Friday's opening bounce was due in part from news that Google was finally going to be added to the S&P. The opening bounce on Google sprinted to $370 and a +28 point gain. This powered the Nasdaq and NDX to about a +8 point gain at the opening bell. The news that Alcatel could be in a deal to buy Lucent powered additional buying as talks of consolidation in the telecom and networking sectors added fuel to the Nasdaq bounce. The NDX sprinted +17 points higher and the Nasdaq Compx +15 before the first hour of trading was over. Shorts were forced to cover once again and the downtrend that formed on Thursday was temporarily reversed.
Dow Chart - 15 min
Nasdaq Chart - 240 min
S&P Chart - 240 min
The Google news may have been instrumental in the Nasdaq jump but that is only a temporary blip. Economic news out Friday has the potential to produce longer-term market pressures. We saw on Thursday that existing home sales spiked +5.5% and traders cheered. Market analysts were speculating that the housing bubble was not going to burst after all. Yes, a rebound in the housing market may push the Fed to an additional hike but the economy was ok. Are they right or wrong? On Friday the new home sales numbers were released and new home sales fell -10% in February and -13% year over year. This was the fourth consecutive month of declines and inventory for sale rose to 548,000 units or 6.3 months at the current sales rate. The drop in new home sales was the largest drop since 1997 while the inventory of new homes for sale reached levels not seen since Jan-1996.
Now there are probably a few readers thinking what the heck? Existing home sales are up +5.5% while new home sales are down -10.5%. How can that be? Isn't that a contradiction of facts? The answer is simple. The housing bubble has been a hot topic for months. The average homeowner has been reading the news and thinking it was time to bail to escape from the mountain of debt they have accumulated in their home equity ATM. Consumers have folded their credit card debt, new cars and loan consolidation programs into their tax deductible home mortgage for several years. The 125% loan to value programs even seduced many homeowners to borrow money against their homes to raise investment cash. After all homes were going up at record rates. Many homeowners had borrowed against their equity to buy second homes or homes to fix and flip. You can't turn on cable TV without seeing dozens of shows that are based on the escalation in home prices over the last five years. Design to Sell, Fix and Flip, Sell That House, etc. Fear that this bubble was going to burst and leave homeowners holding the bag sent consumers to their closest realtor. Buyers watching house prices rise for years were waiting to buy the dip.
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The answer to the new home/existing home headline diversion comes from the timing of the transactions. Existing home sales are counted when they close. The +5.5% increase in existing home sales in February were the result of decisions made at least 90-120 days ago or approximately October/November. Homeowners made the decision to sell, slapped on a new coat of paint and cleaned out the garage prior to listing the property. Once the spruce up was over the homes were listed for sale and the process began. The traditional December sales lull due to holiday preparations put home shopping off until January. Competition for available buyers caused a downtick in asking prices as sellers maneuvered into a favorable position in the market. Buyers hoping for a dip saw these "bargains" appear and took the plunge. Contracts were signed in the Jan timeframe and the brain numbing appraisal, inspection, loan, title search, closing process began. Finally in February those Q4 sales decisions began to close and the sales numbers soared.
For new home sales the numbers are counted when contracts are signed. Delivery and closing of those homes can take up to a year depending on options chosen and inventory available. The headline number for new home sales is the very beginning of the sales process and represents a longer-term decision for buyers. New homes are typically more expensive and require many more buying decisions than purchasing a preowned home. It is less impulsive and represents more of a longer-term plan rather than a sudden urge to move. New homes are also seldom bought for speculation. Homeowners looking to speculate in the real estate market will normally buy an additional preowned home to fix and flip or as a rental property and seldom buy a new one for that purpose.
I described the process behind the sharp jump in existing home sales for February and that the process likely began in October. If we dig a little deeper we see that October was also the second highest month of new home sales ever at 1.345 million units on an annual basis. July was the highest at 1.371 million. The decline began in August as inventory levels began to climb. The October spike was the result of a quick reaction by builders to step up marketing, price reductions and move in specials to try and flush inventory before winter arrived. Since the 1.345 million headline number in October sales have fallen to only 1.08 million in February. This represents a -20% drop in new home sales in only four months. In some areas of the country such as the west coast sales have declined more than -30%. That is the sharpest decline in nearly a quarter century. The average price of a new home has dropped to $230,400 and a four-month low. Obviously that is not a west coast price. Builders are also reporting a surge in cancellations, which began in the November/December timeframe.
To recap this analysis the key point should be clear. The media has been talking about the bursting housing bubble in some form for about six months. That stretches out a little longer if you take into account the talk about the bubble while it was still rising but little action was taken by consumers during that period. They adopted a wait and see attitude with their finger on the proverbial trigger. Once the signs of weakness began to confirm the talk, consumers sprang into action. That pivot point for consumers appears to have been October in both existing home sales and new home sales. Only the reporting was different due to the different time frames and methods for counting sales. In October consumers began to react to the bubble warnings and the process is continuing as prices fall and interest rates rise.
Is this the end of the world for housing? Definitely not! The rate of sales just prior to the decline was an all time high and simply not sustainable. Interest rates were at decade lows and the consumers were coming out of their 9/11 cocoons. It was simply a buying cycle where all the factors converged for strong gains. Nobody expects a housing disaster, just a return to normal conditions. I was talking about this with an office manager for Countrywide Financial this week. He had just been in a meeting where Countrywide had told them they expected the weakness to firm soon and resume its normal course. According to Countrywide the average age of baby boomer children is now 32. This is also the average age where families purchase the house where they will raise their family. Their 20 something years are behind them and early children are reaching school age. They spend more time actually planning for the future and taking into account things like extra bedrooms, home offices, larger garages, distance from good schools, etc. The home they buy at 32 is one they are likely to be in for many years. According to Countrywide the weakness is only temporary because there has been no reduction in the number of new households created each year. That number is currently 1.2 million and corresponds quite nicely with the recent historical average of new home sales at just over 1.2 million units per year. There will always be peaks and valleys and we are simply shaking off the excess from the 2005 peak.
Chart of Personal Bankruptcy filings. Source = economy.com
The wild card here is the over committed consumer. I discussed last Sunday the expected 2006 economic slowdown due to a rising consumer debt load. This rising debt and slowing economy scenario could keep the pressure on homebuilders and home sales for the rest of 2006. This is not a bad thing just a necessary workout period. All of these factors will be taken into account at next weeks FOMC meeting. They are fully aware of the factors depressing the housing sector and they welcome the pause as a needed cooling off period. However, they also don't want the cooling to become a new ice age in home buying with sales frozen to a standstill. The economy needs the housing sector to prosper in order for the economy to prosper. For the Fed it is all about stable growth rather than a constant boom/bust cycle.
The Fed will have to balance their desire to increase rates with the slowdown in housing. Determining what rate will push housing and the economy into a dive is a prime focus for the Fed. Also pressing their decision next week is the drop in Durable Goods announced on Friday. The headline number was actually a gain of +2.6% but nearly all the growth came from transportation equipment. However, core capital goods ex-aircraft actually fell -2.3%. Boeing said sales of civilian aircraft doubled in February over January levels. A drop in sales of aircraft in January was responsible for the -19.8% drop in the January durable goods number. There has been an underlying weakness in capital goods for the last two months and this could be signaling a lengthening slowdown in the economy that most had thought was already behind us. The durable goods report is always confusing but the Fed will doubtlessly take these numbers into account for their decision next week.
The markets seem to be undecided about the Fed direction despite several speeches and much analyst coverage of Fed expectations. The official outlook is still for a quarter point hike in March and again in May. However, the likelihood of another hike in June is slipping. In fact there is an increasing amount of rumors suggesting a potential Fed cut in Q1 of 2007. According to Fed watchers the slowing in housing, slight rise in jobless claims, rising gasoline prices and mixed economic signals suggests the Fed should stop soon and may have already gone too far.
The weak housing numbers gave the market an added boost at Friday's open because it puts that additional pressure on the Fed not to overshoot. The Fed language next week is going to be even more important than normal. I know we say that a lot but it always seems to be true. Over the last two weeks the market has stalled at the current highs and we can't seem to make any headway. We are seeing a lack of conviction by the bulls ahead of the Fed meeting and that should continue until the language is dissected. They will look for any clues that the Fed will quit in May or any clues that they will continue past May. The future of the market in the short term will depend on that language.
You should also note that the FOMC meeting next week has been increased to a two-day meeting from the originally scheduled one-day event. Bernanke must have decided he would need to add the additional time for his first meeting in order to get everyone on the same page and reevaluate all the prior data. I applaud his decision to take this step. Unfortunately it makes our Option Investor mouse pad calendars incorrect since this was scheduled to be only a one-day meeting when they were printed.
Offsetting the market's Fed fears is the approaching end of the quarter. Typically we see the indexes move higher as the quarter ends as retirement contributions begin to appear. We also see tape painting by the funds in order to show the greatest possible spin for those quarterly statements. This may not be readily apparent ahead of the Fed but I believe the dip buying over the last week could have been funds supplying support going into quarter end. Tape painting works best when the markets are near their recent resistance highs. If they were tanking the fund efforts would have less of an impact. With the month/quarter end on Friday and the Fed decision on Wednesday afternoon that leaves two days for a strong tape painting rally on some favorable language. I am not sure how funds will react if the language is not favorable. They still have money to put to work and statements to print. It should be interesting.
Since energy has been holding above support for the last month and many energy stocks are beginning to break out again it would make sense to me that funds will want to show how smart they are by owning energy stocks. Oil prices closed at $64.30 on Friday and moving very close to resistance at $65.50. You may remember that resistance on the expired April contract was just under $64. If you compare apples to apples that equates to the $65.50 level on the May contract. I could easily see that $65.50 level broken before next Friday as funds paint the tape. It is simpler to buy oil futures, which float all boats than buy a couple dozen individual stocks if you want your energy portfolio to shine. You can get in quickly and out quickly compared to stocks. With 7,000 hedge funds and more than 17,000 mutual funds it takes very little imagination to imagine this scenario playing out. If it does then we can also expect some undressing in the futures around April 4th.
Chart of May Crude Oil - Daily
Oil prices continue to be artificially inflated by geopolitical concerns but there is widespread agreement that $60 should remain the bottom on any correction. Italy's Eni SpA declared force majeure last week on a Nigerian oil pipeline that was attacked my militants. The 75,000 bpd pipeline is expected to be back in service sometime next week but it is just one more increment of production taken offline by the group. They claim they will stop the flow of one mbpd and the market is afraid they can do it. Nigeria produces the light sweet crude needed to make low emission gasoline. Nigeria is the 6th largest OPEC producer and the 4th largest supplier of oil to America.
Meanwhile Boliva is expected to nationalize its energy resources the first week of April. This move is being made by the socialist president Evo Morales. Three former presidents have been charged with violating the constitution after privatizing the energy sector more than a decade ago and entering into contracts with foreign oil companies. Those companies invested more than $3 billion into Boliva as a result of the contracts in an effort to modernize its energy production. I guess Bolivia feels there are no further investments coming and it is time to take back those modernized fields. Why is it that companies never learn that dealing with rapidly changing socialists governments tends to be detrimental to their financial health. Companies impacted include Spain's Repsol YPF, Petrobras, Total and Exxon among others. Venezuela just took back half of the exploration blocks foreign companies bid on and paid for in the 1990s. The oil minister said they had plenty of opportunities in the remaining half and basically if they didn't like it they could leave. Is it any wonder that exploration companies are gravitating towards Canada and the Gulf of Mexico where the rule of law applies and the only surprises are whether or not you hit oil or gas.
The next OPEC meeting is June 1st in Venezuela and the VZ oil minister has already said they will be pressing for a cut in production again. Heck, I would be afraid Chavez would take them all hostage and nominate himself as the new OPEC president.
Outside of Google and housing there was little news moving the markets on Friday. The next most popular topic was a potential takeover of Lucent by Alcatel to create a $33 billion telecom firm. The rumors of a Lucent takeover have been making the rounds for a couple years and many times Alcatel was the suggested suitor. Friday's news that it was nearly a done deal was so anticlimactic that both companies only gained about 25 cents each. Of course that was a +8.5% gain for Lucent. If the deal goes through the NYSE will have to find another stock to take the spot as the daily volume leader that Lucent normally fills. For instance, Lucent traded 531 million shares on Friday or 22.5% of the total volume on the NYSE. I am sure the market makers in Lucent will be sorry to see that cash cow leave for greener pastures.
Chart of Russell 2000 - Weekly
As the quarter draws to a close we have a chance for a record quarter on some indexes. The S&P close today represents a +4.3% gain for the quarter with several strong days likely ahead. The S&P has not posted a quarterly gain of more than 4.3% since late 2004. If Friday's close was the quarter end the Dow would have posted a +5.2% gain, Nasdaq +4.89% and NYSE Composite +6.4%. Those were blown away by the Russell-2000 small caps posting a +12% gain for the year and the Dow transports adding +9.5%. The last index on the list is the NDX, which posted a gain of only +2% mostly due to the addition of Google to the index in late December. Google was trading around $440 when it was added and it closed at $365 on Friday. This was +$24 more than Thursday's close due to the S&P addition. Without that S&P news the NDX would have barely edged over a +1.5% gain for the year. The NDX closed at 1688 the day before Google was added in December and closed at 1679 on Friday. The lackluster performance was not entirely Google's fault with INTC, EBAY, AMZN, YHOO and SNDK leading the miserable NDX performance.
Chart of Google - Weekly
Other than the NDX the remainder of the indexes are still pegged at or near their highs. The Russell closed at a new historic high on Friday at 753 while the Dow, SPX, Nasdaq and NYSE Composite are still struggling just a few points below their respective highs. I have to admit I thought this week would turn out a lot worse when I wrote about it on Tuesday night. Whatever produced that monster dip on Tuesday was forgotten after several Dow components announced positive news before the bell on Wednesday. Microsoft's announcement about the delay of the new Windows software knocked the Nasdaq for a loop but it was quickly forgotten and Friday's close brought us right back to Tuesday's levels before that event. Yes, the bulls are alive and buying every dip.
This suggests to me that the Fed decision language will be viewed through rose-colored glasses as long as the shock of a very negative report does not break the glass. Anything even remotely market friendly will be met with a strong finish for March. You only need to look at the homebuilder stocks on Friday for a sign. New home sales were down -10.5% and Centex gained +1.16, Lennar +.47, NVR +2.98. Only Beazer and Hovnanian could not quite make it back to positive territory and finished with fractional losses. The bad news bulls are alive and leading the charge. There are some high profile economic reports next Thursday and Friday but after the Fed meeting they may just be additional stepping-stones for the end of quarter buying.
The qualification for all of this is the same gains that I listed above. While I
would not expect the funds to take profits before quarter end it is always
possible. It also sets up the potential for some
relatively strong undressing
the following week. Funds may not want to hold over what could be seen as
questionable earnings. If the end of quarter scenario does play out as expected
I would plan on either exiting at month end or tightening stops on April 3rd.
Yes, it is time to sell too soon!