After two weeks of consolidation and waiting for things like mid-quarter chip updates and economic reports traders are starting to worry that Santa has lost his way. The old adage states this worry perfectly. "If Santa Claus should fail to call, Bears may come to Broad and Wall." While the Santa rally alluded to in the rhyme is the last five days of Dec and first two days of Jan it does not prevent traders from worrying about the current market weakness. Historically December sees an average gain of +1.8% over the last 33 years but that statistic is not providing much comfort today with the Dow down over -150 points from its November highs.
Dow Chart - 30 min
Nasdaq Chart - Daily
NYSE Composite Chart - Weekly
What difference does that 150 points make? None in the long-term view of things but quite a lot for investors nervous about protecting profits from the strong November rally. The dynamics of the recent decline have been orderly and there is no evidence of any material change in the trend. Until those dynamics change the outlook for the end of December is still the same. That outlook is for another run at the highs beginning on the 19th with new highs possible. While I doubt any new highs will be significantly higher nothing has changed in my view to prevent the attempt.
However, as I stated last week the longer we find fund managers selling the rallies the more that strategy will increase. Those managers with profits will begin to doubt the normal end of December rally and begin to lighten the load as well. This was a critical week for market sentiment and so far it was only dented and not damaged.
All week traders waited for the mid quarter updates from the chip sector with TXN and Intel the headliners and Xlinx, QCOM and National Semi the supporting cast. Texas Instruments updated guidance as expected but traders were not impressed. TXN fell nearly -2.00 after the news. XLNX boosted its outlook but investors knocked it for more than a $1 loss on less than hoped for margins. NSM posted better than expected profits and beat the street by +4 cents. After a brief spike on the news NSM dipped over -$2 on what traders said was weaker than hoped for guidance despite a boosted outlook by NSM. QCOM raised its earnings outlook to 38-39 cents, up from 36-38 cents, with analysts expecting 37 cents. Intel closed the show with narrowed guidance to the middle of the current range and investors promptly hammered the stock for a -$1 loss. Intel had fallen from last Friday's close at $27.42 to a low this Friday's of $25.17. Analysts said cracks were beginning to form in Intel's armor in the battle with AMD for market share. AMD (+$1.25) chips are said to provide equal or better performance for less cost. Intel is seen to be struggling to maintain its lead and companies that use only Intel chips, like Dell, are losing ground as well. Dip buyers found the $25 level attractive on Friday and Intel managed to post a minor gain on Friday and helped rejuvenate the devastated SOX.
SOX Chart - Daily
The SOX had reached a new 20-month high at 510 on Tuesday ahead of the chip updates but the hang time at that level was brief. The -5% drop back to prior resistance turned support at 485 was very sharp but the rebound was sharp also. The rebound began before Intel reported and the bounce in Intel on Friday helped power it back to close near 500 once again. The best news of the week was a common thread of warnings from nearly all of the chip companies that inventory levels in the channel were very low. National Semi said whenever channel inventories had reached this level in the past a strong build cycle emerged. This was good news for chip buyers and for techs in general. This rebound in chips helped push the Nasdaq back to 2256 and the middle of its recent range from 2230-2275. The Nasdaq could be the spark that eventually rescues the December rally but it has one more hurdle to jump first.
Dick Arms was on CNBC this week saying the markets at the end of November were as overbought as he had seen since the peak of the Internet bubble in 2000. The +8% jump in the indexes from the October lows had everybody with an extra dollar going long in hopes for a breakout into year end. Unfortunately there is that lack of conviction problem now that we have touched the highs without a convincing breakout. Historically the Oct/Nov rebound has produced a 1%-3% gain over the last 35 years. December normally adds another +1.8% and is considered the strongest month of the year. However, if you go back and study years when November gains were the strongest you will find that December was normally flat to slightly down. Essentially strong November gains cannibalize early December buying as surplus cash is put to work earlier. There is no guaranteed December rally and with the markets at multi year resistance highs the problem becomes more complicated. Resistance highs require stronger conviction and higher volume to break than resistance at lower levels. Currently fund managers are sitting on only 3.8% cash and very close to historically low levels. They don't currently have the purchasing power to push the markets over the top with conviction. They are forced to hold some cash in reserve for withdrawals and early December typically sees withdrawals as investors gather cash for holiday gifts. While that may be the norm we did see $1.96 billion flow into funds for the week ended on Wednesday. As we near the end of the month those bonuses are going to start flowing with 160,000 Wall Street employees expecting nearly $20 billion in bonuses and millions of employees across America expecting their annual Christmas bonus checks. Some of that money will find its way into funds. End of quarter and end of year retirement contributions will also begin hitting fund accounts in late December and the combinations of all these factors powers the end of year rally.
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This normally bullish period is also being restrained by the conflicting signals coming from the economy and the Fed rate hikes. Toll Brothers announced record earnings last week with a +72% jump in earnings and raised their expectations for 2006. While that is very good on the surface you need to understand that their contracts are normally signed up to a year in advance and their homes sell for prices in the $600,000 range and higher. This is the high end home market that is said to be showing the most signs of stress. For this reason Toll warned that 2007 sales could be lower that the +20% growth they had previously expected. The CEO said, "these are uncertain times and results could be better or worse than prior guidance" and "the increases of 2004 and 2005 were not sustainable and were fueled in part by speculation." This does not paint a strong picture for the future and confirms to some extent the easing housing bubble.
Adding to the fears of investing at this level is the fear of a January decline. Over the last few years January has not been kind with declines rather than gains in all but one year. Last years performance is probably etched into their memory as the nearly perfect year end rally scenario and everyone is waiting for a repeat. So far the pattern has been nearly perfect. If you were confident of a repeat then you should be long now and exit on December 29th. Since patterns never repeat exactly that means fund managers are hoping for a repeat but are probably watching carefully for signs of a stampede to the exits. They want to add another +3% to their gains for the year (11250) but don't want to lose the gains they already have. This is a very tough time for marginally profitable funds. Every day is another step in the December minefield and brings them a day closer to a profitable January exit. As long as support at Dow 10720, SPX 1250, Nasdaq 2230 holds the odds are good there will be another set of higher highs. Should those levels break even slightly it could trigger that stampede to the exits.
Chart of Dow - Oct 2004 to Feb-2005
Dow Chart - Aug-Dec 2005
The major markets may also be experiencing cash drain as money chases performance in gold stocks. The gold ETF (GLD) hit another high on Friday at $52.90 as gold continued its ramp with a $531 intraday high. Around the globe countries are pouring their oil dollars into gold as a hedge against a future energy induced recession and countries are adding gold to their currency investments in record amounts. I personally believe Middle Eastern OPEC nations are leading this buying spree because they alone know how close we are to a production shortfall in oil. Other Asian countries like China are trying to rebalance their currency portfolios and raise their gold allocations to something more than the current 2% range. Strong demand is also being seen for gold jewelry and for gold in manufacturing applications like circuit boards and electrical contacts. All these factors are creating a perfect storm for the gold bears that have been predicting a top since $350. Reportedly fund managers and many hedge funds have been parking excess cash in gold investments rather than risk it on regular equities in this period of instability. Volume in GLD on Friday was 5.88 million shares compared to the 30-day average of only 2.02 million. Volume has been increasing steadily for the last month. As more investors resort to the GLD shares as an investment in gold the fund must continue to buy more gold to cover the open interest. The fund sponsor is World Gold Trust Services and they hold the gold represented by the shares. As demand grows they issue new blocks of 100,000 shares each and buy gold with the proceeds to back the shares. The last reported quantity held was 7,469,219 ounces valued Friday at $3,851,491,895.52 per the StreetTracksGoldShares.com website. This is up from the 5,638,445 ounces held on June-30th or nearly a two million ounce gain. Looking at the picture below of their vault I kept expecting to see Scrooge McDuck appear.
Picture of World Gold Trust Vault
GLD Chart - Daily
Energy stocks were knocked down again on Friday after a week of gains despite oil rising to $61.50 in overnight trading. There is little reason for oil to be trading higher other than following natural gas to a new historic high at $15.50 on Thursday night. The cold weather blanketing the U.S. is just a preview of what may be ahead but it was enough to send both oil and gas spiking to two-month highs. That produced the "buy the forecast, sell the storm" trade we saw last week. Traders took profits quickly knocking oil back to close -$2 off its Friday highs and gas back to a still expensive $14.28. This time last year it was selling for $7.20 and producers were locking in profits at what they thought was an absurd level by selling futures well in advance. Now they are paying the penalty for that hedging and are delivering gas for $7 now they could be selling for $14. But, that is not the point.
The factor we should be watching now is the forecast. The American Gas Association president said on Friday that current gas supplies (3.166 trillion cubic feet in storage) would be enough for a moderate winter but that a protracted period of colder weather could create shortages. The current storage level is +6.7% above the five-year average for this period but -45 bcf below last years level for the same period. Analysts are expecting a drop of up to -300 bcf in storage over the next two weeks due to the current cold snap. That is -10% of current storage. Last year we saw the spike from $4 to $7.20 that nearly doubled the price due to several near shortages where pressure in the pipelines dropped to dangerous levels. This year we have nearly one million more homes and several new generating plants consuming gas at a faster pace. However, we are seeing some demand destruction due to price. Setting the thermostat lower may help somewhat but Americans are not likely to sit and shiver for very long. The real cost of gas has not made it through into home heating bills yet. Utilities that bought gas futures at $7 from the producers a year ago are enjoying a cheaper price today but that will eventually end. Even at the lower prices most electric companies are paying for gas today it still costs 7 cents per KWH for gas-fired plants compared to 2 cents for coal fired plants. Most analysts expect higher prices to hit utility bills in January just as the holiday credit card bills arrive in the mail.
Real demand drop is coming from businesses that use large amounts of gas. The impact of higher prices is causing them to be more conscientious about conservation and that could help offset SOME of the additional annual demand that grows every year. We already consume more than we produce during the winter months and that is not likely to change. The coldest months of the winter are December through February and the cold weather is just getting started after four weeks of an unseasonably warm fall. For energy investors I would continue to buy the dips until January. There are still some good trades to be made before we begin to see spring in the forecast.
Crude Oil Futures Chart - Daily
Natural Gas Futures Chart - Daily
Another reason for the price drop in oil was the OPEC meeting on Monday. The president of OPEC said again on Friday that he was recommending continued production at the current reported level of 30.3 mbpd. This comment helped knock oil from its $61.50 overnight high to close at $59.40. Since the OPEC decision was already expected to remain at full production this was another case of simple profit taking ahead of the actual news announcement. Nothing changed in the demand pattern or available production. This is just volatility ahead of an expected decline in January as seasonal demand begins to slow. OPEC will probably discuss the price they want to defend and where production cuts will occur to defend that price. Some feel $50 on the OPEC basket of crude is the line in the sand. Currently the composite basket of 11 crude oils representative of actual OPEC production is $52.88. Crude Oil futures for light sweet crude currently at $59.40, should return to the lower $50s by March but it will just represent another long term buying opportunity for the next cycle. If OPEC chooses to defend $50 on the OPEC basket that sweet crude price should remain above $55.
It was announced after the close on Friday that Viacom was going to acquire Dreamworks SKG through its Paramount Pictures unit. Dreamworks had been in talks with Viacom and NBC Universal seeking $1 billion in cash and assumption of debt reportedly as much as $500 million. This is different from the DreamWorks Animation (DWA) company that controls over 60 titles including films like Saving Private Ryan and Shrek. Though related they are separate.
Also rumored to be close to a deal was TheStreet.com. (TSCM) TheStreet has been shrinking for years and openly in search of a takeout. The company has been shedding employees and services like its research and brokerage unit blaming slow growth and shifting dynamics in the industry. The unit spent more than twice its revenue in 2004. TheStreet reported a +26% increase in ad revenue in Q3, which was the first sequential quarterly increase since 1999. This was probably due to Crammers Mad Money show on CNBC attracting more viewers to the website. TSCM currently has a market cap of $154 million and a drop in the bucket to any real media player but it is seen as too much of a niche market. If Crammer stepped in front of a truck the company would take a serious hit in subscriber numbers. TSCM has risen a buck to $6.13 over the last two weeks on speculation on a takeout.
The Mizuho Bank of Japan is probably looking for a new trader this weekend after an improperly entered order cost it $225 million. The trader wanted to sell one share of J-Com a new IPO at 610,000 yen. ($5,041) Instead the order was entered to sell 610,000 shares at 1 yen. Traders quickly scooped up the incorrectly priced offering causing a reported $225 million loss. The number of shares offered was 41 times the amount of outstanding stock. The company did not disclose the error until after the market was closed and late estimates tonight suggest the loss to cover the problem could rise from $225 million to as much as $800 million. Once traders realized there was an error there was a rush to cover positions and shares of J-Com jumped to 772,000 yen ($6,379) before trading was halted. Covering that short squeeze for Mizuho could be a real headache.
RIMM surged +3.38 after rumors surfaced that they had reached an agreement with NTP to settle for what appeared to be a very reasonable amount compared to estimates as high as a billion dollars. Rumors had RIMM paying $450 million to NTP plus 5.7% royalties through 2012. Since RIMM has been escrowing money for years from sales this would amount to about the same terms as the prior settlement that was never completed and a sweet deal for RIMM. Unfortunately, NTP was quick to respond that they had not accepted the offer and there was no settlement. The patent office has now issued preliminary rejections of all five patents that were the basis of the initial suit in 2002. NTP is downplaying the rejections as procedural while RIMM claims it has been vindicated. The judge, critical of RIMM's delaying tactics refused to stay the injunction until the patent office issues its final ruling. This puts RIMM square in NTP's sights but NTP is smart enough to realize there is a time limit involved and they could lose everything. Also shutting down the Blackberry product would also harm its eventual payouts since it has claim on all sales through 2012. NTP should be taking the cash and calling it a day. NTP said late Friday that it made an offer to RIMM that included an up front payment of all royalties through 2012. Since nobody knows what those will be and competitors are cropping up everywhere I doubt RIMM will accept unless there is a significant discount involved. The judge has asked both sides to submit briefs outlining their offers. NTP said they might ask the judge next week to shutdown the network if a settlement cannot be reached. The clock is ticking on this high stakes game of chicken but I am betting on RIMM to eventually escape the NTP clutches through a settlement or a win in the Supreme Court. NTP claims it has a workaround to avoid the NTP patents in question but it has yet to see the light of day. If it works the payment equation could change quickly since NTP could no longer force a shutdown.
Next week we face another Fed meeting on Tuesday and there is strong disagreement on the outcome. Everyone expects another quarter point hike but nobody can agree on the change in statement. Some feel the "accommodation" language will disappear with others feel the "measured pace" phrase will change. After a month of Fedspeak concerning the need to change the statement soon the analysts have been working overtime trying to diagram potential changes in the statement. It should not impact the markets UNLESS there is no change. No change would indicate there is at least two more rate hikes in 2006 and that puts us at 4.75% after the March meeting. One additional hike to cement Bernanke's image could occur at the May meeting to round the neutral rate out at 5.0%. The fear of a statement change, or maybe no change, could keep the markets in check until Tuesday.
Also adding to volatility next week is the annual rebalancing of the Nasdaq-100. Nasdaq announced after the close that the following changes would be made to the Nasdaq-100 at the close next Friday to coincide with quadruple witching. The S&P-500 will also undergo changes in components on Friday but the details have not been disclosed yet. Maybe Google will finally get its shot at the S&P-500 and the Nasdaq in the same week.
Nasdaq-100 Change Table
Next week should be the make or break week for the December rally. If the Fed does not spoil the party with something unexpected on Tuesday the markets should be free to continue higher. The week is back end loaded with economic reports with all the market critical reports on Thursday. Headed by the CPI we also get NY Empire Manufacturing, Industrial Production and the Philly Fed Survey. This means a positive Fed meeting could give us a head start Wednesday and Thursday's reports could add fuel to the fire, or douse it completely. But, after adding in the quadruple witching, Nasdaq-100 rebalance and the S&P changes all on Friday the volume and volatility is going to be huge. We would hope the chip rebound will continue based on the low inventory levels and that will give the Nasdaq enough lift to break the 2275 resistance convincingly but I would not count on it.
There are two problems to this scenario. One comes from the 12 companies being kicked out of the NDX. They could be a drag as index funds dump them ahead of the switch while they are still part of the index. Adding to this confusion is the QQQQ rebalance. The QQQQ must also make the switch within three trading days of the change. There are 498 million QQQQ shares outstanding representing $20 billion in market cap that must be adjusted. Unfortunately for the NDX the market cap of companies going into the index is over $179 billion while the cap of those coming out is less than $39 billion. The Nasdaq-100 is not purely market cap weighted the weighting is "calculated under a modified capitalization-weighted methodology using a proprietary algorithm" according to the Nasdaq site. This means there will have to be a lot of other Nasdaq-100 issues sold to make up for the $140 billion market cap difference in the additions. The Nasdaq does take into account companies with market caps over 4.5% of the Nasdaq-100 group. In 2003 the Nasdaq changed from a pure weighting to their modified weighting when they found the top five stocks compromised 61% of its value. Under their new weighting algorithm their value was lowered to only 40% to give the index more diversification. Later that was modified to allow the top ten stocks to represent 40% of the index. How the addition of $140 billion in additional market cap will impact the rankings under their algorithm is impossible to determine. With a total market cap of $1.98 trillion you would not think $140 billion addition would make much difference but it does represent 7% of the current index. It would not be accurate to say that 7% of the current positions would have to be sold but even if it was only 2% under their algorithm it would be a lot of shares. The second problem is the S&P changes to be announced next week and you see the problem for the markets. The last two days of the week could be under serious pressure. This is always a volatile time of year and the change in the indexes just makes it crazier.
I suggested everyone wait to add to positions until after the Intel update and that tuned out to be wise advice. The markets all posted losses for the week despite the gains on Friday. The lows for the week came at Thursday's close ahead of the Intel data. If you bought the dip on Friday you probably have as good an entry as could be expected for a short-term trade. Monday could open weak and I would only add to those positions sparingly until after the Fed meeting. I would then plan a strategic exit ahead of the index rebalancing.
I went back to see how the Nasdaq re-ranking went last year and I was very surprised. The Thursday before the announcement, 12/9/04, was the low for the month as was last Thursday 12/8/05. Monday 12/13/04 saw a +20 point jump ahead of the Tuesday Fed meeting. That rally continued through the Fed meeting and quarter point hike and continued through Wednesday's open to set a new high for the year and a +43 point gain for the week to date by 10:30. A decline began almost immediately after that opening spike. The entire +43 point gain was completely erased by a drop starting that Wednesday morning and continuing through the close the following Monday as index funds rebalanced to the new weightings. This drop also corresponded to the announcement of the new S&P changes on Wednesday. That Monday, 12/20/04, after the expiration and rebalance was the start of a new rally that ran for +60 points and lasted until a new yearly high was reached on Dec-31st at 2185. I don't know about you but I would be perfectly happy if this year's rebalance followed the script from last year. I would doubt it would follow exactly since the market cap added last year was less than half this year's amount and the largest addition was ERICY at $50 billion, far less than Google's $120 billion. I have tried to illustrate the potential scenario as simple as possible but execution will never be simple. We just need to play the cards as they are dealt.
Nasdaq Chart - 2004 NDX Re-Ranking
If I had to bet on a low for the week I would obviously pick Friday due to the index changes. This means we should look to exit any short-term trades on any post Fed bounce and look to reenter at Friday's close or Monday's open. There is normally a post balance dip as arbitragers dump the new stock they bought in advance of the rebalance hoping to sell it to the funds on Friday as funds swapped index stocks at Friday's close. My plan will be to short any post Fed bounce and buy any post balance dip on Monday in hopes of a two-week ride into year-end. How you play it is up to you and the odds of it playing out exactly as I explained it are nearly zero. Just consider my game plan a rough draft and use it to build your own strategy. Next Sunday I will recap it and see how close we came.
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