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Market Wrap

Another Week, Another Fed Rally

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Every week it seems traders find one more reason to rally on hopes the Fed is going to stop hiking rates. Eventually the market will be right. Until that day comes every "Fed is done" rally is at risk for a retracement as new economic data appears. This week's rally was built on a Beige book foundation with a GDP cornerstone. Those would seem like two fairly stable building blocks but inflation is still at work attempting to erode that base.

On Friday the US GDP for the second quarter came in with a headline number showing +2.5% growth. This was less than the consensus estimates of +3.1% growth and far less than the +5.6% growth we saw in Q1. The weakness in the second quarter was very widespread showing a drop in capex spending, exports and personal consumption. Residential investment fell for the first time in three years. Core inflation as evidenced by the PCE deflator jumped +2.9% for the biggest gain in more than a decade. Despite the sharp jump in the PCE and the sharper than expected drop in GDP the markets roared off to yet another Fed is done rally. The expectations were almost unanimous among analysts that the Fed would pause in August. They are still split on whether there will be a hike in August but almost unanimous that August will be the last move. Goldman Sachs went way out on a limb predicting cuts of -150 basis points beginning in early 2007.

Bond yields plummeted with the 10-year note yield falling to close at 4.90% and a seven-week low. The Fed Funds Futures are only showing a 28% chance of an August hike and almost no chance for a hike at any future meetings. The term "soft landing" has been dusted off and has suddenly become the new buzzword of choice. A GDP of +2.5% is seen to be the Goldilocks number that signifies a soft landing and a number that will put the Fed on hold. Had the GDP come in at the consensus expectations of +3.1-3.3% the Fed may have needed to remain vigilant according to some analysts. Under 3% is a danger sign for the Fed that they may have already gone too far. According to analysts this is a screaming halt warning that the Fed must obey.

The markets rallied with another round of gains on top of strong moves earlier in the week. The Beige book had also shown a broad based slowdown and tame but rising inflation. This was seen as a prelude to the Q2 GDP number and confirmation we were nearing an end to hikes.

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Personally, I believe this wishful thinking is extremely overdone and will come back to haunt us soon. Since the Fed goes too far the vast majority of the time and the last nine months of hikes have not completely filtered through the system it seems to me that traders are looking at the numbers through heavily rose tinted glasses. If the GDP has fallen -55% in just the last three months with six to nine months of rate hikes still making their way through the system then tougher times could be ahead. The recent manufacturing reports have shown a slowdown in capex spending and a buildup in inventory levels from slowing sales. These reports are much more current than the Q2 GDP. Next Tuesday we will get the ISM Index for July and the most current read on manufacturing conditions in Q3. That report will be followed by the Nonfarm Payrolls on Friday. These reports could either confirm the soft landing scenario or raise new warnings that the economy has fallen off the cliff and the -3.1% drop in GDP was just the beginning of a longer drop. If that is the case we may not be talking about future stagflation but the return of the "R" word.

On Friday we also got the Employment Cost Index for Q2 and that showed employer costs rose sharply by +0.9% in Q2. This was +50% faster than the +0.6% rise in Q1. This was the fastest rise in wage costs since 2000. This is a clear sign of rising wage inflation and exactly what the Fed does not want to see. As we have seen the Fed can stomach some price inflation and even some inflation from rising oil prices but the appearance of wage inflation is a critical warning sign. The bulls completely overlooked this report and focused instead on the GDP soft landing scenario. Those rose-colored glasses also have a very narrow range of vision to keep from distracting the bulls from their goal. The ECI report should guarantee another rate hike in August despite whatever dreams the bulls might have. That does not mean the bullish case is wrong but just a greater potential for at least one more hike.

There can only be so many "one and done" rallies. We have seen rallies in advance of the Fed moves or on shifts in Fed expectations for months. They have all failed when reality returned to stare us in the face. Eventually the market will be right but after last weeks gains we are risking the potential for a sell the news event rather than a continuation spike to higher levels. The Fed meeting is only six trading days away and bullishness is already rampant.

The Dow gained +351 points or +3.23% for the week. The talking heads will tell you this was the best weekly gain since November 2004. They will also neglect to remind you that it fell -351 points for the week ended on July-14th. The statisticians were dragging out all the superlatives like best points since 2003, best percentage since 2004, best S&P gain in 3 years, etc, etc. It is all true. The Dow has rebounded from the low end of its range at 10700 to a dead stop at exactly the high end of its range at 11250 in only nine days. Three cheers for the bulls but we need to put this into context. This was the second rebound of this magnitude since the first touch of 10700 on June-14th. The first rebound took 12 days but evaporated in only 6 days. That was also a Fed done rally that ended badly.

Dow Chart - 180 min

I am not claiming that this rally will fail next week, only that we just made a round trip on expectations rather than reality. We had the Bernanke testimony, the Beige book and now the GDP to support the bullish case. The bulls are extended due to the very fast rebound and we are still over a week away from the FOMC meeting. Those critical economic reports, ISM and Nonfarm Payrolls, could either push the indexes over current resistance or send them right back to the low of the range very quickly.

Economic Calendar

The earnings tsunami has passed and while there will be further reporting waves they will be of decreasing strength as the cycle draws to a close in the coming weeks. The earnings have been stronger than expected and may possibly end up as the most profitable in history but forward guidance has also been weaker than expected. This is a function of the slowdown in the economy and rising energy and commodity costs. Neither of those costs are expected to decline. Analysts have not yet begun to ratchet down earnings estimates for the rest of 2006 but that should begin soon. Once it does the fears of a harder landing should begin to appear. The business investment component of the GDP showed that investment increased just +2.7% and that was the lowest gain since Q1-2004. Add in the current housing crash and that leads me to believe that economic slowdown discussions will be a lot more prevalent over the next few weeks. On the positive side a drop in the interest rate with the ten-year note yielding under 5% on Friday will eventually have a positive impact on housing. Those homeowners with ARMs about to reset will be breathing a sigh of relief and lining up to refinance soon. After 17 rate hikes a pause could bring the home buyers back into the market place and actually create a softer landing in that sector than had been previously feared. This point was not lost on investors with all the major builders adding to gains for the week. You see there is some good news in the slowdown cloud if you dig deep enough to find it.

Energy stocks were mixed for the week with oil prices falling below the $73.50 support level on Friday. Despite the record high at $78.40 two weeks ago performance in the energy sector has been mixed. High oil prices have not generally translated into high stock prices although some individual issues have been moving higher. Friday's -1.15 drop in crude to $73.30 was due mostly to a feeling that the Israel/Lebanon conflict was about over. Expectations for a peacekeeping force and an Israeli withdrawal from Lebanon made it more likely that oil producers Syria and Iran would remain out of the conflict. The joint Bush/Blair press conference ratcheted up the likelihood that the US would tell Israel to start winding down their excursion and prepare to terminate fighting. Another factor hurting the price of oil was the lower than expected GDP. Analysts started talking about a reduction of demand due to slower economic growth. This was excessive speculation in my view since the US is not a developing nation. Our oil growth is relatively stable and would not be impacted materially by a couple quarters of weak GDP.

Gasoline demand by consumers continued to remain strong after the July 4th peak. The chart below shows 2006 demand (red) through last week compared to 2005 demand (blue). The week before July-4th was the peak in both years. Note that demand leveled off after the July-4th peak in 2005 but still remained in an overall down trend until the post Katrina crash. Katrina hit New Orleans on Aug-29th. Demand in 2006 was not as high on the July-4th spike as 2005 but has remained strong and well over the 2005 levels even with prices over $3.00. If gasoline demand and gasoline prices are supporting crude then crude is living on borrowed time. There are only four weeks left in the high demand gasoline season and we know that traders don't wait for the event to arrive before exiting with profits. Even if we don't get a hurricane gas demand will decline sharply after Labor Day. If traders begin to see an end in sight in the Middle East conflict it will only hasten the exit. The wild card here is still hurricane season and so far the Gulf oil patch has been very lucky with no developing storms. I would say traders long oil futures are pressing their luck.

Gasoline Demand Chart

September Crude Oil Chart - Daily

Last week was energy week in the earnings parade. The majority of energy companies reported including the majors. Exxon posted record profits of more than $10 billion (+36%) renewing calls from lawmakers for additional taxation of big oil. It has been tried before and never worked but that does not mean it won't be tried again. Exxon broke with the "enough oil for everybody" mantra and Exxon's VP of investor relations, Henry Hubble, told analysts, "We are selling everything we can produce." Hubble said Exxon was adding another $1 billion to its stated $19 billion capital spending budget for additional exploration and production. One third of that budget is going to pay for increases due to rising costs for labor and increasingly specialized equipment needed to extract oil from increasingly difficult locations. Royal Dutch Shell posted a +40% increase in profits to $7.3 billion and Chevron posted a +18% increase in profits to $4.35 billion. Chevron fell short of analyst estimates and lost -1.68 on Friday.

Next week earnings will slow slightly and all eyes will be on economics rather than the slowing earnings parade. The ISM on Tuesday is expected to come in flat with June but that may be wishful thinking. All indications are for a slight decline possibly to something in the 51-52 range. Anything over 50 means an expanding economy and under 50 is contracting economy. The Jobs report next Friday is expected to show a gain of +150,000 jobs in July compared to a gain of +121,000 in June. Jobs have been coming in under the estimates for several months with last months estimate of +175,000 being missed severely. The table below shows the misses for the last year. Some whisper numbers for next Friday are in the +50K to +75K range. Another significant miss just before the Aug-8th Fed meeting could give them more freedom to halt the hikes especially if the ISM is weak as well.

Jobs Table

Semiconductor Index Chart - Weekly

I mentioned the Dow's performance earlier and the other major indexes resemble clones. The S&P-500 rebounded to resistance at 1280 from support at 1225 for a +3% gain for the week. The Nasdaq rallied +74 points for a +3.6% gain to stall just under resistance at 2100. While these were strong gains the Semiconductor Index beat them all. The SOX rallied +7.1% on the back of some strong chip earnings and that sparked a fire under the Nasdaq as I suggested it might on Tuesday. This powered the Nasdaq and without the Nasdaq acting as an anchor the Dow and S&P were free to move higher as well.

The index with the most headaches for the week was the Transports with a decline of -41 points while the others were putting in three-year performance gains. The Transports were hit by the UPS earnings, NSC earnings, continued oil prices in the $75 range and worries about an economic slowdown. Thank you UPS. Were it not for a +109 point, +2.5% gain on Friday the Transport index would have closed at a five month low. This is the opposite of a confirmation of the Dow gains that Dow theorists would like.

Dow Transport Chart - Daily

Nasdaq Chart - 120 min

Russell-2000 Chart - 120 min

I was concerned about the Russell-2000 most of the week as it exhibited high volatility between 685-700. It struggled to hold the gains from Monday but finally finished at that critical 700 resistance level on Friday. The Russell did end with a +4% gain for the week but it was all on Monday. The volatility suggested to me that fund managers were exiting small caps on any rally ahead of the normally weak Aug/Sept period. Buyers continued to show on the dips but it was a battle all week. I would continue to watch the Russell as an indicator of fund traffic. TrimTabs said on Friday many domestic funds were seeing net outflows despite the official headline number of +$200 million average in contributions over the last four weeks. If the Russell begins to weaken relative to the Dow and S&P-100 I would see that as a warning sign ahead of the historical late summer volatility. You can see in the internals snapshot below that Monday and Friday were the only really bullish days with the rest of the week (Tue-Thr) favoring the sellers as the week progressed.

Market Internals Snapshot

I wrote last week that I was expecting a rally ahead of the Fed meeting on August 8th. I was not expecting it to be this strong or this soon. With all the indexes now overbought and at strong resistance the obvious call would be for some profit taking. That may be the wrong call this time around. There was no profit taking going into Friday's close and most of the indexes closed at or near their highs for the week. This is unusual for a summer Friday after a better than +3% rebound for the week. This indicates to me that the bulls are feeling energized and are hoping for some greener pastures after the Fed meeting. The problems ahead for this bullish scenario are six trading days and two critical economic reports. If those reports are market friendly there is plenty of money on the sidelines to push the indexes higher. Will they do it or is there enough concern over a possible negative Fed outcome on the 8th?

SPX Chart - 180 min

Based purely on a chart view I would be ready to buy a breakout on the S&P and Russell assuming there were no economic potholes in our future. Unfortunately that is rarely the case. That leaves me questioning the wisdom of doing anything on Monday. The better plan would be waiting for a trend to appear after the ISM on Tuesday. A breakout on a market positive ISM could be a good trade since there would be a considerable amount of short covering above 11250 and 1280. The challenge to a breakout would come at S&P 1290-1295 and a likely failure point. The 100-day average on the S&P is 1280 and exactly where we stopped on Friday. My long-term view has not changed and I still expect another strong dip later this year. My short-term view of a rally ahead of the Fed meeting has run its course but I am willing to concede another leg higher to 1295 on market positive data. All bets are off if the ISM comes in much stronger than expected. A resumption in strong growth with our current rising inflation would not be Fed positive and give us another failed "Fed done" rally. I am wearing out these words but "trading in the summer is difficult" and next week is likely to be a difficult week. Buy a 1280 breakout or short a 1280 failure and beware Tuesday's ISM.
 

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