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Market Wrap

Fed Fizzle

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The Fed paused hiking rates at their meeting today and some think it signals an end to the cycle that saw 17 consecutive hikes over a two-year period. Former Fed head, Bob McTeer, said the pause today put the Fed into a box it cannot escape for several months. Even if inflation rose over the next month McTeer feels the Fed cannot hike at the Sept-20th meeting without giving the appearance that they made a mistake in August. This would be detrimental to the fragile confidence in the new Fed board. This makes October the first month where another hike could appear. That is actually a very positive sign for the markets since the full impact of the summer slowdown should be known from the Q3 GDP. We will have two additional months of inflation data and any Fed hike will be based on that data not on the peer pressure seen in prior Bernanke meetings.

Dow Chart - Daily

Nasdaq Chart - Daily

The 17 consecutive hikes was a record streak for the Fed but it was not a record for actual points hiked. The pause by the Fed at 5.25% is far from a restrictive level for rates. Over the last 15 years the Fed rate highs were 8.0% in July 1990, 6.0% in 1995 and 6.5% in 2000. Lulls between those peaks averaged between 3.0% and 5.0% and the economy did just fine. When compared to the current inflation rate of +2.7% year over year or +4.0% over the last six months, the current 5.25% Fed rate is very tame. After adjusting for annual inflation it is barely over 2.5%. The current rate should not provide any hindrance to economic growth.

The Fed statement noted that economic growth had moderated from the heated pace seen in Q1 due mostly to the gradual cooling in the housing market and the lagging effects of prior rate hikes and higher energy prices. They said although inflation readings had been elevated in recent months the high levels of resource utilization and high energy prices along with other commodity prices had the potential to sustain inflation. However, the Fed restated its view that inflation would moderate over time due to the cumulative effects of monetary policy and other factors restraining aggregate demand. The Fed did say that some inflation risk remains and that additional firming may be needed to address this risk and that firming would be dependent on the future evolution of inflation data.


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The vote was not unanimous with 9 members voting for the pause and one member, Richmond Fed president Jeffery Lacker, voting for a +25 point hike. It is very unusual for a member to break ranks and go against the group. This suggests Lacker was very adamant in his views and could not be converted to the group mindset. It will be interesting to see the minutes of this meeting later this month.

The Fed appears to be trying hard to manage a soft landing and not follow the historical Fed pattern of overshooting and pushing the economy into recession. Some analysts feel the Fed action today was based more on hope that slowing economic growth would slow inflation rather than current data. Analysts point to the growing signs of stagflation as future problems the Fed will have to manage.

The Fed statement surprised almost everyone with its moderate stance. Granted they had to remain slightly dovish since they did not hike rates but it was a very tame statement. It would have been tough to take a pass and then make any harsh comments on inflation. They appeared to walk a thin line trying to assure investors the economy was still strong while warning softly that dangers may still exist.

It should have been the perfect Goldilocks statement and the best outcome investors could have expected. The markets imploded shortly after the release on very high volume. The initial euphoric bounce was met with a very strong blast of multiple sell programs that knocked -3000 issues off the advance/decline line. I mentioned on Sunday that I expected funds to unload into the post Fed bounce and it happened right on schedule. The bulls bought the dip only to be hit by another bout of selling into the rebound. The market participants eventually fought to a draw and the markets went dormant as they moved into an uneventful close.

Now that the Fed is actually done where was the real "Fed done" rally? Now that the worry about the Fed is over you would think the bulls would be celebrating. I would not read too much into the market action since the Fed move was highly anticipated. The Fed pause was fully priced into the market and there was nobody left to buy the news. The selling was simply profit taking from the last month of Fed done rallies. The Fed news is out, there was no rumor to buy. The Fed is now done. In theory a real rally should appear tomorrow as investors cheer that event. Unfortunately the spotlight will now turn to the economy and every economic report will be scrutinized for every minute detail that could suggest how fast the economy is slowing. Fears of a hard landing will continue to grow until proven wrong.

The discussions will begin to increase expectations of future rate cuts. I know that is hard to imagine on the same day the Fed paused but analysts need something to occupy their day and face time on stock TV. Personally I believe we need to ignore the Fed for the next couple months and begin to position ourselves for any future rate cut cycle in 2007 using any end of summer weakness as a buying opportunity.

After the bell Cisco reported earnings of +30 cents that beat estimates by two cents. Revenue at $7.98 billion also beat estimates slightly. CSCO initially gained +28 cents in after hours trading. Futures barely showed a pulse much less a bounce on the good news. Once the conference call began and the tone was strongly positive CSCO caught fire and extended those gains to nearly +$2. Chambers said earnings growth for the current quarter could rise by +19% to +21% and sales for the year could rise +15% to +20%. Nasdaq futures spiked nearly +10 aided by positive news from Seagate Technology. Seagate sank on actual earnings results with charges related to the Maxtor acquisition but the Seagate CEO said disk demand had grown by +50% over the last year. This is very positive for techs suggesting PC sales could be firming. Seagate also announced a $2.5 billion stock buyback.

With the Fed mentioning energy prices in its statement it made the recent BP news even more critical. Various updates today suggested the BP pipeline outage could last several months and not be completely corrected until February. Between 11 and 21 miles of pipeline will need to be replaced and analysts are worried this could evolve into an even bigger problem impacting other pipe sections in the area. Winter will be starting soon for that area and any day above freezing will be considered a warm day. Energy Secretary Samuel Bodman held a press conference to assure consumers there was enough oil in inventory at refiners and available on the open market to handle any demand until the pipeline is repaired. Fortunately we are nearing the end of summer and a slowdown in the peak-driving season and a weakening of gasoline demand. If the warm weather continues into fall there will also be less consumption of heating oil. The wild card here is the coming peak hurricane activity months. Katrina shutdown -1.4 mbpd in 2005 and analysts are worried a repeat of Katrina could create a drop in crude inventories to a dangerous level. The official NOAA hurricane forecast was lowered today due to the lack of strong storms this far into the season. The old forecast was for 13-16 tropical storms. That was revised down only slightly to 12-15 storms. Expected hurricanes were lowered to 7-9 from 8-10. Expectations for major storms were lowered to 3-4 from 4-6.

Crude Oil Chart - Daily

The oil from the Prudhoe Bay field is the light sweet crude easily refined into gasoline. The majority of this Alaskan oil is routed to California refineries putting them in a position of scrambling to assure future inventory levels. The oil Bodman was referring to from Saudi Arabia is the heavy sour crude that cannot be refined by most refiners. Not all oil can be refined by all refiners and the loss of -400,000 bpd of light sweet production from Alaska is just one more problem impacting the price of oil. Nigeria now has 750,000 bpd of light crude offline due to rebel problems. With this commodity already in short supply the hit from Alaska will push global supplies to critical levels. Fortunately it would have been much worse earlier in the summer when gasoline demand was highest. Should a hurricane appear headed for the Gulf we could easily see prices for oil over $80. The pipeline was engineered for a 25yr lifespan on the assumption the fields would be depleted over that period. The pipeline is now 29 years old and although production has slowed significantly from the Alaskan fields they have lasted longer than previously expected. New technology and additional drilling has extended the field life at lower production levels. Current Alaskan production has declined from over 1-mbpd to just under 700,000 bpd. Experts have already warned that 5% to 10% of the -400,000 bpd of production that will be shutdown for pipeline repairs may not come back online. When production stops for an extended period of time the oil underground can cease to flow for various reasons. Porosity of the formations can decline if oil is not flowing.

This type of problem is just another reason for Peabody Energy (BTU) to get off their coal duff and start constructing coal-to-liquids plants. BTU has said it is looking at dozens of sites to construct CTL plants with partner Rentech (RTK). According to the governor of Montana he is expecting Colstrip Montana to be one of the sites selected. BTU has nearly 10 billion tons of coal reserves and is reportedly planning on building several CTL plants each with production of up to 30,000 bpd. The BTU technology can convert coal to gasoline or diesel for less than $1.20 per gallon. This would require quite a few plants to offset existing crude oil refining but it is not as if we have a choice. If we wait until the Peak Oil crisis arrives to begin constructing CTL plants we will be well behind the curve. A 30,000 bpd plant is estimated to cost around $1.5 billion. 30,000 bpd equates to 1.26 million gallons of gasoline per day. The Defense Dept is also experimenting with converting coal and natural gas into just fuel to provide them with a domestic source of fuel should a future war breakout.

Pixar made the headlines again today after news broke that executives received options for several years from 1997 to 2001 at the exact low of the year for the stock price. Either the board was psychic or options were backdated. Apple Computer has already warned that financials for the period will be restated for several years to accurately reflect this options backdating. John Lassiter, head of the Pixar creative dept, received 250,000 options in Feb-1997 with the price of the stock pegged to the last business day before Pixar announced a new 5-year agreement with Disney. The options were priced at $7.06 and PIXR stock jumped to $10.50 on the announcement. The grant was announced more than a month after it was made. In 1997 and 1998 Sarah McArthur, VP of Production received 400,000 options at the split adjusted price of $6.38 in 1997 and $10.69 in 1998. According to Bloomberg those were exactly the low for the stock in each of those years.

In related news ex Comverse Technology founder and CEO Kobi Alexander is said to have fled the country to avoid option backdating charges. According to CNBC, Alexander has a court appearance scheduled for Wednesday morning and a failure to appear will result in fugitive charges being filed. Backdating is not illegal as long as it is disclosed in financial releases and the impact on profits is calculated correctly. Executives trying to avoid hits to earnings back in the tech boom routinely failed to account for costs correctly. It is coming back to haunt them now with more than 80 companies under scrutiny by the SEC and several hundred others likely to join the list.

The Fed meeting was not the only economic event today with Productivity and Costs for Q2 released at 8:30. Business productivity at +1.1% was stronger than expected although well below the +4.3% rate we saw in Q1. Inflationary pressures were clearly evident with nonfarm unit labor costs spiking by +4.2% and the biggest jump since Q3-2004. Hourly compensation jumped +5.4% on top of a +6.9% spike in Q1. This report probably gave the Fed some cause for worry. With productivity slowing drastically and wages rising sharply it was exactly the kind of report that gives the Fed heartburn. Evidently they popped some Maalox and got past it but that does not change the facts. The economy is slowing and inflation is rising. The Fed showed a lot of faith in their outlook by not raising rates today. Let's hope they are right.

The Fed is now officially done and so are earnings. Once the Cisco earnings hit the cash market tomorrow there is little to look forward to but the end of summer. Fund managers will be bailing in droves with the vacation calendar running quickly out of days. Just because they are gone does not mean they are out of the loop. There is a market saying in New York, "If a trader sneezes it is heard in the Hamptons." Still, August and September are known for rocky markets and without any material events to provide positive momentum the odds are good for weakness in our future.

The Dow has risen over the last four weeks to prior resistance at 11250. It has languished there since July-28th with every spike higher quickly sold. The drop today halted well above initial support at 11100 leaving it poised to spring higher if traders feel inclined to celebrate the Fed decision. I would view that 11100 range as a critical indicator of market sentiment. If it breaks it would mean investors are bailing from the relative safety of blue chip industrials on worries of slower growth.

The Nasdaq was weaker than the Dow today with a solid top at 2080 and solid support at 2055. The Cisco news has added about +8 points to the Nasdaq futures as of 8:PM but that is not enough excitement to push the Nasdaq back over 2080 by itself. However, we know that it should provide a spark at the open. Just how much of a spark is unknown and how much it will energize tech buyers this late in the summer. The SOX has been no help but the Semiconductor Holders (SMH) did see a sharp pop in after hours on the Cisco news. Resistance on the SOX is still 415 with a 405 close.

The S&P-500 continues to honor the resistance at 1280 and closed nearly -10 points below that level at 1271 today. The Cisco news gave the S&P futures a +2 point push but in the greater scheme of things that is a minimal move. 1280 remains resistance and our indicator of choice. I would remain short under 1280 and very cautiously long over 1280. The couple of spikes over 1280 have been very short lived and represented opportunities to get short at a higher level rather than back up the truck with longs. Continue to remain cautious on long positions.

SPX Chart - Daily

It is entirely possible we will see some post Fed rally attempt but I believe it will fail. The Fed decision was already priced in and worries about slower growth will now take center stage over a traditionally weak period in the markets. This should be a time when investors celebrate the end to Fed hikes but the lack of a hike by the Fed today could be telegraphing a weaker economy than most investors are expecting. It is the catch 22 I spoke about last week. A failure to hike, even though expected, will now be questioned in light of what we know about current conditions. I know, it is a never-ending story. With the Fed over I am still expecting a directional market to appear but it may not be a bullish direction. Our bottom line as traders is not to get married to our bias. Let the market filter all the headlines and then follow its lead. Remain short under SPX 1280 and cautiously long over that level.

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