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Focus on the Fed

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It has been four weeks since the last Fed meeting but with only nine days left before the next one the probable Fed actions are coming back into focus. The Fed Beige Book was released today showing steady growth, tightening job markets and rising inflation due to higher energy prices. The immediate result was a weakening of the equity markets and a firming in the Fed funds futures for June. Bernanke will testify before the Joint Economic Committee of Congress on Thursday and traders will be holding their breath for clues to Fed direction.

Dow Chart - Daily

Nasdaq Chart - Daily

Economic reports vied with energy earnings to capture investor attention today. The economic news grabbing the early morning headlines was the +6.1% jump in Durable Goods orders for March. This came after a +3.4% jump in February and was the largest monthly gain since May-2005. Nondefense orders jumped +14% including transportation sales but after removing those sales it was still a healthy +3.0% gain. The early year weakness where January declined -8.9% has just about been erased with the two months of strong gains. Backorders jumped +2.8% in addition to the +6.1% of new orders. This suggests the flow of orders in the pipeline is steadily increasing. Shipments were also up +3.0%.

The Durable Goods orders showed the manufacturing sector gaining strength and the afternoon Beige Book confirmed it. The Fed Beige Book showed that all areas of the country were growing steadily despite rising energy prices and commodity shortages for steel, aluminum and building materials. The Cleveland and Richmond districts showed the least growth with Atlanta calling the economic picture mixed. The report showed that home sales were cooling slightly and well within acceptable ranges. Sales of used cars improved more than new cars indicating consumers were becoming more cost conscious.

On the troubling side the labor markets for skilled workers were seen to be tightening in many markets with wage pressures rising. High energy prices were also seen to be dragging on manufacturers but were not yet pressuring profits. It is a battle but growth in the economy is offsetting those pricing pressures. However, many companies reported an inability to pass these price hikes along to consumers.

When coupled with the Beige Book the Durable Goods orders suggest corporations are finally spending some of their accumulated cash. Companies in the S&P are rumored to be sitting on huge amounts of cash. Goldman Sachs estimates nearly 9% of the value of the S&P is represented by cash. After the corporate spending boom for Y2K corporations were forced to cut costs and conserve cash as the recession gripped the country. This fueled a massive consolidation phase and a record number of stock buybacks. Now that the economy has managed to produce 11 quarters of double-digit earnings corporations are starting to relax. Equipment purchased for the Y2K change is now old and in the case of computer equipment positively antique. Consumers have enjoyed several years of strong employment and the rising equity markets brought prosperity back to those who weathered the 2001-2002 crash. Based on the Durable Goods report it appears both corporations and consumers are starting to loosen those purse strings, which had been drawn tighter than normal due to the 9/11 attacks and terrorist fears. The economy appears to be in a sweet spot commonly referred to as the Goldilocks economy. Growth is steady and is expected to be in the +4.9% range for Q1 when it is reported on Friday. Jobs are strong but not overly so to the point of inflationary wages. To illustrate just how strong and stable the economy is we only need to look at the markets. The Dow closed at a new 6-yr high on Wednesday with oil prices hovering near $75. This is nearly four times the price of crude when the recession occurred in 2001.

Oil prices are a very serious drag on any economy and it is positively amazing that GDP growth is so strong. Every dollar rise in the price of crude removes $1 billion per month from consumer pockets. Since May 2004 the price of oil has more than doubled and at today's $72 level is costing consumers $1.1 billion PER DAY more than in May 2004. This has barely dented the consumer despite the constant whining on the airwaves and in print. Consumer Confidence as reported on Tuesday was 109.6 and the highest level since 2002 when oil was $20 a barrel.

Further proof that consumers appear to be bullet proof is the +13.8% jump in New Home Sales reported today. After two months of declines the March sales surged at a monthly rate not seen in 13 years. Total sales of 1,213,000 units were still -7.2% behind the 1,304,000 rate seen in March 2005. The 1.213 million units in March were an explosion from the 1.066 million units in February. Those are annualized rates. Despite the jump in March the average units for the first quarter of 1.16 million units was a decline of -33% from Q4 and the slowest quarter since Q4-2003. Housing inventory levels slipped slightly from 6.3 months to 5.5 months but the quarterly average is near a ten year high. Still, given the doubling of gasoline prices over the last two years has failed to dampen consumer sentiment and new home shoppers were out in force.

Investor sentiment is entirely a different matter. The UBS Index of Investor Optimism dropped -16 points in April to 63 and a five-month low. January started out very bullish at 93 and has declined ever since. The January peak nearly equaled the last cycle high of 95 set back in June 2004 but remains well off the multiyear high of 108 set in Jan-2004. This represents a -42% decline in optimism since Jan-2004 and a -32% decline just since January of this year.

The remaining reports for the week are Kansas Fed survey on Thursday and a boatload of news for Friday. GDP, NAPM-NY, ECI and PMI are all released on Friday along with April Consumer Sentiment, which should mirror the Consumer Confidence numbers.

June Crude Oil Chart - 30 min

Earnings are not just flowing but flooding this week. 143 companies were scheduled to report after hours on Wednesday alone. While tech earnings have been a minefield of results with numerous implosions the overall earnings picture has been very bright. According to Thomson Financial with more than half of S&P companies already reported and earnings were up +13.3%. This is higher than the +10.4% estimates as of April-1st and the +12.1% estimates as of January 1st. The declining estimates have ceased and now they are predicting strong earnings for the rest of 2006. Currently the materials sector has beaten estimates by +18%, financials are beating estimates by +10%. Energy stocks are still the leaders posting +41% growth over the same quarter in 2005. Information technology is second at +18% and +17% for industrials. Thomson feels like the current earnings environment will see financials pull out in front in the second half as energy stocks face the tougher comparisons from the oil highs of the 2005 hurricane season. I will believe it when I see it.

Energy stocks have been taking the heat for doing so well and the three giants all report this week. Conoco reported earnings that were inline with estimates despite a refining division that was only able to manage 83% of capacity due to hurricane damage. Conoco made a profit of $3.29 billion on revenue of $47.9 billon or +6.8%. Exxon reports tomorrow and is expected to earn $9.224 billion followed by Chevron on Friday at $4.136 billion. The total profits for those three should total over $16 billion for the quarter and that is drawing fire from Congress and elected officials everywhere. Unfortunately the big dollars overshadow the facts. Exxon, the biggest US oil company and the only US company in the global top ten, has profit margins around 8.8%. Chevron is expected to come in at +7.3% and Conoco was 6.8%. This is significantly lower than profits from other major companies. Citigroup for instance posts a +25% profit margin, Microsoft 30% and Pfizer +34%. I don't think anyone would argue that exploring and producing oil in some of the harshest environments on earth and in some of the most politically unstable countries contains higher risk than developing software from the comfort of Redmond Washington. Venezuela announced this week they were going to seize oil properties that five large companies have invested $16 billion in improving over the last five years. Exxon said today they were going to increase security in Nigeria to prevent its workers from being captured and killed. Final damage estimates from the 2005 hurricanes are expected to be well over $25 billion. Over 240 platforms were destroyed.


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Operating a drilling rig in 10,000 feet of water costs $350,000 per day and the rig can be under contract for a couple years to drill out a field. When oil is discovered it takes between 5-7 years before it can be turned into gasoline in your tank. Those integrated oil companies with refineries and retail operations in the US average about 8 cents profit per gallon sold at their stations. Using the national average of $2.79 per gallon for unleaded today that 8 cents represents a 2.8% profit margin. Does 2.8% seem too high for a company that had to spend tens of billions 5-7 years ago to discover the oil. Another $10 billion or so over that period to build platforms, pipelines and production facilities. That oil is then transported to refineries, turned into gasoline and piped/trucked thousands of miles to the individual service stations that sell it. Those ground under those stations had to be purchased, prepared, buildings and islands built and staffed and constantly updated. Is this worth a 2.8% profit on each gallon?

The massive profit numbers are simply because of the massive number of gallons consumed around the world not because they are gouging customers. Oil companies don't set the price of oil. They are at the mercy of supply and demand. When prices are high they benefit and when they are low they suffer. Oil prices are set by a very vigorous open market that spans the globe. All oil prices are not the same. There are many grades of oil from a gooey tar like substance with many impurities known as heavy oil that comes from Venezuela to a light sweet crude that is produced at various spots around the globe. The light sweet crude is the easiest to refine and the product needed by most of the world's refineries. It is also the product in the shortest supply. There is plenty of heavy sour crude available with nearly two million bbls per day going unsold at present. I have used the analogy in these pages numerous times about gasoline vs diesel. If you need gasoline and pull into a filling station that is out and only has diesel it does not matter if it is 25 cents a gallon. You just can't use it. That is the same with the heavy sour crude. We could have 10 mbpd of excess sour crude at $30 a bbl and light crude could still cost $75 a bbl. Consumers need to get over it and either pay the price or park the car. The shortage of light sweet crude is simply a fact of life that I have been warning about for more than two years. It will get worse as the decade continues but not necessarily in a straight line. Prices will ease with seasonal patterns and the return of the hurricane damaged Gulf refineries to production. As global demand continues to increase the problem will continue to get worse. Some refineries are being upgraded to use the heavy crude but that process will take years and we will still be behind the demand curve. Americans are spoiled when it comes to gas prices. Many countries are have been paying a lot more for gasoline for many years. The table below shows some of the prices this week. I also included some of the low prices where prices are controlled and subsidized by the government.

Gasoline Price Table

Other earnings reported today showed the results of the increased demand for drilling and the damage repair efforts in the Gulf. Baker Hughes (BHI), a drilling equipment, oil service company saw earnings soar +89% for the quarter and beat estimates by +14 cents. BHI jumped +5.10 intraday but was losing ground rapidly at the close. It will likely be down hard tomorrow. National Oilwell Varco (NOV), saw earnings spike +237% on revenue that almost doubled. NOV rose +3.50 intraday but closed in negative territory. Rowan Drilling (RDC) saw a +39% jump in profits but fell -4 over the last two days. Diamond Offshore (DO) saw profits jump from 23 cents to $1.06 per share, more than +300% gain, but has lost -$5 since Tuesday's historic high. Valero (VLO) posted a jump in income of +58% to a company record of $1.33 billion for the quarter but broke the cardinal rule of being inline with estimates. VLO has fallen -7.50 since the announcement high.

These post earnings declines should not surprise anyone. It is a historical fact that when great earnings are expected the gains are baked into the cake before the announcement. Add in the decline in oil prices from $75.40 to $72 and the temporary removal of the ethanol mandate you have conditions ripe for profit taking. The dip is only temporary but that means different things to different people. Hurricane season is only four weeks away and weathermen are getting ready for the worst. Rig repair crews in the Gulf are under pressure to complete as much as possible before the weather turns nasty again.

The IAEA report on Iran is scheduled for Friday but unless they found a smoking gun they have not leaked to the press it should be a non-event. Russia and China have both gone soft on the topic to keep from harming their weapons sales and in the case of China protect their oil imports. There is probably going to be a lot of smoke but no substance.

The markets will probably be more interested in what Bernanke will say on Thursday than the Iran news on Friday. Bernanke will dodge radioactive questions of his own as the joint committee grills him on the future direction of the Fed.

I scanned the 143 earnings reporters tonight in an effort to find something of a non-oil nature to discuss but the cupboard was bare. Most of the big names have already reported and tonight's offerings were a motley collection of average companies. On Thursday we will hear from some large caps including AET, BZH, CAH, DCX, XOM, HET, HIG, MRO, MGM, MSFT, PD and DOW to name a few. Thursday is richly populated with earnings from the rest of the oil sector and dozens of biotechs. The highlights will of course be XOM and MSFT. Sell the news should be the order of the day for anybody reporting.

One interesting note on the financial sector. Rising interest rates do not appear to be hampering Bank of America. Their board authorized another buyback of 200 million shares for up to $12 billion. They did the same thing last year and there are 47 million shares left on that authorization. They plan on doing this over the next 18 months. BAC claims it has returned $46 billion in capital to shareholders over the last five years through dividends and buybacks. They also claim this will not slow their current build out of new branches across the country. BAC has 4.6 billion shares outstanding. Personally I would like to see them buy something with all that excess cash that will add to earnings going forward. They could re-launch the BankAmericard credit card once again. BAC is very unhappy with Visa after spending billions to help build the brand over the years. BAC represents 20% of Visa's total business. Citigroup has also pondered leaving Visa to launch a branded card of its own. Both pay huge fees to Visa, rumored to be in the range of 8 cents per transaction. If both left the Visa fold it could cost Visa $250 million in annual fees plus remove nearly 35% of its card base. Could be our credit card rates are about to get a lot cheaper if both these companies launch competing products.

Picking a market direction for the rest of the week could be tricky tonight. A lot depends on Bernanke tomorrow given the Fed meeting on May 10th. Perception is a powerful motivator and the perception the Fed is about to quit could power another try at the highs. Similarly should the perception increase that the Fed is worried about rising energy prices pushing inflation higher and producing the need for more hikes it could get ugly. The Fed funds futures are now showing a 62% chance of another hike to 5.25% at the late June meeting.

Investors are at a crossroads this week as the worst six months of the trading year begins May 1st. Do they hang on and hope for some sign at the May FOMC meeting that they are done or bail out now and take their profits. With the markets struggling at their highs it is never a bad time to take those profits. I suggested last weekend that we short a break of SPX 1310 and that happened at the open on Monday and again on Tuesday and again on Wednesday. There have been plenty of chances for those shorts to be entered. That is still my recommendation tonight. Remain short under 1310.

I know the +71 on the Dow today may look like a rally but the gains were mostly from GM, CAT, PG and IBM. You can't look at the Dow as a proxy for the markets regardless of how much the talking heads on CNBC repeat the numbers. You have to depend on the broader indexes for market direction. The S&P has been trapped in the 1295-1310 range since March 14th with only a couple serious attempts to move higher. 1315 is the May-2001 resistance high and it has been solid resistance. Until that resistance breaks the markets are not going higher. I know that sounds dumb but there is no other way to put it. Without the Fed in the picture tomorrow the risks would be to the downside. At least that is the path of least resistance.

SPX Chart - 120 min

The Russell has been a moving force supporting the markets since last October. Last week's short squeeze push to 778 was a new historic high. Since that spike the Russell has not been a pillar of strength and is in danger of breaking support at 760. Add in the Nasdaq weakness ahead of Microsoft earnings tomorrow and that creates added stress. Nasdaq 2300 is still the key and it has been strong support. However, we are approaching the summer doldrums and investor interest will begin to wane very quickly as summer weather arrives. I would like to maintain a bullish bias because of the NYSE Composite's stellar performance and new historic high last Friday but much of the $NYA.x move was related to the energy sector and that ramp to $75 last week. With energy earnings over this week and the beating energy stocks are taking after reporting I would worry about the chances for continued NYSE strength. Therefore, remain short under SPX 1310 and lets see what thrills and chills Bernanke can create on Thursday. Anything but an outstanding market friendly performance will just add to the gathering storm clouds.

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