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Market Wrap

Goldilocks Returns

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The Non Farm Payroll number on Friday was as perfect a number as possible with the Goldilocks attributes of not too hot and not too cold. It was just right according to analysts despite missing estimates by -37,000 jobs. The Dow spiked 80 points at the open on euphoria over an end to rate hikes. That euphoria evaporated almost immediately as traders began to look into the future and worry about profits. At least that was the official view as to why the markets imploded. I believe it was just profit taking after another "Fed done" rally. It would be nearly impossible to find anyone that does not believe a Fed pass on Tuesday was not already priced into the market. Everyone had already voted with their cash there was nobody left to buy the top. Even more amazing there was no short squeeze from the spike over resistance. Shorts just added to positions rather than covered existing ones.

S&P-500 Chart - Daily

Dow Chart - Daily

Nasdaq Chart - Daily

The Non Farm Payroll report showed that 113,000 new jobs were created in July. June was revised higher by 3,000 to 124K and May was revised higher by 8,000 to 100K. The headline number missed the consensus of 150K by -37,000 suggesting the economy was weaker than expected. On the surface this would seem to guarantee a pause by the Fed next week but the tendrils of inflation were clearly evident. Average hourly earnings rose 0.4% and wage inflation is a major stimulant to Fed rate hikes. That represents a 3.8% jump in wages over the last 12 months. Also pressing the case for a pause was an unexpected jump in the unemployment rate to 4.8% from 4.6% in June.

The first table below compares the consensus estimates to the actual headline numbers for the last twelve months. The second table adds in the household payroll survey to show the monthly total. Normally the household survey shows a significantly higher production of new jobs than the non-farm survey because this is where new home-based businesses are born and the Internet economy is most easily utilized. This is also where the unemployment rate is calculated. You will note that there was a LOSS of jobs in the household survey in July. This is the first loss since the hurricane related drop in the 4th quarter of 2005. Clearly the production of new jobs fell off a cliff in July. The only lower number was in September 2005 and a direct result of Katrina, not the economy. Something changed dramatically and this is why traders celebrated and end to Fed hikes at Friday's open.

12 Month Non Farm Payroll Consensus Vs Actual Table

12 Month Jobs Non farm and Household Table

12 Month Non Farm Payrolls Chart

Unfortunately the household portion of the jobs report is like a stealth component and is not widely reported. Once that job loss number filtered through the markets over the next couple of hours those same traders celebrating at the open recoiled in shock at the -34,000 job losses. The feeling the Fed would pause was quickly replaced by concerns that the economy was slowing faster than expected and profits were likely to get squeezed. Whether it was the true reason for the selling or not it was the reason the talking heads used to explain the sudden change in sentiment.

I think the selling was more likely the result of two factors. The first was profit taking on yet another Fed done rally that saw the indexes spike above current resistance on a Friday before the Fed meeting. You have to admit the anticipation for a Fed pause was fully priced into the market and even overpriced in the opinion of many. That set up a prime sell the news event. Profits are not profits until turned into cash.

The second reason could be a lot of chicken counting before the Fed eggs are hatched. While traders were counting their chickens the Fed was counting the different ways inflation was creeping into the system. The July wage inflation of 0.4% pushing the 12-month rate to 3.8% was just more confirmation the Fed's work is not done. In other words the foundation began to crumble on Friday's Fed done rally when reality settled in on traders. As of Friday morning a Fed pause was fully priced into the market and the only possible surprise would be another hike. 22 of 23 bond dealers surveyed by Dow Jones expected the Fed to pause. The Fed funds futures fell to only an 18% chance of a rate hike. There was no upside potential left for traders at the end of a long rally. The fear of a faster than expected drop in the economy sent other investors into the safety of bonds driving yields to multi month lows. The 30-year yield fell under 5.0% for the first time in four months. The ten-year note traded below 4.9% intraday.

Chart of Ten year Yields - Daily

Another realization also came back to haunt traders. A Fed pause Tuesday does not mean a halt in rate hikes. The November Fed funds futures are still showing a 70% chance of a hike over the next three months. That was down from a 90% chance before the jobs report but still nearly a guarantee of another hike. Major analysts were split on how it would happen but several were openly predicting further hikes. Further hikes? That was far from the Fed pass that was priced into the market at the open. A noted Cantor Fitzgerald analyst expects a 25-point hike next week and a statement saying the hikes were over unless conditions worsened. A Barclay Capital analyst expected a two meeting pause then another hike in October. A JP Morgan analyst said the Fed had to hike again to cover its inflation bases given the continued signs of rising inflation. He felt the Fed would keep hiking and produce the proverbial Fed rate hike recession. Traders were faced with both an economy falling faster than expected as evidenced by the household jobs survey and by a crumbling belief that the Fed would pass on Tuesday. It was not a pretty sight and that combination of factors erased a 80 point Dow gain and pushed the Dow to a -55 point loss intraday.

From a purely sentiment point of view the markets had rallied above current resistance of 11250, 2100, 1280 on the morning spike and the worst two months of the year are August and September. It was the perfect opportunity for funds to exit on strong volume at market highs ahead of their normal vacation period. Typically fund managers take their vacations over the last three weeks of August. Earnings are over, volume is low and there is little to stimulate market movement. TrimTabs said on Friday the cash inflows to funds for the first week of the month was the lowest level since February. Funds need to keep cash on hand for withdrawals ahead of the normal Q3 weakness and there is a shortage of cash in the mail. Given these factors I am surprised the selling was not worse. An end of day bout of short covering did rescue the markets from a deeper slide but it may have been only a short-term reprieve.


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If the Fed does pause next week I am sure we will see another sprint higher but it may be very short lived given the placement on the calendar. It is already priced in and the economic fundamentals are weakening. Yes, traders will be glad they paused but now we are at the point where a pause could have a deeper meaning. I know this analysis is brain numbing but stick with me for one more point. If the Fed does pause in the face of rising inflation THEN the question immediately becomes, "does the Fed know something we don't?" Is the economy worse than it appears on the surface? This used to drive me crazy back in prior hike cycles. We want the Fed to pause but will they pause for the right reasons? Is the underlying jobs data pointing to larger issues? Is the housing sector about to implode rather than slump? What does the Fed know that we don't? This almost makes another rate hike a reassuring event. We would assume the Fed would not hike again if the economy were really weaker than we have seen from recent reports. Of course the Fed has a history of over hiking and pushing us into recession but you get the idea. I could continue this train of thought for several more paragraphs but I think everyone understands now that a) a Fed pause is not guaranteed and b) a pause is not a halt and c) a pause on Tuesday could create a new set of sentiment problems.

One more thought before I end this Fed topic. If the Fed did pause next week they have to leave us with a hawkish statement or leave themselves open for a serious bout of second-guessing. They have to say in strong words that future decisions will be data dependent and that further rate hikes are always an option. They can't just say, "we are done" and move to the sidelines. They have to keep the bond markets off balance or rates will implode forcing them to come back with further hikes to offset that decline. Bond yields are already well under Fed funds so the bond market is already discounting an end to hikes. The Fed has to combat this and their only tool other than hikes is a strong verbal attack. If the Fed did pause I would expect the Fedspeak over the next couple weeks to be very hawkish to keep the bond market indecision high.

If you have any doubt a halt to rate hikes is not priced into the market you only need to look at the homebuilders. Even with Hovnanian warning again on Friday the sector is still showing signs of life. Most builders found a bottom in mid July and anticipation of an end to hikes has given them wings. For instance Toll Brothers (TOL) has risen 22% since hitting their low of $22.25 on July-18th. If the Fed pauses you can expect these companies to quickly recover more lost ground despite the profit warnings. HOV is still projecting earnings of up to $5.75 per share ($354 million) compared to analyst estimates of $6.46. That is down from record profits of $7.16 per share in 2005 but still a nice chunk of change.

Apple Computer announced on Friday that financial statements dating back to 1997 could be restated due to further investigations into backdating options. Steve Jobs is under fire for options on 27.5 million shares granted several years ago. The options expired underwater without being exercised but the board then gave Jobs restricted stock in their place. Most analysts expect little change to the financials but are more afraid of ramifications to the continued employment of Jobs after the Brocade CEO was jailed. If Jobs was attacked by the SEC and forced to resign, or worse, it would be extremely negative to Apple stock. AAPL dropped nearly -$5 intraday but recovered at the close to end down only -$1.29.

Oil prices eased ahead of the weekend as tropical storm Chris was downgraded into a tropical depression. Oil closed down -71 cents at $74.75. Based on the projected path below it may be too soon to start cheering since it will be into the Gulf by noon on Monday. It could easily revive into a full-fledged hurricane and be well within the 3-day warning cone that would require shutdown and evacuation of the offshore oil patch. Don't count Chris out just yet.

NOAA Hurricane Path Map

Crude Oil Chart - Daily

For the week the markets were bipolar with the major indexes mixed for the week with small gains or losses. None were more volatile than the transports. The transports hit a low of 4265 on Tuesday and a high of 4560 on Friday for a range of 295 points or 7%. The index closed on Friday at 4378 and a -36 point loss for the week or less than -1%. A 7% range with less than a 1% result. That would have been a nice trade using the Transport ETF (IYT). Unfortunately there are no options. You could use options on FDX or CSX as a proxy for the Transports for future moves.

The Dow spiked at the open to 11344 ( 80) and well over the recent resistance at 11250. That spike was erased with a -157 point drop to 11187 and the low of the day. The end of day short covering pushed the Dow back to 11240 and right under that previous resistance. Normally a complete erasure of that kind of spike is a very negative omen. I believe the morning drop was simply profit taking along with shorts opening new positions. The afternoon rebound was short covering and dip buying. The retail bulls are convinced the Fed will pause and an explosive rally will result. Where the Dow will be when that rally starts and how long it will last is anybody's guess but I would not be surprised to see any rally erased as quickly as Friday's once the selling begins.

Weekly Market Internals Snapshot

If I only had the chart on which to base my predictions I would be bullish. The strong advance since the July 18th low at 10683 appears to still be intact despite four strong attempts to sell off. The closing rebound on Friday would appear to be an indication of a strong open on Monday. However, once you add in the Fed and the calendar I become much more cautious.

The Nasdaq also spiked over current resistance at 2100 to hit 2119 intraday. The same profit taking pushed it back to 2068 intraday for a -51 point drop but the Nasdaq also recovered at the close to end only -7 at 2085. This is right in the tight 2055-2095 range we have seen for the past two weeks with resistance at 2100 still intact. The NDX closed at 1503 and in the middle of its 1480-1520 range. The NDX is showing far less bullishness than the other indexes but managing to avoid the cliff edge. The SOX rallied as high as 424 intraday and closed at 411 with the two-week uptrend still intact.

The S&P-500, my indicator of choice, managed to spike past 1280 resistance to briefly peek over 1290 before crashing back to earth. The close at 1279 was right at the same 1280 resistance that has held it in check since early July. Like the other indexes the SPX has a bullish trend but is still looking for buyers to hold any spike over 1280. There appears to be no shortage of sellers on every foray over resistance but continued spikes would eventually exhaust supply without any external forces like the Fed and the calendar.

For next week I would be cautious. Every Fed done rally has been sold because it was based on speculation and hope. Next Tuesday we will know for sure what the Fed is going to do and the expectation and hope will fade under the glare of reality. If the Fed surprises everyone and takes a pass and posts a positive statement I think everybody will want to rally but immediately start asking why the Fed was so accommodative. What do they really know? The best outcome would be a hike and post a halt statement that clearly says they are done unless the data forces another move. Traders would celebrate the end of uncertainty and a low upper rate of 5.5%. I would not hold my breath for that event. Whether they hike or not I expect a hawkish statement and that could spoil investor sentiment. It is not the hikes at this point but the expectations of more hikes that will give traders indigestion. Let's hope the Fed takes a chance and throws the market a bone. The economic calendar for next week is rather bland with only the FOMC meeting and Productivity on Tuesday to wake the bond groupies. Clearly the only focus for the week is the Fed at 2:15 on Tuesday.

Economic Calendar

I would not get too excited about any market moves before 2:15 on Tuesday because speculation and fund positioning will be rampant. Funds could be looking to use any post Fed spike to exit on volume so market internals will be of critical interest on Tuesday night. We will have this discussion again in the Tuesday newsletter and hopefully we will have a clear vision of the future with the Fed behind us.

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