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Market Wrap

Fed Takes First Step

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The Fed Open Market Committee took the first step today to end its 18-month, rate hike cycle. They raised rates another quarter point as expected but the big news was a substantial toning down of the position statement. On the surface the markets reacted positively but the gains were mostly on the back of one major buy program. Nonetheless it was a positive day as we expected it to be. So far the game plan from Sunday is right on track.

Dow Chart - 30 min

Nasdaq Chart - 60 min

SPX Chart - 30 min

The Fed meeting was the big news of the day although there were other market moving events. The Fed completely reworded their statement even more so than most analysts had expected. Gone was the language referencing the Fed's accommodative stance. Translation, if they are no longer accommodative then they are already in neutral territory. Gone was the measured pace phrase although they did keep the word measured to keep the bond groupies from panicking. This is the key phrase of the new statement:

"The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives."

The measured pace language was replaced by "furthered measured policy firming is likely" but they added this key phrase, "as needed." As needed means the Fed does not have to raise in the future as the measured pace language implied. The Fed also kept the market friendly portion of the past statements regarding the health of the economy. They said the expansion appears solid and core inflation has remained low with expectations contained. They did acknowledge that elevated energy prices could have the potential to add to inflation pressures.

Before the announcement the Fed Funds Futures were predicting a 70% chance of hikes through the March meeting with a 5% top by June. After the announcement there was a new shift in that outlook to as little as one and done to 4.50% in January or two and through to 4.75% in March. The idea that Bernanke would have to push the rate to 5% after Greenspan leaves to achieve credibility as an inflation fighter has faded. The market should take this new posture and celebrate as the year draws to a close. Since there was no pre meeting rally the news was not priced into the market ahead of time.

The positive comments about the economy should be encouraging to the market although it is just boilerplate for the announcement. What are they going to say? The economy stinks and rising energy prices are going to push it off a cliff? No, they want to remain a cheerleader for the economy and equities to justify their hikes. Still, the herd sees the statement and assumes it is gospel.


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Other economic news included the Retail Sales for November, which posted a +0.3% gain. This was lower than expected and was bolstered substantially by a +2.6% jump in auto sales. Without autos the number came in for a loss of -0.3%. The next biggest contributor was building materials dealers with a gain of +1.9% pushed higher by hurricane rebuilding from Texas to Florida. Gasoline sales posted their biggest drop since April 2003 as gasoline prices dropped back to around the $2 level. As a component gasoline stations fell to +16.8% over last November compared to +27.6% in October. Overall Retail Sales in November were lackluster and it is thought the culprit is the constant warning about rising energy prices.

Business Inventories rose only +0.3% in October and slower than analysts had expected. Business sales rose +0.8% in October and only slightly more than the +0.7% rise in September. The inventory to sales ratio remains at the record all time low of 1.25. Most analysts feel the economy is growing steadily and CapEx spending is rising but it is not being shown in the Business Inventory numbers. This suggests continued caution is warranted. On the flip side the low inventory to sales ratio could result in a strong build cycle if sales suddenly rose when the Fed does halt its rate hike cycle.

The Job Openings Labor Turnover Survey (JOLTS) released today showed a drop in those leaving their jobs for any reason across all industries and governments. The separations rate fell to 3.1% from 3.6% in September. The higher September rate was driven by the hurricane job losses. Job openings rose +2.9% and the highest since 2001. 3.57 million positions were listed as available. The largest gain in positions came from the professional/business sector at 886,000, up from 725,000 in September. Ironically hiring in the sector fell to 770,000 down from 925,000 in September. The jobs are there but employers are either being more selective or there is a shortage of qualified workers.

There was plenty of stock news today as we waited for the Fed announcement. Best Buy (BBY) was knocked for a -12% loss from $50 to $44 after posting earnings that missed street estimates. Volume was huge for BBY at 38 million shares and analysts wasted no time in downgrading the retailer. BBY said the main reason for the earnings miss was due to added expenses for new services. The CEO, Brad Anderson, said BBY has been adding personal shoppers, business experts and home theater installers so it could focus on its most profitable customers. He said the current spending for this conversion was unsustainable and would decline as the effort matured. BBY reported 28 cents compared to analyst's estimates of 30 cents. Sales were up +10% to $7.3 billion. Offsetting this sales gain was a +22% jump in sales and administrative expenses as the stores were upgraded to the current sales model. BBY opened 154 of these new "segmented" stores in Q3.

Hewlett Packard (HPQ) told analysts on Tuesday that earnings would be higher than current analyst estimates but revenue could disappoint. HPQ has been the best performing Dow stock in 2005 with a nearly +40% gain. It lost -3% on the revenue news. HP told analysts again that they were not planning on spinning off any segments. They have been pressured to spin off the PC division due to low margins and stiff competition. HP expects revenue to be in the $89.5-$91 billion range for the year. Analyst's estimates were $90.85 billion. The drop in HPQ carried over into another Dow component, IBM, which lost -2.25 and is down nearly -$7 in the last four days.

Lehman beat the street with a +41% jump in profit to lead off the parade of broker earnings due out this week. Lehman saw a +28% jump in revenue and profits of $823 million for the quarter or +$2.76 per share. Analysts had expected earnings of +$2.64. Despite the news LEH opened lower after they said investment underwriting was less active and capital markets revenue was down -6% in the quarter. The dip was short lived and LEH finished positive for the day.

Overstock.com fell -$1.72 or -4.48% to $36.64 after Crammer mentioned another downgrade on CNBC. The shorts smell blood again and the pop to $42 last week is quickly eroding as the holiday retail bounce for everyone begins to unravel on low sales numbers.

Oil took center stage once again as weather forecasters began predicting a 100-year winter. Yes, some forecasters are now saying this could be the coldest winter since the 1800s. A new front is headed south from Canada into the Midwest and is expected to cover two thirds of the U.S. by the weekend. Heating levels from last week's cold front rose to more than 30% above normal. Oil rose to $61.95 and a five-week high on expectations that heating oil demand would rocket higher. Natural gas rose to $15.78 intraday and a new historic high. Nobody is backing off their positions and the rallies are being sold with far less conviction.

Crude Oil Chart - Daily

Natural Gas Futures Chart - Daily

The bullish sentiment in energy was bolstered from several different sources. Goldman Sachs reiterated their $105 price target for crude and then expanded their outlook even more. Goldman Sachs said this was the beginning of a "super-spike" phase that could last 4-5 years. The Global Investment Research division said they disagree with the growing consensus that prices peaked in 2005. They said demand remained resilient and supply growth lackluster and that prompted them to leave their average price target for 2006 unchanged at $68. In 2005 the price of crude has risen to an average of $56.59. They said prices could spike above their average target of $68 to as high as $105. Goldman has taken a lot of heat over the last several months over this call and they refuse to back off after a review of the data. They claim OPEC is not showing any real success in raising production other than just enough to meet current demand. While OPEC claims it is set to raise capacity by +3.1 mbpd by the end of 2006 according to Goldman there are no real details to back up this claim.

Adding to the bullish price picture was an upgrade to the demand growth picture by the International Energy Association. The IEA, an energy policy advisor for 26 nations, revised their demand growth outlook beginning in 2006 to an average of 1.8-2.0 mbpd PER YEAR over the next five years. They said rising demand in China and India would cause much of the increases. This is stronger than the +1.18 mbpd demand increase they are projecting for all of 2005. Think about this for a minute. Using the round number of +2.0 mbpd growth for the next five years that suggests daily demand by the end of 2010 will grow to 93.5 mbpd compared to current production of 83.5 mbpd. That +10 mbpd increase is like adding another Saudi Arabia into OPEC. It is literally impossible for Saudi to double production in five years from its current 10.2 mbpd to 20 mbpd. They are currently in the middle of a $50 billion project to drill new wells and upgrade older ones in hopes of growing production from declining fields to 12.5 mbpd by 2009. Even if successful 12.5 mbpd is woefully short of the 20 mbpd that will be required if the IEA is correct in their outlook. There are other sources of new oil coming on stream over the next five years but nearly all analysts agree that they will only offset declines in older existing fields. Over the next five years nearly 150 million new cars and trucks will take to the global highways and over 25 million new energy consuming households will be formed.

While I agree with everything Goldman says I do not believe oil prices are going to make new highs in December unless a new ice comes to the northeast. Energy demand is cyclical with a seasonal pattern. The winter demand cycle runs from November to February. Once it appears the storage tanks will not run dry before milder weather arrives the price of oil and gas will drop. The next demand cycle is summer driving and that starts in June although price anticipation will begin much earlier. Oil prices tend to precede demand by two months. This produces a lull in March/April and our next real long term buying opportunity for oil stocks.

The battle for existing and future reserves is getting costlier as we saw in the Conoco/Burlington Resources acquisition this week. Conoco is paying over $30 billion for Burlington in a move that will make the merged company the largest gas producer in North America. Conoco shares have been trashed since the announcement losing over $6 billion in market cap but that cap has been transferred to Burlington with its +$10 jump in price. Conoco has been criticized in the press for buying Burlington on a week when gas prices hit an all time high. Conoco claims the deal will be profitable even if gas prices return to the $5 range. Conoco claimed it was the best time to buy Burlington and said they doubted gas prices would decline below $8. Conoco said they would completely pay off any debt related to the deal out of cash flow over the next 2-3 years.

Focus on this paragraph! Talk is cheap. Anybody can claim oil and gas prices are too high and will return to much lower levels. Conoco is the third largest energy company in the U.S. and they are not stupid. Do you honestly think they would subject themselves to ridicule and abuse by making a $30 billion acquisition at the top of the gas market if they did not think prices would eventually go higher? I think not! I have long said that Conoco was the only energy company that was acting like the end of cheap oil was really coming. Among the majors they are the most aggressive in exploration and in acquiring reserves. They have found it is cheaper to buy reserves than find them and they have proven they know those reserves in the ground are going to be more valuable in the future than they are today. Listen to all the analysts and quasi energy experts claiming world production will rise 50% over the next 20 years but weigh them all against the $30 billion purchase by Conoco. Are you going to bet your future on somebody that gets paid to push numbers to please some governmental agencies outlook or on a $30 billion commitment to higher gas and oil prices? COP has fallen from $64 to $58 on the news. This is initial support but I would NOT buy it yet. I made that mistake with Chevron/Unocal. There is always fear of another bidder and this could knock COP back to stronger support at $50. Since Conoco does not have $30B in the bank they are going to issue stock to make the acquisition. This will further dilute the current price. While I believe COP made the right move this is not the time to buy the stock. Be patient. The deal is expected to close early in 2006. This is shaping up to be a major play in our March/April window.

I would like to report that the markets are racing into the year end on the horns of a strong bullish rally. Unfortunately I can't and for the reasons I outlined in the weekend commentary I do not think any year end rally will appear until next Monday. I am not going to repeat the entire scenario here but the general idea is for a move higher at tomorrow's open and then a decline into Friday's close. Obviously it is impossible to predict market direction with ay certainty but I think the index rebalancing and quadruple expiration will combine to send us lower before the weekend.

The Dow has found support at 10740 and the post Fed buy program sent it soaring back to break resistance at 10850 but it could not hold that level. We still have a strong sell the rally cycle in place and it is likely to remain in place until after Friday. The Nasdaq continues to trade in the middle of its 2240-2275 range and the post Fed spike sent it back to the upper end of that range. The Nasdaq is likely to see the worst of the index selling due to the inclusion of Google into the NDX. Google is so large it will require funds to sell some of the other top Nasdaq stocks to make room. This should pressure the NDX and the Nasdaq by default.

The SPX managed to rebound to its four-year highs near 1272 and a level it has been unable to penetrate on its last three attempts. The S&P has been the least volatile of the big three indexes but you could not tell from the spike today. The +10 point post Fed spike was due mostly to a monster buy program that was launched on the announcement but it did manage to hold near the highs. A breakout over 1275 would be very bullish ahead of the expected volatility later this week.

NYSE Composite Chart - Daily

The NYSE Composite ($NYA.x) has been the clearest indicator of underlying market strength and the NYA broke out to a new all time high at 7851 today. The reverse of this bullishness was seen in the transports, which have been falling since their November 25th high at 4190. They hit a new four-week low at 4050 today. Clearly rising oil prices have had an impact but it is not the entire story. Oil prices did not begin to rise until after the $56 low on Nov-30th and then moved sideways for two weeks after the 5th. To put it simply the transports are no longer confirming the Dow advance and have given up more ground than the Dow over the same period. This could be simple profit taking given the sharp +640 point rally from the October lows to all time highs. I am seeing a lot of profit taking in some of the high flyers not related to the transports so it could be just a seasonal adjustment as we near year-end.

For the rest of the week Thursday is the only day with economic reports that could move the market but I think all the good news has already been factored into prices. The Fed news should be the mover tomorrow and the index changes the potential drag into Friday's close. Oil is rising overnight as I type this and currently $61.50 ahead of the Oil and Gas Inventories on Wednesday morning. Expectations are for declines across the board. The big energy mover will be the Natural Gas Storage Levels on Thursday morning. After the cold front last week we should see a significant drop. More than 75% of the nation saw temperatures lower than normal for this time of year. That big sucking sound you heard was gas being draw out of reserves to heat homes and generate electricity. Gas is currently $15.48 overnight and odds are very good we will see another new high this week. Personally I am looking for another sell the news event but will remain long energy until it appears. I would look to short/put the NDX/QQQQ on any weakness on Wednesday and maintain that short until Friday's close as long as weakness prevails. I didn't expect the Fed to change its statement so dramatically and it is entirely possible that could offset any potential NDX weakness. Only time will tell.

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