Option Investor
Market Wrap

Taking A Rest

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After a very strong beginning for January the markets finally appear ready to rest. New highs and strong internals gave way to mild profit taking on light volume ahead of Monday's market holiday. Mixed economic data ahead of the long weekend also gave the markets a reason to rest. Nothing indicates this is a change in the trend but the current rally is very extended. Next week is going to be crucial to market direction as major earnings begin to flow.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday's economic reports were headlined by the Producer Price Index or PPI. The headline number jumped +0.9% for December and more than twice the +0.4% rate that was expected. It was also a complete reversal of the -0.7% drop we saw in November. On an annual basis producer prices have risen +5.7% and the fastest rate since 1990. However, the core rate, ex food and energy rose only +0.1% for December, +1.7% on an annual basis. Energy costs remain the biggest driver in producer prices with a +23.9% increase for the year despite the post hurricane drop in oil. That +23.9% rise in energy prices is after a -5.4% drop in December and a -4.2% drop in November. The rise in energy prices will undoubtedly be a factor in Q4 earnings as they begin in earnest next week.

Total retail sales in December rose +0.7% but it was mostly due to yet another sales event at auto dealers and rising gasoline prices. Ex-autos sales rose only +0.2% and all of that was due to higher gasoline prices. This was a disappointing report and suggests holiday buying was neutral at best. The only segments outside of autos and gasoline stations that showed a decent gain were sporting goods stores and restaurants. On an annual basis sales rose +6.4%, up mostly on those higher prices at gasoline stations offsetting overall weakness in auto sales. The auto dealers are seeing zero traffic when their sales promotions expire and double-digit declines in auto sales have plagued GM and Ford.

Business inventories rose +0.5% and slightly higher than expectations of +0.4% but still lackluster. The inventory to sales ratio rose only slightly to 1.26 months compared to the record low of 1.25 months seen in October. Nobody is stocking up for an economic boom and the outlook from manufacturers appears to be very cautious. Nobody wants to get caught holding inventory if the Fed pushes us into a recession. This caution is preventing an inventory build out and the corresponding boost to the economy. This is turning into an economic game of chicken between manufacturers and buyers.

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We are two weeks away from the next Fed meeting and their expected +25 point hike. The economic reporting schedule for next week is light but highlighted by Industrial Production, Consumer Price Index and the Philly Fed Survey. The schedule intensifies on the following week with the Fed meeting the next week on Jan-31st.

Economics will not be the focus next week with the spotlight on corporate earnings instead. Leading off the week will be Intel, IBM and Yahoo on Tuesday and this could set the stage for the rest of the cycle. As this week came to a close commentators began to devote more airtime to warnings and disappointments from companies like Tyco, Lucent, Tiffany, Phelps Dodge, Alcoa and Dupont. All of those companies disappointed investors in one way or another as the Q4 earnings cycle heats up. These disappointments helped to convince investors that it might be wise to take profits from the January rally ahead of earnings. Analyst downgrades also added to this disappointment cycle with downgrades on Harley Davidson (HDI), Allianz (AZ), Siemens (SI) as prime examples. Goldman Sachs downgraded the entire healthcare sector causing steep losses in companies like United Health (UNH) and WellPoint (WLP).

This should be the 10th consecutive quarter of double-digit earnings gains for the S&P according to Thompson Financial. Those gains are expected to decline to +12% to +13% and well off the much higher levels we saw in 2004 and early 2005. The S&P will be boosted again by the energy sector with gains expected to be in the +46% range. Technology is expected to provide a much weaker +17% boost with industrials and materials stocks adding a remarkable +14%. This is remarkable due to the higher cost of energy eating into their manufacturing profits. The energy excuse is likely to be the major get out of trouble free card played by most manufacturers. Once the first few big names blame energy for lower earnings the rest of the players can copy that excuse and escape basically unscathed.

Natural gas prices have declined to $8.79 and approaching a 50% haircut from their highs. Support is $8 but that is still above the $6.91 level where we started 2005. The decline in gas prices will be very beneficial to manufacturers who depend on cheap gas in their manufacturing process. Unfortunately this will not help Q4 earnings with gas over $14 as recently as Dec-21st. The early price spike in Sept/Oct was too late in Q3 to impact earnings substantially with the impact lagging right into the middle of the Q4 period. This is the earnings cycle that will show the biggest impact and it is likely to be painful.

Natural Gas Chart - Daily

The string of double-digit earnings gains will be helped significantly by stock buybacks last year. 2005 was a record year for buybacks with more than $315 billion in shares removed from the market. Companies with huge buy back programs will see earnings per share rise simply due to the smaller number of shares outstanding. This is a false increase in earnings and will not be reported by the major media. Companies with flat earnings but a significant share buyback can appear to be a winner when they announce earnings that beat the street. That is because the street does not know how many shares have been repurchased until after the earnings report. They are forced to base their estimates on the shares outstanding in the prior quarter. IBM has been a habitual offender in this area for years. Buying back a couple million shares can add 2-3 cents to earnings and produce a positive surprise. With 2005 a record year shares removed from the market have been huge. For instance OfficeMax (OMX) bought back 24.4% of its shares, Kerr McGee (KMG) bought back 23.6% and Radio Shack (RSH) 14.9%. With those types of numbers the artificial boost to earnings per share will be huge and also a one time event.

IBM was a drag on the Dow on Friday after the SEC announced a formal probe into its accounting practices. The probe is questioning how IBM accounted for stock options in early 2005. This kind of action can drag on for years and IBM is expected to see some selling pressure once earnings have passed. With their buyback program they are expected to beat the street but any bounce could be short lived.

Home Depot (HD), another Dow component was under pressure after a whistle blower claimed he was fired after alleging they were incorrectly accounting for supplier returns. Wal-Mart (WMT) was also under pressure after Maryland passed a law forcing them to spend more on employee healthcare or pay the money into the Maryland healthcare fund. It is feared that other states will take up the battle and pass the same laws pushing Wal-Mart's costs even higher. JNJ was also a drag as investors feared the bidding war for Guidant would force too steep a purchase. GM also pushed the Dow lower after several analysts reiterated their caution about an eventual bankruptcy. Considering the multitude of Dow negatives it was remarkable it only lost a couple points for the day.

Oil has been the focus this week due primarily to the growing concern over a possible Iran embargo. Iran exports 2.5 mbpd and has 10% of global oil reserves. Should the UN elect to impose sanctions against Iran it could produce a global oil panic. Because of this potential I do not expect the UN to take action. However, Iran is also able to use oil as a weapon if the UN does take some kind of action against them in another area. If Iran elected to cut exports they could quickly send oil prices much higher to $75, $85 or even $100 depending on the length and severity of the cut. Commentators are obsessed with the threat of UN sanctions against their exports but are overlooking Iran's power to control their own fate. Not selling oil at $64 a bbl would cause a serious crimp in their cash flow but sending prices significantly higher would guarantee them increased proceeds once production resumed. Don't underestimate Iran's potential to cause global pain. Despite their stubbornness they are holding the trump card.

Rebels in Nigeria, unrest in Venezuela and the possibility of nationalized oil in Bolivia also kept upward pressure on prices. The majority of unexploited oil around the globe is in politically unstable countries and continued exploration and production is far from guaranteed. It is not enough that we have to worry about demand outstripping production permanently but we must also worry about production falling for political reasons as well.

Oil Chart - Weekly

Analysts jumped on the January rally and were quick to raise targets for 2006 proving that they are not devoid of emotions. Two weeks of strong gains converted numerous bears into bulls despite no positive change in economic outlook. Abbey Cohen was probably the highest profile with a 10 min scripted appearance on CNBC. Her target for 2006 is now 1400 on the S&P but she was uncharacteristically candid on her predictions. She suggested that small caps were done and investors would be shifting into the least economically sensitive large caps. Reading between the lines of her bullish forecast was a concern that the economy was going to soften and investors better prepare for trouble ahead. The S&P 1400 target was never mentioned to be a year-end target but only a 2006 target meaning it could be reached ahead of the expected economic downturn. Ms. Cohen is typically a cheerleader for the bulls and despite her 1400 target I detected a rising note of caution creeping into her scripted presentation.

I am also beginning to hear more mention of second year election cycle concerns. I have mentioned this before but it deserves a review. Historically the second year of a second term president tends to be rocky for the market. The president is not facing reelection and they typically use this year to correct errors made in the first term and make sweeping changes before the next election cycle. The hope is that the public will forget the hard to swallow medicine for the current year long before the race heats up for the next election. This has been the trend for decades and there is no reason to expect Bush to be any different.

Also adding to the market risk is the coming end to the Fed rate hike cycle. Many expect a halt after the Jan-31st meeting and nearly everyone feels they will quit on or before the March-28th meeting. Any change to this outlook could be very detrimental to the market. The market fears a repeat of a very strong Fed trend. 14 of the last 16 rate hike cycles resulted in recessions. That is an 87.5% chance of economic damage from a Fed cycle and pretty good odds for the bears. However, this cycle may be different with economic growth already weak and higher energy prices already restraining growth. The Fed should be comfortable with a halt before any material damage is done and the markets would celebrate a neutral stance after the January meeting.

Answer this quickly, were the markets up last week? If you answered yes you might be surprised if you review the table at the beginning of this commentary. The Dow and S&P were perfectly flat for the week with the Nasdaq gaining only +11 points. The NYSE Composite index, the most bullish leading indicator for the last two months, lost ground for the week. After a week of new highs on almost all the indexes the fade into the weekend was simply profit taking on light volume. Friday was the lightest volume day for the year BUT it was not really light at 4.28B shares. The dips were bought and support appears to be rising. Nothing has changed in the internals but volatility is building.

SOX chart - Weekly

S&P chart - Weekly

The major indexes are holding near their recent highs and an explosion of earnings news is near. The indexes appear to be priced to perfection and while there have been some high profile disappointments the number of warnings is still below normal. The stage is set for Tuesday with tech heavyweights IBM and Intel ready to confess. The key will be expectations. Can both companies beat expectations both in earnings and guidance? Can they beat both with enough excitement to push the markets higher? Given their recent history of earnings and guidance that may be less than a 50:50 chance. Yahoo rounds out the trio for Tuesday and it may be tough for Yahoo to produce earnings strong enough to excite investors when investors compare its performance to Google. That is a huge bar to jump for Yahoo. To put it bluntly if I had a choice of three companies to set the tone for Q4 I would not pick either of these three. That makes me cautious for next week.

SPX Chart - 60 min

My market indicator of choice is still the S&P with 1270 the long/short decision point. I would continue to buy dips above 1270 but with decreasing levels of enthusiasm. A typical market correction after a strong rally is something in the 20% range. From the 1168 low in October to the 1295 high in January is 127 points. A -20% correction would be -25.4 points OR almost exactly to 1270 and our long/short decision point. In theory a drop back to 1270 would be an excellent entry point ahead of the FOMC meeting on the 31st. A break of that same level would also become very negative to market sentiment. I would love to see this rally continue but far too many investors have turned bullish and are investing on emotion rather than logic.

Shorts started rebuilding positions as the markets faded and that may be the best thing for the bulls. Positive earnings surprises on Tuesday could produce another short squeeze to send us back to retest the highs. Merrill took the unusual action on Wednesday of recommending investors in small caps take the money and run. They claim the gains have been too far, too fast and the impact of the January effect may be fading. They cited concerns about seasonal factors as well as earnings pressures on small cap stocks as additional reasons to bail out. I know we say this a lot but this week should be pivotal to market direction and a sharp move could be the result. Tighten your stops in case that move is contrary to your bias.
 

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