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Inflation Race

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Friday's PPI report showed core inflation rising at a surprising rate just when the market had discounted only two additional Fed rate hikes. The market gains this week surrounding the Bernanke testimony were on the hopes that the Fed was nearly done. Two more hikes had been discounted into the market and traders applauded Bernanke's strong outlook on the economy. Everything was right with the world until storm clouds began to appear on Friday. Now it appears the Fed may be heading into a sprint to the finish to head off further inflation. Two hikes remaining, try four say some analysts.

Dow Chart - Daily

Nasdaq Chart - Daily

The headline number on the PPI was only +0.2% and well below the +0.6% we saw last month. However that was quickly ignored due to the strong jump in the core inflation rate by +0.4%. This was the strongest jump in core inflation in more than 13 months. The rise in core intermediate goods was three times the rate of finished goods. The sharp jump was reportedly caused by a rise in auto prices with the expiration of the December incentives. Auto prices reversed a three-month decline and increased at the sharpest rate in 19 months. Overall finished goods prices are +5.7% higher than in January 2005 and finished energy goods have risen by +25% over that same period. Crude producer goods have risen +23.6% in the same period driven of course by the rise in oil prices. The sharp jump in producer prices suggests rising inflation may continue in the months ahead. With the nation at almost full employment we are likely to see some wage pressures ahead and wage inflation is a critical economic warning sign for the Fed. There is little doubt that we will be at a 5.0% Fed rate or higher in May and now there are some analysts suggesting we could see 5.5% by October. The inflation monster appears to be gaining strength despite 14 consecutive rate hikes. While the market appears to have already discounted a 5% rate we are likely to see some apprehension build against additional hikes.

Consumer Sentiment fell nearly -4 points to 87.4 in February from 91.2 in January. The reason for the decline was a drop in the expectations component of -4.5 points and a drop in the present conditions component of -2.6 points. Rising gasoline prices and the weakness in the stock market were listed as consumer concerns as well as the return of cold weather in early February. Increases in home heating bills received over the next four weeks could continue to pressure sentiment through March.

This was a week for startling economic news. For instance New Residential Construction for January jumped +14.5% to an annualized rate of 2.276 million units. December was revised higher by +55,000 units and November was revised up by +15,000 units. Housing permits spiked +6.8% thanks to the warmer January weather. This was the highest level of housing starts since March 1973. Did the housing bubble suddenly reverse into a new rally? Not hardly. January's numbers simply relate to the warmer weather and a drop in mortgage rates early in January. Those rates have already moved higher and colder weather in February will likely push the housing numbers back into the normal range. Still, the spike did energize the equity market somewhat as investors breathed easier. However, homebuilder stocks quickly lost any early gains and remained under pressure as the week ended.

Another report that was mostly overlooked was the Semi book-to-bill for January. That number rose only +0.01 to 0.97 compared to the previously published December number at 0.96. However the December number was revised down to only 0.93 making this +0.04 point spike noteworthy in the eyes of the SEMI association. Personally I believe these numbers are routinely "managed" by SEMI in order to put forth a positive front. For example September 2005 was originally reported as 1.02 and August as 1.05. This was heralded as a breakout of the sector from a two-year slump. The numbers were revised down over the next couple months to 0.90 and 0.97 respectively without any fanfare or comment despite the drop to 0.90 and a substantial difference from the two months of "breakout" performance. Last weeks 0.97 for January will likely be revised down in March long after investment decisions have been made. As it stands it represents the 16th consecutive month of below parity performance where fewer orders were received than shipped. This is the longest period of weakness in the last decade. Meanwhile the SOX is at the highest level we have seen since Jan-2004. For investors I believe it is like betting the next flip of a coin will produce tails after 24 consecutive flips that produced heads. They have been told for so long that semis are improving but the proof of that improvement has failed to appear. Conventional wisdom suggests the streak of sub par performance has to end soon and investors will be rewarded by stellar gains. Let's hope that actually comes to pass.

While we are waiting for the SOX news to appear the news for Intel continues to get worse. Soft guidance from Dell sent Intel spiraling lower to close just above $20. Helping that plunge was a downgrade from RBC Capital Markets. Analyst Apjit Walia said there is no bottom in sight for Intel as it loses market share to AMD. RBC said there was a noticeable buildup of inventory in the channel and Intel's Q1 performance and 2006 as a whole could be significantly lower than current expectations. RBC said the weakness in Intel products could spill over into other areas of the chip sector. RBC cut their price target for Intel to $21 and said the stock is likely to fall noticeably below that target in the near term. Jefferies and Co. analyst John Lau said that recent price cuts by Intel were more dramatic than previously expected but the market could stall before they take effect. Those sharp price cuts along with slowing sales could force Intel to miss estimates for Q1. Ironically Intel announced in January it was discontinuing its mid-quarter business updates. That will prevent investors from making decisions between earnings reports. Let your conscience be your guide!

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Dell fell -1.58 on Friday after posting guidance that many thought was soft with sales growth in Q1 targeted between +6-9%. Some say Dell's strong Q4 profits were due to an extra week of sales in Q4 compared to Q4-2004. PC sales are growing slowly for Dell as competition heats up. Many analysts slashed forecasts for Dell for 2006 despite the fact that new products are selling briskly. Dell receives most of its revenue from PC sales and Hewlett Packard is taking market share. After two quarters of missing estimates Dell is thought to be back on track but there are some tough quarters ahead. With many notebooks now selling for less than $500 Dell's profit margins are being squeezed and there is no help on the horizon. I have mentioned many times over the last few years that Dell was going to fall out of favor with investors as PC prices continued to fall. It is easy to cut prices to hold off competitors but it is almost impossible to raise them again. As Dell cuts prices it is forced to sell even more units just to break even much less show revenue growth. If you sell 10 million PCs a quarter as they do, a -$100 drop in price on a $1000 computer means they have to sell +10% more units in the next quarter just to break even on revenue. That becomes +20% more in Q2, +30% in Q4, etc. It is a moving target and impossible to hit forever. Dell may be gaining share overseas but the overall model will eventually fail. Sooner or later they will be unable to sell enough additional computers to remain a growth company. Revenue will flat line as will their profits. This is not a bad thing for Dell to make nearly $1 billion per quarter but their stock price will suffer. They are currently at a PE of 22 compared to a trailing five-year average of 31. Once growth stops that PE could decline to 15. Coincidentally HPQ is currently trading at a PE of 37 and right inline with their five year average.

Hewlett Packard reported earnings on Thursday that showed a +30% increase in net income and gave guidance that was higher than analysts expected. HPQ reported falling costs and rising sales and that news sent HPQ stock to $34 and a new five-year high. The company reported all but two divisions produced better than expected results for the quarter. With improved performance and a strong outlook it appears HPQ is the growth story for 2006 and at Dell's expense.

Not all earnings surprises were positive. Radio Shack was hit with a -62% drop in earnings and announced plans to close 400-700 stores and two distribution centers. RSH fell -8% to $19 but the stock already had a negative bias going into the report. The CEO, David Edmondson, was ridiculed last week after he admitted he lied on his resume. He claimed he had a theology degree and a psychology degree from Pacific Coast Baptist College. Last week the school said Edmondson only completed two semesters of study and they never offered psychology degrees. Edmondson is awaiting trial on his third drunk driving charge and his future does not look bright given the new revelations. As for Radio Shack it appears Best Buy, Circuit City and CompUSA are stealing share at a rapid rate and the Radio Shack customers of old are finding other places to shop.

XM Satellite and Sirius reported earnings last week and both fell out of orbit. XMSR has 5.9 million subscribers and expecting 9.1 million by the end of 2006. SIRI has 3.3 million and expecting 6.5 million by year-end. Both sets of numbers are very strong given their short history but the problem came in acquisition cost per subscriber. Both saw prices soar as SIRI promoted Howard Stern and XMSR gave away free deals to offset the SIRI Stern promotion. SIRI claims they will see positive cash flow by Q4 and for all of 2007. That is the Holy Grail they both seek and I believe they will eventually find it. However both stocks took a dive on Friday with XMSR losing -10% and SIRI -7%.

Oil prices also kept a lid on the market on Friday after they rebounded from a low of $57.40 on Wednesday to hit $60 again on Friday. Driving the gains were several factors. Nigerian rebels called for an all out attack on pipelines after the military stepped up attacks on suspected oil thieves. Shell halted production at one 37,800 bpd flow station after a nearby well was set on fire. Oil companies in the region are evacuating nonessential personnel and putting helicopters on some rigs to enable a quick escape if the rig is attacked. This is not a climate conducive to continued production and Nigeria is a large exporter of the light sweet crude currently in demand. This problem is not expected to be resolved in the near future and production levels will be at risk.

Also impacting prices was a Venezuela call for OPEC to cut production. Amazing how that $58 level triggered those outbursts just as we expected. Venezuela was the first to call for a production cut because a cut will not impact their production. Venezuela is currently producing less than their quota due to numerous factors including the fight with 29 oil companies over a new retroactive tax on oil and the nationalism of their oil fields. Venezuela would benefit from a cut in OPEC production and the rise in price because even a 10% cut in their quota would still be more than they can currently produce. To put is simply, Venezuela would pump the same amount of oil at a higher price while other OPEC countries would collect higher prices but be forced to produce lower amounts. OPEC quotas have been acknowledged with a wink and a smile for the last year as countries try to capture as much of the higher prices as possible. I am sure as we get closer to the March meeting the number of calls for "verbal" production cuts will increase but it will take several months to see if they actually occurred.

China and Iran are doing a deal for Iran to supply oil to China for the next 25 years. China will acquire a 51% stake in the Yadavaran field reported to hold 3 billion barrels of reserves and output of 300,000 bpd. They will also receive 10 million tons of LNG annually for the next 25 years. Now, the question everyone should be asking is why would Iran do a deal of this magnitude with China? Answer, because China is a permanent vote on the UN security council and they have the clout to ignore any oil sanctions. Iran's deal with the devil in this case guarantees them revenue for the next 25 years and a friend in any international fight. China will stand behind Iran and support them in whatever trials they are going to face given their nuclear ambitions. While the world may try to penalize Iran for going nuclear their new bodyguard will make sure the penalties are minimum. Would the U.S. attack Iran if China huffed and puffed and warned them not to do it? I doubt the US has the stomach to take on China and Iran at the same time. This deal with the devil was a good play on the part of Iran as they face the UN problems ahead.

For the oil community they means the potential for oil sanctions has been reduced and UN actions will be tempered with restraint. It does increase the likelihood that selected nuclear sites in Iran may be destroyed since sanctions are no longer a valid option. I am sure the US could convince China that it was in everybody's best interest not to have a nuclear Iran and convince China to look the other way while a couple key sites were targeted. Once China has its deal in place with Iran it will want to maintain the status quo and that may include not letting Iran reach the point where its oil fields are threatened. This may sound a bit confusing but the bottom line is that China just captured 300,000 bpd of oil for the next 25 years and in doing so may have stabilized Iran as a producer for that period. You can bet that any Iranian attempts to halt the flow of oil to China would be dealt with harshly by China. Iran sold its oil soul to the Asian bully in order to protect itself from the west and the UN. It will be interesting to see how this plays out over the coming years.

The New York Times had an article this week on the increase in global consumption with specifics about China's growing needs. The article suggested prices could rise to $80 on any blip in output. At the same time OPEC lowered its demand growth forecast for 2006 to +1.7 mbpd to 84.69 mbpd. This is still a hefty amount. Boone Pickens was on CNBC this week saying he did not expect to see $50 again in his lifetime and felt $53 was only a remote possibility. Boone, I hope you live a long time!

March Crude Oil Chart - Daily

The March crude contracts roll over next week and we will begin dealing with the April contract as the current month. March closed at $59.88 on Friday with April at $61.29. For reference purposes I thought it would be interesting to show the closing price for some of the longer dated contracts.

Light Sweet Crude Futures Contracts

You will notice that the price peaks in June 2007 and begins to decline. It does not mean specifically that prices are going lower after 2007 but that is about the limit of visibility for future production. Production can be charted by well/field but reliability of guesstimates decreases after about 18 months. There is also the cost of money to consider. Someone buying a December 2012 Crude Futures contract at $61,000 must consider his cost of money and margin costs for six years into the future. Personally I think you can double all those numbers after June-2007 and by 2012 consumers would be glad to pay it. We will revisit this conversation as each year passes to monitor the progress.

I believe the spike in oil prices on Friday was related more to expiration pressures and the fear of being short over a three-day weekend rather than investors thinking oil was a bargain. We did get the bounce I was expecting right at $58 but it remains to be seen if it will stick.

This was a big week for the markets but the majority of the gains came on Tuesday at the open. Investors covered shorts ahead of the Bernanke testimony and positioned themselves for some upside should his testimony appear bullish. That Tuesday rally took the Dow to 11068 and the next three days of trading only managed to add +42 points. That was a total of +63 points if you count the intraday high on Friday. Still it was a monumental week with the Dow moving over 11000 and then holding that level for four days while inching slowly higher. This puts the Dow at a new 4.5 year closing high and would appear to be sending a message that it is ready to go higher. If this bullish move continues higher the next material resistance is 11350-11425. Those are some awfully big numbers considering the weakness in the recent earnings cycle. Not to look a gift horse in the mouth but I would advise caution at this level due to a lack of confirmation by the other indexes.

The Nasdaq failed on Friday exactly on the downtrend resistance dating back to Jan-11th. Dell disappointed and the chip sector led by Intel lost ground for the week. This does not produce a strong confirmation for the Dow. It appears the Nasdaq will be the anchor the Dow will have to drag on any further advances. The Nasdaq 2290-2295 level could be tough to crack without any positive news from tech land.

Nasdaq Chart - 60 min

Dow Chart - Daily

In a remarkable show of strength the SPX caught fire and rallied back over the 1287 resistance level and managed to stay there most of Friday. The close right at 1287 indicates that there is still upward pressure but there is a battle underway at that level. I believe the S&P benefited from the rebound in energy stocks with many of them up several dollars since Wednesday. In round numbers some of the leaders helping the S&P were AHC +5, APC +6, BHI +4, BR +3, CVX +2, COP +3, DVN +4, EOG +5, HAL +4, KMG +3, KSE +5, KMI +3, MRO +6, MUR +2, NOV +4, OXY +5, SLB +4, SUN +6, VLO +6 and XTO +3. These are all S&P components and those are the gains in round numbers from the Tue/Wed lows. Numbers like those help offset some of the losers like Radio Shack. Energy stocks not helping the S&P were RIG and NBR both of which crashed on RIG's warnings on Tuesday. Also helping the S&P was a strong rally in financials after the Merrill/Blackrock merger was announced. The Broker Dealer Index (XBD) jumped +5% for the week and many of those leading financials are S&P components. The Biotech Index (BTK) also jumped +6% on various news items from the sector. When you have energy, financials and biotechs all spiking strongly I am surprised the S&P did not move higher. This causes me to question direction for next week since we are not likely to have all three of those sectors continue their moves higher. Since Tuesday the S&P was only able to add +11 points despite all that sector help. Kind of makes you go hmmmmm as you ponder why. I had a hard time fighting off the urge to short it at the 1286 closing level and I finally took a small short in the futures at the close just to hedge my energy longs over the weekend.

SPX Chart

NYSE Composite Chart - 90 min

The Russell-2000 and the NYSE Composite both rallied back to just below prior strong resistance on Friday afternoon. The Russell stopped at 733 and just under the 736 level which held as resistance back in late January. This would be the prime spot for a failure if that is what the market has up its sleeve. The NYSE Composite came to a dead stop at 8100 on Friday. This is also just below the 8125 level that held in late January. The NYSE Composite is heavily weighted with energy stocks since most of the 500 or so energy stocks trade on the NYSE or about 18% of the index. Financials are also a large portion of the index. The bottom line on both the Russell and the NYSE is they are both right below historic highs. This is where a failure has a stronger chance of occurring rather than a breakout at this point on the calendar. If both do break their highs with the Dow on a roll then the breakout could be huge. The Transports already hit a new high on Thursday so all the dominoes are lining up and we just need that next event to push them over and a new rally begin.

However, what will that event be? Earnings are over for all practical purposes. Monday is a holiday and the next material economic report is the CPI on Wednesday. After the PPI last week the CPI may be anticlimactic. Thursday has a flurry of reports including the CFNAI, Mass Layoffs and the Kansas Fed Manufacturing Survey. Friday closes the week with Durable Goods. Not a lot of market movers in that list. They normally attract attention but do little to produce movement. Options expired on Friday and Tuesday will be cleanup day. That normally produces extra volume but little in the way of direction. That directional push we are seeking may come from the FOMC minutes of the January meeting that will be released at 2:PM on Tuesday. While Bernanke probably gave us the condensed version in his testimony last week the reinforcement of the Fed's view of an on track recovery could energize the buyers once again. The problem remains the inflation rate. If the minutes suggest the Fed is more worried about inflation then traders may start really worrying about how many hikes are still ahead. The minutes will be sifted like tea leaves for clues to our future and our direction could come from those clues.

If you are following the SPX indicator I have been giving then you should be cautiously long over 1275. I already admitted above that I took a small short at the close to hedge my energy longs so you know I am very cautious at the 1287 closing level. With the Dow breaking out I would have hoped for more confirmation from the other indexes to allow me to strengthen my long recommendation but we did not get that confirmation. Remain cautiously long until we get a breakout across the board including the Dow, SPX, NYSE Composite and Russell. Hopefully that event will bring buyers back to the Nasdaq but I don't have high hopes. It would be really easy for me to roll over and suggest a short here but that would be my emotions speaking and not the facts. Continue to remain cautiously long over 1275 and short under 1270. Anyone not long the current market would be wise to stand aside and watch for a direction to develop.
 

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