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Market Wrap

Not Done Yet

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The Fed Is Not Done Yet

Just when investors thought it was safe to go back into the market additional Fed rate clouds appeared on the horizon. The economic reports for the week have put the fear of the Fed back into investors. The idea of one-and-done self-destructed as indicators of economic strength and rising inflation became headlines once again.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - 30 min

The Jobs report on Friday came in weaker than expected with a headline number of only +190,000 when analysts had expected +250,000 to as much a +300,000. On the plus side there was an upward revision to the prior two months of +81,000. This was good/bad news as the headline number disappointed but upward revisions suggested stronger growth than previously thought. The unemployment number fell to 4.7% and the lowest rate since mid-2001. This was a drop from 4.9% in December. However, the method of measuring the unemployment rate has changed and the data has been adjusted and may not be comparable to prior reports. Jobs in December were revised up to +140,000 and November was revised up to +354,000.

The bad news came in the form of a +0.4% jump in average hourly earnings for the second straight month. November was flat but October posted a +0.6% gain. The sudden sharp rise in earnings suggests wage inflation has begun and the Fed will have to shift into offensive mode to combat the problem. Hourly earnings have grown +3.3% over the last 12 months. This is the strongest jump since early 2003. With the employment rate falling, hiring lagging estimates and wages rising it is the perfect storm for the Fed. Confirming the concerns in the employment report was the Productivity report on Thursday. Hourly productivity output fell by -0.6% in Q4 while wage costs jumped +3.5% for the same period. This was the first decline in productivity since Q1-2001.

IIf you recall I discussed last week that the market had priced in a one-and-done scenario for the Fed after a drop in Q4 GDP to only +1.1% growth. I warned that a Fed surprise could be detrimental to the markets. The Fed cooperated on Tuesday by taking the measured pace language out of the statement and moving to "further policy firming may be needed" instead of the "will likely be needed" stance. The Fed appeared to be moving to neutral at 4.5% after 14 consecutive hikes. The new language was satisfactory while not really suggesting a halt. The language moved to a stance that would be driven by economic factors. That was the problem. The economic factors took a sudden turn higher after the meeting. The ISM only fell to 54.8 from 55.6 on Wednesday and much better than the whisper numbers in the 52 range. Chain store sales soared +5.1% for January and much better than the +3.5% growth in December. Signs are growing that February sales will also be strong. Construction spending jumped +1.0% compared to +0.5% in the prior month and well over the +0.1% consensus estimate. Vehicle sales jumped unexpectedly in January to a 17.3 million rate and the first sales gain in months. 2006 is expected to be the weakest sales year for automakers since 1998 and a sudden jump in sales was surprising. Jobless claims are falling with weekly numbers hitting lows not seen since mid-2000.


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This sudden burst of good economic data along with the sharp spike in wage inflation and dip in unemployment sent the Fed funds futures into overdrive. Instead of the one-and-done scenario favored just a week ago we are now looking at a strong possibility of at least two more hikes. The futures are projecting better than a 50% chance of a 5.0% Fed rate after the May meeting. Surprised by the sudden turn of events investors began taking profits.

Economic events were not the only factor pressuring the market last week. Negative earnings surprises continued to appear and some from very high profile companies. Guidance continues to be weaker than expected from a broad range of sectors. S&P said Q2 earnings would likely break the string of double-digit quarters dating back nearly four years. S&P estimates are for earnings growth have fallen to only +7.7%. Rising inflation, rising rates and slowing earnings are not a recipe for a bullish market. The markets rolled over after the Fed meeting when resistance proved too strong for a questionable future. Markets want to rally on the final Fed rate hike in any series and the sudden change in outlook from one-and-done in January to at least two more through May was too much bad news. If the Fed did halt in May it might not attract too much investor interest since that would correspond to the beginning of the "sell in May and go away" six month cycle. Add in a drop in earnings expectations into single digits and suddenly the outlook for investors dimmed considerably.

Markets reacting to the storm clouds on the horizon could not even shake off the gloom after a -$5 drop in oil from $69 on Wednesday to $63.90 on Friday. There was an initial reaction spike in equities but it was quickly sold. Oil prices are finally showing signs of collapsing after holding near their highs for nearly a month. The price of oil has been holding at an abnormal level due mostly to geopolitical concerns. As the week drew to a close the International Atomic Energy Agency (IAEA) delayed a decision on sending Iran's nuclear plan to the UN Security Council. The 35-nation board of IAEA governors had opened an emergency meeting on Thursday in Vienna. The meeting will continue on Saturday. Politics is playing a crucial part in the decision with various countries lobbying for their own interests. One sticking point is the discussion of a Middle East nuclear weapons free zone. Since Israel is already thought to have nukes it would be a challenge to ignore them in the context of the zone. It appeared late Friday that tensions were cooling as many proposals for resolution continued to surface. Russia wants a delay until the March meeting to give diplomats more time to work. The U.S. also appeared to be softening in regard to the timing of a decision. The U.S. does not want to be seen as the instigator of action against Iran. This cooling of tensions sent oil prices spiraling down from their highs.

CCrude Oil Chart - 60 min

Oil has been trading with about a $10 risk premium built into the price. When Venezuela sided with Iran last week the prices rose to hit $69 on Wednesday. According to the EIA oil inventories rose +1.9 mb in the week ended Jan-27th. The API showed a larger rise of +5.9 mb. The EIA showed a gain of +4.3 mb of gasoline while the API showed a gain of +3.7 mb. Crude inventories totaled 321 mb according to the EIA. This is well above the five-year average for this week of 289 mb. Gasoline, jet fuel, distillates and fuel oil are also above their five-year averages. Despite forecasts for colder than normal weather over the next 15 days there is almost no scenario that would produce a significant draw in supplies. Refineries are shutting down for maintenance and to convert from heating oil to gasoline for the summer driving season. This will continue on a staggered basis for another six weeks. I have been telling everyone for several weeks that conditions were not supporting the rise in oil prices. The hurricane impact took a substantial portion of demand off the market in Q4 and this allowed crude inventory to build significantly above normal levels. Eventually this bubble had to burst as the spring demand slump arrived. While the Iran story has yet to play out I believe there is a good chance it will be delayed until March. This should allow prices to correct and take some pressure off equities. The challenge now is to pick the bottom of the correction in preparation for going long energy once again.

The OPEC meeting last week was a neutral event with prices nearing $70 once again. The prospect of a production cut to defend prices at $55 was laughable. They satisfied themselves with the threat of a production cut after the March meeting and a couple warnings that prices could hit $100 if something happened to Iran's output. With their bank accounts overflowing with cash and no real demand drop in sight despite the $69 oil a back slapping good time was had by all. I would personally like to see them slow production to support prices and then get behind the curve again like they did in 2005. The global economy is still growing and the next time OPEC screws up while trying to be cute and protect prices it could have dramatic consequences.

Greenspan has moved off the firing line and into the history books with his term as Fed Chairman now over. CNBC celebrated his retirement by having artist Erin Crowe, a painter of Greenspan portraits, paint her last portrait of Greenspan on the air on Tuesday. CNBC auctioned the painting off on Ebay and will give the proceeds of $150,400 to charity, Autism Speaks. Could this price be true "irrational exuberance"? Not bad for an artist whose previous high for a painting was $12,000. I am sure Bernanke is just hoping somebody will want to paint a picture of him rather than burn him in effigy when he leaves the post. Remember, Greenspan took office in 1987 only two months before the biggest market crash in history in October 1987. He recovered from that disaster and managed to forge a significant legacy. If I were Bernanke I would be very concerned about the next few months of this aging recovery and I would want to be very careful I did not make that one extra hike that breaks our economic back and produces a severe recession.

The four horsemen of the Internet rode into the sunset on Friday after Amazon, the last of the group, reported earnings Thursday night. Maybe I should say they hobbled off into the sunset. It has not been a pretty picture with Yahoo, Ebay, Google and Amazon all disappointing in some form. Ebay was punished the least after a couple upgrades erased some soft guidance. EBAY rallied to $48 on the upgrades the day after earnings but quickly entered a downhill slide, which accelerated as each remaining Internet stock confessed their sins. EBAY finished the week at $40.50 but that -$8 loss was kind compared to the -$50 drubbing suffered by Google. Amazon was the final act with its earnings miss and -10% drop on Friday. After YHOO, EBAY and GOOG expectations for Amazon were already lowered. It did not take long before the old Amazon.bomb nickname penned originally by Barron's returned to print where I saw it several times on Friday.

It was a bad week for the indexes with the highs for the Nasdaq and SPX set on Monday. The Dow managed to hold its ground and set its high on Wednesday on good news from GM and Boeing. However, before the week was out the results would be the same across the board. All the major indexes lost more than 1% for the week with the NDX dropping -2.72% thanks to a -$50 drop in Google. The SOX dropped -4% on the largest decline in semiconductor billings in over a year. Semiconductor billings for December fell -2.3%. This is a three-month moving average so the actual number was probably much lower. Notable declines this week were MOT -7%, AMD -7%, QCOM -6% and RMBS -15%. Let us not forget the Intel massacre of -19% since their earnings on Jan-17th. Despite the -5.5% decline in the SOX since the high on Jan-27th the SOX at 529 is still well above support at 515. Chips have been on fire since the October low but that rally appears to be fading. Despite the high profile disappointments by some chip companies this is probably just a normal sector rotation rather than a new direction. The fourth quarter is typically kind to chip companies in anticipation of a wave of seasonal profits. The first quarter is typically soft for tech and it is only natural for rotation to occur. Chips benefit from the January effect and in case you havent noticed the calendar turned over last week.

SOX Chart - Weekly

The January effect is typically seen late in Q4 and early in January as year-end fund flows migrate into small cap stocks, primarily techs. The Russell 2000 was the primary beneficiary of these fund flows and a new high of 736.45 was set on Wednesday. Given the changing economics, weak earnings guidance and strength of the Oct-Jan rally it should be time for small caps to rest. February and March typically produce volatility in the Russell as fund managers rotate out of stocks and sectors that have outperformed. It is not a fundamental change but only a cyclical event..

On a purely technical basis the Dow posted a lower high last week and closed Friday right in the middle of its recent range at just under 10800. Initial support is just under 10700 at 10675 but without the benefit of earnings hype this may be only a bump in the road as sector rotation accelerates in February. On the Nasdaq the close at 2262 is only +20 points above initial support at 2240 with 2200 not far below.

WWe have been using the SPX as our index of choice for deciding which direction we should trade. Last week the SPX broke out of resistance at 1275 and tried valiantly to crack the next level at 1285. After three days of failure a feeling of resignation began to settle in and upper level support at 1280 finally broke with a straight drop through our neutral zone between 1270-1275. The 1270 level attempted to hold the drop but was unsuccessful. The recommendation for the last several weeks was to be flat or short under 1270 and that puts us into a short bias for the week ahead. The SPX was actually the weakest link for the week with a Friday close very close to critical support at 1260. This was probably due to the implosion in the energy sector after the price of oil finally cracked. That makes it a little harder to predict for next week since energy is due for a bounce. One that will likely fail but still a bounce. That would probably bring the SPX back into parity with the Dow and Nasdaq but still maintain a negative bias.

Russell Chart - Weekly

NYSE Composite Chart - Weekly

The indexes still maintaining a bullish bias are the Russell and the NYSE Composite. The Russell has intermittent support from 700 to 720 and any decline is not likely to be sharp. Dip buyers should appear about every 5 points. The NYSE Composite has been very bullish since the October lows and set a new high at 8130 on Tuesday after the FOMC meeting. That high lasted about one day before investors began taking profits and the index declined to 8000 at Friday's close. Critical support at 7950 is only one good decline away and a level where buyers should appear. If they are unsuccessful the next stop could be just under 7800.

The bottom line for me next week is boredom. The economic calendar is sparse and the majority of earnings excitement has passed. Oil pulled back to support at $64 and buyers appeared at the close on Friday. This could have been just short covering but it may have been strong enough to attract attention from those looking to buy the dip. I hope it was just a false bounce from short covering. I would love to see crude return to real support at $58 and a very good entry point for a summer surge. However, I did buy the dip with some speculative positions on Friday just in case the dip to $64 is all we are going to get. On the broader market it is about time for the post earnings depression to appear and I would be very careful getting married to any long positions, even in energy. Continue to honor the SPX 1270 short indicator and the 1270-1275 neutral zone. Remain short under 1270 and cautiously long over 1275. I say cautiously long because my fundamental bias has become more negative. I don't want my bias to get in the way should a new rally break out so I will only be cautiously long over 1275 and suggest you do as well.

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