When Santa fails to call, bear may come to Broad and Wall. Santa definitely failed to appear and the outlook for January is rapidly turning negative. A failure to rally during the last week of the year sends shivers through the analyst community. The weakness was not due to a lack of cash with investors sending $2.8B to mutual funds for the five days ended on Dec-28th. This was in addition to the inflows of $4.9 billion in the prior week. The drop was due to profit taking by funds ahead of a potentially weak January.
Dow Chart - Daily
Nasdaq Chart - Daily
SPX Chart - Daily
The undercurrents are turning into a whirlpool as we approach 2006 and the market weakness over the last week represented early exits by nervous funds. Funds talk to each other and there is a real fear that January could see a market reset as the year begins. The profits from the October lows will need to be taken with markets stalling at the resistance highs. The S&P and Wilshire-5000 both ran into a brick wall at 1275/12750 and five weeks of trading failed to penetrate. The last week saw very little retail buying and every sell program turned into a disaster in the low volume. Traders are seeing that 1275 level as a top and are waiting on the sidelines to see what January will bring.
For 2005 the year ended with a thud and were it not for the strong November rally it would have been even worse. 2005 duplicated performance for 2004 with weakness for most of the year punctuated by a year-end bounce back to the highs. Unfortunately that bounce was just enough to push the indexes back into the green with the exception of the Dow. Note the slowing from the 2004 pace.
TTable of U.S. Indexes with Changes for 2005 and 2004
The -0.6% loss for the Dow was the smallest annual loss dating back to 1902. That is slim consolation for traders. With several dogs losing large amounts it is amazing it was not worse. GM led that list by giving up -51% for the year. That was offset in part by strong gains from HPQ, BA and MO. The gains shown for AT&T in the table are skewed from the SBC/AT&T merger.
Table of Dow Components Sorted by Yearly Change
The poor performance by the U.S. markets is even worse than it appears when compared to some other markets around the world. Granted some of the smaller ones contain huge amounts of risk but you can see why international funds and iShares have been so popular. Investing has taken on a global view for retail traders more so than any other time in the past. Instead of being confined to the 7500 U.S. stocks we can invest in an individual basket of stocks from a single country like Japan or trade a basket that covers all of Asia. The investing world has changed and the ability to invest globally has taken cash out of the U.S. markets that would have been fuel used in the past to push our indexes higher.
Table of Global Indexes
Money flows into funds in general have been weaker than in 2004. Overall stock funds received $125.5 billion through November 30th compared to $167.6 billion for the same period in 2004. This raised total assets of U.S. based mutual funds to $8.76 trillion as of November's end. TrimTabs said expected inflows in December would be in the $20.2 billion range with only $8.6B remaining in U.S. equities while $11.6B would be heading overseas. This is well above prior years and a key reason why the U.S. market is floundering.
Commodities have also taken their place on the retail stage in the U.S. markets. Instead of having to use separate brokers and different accounts with reams of complicated paperwork the rules have changed. Many major brokers are offering combination accounts where the various futures contracts can be traded as simply as trading stock like IBM and GE or options on stocks or indexes. With the greater volatility and higher leverage the futures markets have also been attracting traders away from conventional equities. Metals have also been very attractive with copper and titanium taking their places with silver and gold as strong gainers for the year. Steel prices soared with the global construction boom and traders participated using individual stocks not normally known from multi month moves.
Table of Commodity Gains
However, 2005 will be known as the year energy caught fire. Oil prices jumped from $40 in January, already up strongly from the $27 low in 2004, to more than $70 in the aftermath of Katrina. Natural gas prices more than doubled from their January low of $6.53 to trade over $15 as huge amounts of U.S. production was taken offline in the Gulf. More than 2.3bcf is still offline and much of that could be offline until Q2. While prices for both commodities have declined significantly from the highs they are still holding above the yearly average of $57.38 with oil at $61 and natural gas at $11.25. OPEC appears to be headed for a production cut at the end of January of at least one million bbls and the future is clear to those watching the proceedings. Prices are not going much lower with the average price of oil in 2006 expected to be $58.46 according to a survey of energy analysts. It should be no surprise that the S&P Oil and Gas sector rose +38% for the year. Retail investors piled into the sector iShares, Holders and SPDRs and were rewarded with spectacular gains through year-end.
Energy iShares, Holders and SPDRs
2005 could also be called the "Year of Takeovers." According to the bean counters that keep records of these things more than a trillion dollars in takeovers either occurred or were announced. The list below is only a representative few but they amount to nearly $300 billion in ten deals. This is a massive amount of money and shows how much corporate cash had accumulated but also suggests that valuations had improved significantly enough to stimulate these transactions. Conversely there is another train of thought that suggests corporations had topped out on organic growth and cost savings and were forced to shift to acquisitions to maintain forward motion. $277 billion of the acquisitions were cash takeovers of public companies and that topped the $231 billion record set in 1999.
Top Ten Acquisitions Announced in 2005
There was so much excess cash stuffing the corporate coffers that stock buybacks set a new all time record of more than $456 billion. This shattered previous record of $312 billion set in 2004 by +46%. 728 companies bought back shares in 2004 compared to 1012 companies in 2005. Historically whenever record amounts of money were used for buybacks the markets moved higher according to TrimTabs.com. Not so in 2005. According to Charles Biderman of TrimTabs.com investors did not see the buybacks as evidence of a strong domestic economy. They saw the buybacks as evidence that companies did not have any better use for the money. CapEx spending was not especially strong and they had to do something with the money to keep shareholders happy. If you are not growing revenue or making acquisitions that will help future growth then buying back shares seems to be the right thing to do. Investors were not impressed. This perceived lack of growth potential helped to push investors into those investments in other countries I outlined above. Growth is growth regardless of country. To illustrate this lack of investor interest Exxon bought back a massive $13 billion in shares and the stock only gained about +10% for the year. Microsoft repurchased $9 billion but its shares ended flat. The key to attracting American investors is growth and that was noticeably absent from the economic picture despite a +3.5% GDP.
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Also sucking money out of equities was a very strong IPO calendar in 2005. Every new issue takes money away from the rest of the market. Google, who launched their IPO in Aug-2004 shot higher throughout 2005 adding more than double its $59 billion market cap as of 12/31/2004. With a current market cap of $123 billion that was a huge blackhole sucking money out of other stocks as investors abandoned other equities to jump on the Google train. The IPO bubble is only getting stronger with 140 already registered for 2006 for an estimated $23 billion. Thomson Financial thinks there will be as many as 300 in 2006 with more than a $50 billion price tag.
If 2005 was a dog for everything but energy stocks how is 2006 going to rate? If I knew beyond a shadow of a doubt I would be mortgaging everything I owned to bet on that outcome. Unfortunately nobody has that proverbial crystal ball but there are quite a few analysts betting their reputations this week. Various analysts were interviewed publicly or published their expectations for 2006. The list below also includes an unscientific survey of 112 NYSE floor traders. Their average target for 2006 was 1293 for a +3.8% gain. However, fully one third of those traders were bearish and expected a rocky year. For five of the last six years traders were more bullish than the actual market the next year. On the one year they were bearish the Dow rose +25% the following year. This illustrates perfectly that the markets exist only to frustrate the most people possible in any given year. Despite one third of those being surveyed being bearish the survey still projected that +3.8% gain for 2006 to 1293. If those traders have historically been too bullish then it would suggest something less than 1293 for 2006.
Table of Broker Targets for 2006
The vast majority of analysts taking a position in print agree mostly with a target in the 1300 range with those three companies above with estimates at 1400 standing well out of the crowd.
About the only thing most agree on is that the energy sector will continue to provide above average returns. With OPEC likely to support a price in the mid $50 range the odds of oil retreating under $50 are slim, always possible but slim. Energy companies are still seeing their stock being valued using oil in the $30 range. This suggests there is still plenty of room for price appreciation. Does anybody really believe ConocoPhillips is overpriced with a PE of 7? How about ChevronTexaco at 9 or even ExxonMobil at 10? The price of energy stocks will continue to rise but maybe not at the meteoric rate we saw in the summer of 2004. They will rise because very few companies outside the energy sector are growing earnings at rates of +40% to +85% or more. Of course there is always the expectation for Peak Oil to arrive in 2007 to keep the speculators active.
Crude Oil Chart - Daily
I am sure there will be some more consolidation in the industry simply because it is cheaper to buy reserves than find them. There are plenty of companies with valuations far below acquisition levels. For instance Apache (APA) has a market valuation of only $13 per bbl of reserves and very strong management. Chesapeake Energy (CHK) has been on an acquisition binge but it may be just to keep potential acquirers of itself off balance. CHK controls the third largest reserves of natural gas in North America and yet has a market cap of only $11 billion and a price to reserves of only $17 a bbl. Coincidentally insider buying at CHK is out of sight. Since Dec-14th the Chairman and the President have purchased 2,272,000 shares in the open market for something north of $72 million dollars in 14 separate transactions. Personally if they are buying their own stock at $32 in that quantity I seriously doubt it is going much lower. If they are willing to invest $72 million near the top of the market what does that tell you about their expectations?
The downside for 2006 remains the homebuilders and the housing sector in general. Even if the Fed rests at something under 5% there is still a lot of negative sentiment about the sector. Several years of speculative excess has pumped prices to extreme levels and inventory for sale is growing quickly. Once the speculators finally accept reality there could be a sudden downdraft. Inventory numbers for existing homes for sale were just released last week at 2,903,000 and that is a +31% increase over the same period in 2004 at 2,214,000. New homes for sale were reported at 503,000 a week earlier and +83,000 over 2004. Add those numbers together and you have a total of 3,406,000 homes for sale, up +29.4% from 2004. Since new households only increase at a rate of about 1.2 million per year there is a lot of inventory for sale. Many of those new households will be apartment dwellers making the inventory numbers even more dramatic. I would be very surprised if the homebuilders rise from the dead in 2006. However, many builders have backlogs up to 12 months out so they will still continue to produce profits, just not at the rate of past years. Since some estimates say new homes account for as much as 50% of our current GDP levels that will make it hard for GDP to post any gains in 2006. (Thanks Joe for the heads up)
On the positive side the Fed is likely to quit raising rates in March if not before. This is typically an all-clear signal for the markets BUT it is also typically a signal that the economy is in good shape. Our economy is far from ready to sprint higher when the Fed moves to the sidelines. Besides the expected drag from the housing sector we will have the continued drag from higher energy costs. Earnings from Q4 will be the first round where the real impact from record energy prices will be felt. I suspect there will be quite a few companies use the energy excuse for lackluster earnings. This will continue to drag on the economy simply because everything made or transported in the U.S. is impacted by those higher prices. Few analysts have connected the dots that $55 oil and $10 gas is not going away and anyway you count it that is a significant earnings drag over 2004 levels.
Earnings are expected to decelerate into single digits after a very long run of consecutive double digits quarters. This will force some PE compression and probably give us another year of range bound trading. The S&P spent most of 2004 in 1075-1150 range. The Q4 rally in 2004 pushed the S&P above that range to establish a new range from 1150-1250. That range held all year until the same Q4 breakout occurred in 2005. These two years of consolidation from the +350 point rebound out of the 2002 bottom has pushed the S&P about as far as it can push without some help from somewhere. We already know the indexes would have been severely negative for all of 2005 without the +38% jump in the energy sector. Still they just broke even for the year.
With 2006 coming under attack from all directions it is highly unlikely there will be a breakout soon. I believe traders are going to be focused on the Fed and on energy. The last Fed meeting for Greenspan will be Jan-31st and odds are good he will leave with a 4.5% Fed rate. Bernanke will then take charge with his first meeting on March 28th. If the Fed does not change the statement to a neutral position in January then all eyes will be on Bernanke's first meeting in March. There are mixed feelings now on whether he will hike again to prove his manhood or go soft on the markets with a wait and see position. This should be the key pivot point for 2005. Regardless of what the markets do for the next 90 days that should be the make or break moment for 2005. Of course all bets are off should the Fed stand aside in January. That could light the rally fire before the energy grinch has a chance to damage investor sentiment over earnings.
Chart - Weekly
Personally I believe January could get rocky. Last week should have been a wakeup call for everyone. The tape painters tried to recover from the Monday massacre but they were either under funded or too scared to make much difference to the outcome. Wednesday and Thursday traders were walking on eggshells afraid the next tick was going to be the one that setoff the next sell program. That tick finally hit at 3:PM on Thursday and the selling continued into lunch on Friday. I mentioned on Tuesday that I expected 10725 to be defended by the tape painters and that was exactly where they drew the line. They again tried to resurrect the indexes in the last hour of trading and probably got some help from traders covering shorts in the last hour but they had the props kicked out from under them once again by a sell program at the close. I told you last Sunday my calendar had a skull and crossbones on it for Friday and my fears came to pass. It worked out well for me and anybody following my Tuesday night suggestion to short any rally. Remember the VIX chart from last Sunday when the VIX had fallen to 10.27 and very close to a new low? Well, it only rebounded slightly despite the volatility for the week. This suggests far too many traders are still too bullish.
VIX Chart - Weekly
I don't think we need to look any farther into the future than next week. There should be plenty of volatility and opportunity for everyone. If you are a bull just surviving the week may be a trick. While nobody can predict the future exactly I would say the setup has the classic earmarks of a fund dump. I reported earlier that funds received inflows of $7.7 billion in the two weeks ended on Wednesday. Obviously they did not put it into the markets. This should tell us something about next week's chances. Funds have been holding their breath trying to escape 2005 with what little profits they have intact. They probably dressed up their portfolios over the last few weeks with a few winners to make themselves look like heroes but come Tuesday morning all bets are off. They are free to liquidate at will and then shift back into their less visible positions once the dip ends. Some of those positions will be in energy futures. If you want to know which stocks they will be dumping next week you only need to look at the winners for the last two months. Quite a few have already been taken to the woodshed like MHC, PGR, CI, PD, JCOM, UNH, ADSK and GMXR. This is only a taste of what we could see next week. Don't think the energy stocks will be exempt either. The run up in futures we saw the last two days to push crude back to $61 could have been just tape painting designed to keep energy stocks from buckling into year end. The inverted yield curve has gotten enough press over the last week that anyone currently invested should have thought at least once about lightening up on their positions just in case the warning was accurate.
SSOX Chart - Daily
The Transports appear poised to nose dive to 4100 with very little effort after two separate attempts to hold 4275 failed. It is not that the rest of the indexes will need any help moving lower next week but a collapsing Transportation Index will speed up the drop. The SOX collapse under 475 is all the asdaq stocks will need as a warning flag that trouble is near. The SOX found buyers at 475 on Friday but I believe it was tape painters trying to avoid free fall. My suggestion to you this weekend is to tighten up stops on any long positions and be prepared to go to cash or go short on any weakness on Tuesday. In theory the Santa rally continues through Jan-4th but since Santa had a sleigh wreck on his way to Wall Street I would not count on an upside surprise. If we do get one I would consider it a gift of a better entry for a new short position. I hope I am wrong about my bearish outlook but that is the way I am playing it. Plan your trades and trade your plan but be ready to abort that plan if your bias turns out to be wrong.
Happy New Year!