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Market Wrap

Jobs Porridge Too Hot

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Jobs for March increased by +211,000, which is great for the economy but bad for the Fed. Investors reacted like a diner seeing a sumptuous plate of food placed before them but then recoiling in pain when the first bite sears their tongue. It appears to be a good meal but the eater must wait before consuming it. This is how investors reacted to the strong jobs news. The futures raced higher on expectations but the reaction jump at the open was quickly reversed as the searing pain of 5% bond yields brought reality back into focus.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

I mentioned on Tuesday the need for a Goldilocks type of jobs number for the markets to move higher. Analysts were officially expecting +195,000 for the headline number but hoping for something in the +150,000 range as "just right" for a continued rally. In reality the jobs number was better than it appeared on the surface. It was +16,000 over the consensus but the numbers for January and February were revised down substantially. January dropped from 170K to 154K for a loss of -16K and February dropped from 243K to 225K for a loss of -18K. Add the revisions together for a drop of -34K over the prior two months and that knocks the headline number for March back to a net gain of only +177,000. Of course most people don't look at it that way.

Other employment numbers released on Friday showed the unemployment rate dropping to 4.7% and average hourly earnings rising +0.2% but slower than each of the prior three months. Wages rose +0.4% in Feb, +0.3% in Jan and +0.4% in December. The average wage for an hourly worker is now $16.49 and is up +3.4% over the prior year. Job gains came primarily in the service sector with a gain of +202,000 jobs while manufacturing payrolls fell -5,000 after a drop of -10,000 in the prior month. While the administration always beats their drum about the jobs gains the amount of new workers entering the workforce continues to grow. 166,000 new workers entered the workforce in March. Over the last eight months the economy has created an average of 168,625 jobs per month. As you can see we are barely staying ahead of the curve and far from strong jobs growth.


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Still, the jobs report did provide an insight into the rest of 2006. The hours worked index rose an annualized +2.7%. This is a proxy for GDP growth and when combined with stronger productivity gains suggests annualized GDP growth of around 5.0% for 2006. A +5% GDP is too strong for the Fed and they will likely act to prevent this rate. It was the realization and anticipation of this action that produced the sell off excuse.

The July Fed funds futures are now pricing in a 48% chance of a 5.25% rate after the June meeting. There is a meeting in May and another in June and we are very close to expecting a hike at both. The May meeting was already a lock after the last Fed meeting left the hike language in the statement. After Friday's jobs report the yield on the ten-year note shot up to close at 4.963% and the highest level since June-2002. The 30-year bond soared to 5.038% and the first time over 5% since 2004. By Friday's close analysts were spewing forecasts for much higher rates based not only on our Fed but the corresponding actions by other global banks. It appears higher rates are hear to stay and analysts are starting to ratchet up their predictions.

Those 5% bond yields sent shivers through the equity market for more than one reason. A 5% bond yield is typically seen as the point where a safe return in bonds is better than a risky return in stocks. However, if equities were coming out of a dip with plenty of room to run investors would take on the extra risk in hopes of a strong rally ahead. Instead this bull is already 37 months old, 41 months if you count the start at the bottom in October 2002. This bull is ready for slaughter and the warning about a slowing economy in the second half of 2006 is putting fear in bullish hearts.

We have two separate reasons why the economy may slow. The first is simply its age for the current cycle. The rebound out of the hurricane dip added several months to its life but almost everyone agrees it is going to slow later this year. The second reason is the Fed. I reported above that the Jobs report implied a +5.0% annualized GDP and the Fed does not want that much growth. They will force the economy to slow if it does not appear headed for a vacation on its own. The bottom line is a slowing economy either from its own weight or forced sabbatical from continued Fed rate hikes.

I mentioned on Tuesday the Risk of Recession numbers due out on Wednesday could be a problem. That headline number for March came in at 20.7% compared to the previously reported 15.2% in February. February was revised higher to 20.8%. These are risk levels not seen since last summer just before the hurricanes struck and impacted the data. Individual states are surging higher with Massachusetts, Wisconsin, Idaho and Kansas are all over 35% for March. Obviously those are not key states with major economic impacts on the nation but they are indicative of rising risk.

Another reason given for the sell off in equities was the failure by congress to extend the tax cuts before going home for the Easter break. Investors are hoping to see the cuts extended another two years and the political process is slower than molasses in January. Congress failed to act on the measure to extend before they left for the break. If they do not act soon more than 15 million households will face a tax increase of $31 billion on dividends, capital gains and the AMT. The Senate version would spare an additional 3.5 million households from AMT than the House proposal. While some analysts were blaming this postponement for the market collapse I doubt it was responsible for the drop. The selling was too broad, too sharp and covered multiple global markets including Germany, London, Paris and Brazil. It appeared program related and possibly an asset allocation program by a major fund. The selling was over in the US markets by 11:45 with the markets trading flat the rest of the day.

The market sell off was no respecter of persons and nearly all stocks were hit with losses. Those hit hardest were those with the largest gains over the last week. Oil pulled back from seven-week highs at just over $68 and energy stocks took a needed rest. Tech stocks retreated from a weeklong rally to new five-year highs and the Nasdaq ended with a loss for the week. Financials fell, metals collapsed and even the small caps finally gave up ground. Transports had been rallying despite rising oil prices but traders took profits in those issues as well. All the major indexes rallied to new highs on the open but were immediately hit with major selling. Few stocks were able to brave the storm.

The Chicago Mercantile Exchange headed the list of those companies able to overpower the sellers. The CME has been under competitive fire by the Intercontinental Exchange and they quenched that fire on Friday. They announced a deal with the NYMEX to trade its energy and metals derivatives. The CME soared +$25 while ICE dropped -$6.80. Illumina Inc came in number two on the leader board after raising guidance for Q1. ILMN gained +$3.87.

Leaders on the downside included SafeNet (SFNT), which fell -$5 after warning that results would be lower than expected. RIMM, fresh off its patent battle, reported earnings that disappointed and warned that Q1 would also be below expectations. RIMM dropped -$4.60 on the news. Finishing out the losers list were steel stocks TS, IPS, VMC and miners RTP and PD. Oil stocks AHC, SLB, PTR, FTO and DO led the list of losers in the energy sector. SLB had gained +$8 for the week through Thursday morning ahead of its 2:1 split after the close on Friday. Atwood Oceanics (ATW) also split 2:1 after the close.

May Crude Futures Chart - Daily

May Natural Gas Futures - Daily

Oil prices hit $68.29 on Thursday and fell to $66.25 intraday on Friday. That dip was quickly bought to return oil to $67.35 at the close. Helping to push oil higher was news from Nigeria that facilities knocked offline by militants should be back online by month end. This good news had barely hit the wire before the militants vowed again to cause even more damage to reach their target of 1-mbpd offline. Currently there is slightly more than 500K bpd offline. Also pushing prices lower early Friday was news from the OPEC president that OPEC expects no cut in production quotas this year if prices remained at the current levels. No kidding? Why would any OPEC member voluntarily cut production when they are receiving record prices for their crude? When asked what OPEC would do to keep prices from moving over $70 he said the best strategy would be to build new production capacity. If you read between the lines it means they are powerless to prevent further price rises with their current capacity. He claimed there was a surplus of about 1.9 mbpd currently. That should be consumed once refiners begin producing gasoline again. There has been a bill introduced in the Senate that seeks to ban oil cartels (OPEC) and strip foreign nations of "sovereign immunity" to prosecution under U.S. price fixing laws. The section referring to OPEC is titled "No Oil Producing and Exporting Cartels." (NOPEC) I am not kidding. The bill sponsors are Arlen Specter and Herb Kohl. In what universe are they living? Is Iran or Venezuela actually going to care if we ban their cartel? Are Specter and Kohl so nave that they think they can make countries sell us their oil at the price we want to pay by suing them? This is so stupid it boggles my mind.

The Weatherford CEO was on CNBC on Thursday. He said the inflation adjusted cost of finding and producing new oil was up +80% since 2000. The number of oilrigs in operation was at a 20 year high. In 1999 only 1200 rigs were operational and that number is over 3000 today. He said that despite this increase in drilling efforts global production had only increased +1% since 2003. This is due to the rising decline rate at many aging fields offsetting new production. He said Weatherford had new technology that allowed older fields to be probed deeper, up to six miles, in order to squeeze out every drop available. Weatherford is the fourth largest oil well service firm behind SLB, HAL and BHI.

Helping to push the price of oil higher was news from the Congressional Budget Office that demand from China would likely add $14 to the price of oil over the next five years and +38 cents to a gallon of gas by 2010. The Asian continent is exploding with projected GDP for 2006 now between 7.2-7.4%. China is the leading force but just like Mexico supplies cheap labor and cheaply made goods to the US the countries surrounding China are benefiting from making cheap goods for them. This broadens the economic boom and the demand for petroleum to not only China but the surrounding countries as well.

After the close of oil trading today the AMEX announced that it had received the last approval necessary to begin trading the oil ETF on Monday. The ETF will trade under the symbol USO for United States Oil and will begin trading at the current futures price at the open. Since they waited until after the close of trading for oil to announce the last approval we could see a substantial boost on Monday. I am sure the managers already own a base position but depending on how well it is received by the public they may have to buy a lot more. Add in the speculators that will begin buying futures at the open on Sunday night and volatility is sure to erupt.

Next week is the start of earnings season with the official kickoff being handled by Dow component Alcoa on Monday. The calendar for the first week is light but the pace picks up considerably the week of the 17th. S&P earnings estimates for Q1 according to Thomson Financial are currently for 10.4% earnings growth. This estimate has fallen from 12.6% on Jan-1st, 14.4% on Oct 1st and 16% on July 1st. Despite the decline in estimates Thomson is still predicting another quarter of double-digit earnings growth. This would be the 15th consecutive quarter according to Thomson's calculations but it may also be the last.

According to Thomson that double digit streak will depend on the top three sectors hitting their estimates. Those sectors are energy +43%, healthcare +19% and industrials +14%. If any of those falter then the streak is over. Energy has been broad support for this S&P streak for several quarters but even that is falling. Earnings growth in energy for Q4 was over 56% but stronger comparisons are just ahead. The beginning of the big energy ramp of 2005 was in February but a sharp decline from April 1st to May 23rd should give us one more quarter of easy numbers but Q3 is going to be tough to beat. Oil rose from $51 in late May to over $70 in late August. That provided windfall profits for energy stocks and will be tough for them to match in 2006 even with oil flirting with $70 once again.

Earnings pre announcements have been very light for Q1 but it is tough to say if it has been due to fewer companies giving quarterly guidance or things are going as planned. So far in this cycle we have seen 63% of the tech pre announcements giving negative guidance, 10% inline and 27% positive guidance. This equates to better than 2:1 negative to positive guidance. However, we have also seen many more companies drop out of the guidance cycle. Companies giving quarterly guidance have dropped to less than 50% from 61% only a year ago. Companies are shifting to annual guidance to avoid having a bunch of short-term targets that they must hit or be penalized. According to those making the shift this will allow them more time to focus on running the company instead of managing earnings expectations.

This is the first quarter where all companies must deduct options expenses. It has been several years coming and we have seen many try to beat the deadline with various forms of comparative accounting over the last year. Well the time is up. All the funny numbers will vanish and the dirty cloud of hidden options expenses will be behind us, or so the accountants say. According to S&P options expenses for the S&P should knock about -3.5% off the average earnings expectations. Unfortunately most tech stocks depend on options as a method of attracting and retaining valued employees. It is entirely conceivable that some tech companies could see double to triple the impact. Many companies have moved away from options and towards other forms of enticement in order to avoid this options reporting.

Possibly more important to tech stocks next week is the delay by Microsoft in releasing the new Windows operating system until 2007. The new operating system always generates a wave of tech buying that many tech companies depend on for a needed injection of profitability. By delaying the release until 2007 those companies who had been predicting revenue in 2006 based on the prior dates will be left holding the earnings bag when guidance is revealed.

Business Week has an article this weekend called "Blue Chip Blues" showing that earnings for blue chip companies have increased +200% over the last five years but the average blue chip stock has increased very little. Returns of the S&P-100 stocks, the bluest of the blue chips, has been less than 1% over that same period. The S&P-500 may be at 5-year highs but it returned only +4.3% annually during that period. According to BW the biggest blue chip stocks, S&P-100, returned an average of 16% per year between 1982-2000 but less than 1% thereafter. Small caps are dominating in the US but that is not the whole story. According to BW investors are finding such good returns overseas that the blue chips are floundering. They point to South Korea up +54% last year, Latin America +55%, Saudi Arabia +108%, Russia +87% and Japan +42%. Small caps are so popular now that they support an average PE of 25 compared to 15 for the S&P-100. The blue chip blues are so bad the Fidelity Blue Chip Growth Fund is about to ask investors to approve a switch to the Russell-1000 as its benchmark rather than the current S&P-500. They claim this will give them a wider range of stocks with better growth opportunities. Fidelity Magellan, a $50 billion fund, dumped PFE, INTC and PG among others and boosted its foreign holdings to 25%, up from 4% just a few months ago. Anyone doubting why our markets are having trouble moving higher should look no further. Fidelity Magellan sold $11 billion in US blue chips to move that money overseas but remember they are a conservative fund. Multiply that by hundreds if not thousands of the 14000 mutual funds available and we see why the fund flows report each week continues to show the majority of the cash going into overseas equities.

The Dow spent all week knocking on the resistance door at 11250 and could not break through. Some traders said they were actually relieved to see the breakdown on Friday as evidence something is about to change in the status quo. Traders have feared an impending correction despite the more than three-week levitation at multiyear highs. The Dow was the first to breakout of prior resistance back in mid March but the Nasdaq was lagging. The roles were reversed over the last two weeks with the Dow lagging and the Nasdaq pushing out to new highs. Meanwhile the S&P-500 has remained nearly perfectly flat since March 15th. Among the major indexes there are no winners. Only volatility while time passes and we wait for something to happen.

The lesser known or maybe I should say lesser hyped indexes have been doing great. I have repeatedly mentioned that the NYSE Composite and Russell 2000 have been making new highs. These are doing well because they are not blue chip reactive and represent the true strength of the broader market. Everyone knows the Dow and Nasdaq are each held captive by the movements of a handful of mega cap issues. For instance the Dow was prevented from a major dip on Thursday single handedly by a +$4 gain in MMM. 3M is the second largest weighted Dow stock behind only IBM. The +4 gain by MMM on Thursday, representing approximately +30 Dow points helped hold the Dow to only a -23 point loss.

Dow Chart - 60 min

Nasdaq Chart - 30 min

NYSE Composite Chart - 60 min

For next week we could see some more selling in the big caps especially after the Business Week article. This means the Dow could show further weakness with support at 11100 and just slightly below Friday's close. The Nasdaq big caps could be under pressure as well given the impending earnings cycle and the 2:1 negative to positive earnings warning ratio. The Nasdaq has support at 2330 followed by a vacuum between there and 2300.

SPX Chart - 90 min

The S&P-500 closed right at support at 1295 and a level we have seen a lot of over the last three months. We spent the first two months of the year trying to get over 1295 and the last month trying to stay above it. That level is still the key for me. I would remain long over 1295 but shift to shorts under that level. We have gone too long without a real correction and it would not take more than a couple high profile earnings misses to make that 5% yield in the bond market a lot more attractive. I warned readers two Sunday's ago to tighten up stops on April 3rd just in case the first week of April saw fund managers begin to take profits. If you had done that the morning of April 3rd you would have gotten out very close to the highs for the week.

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