 degrees. This is a preview of what those further east can expect later this week.
Oil Chart - Daily
Natural Gas Chart - Daily
Oil prices continue to flirt with $60 but have been unable to hold over that level. The same is true with natural gas and $14. Increases in both are now data dependent with oil inventories on Wednesday and natural gas storage on Thursday. The very cold weather is going to be seen in natural gas draws as furnaces run full blast to offset the frigid temperatures. Electricity generating plants are also seeing surging demand in areas where electric heat is the method of choice. The demands on the gas system should produce another week of strong draws and push reserves closer to the 3.0 tcf level, down from nearly 3.3 tcf three weeks ago. This is the threshold where concerns begin to mount. The five-year average for this week is 3.035 tcf and the level generally assumed to be safe. If storage levels move under the five-year average shortage worries will begin to rise along with gas prices.
Many major analysts have been releasing their 2006 outlooks and most are positive. Thomson Financial is predicting a rise in the S&P of +9% to as much as +31%. Their reasoning is the S&P forward PE of only 15 compared to the historical 10-year forward average of 18.6. They claim a rise on the S&P to an 18.6% valuation it would produce a +31% jump in prices to something in the 1600 range on the S&P. Their conservative prediction is for only a +9% gain if the S&P remained at the 20-year PE average of 15. They claim this gain would be based on current trends including stock buybacks at historical levels and a +20% growth in M&A due to high levels of excess cash. IPO demand is the highest since 2000 and S&P CapEx spending in Q3 rose more than +20% above normal. They also cited a recent rise in insider buying and the potential for an extended string of double-digit earnings quarters that will break the 1992-1995 record.
Banc America analyst Tom McManus predicted the S&P will rise to 1335 in 2006 along with a Dow at 11700 and Nasdaq at 2450. His recommendations for portfolio allocations were 55% stocks, 20% bonds (TIPS) and 25% cash. Tom expects only 9% earnings growth verses the current consensus of +13%. All of Tom's 2005 forecasts of 1275, 11000 and 2200 were right on the nose with the Dow and S&P already coming within a handful of points of his targets.
Tom is not alone with his expression of concern for slowing earnings. Many analysts are stepping out from the crowd and breaking from the herd consensus and warning that conditions are changing. This is nothing new for this commentary. We have been discussing the potential for decelerating earnings in 2006 for a couple quarters now. It does not mean that the economy is going into the tank just that comparisons are getting harder to beat and inflation from higher costs for energy and raw materials will squeeze profits. Offsetting the higher costs and shrinking profits will be an end to the Fed rate hike cycle. More than any recent year it may be more difficult to predict the future in 2006 than in the past. The bull market, although choppy, has remained intact since the bear market bottom was seen in Oct-2002 at SPX 768. That bull market run has spanned 37 months and a +64% gain in the S&P. By any metric it is long in the tooth and entering old age. According to S&P the average bull market lasts only 34 months. Market gains from bull markets dating back to 1942 average 38% in year 1, 12% year 2 and only +3% in year 3. However, if a bull lasts past its third birthday as this one has then chances are good for a strong growth spurt in year four averaging +14%.
This suggests that the market is hanging on while it waits for the end of the rate hike cycle and there could be one last spurt into the end of 2006. However, S&P says it is not the time to be looking for home runs. In the fourth year of a bull market it is best to invest in stocks that are not economically sensitive such as healthcare and consumer staples. Healthcare stocks typically rise +31% in year four with stocks like JNJ and PG gaining +25%. After year four it is normally time to get your fur coat out of storage and head to cash. The markets react to simple economic cycles and they are as regular as presidential elections. Institutions and funds with a longer term view buy the dips and sell the tops and the rest of us are left following their lead.
The market outlook this morning was bullish with the Nasdaq and S&P trading at new 4.5-year highs. The Dow was up +85 points and bears were nowhere to be found. All the supporting indexes were up strongly and the term Santa Claus rally was being repeated by all the talking heads. As the markets approached the lunchtime lull the excitement faded as resistance highs held firm and traction began to fail. As the afternoon progressed the internals dimmed but prices held at the highs. At the stroke of 3:PM a sell program appeared in the S&P futures and sell stops were hit triggering additional drops. Once these futures sell programs appear they tend to take on a life of their own if the original program was strong enough to trip multiple levels of sell stops. That happened today with a secondary wave of selling that pushed through the morning support on the futures. Buyers appeared just in time to prevent the indexes from giving up all their gains but just barely. There was no rebound, just a dead stop. Why did this drop occur? Obviously nobody knows for sure but I have a guess.
I believe there are simply too many institutional traders and fund managers afraid Santa will skip the market this year. There are too many managers trying to lock in their bonuses just in case the year ends badly. Every return to the highs is attracting new selling and each sell cycle reinforces the fear of an end of year swoon. Before you start putting in your own sell orders you need to realize this is not a new scenario. It happens to some extent every December when these conditions exist. It simply makes sense if you are managing millions with limited success to grasp at profits as the year draws to a close. If you were a less than successful money manager who made some wrong bets earlier in the year the difference between selling at the current highs or letting it ride could be the difference between keeping your job or being replaced. Those managers with solid portfolios are content to let it ride knowing that normal December trend should produce a higher high after Christmas. We all know it is easier to let profits ride when you are setting on a fat gain than when the gains are small and hard fought. Cash flow patterns typically favor gains in the last five and first five days of the month, quarter and year. All of those apply to the end of December and traders have been profiting from this trend for many years. While the repeated selling at resistance does bother me it is not new. The key is interpreting when the selling gains momentum, which means more funds are throwing in the towel. That is the time to bail, not now.
There is another factor to weigh when discussing today's afternoon drop. We have two major mid quarter announcements due out this week. TXN on Wednesday night and INTC on Thursday night. Several weeks ago analysts were thinking both would guide higher. The consensus has since switched to inline guidance. There are fears that maybe the computer sector will be suffering from gas pains. That is budget deflation from higher gasoline prices. There does not seem to be a big computer buy cycle in progress with dollars being spent on flat screen TVs, video games and digital cameras than computers. This is worrying some investors and simply another reason for managers to take profits before Intel's Thursday evening confession. However, after the bell today Wal-Mart said computer sales would be up +2% to +4% in December. On the surface that would appear positive for the sector but in reality it is positive only for HPQ. HPQ is the predominate brand carried by Wal-Mart.
The SOX spiked to a new 20-month high early in the day after a drop at the open. Positive news from Maxim (MXIM) and Altera (ALTR) sent the index higher after both raised guidance for Q4. Apple Computer also soared to a new historic high at $74 tacking on a gain of +2.33 on news of the NBC deal. Fear of the TXN and XLNX updates tomorrow helped knock -8 points off the SOX into the close. Intel is expected to tighten its guidance around the midpoint of prior guidance at $10.5 billion. BAC also expects TXN to narrow guidance around the midpoint with a slight upside bias. Estimates are for revenue in the $3.57 billion range. A positive update from both companies would be permission for the markets to move higher. A positive result is already priced into the market so a negative update may not be received well.
Chart of Apple - Weekly
Chart of KKD - Weekly
Krispy Kreme Donuts, KKD, soared yesterday and today to touch $6.20 from its $4.85 level last week. KKD has not posted accurate financials in many quarters and said the anticipated restatement of 4 years of financials due out Dec-15th would probably not be met. This was the deadline set by lenders for submitting the reports. KKD has not filed a quarterly report since Nov-2004. The spike this week was attributed to short covering by funds heading into year-end. 44% of KKD stock is said to be short. I believe the NYSE is eventually going to delist them as it should have a year ago and they will eventually file bankruptcy. I think the 2007 $5 Put LEAP OKK-MA is a bargain at $1.30. A delisting will be the kiss of death for KKD and remove the ability of those funds still long to continue to hold the stock.
After the close there was also a new blurb that Microsoft was closing in on a deal with Time Warner regarding AOL. The news suggested that MSFT was close to taking AOL search away from Google and directing it to MSN Search. The rumors surrounding the conversations with AOL, TWX, GOOG and MSFT as well as the Carl Icahn pressure prompted TWX CEO Dick Parsons to issue a press release at 6:45PM saying again that AOL was not for sale. He said the discussions were about a deal that could help transition AOL from a subscription based revenue source to one that produces revenue from advertising. Regardless of who ends up with the deal the outcome is clear. AOL users are going to end up with a lot more ads on their monitor and their inbox.
Dow Chart - 30 min
That brings us to the forecast for the rest of the week. Assuming Intel does not disappoint I believe we will finish higher than we closed today. That feeling and $5 bucks will buy you a cup of strong coffee at Starbucks and not much more. On a purely technical basis I don't like the pattern on the Dow with lower highs since late November. However the Dow is not the key to this puzzle. The Nasdaq, S&P, Wilshire-5000, NYSE Composite and the Russell are all showing stronger patterns that suggest the rally is alive and well although currently struggling from some resistance volatility. That volatility will continue to exist until we get a solid breakout across the board. That breakout will ease the conscience of potential sellers and allow the end of year rally to proceed.
Make no mistake this is a critical week for the markets. The economic news calendar is weak and in addition to the chip updates oil is over $60 and natural gas could blow past $14 on Thursday if not before. While that will be good for energy stocks it could pressure the industrials and weaken the overall support. I like to think that gains in 350+ energy stocks is strong market support of its own but that is only 5% of the broader market. The other 95% would suffer from higher energy prices. Keep your powder dry until Friday and add to positions only sparingly until after the Intel update. Should the SPX move over 1275 (DWC 12750) before Intel I would join the party as the short covering over those levels could power the next move higher. While there is nothing to prevent a sudden selling event I believe market sentiment is still bullish enough to overcome any halfhearted efforts. Dip buyers are alive and well but as we saw from today's close they are not chasing prices.
If I had to list one factor for the lack of forward momentum I would say it is a lack of conviction. There are a lot of conflicting currents at this altitude and December is still young. Until a real trend reappears traders are probably going to be comfortable buying dips but not much else. Next week is expiration week and those with large positions are trying to decide which way to jump. Recent history has seen expiration volatility move into the week prior to expiration rather than wait until the last minute. I am guessing there are some heavy bets waiting on the Intel update before they close the positions. If they start to get worried and begin to close in advance of Intel it will only increase the volatility in a market without a trend. For those of us long energy we can watch the chip guidance story from a place of relative safety knowing old man winter is on our side. I say turn up the heat and let the chips fall where they may.