The post Fed decline continued on Friday with all the indexes ending lower for the week. This was a week where most traders expected the market to rally once the Fed rested from its 17 meeting rate hike streak. If you have been reading this commentary for long you know this was not what I expected. I warned everyone that any post hike rally would likely fail and so far the markets have followed our expectations.
Dow Chart - Daily
Nasdaq Chart - Daily
SPX Chart - Daily
The economic report causing waves on Friday was the Retail Sales for July, which came in at +1.4% growth. This was well over last months drop of -0.4% and nearly double the expectations at +0.8%. The challenge here is news of strong consumer buying when everyone expected consumers to be retreating into their shell under the pressure of high energy prices and falling home values. The market reacted in shock to the headline number as fears rose the Fed would have to jump back into the game with another hike at the September meeting. Fed funds futures jumped more than 10 points to a 46% chance of a rate hike over the next two meetings.
If you listened to the talking heads on Friday and the various discussions about the Fed then you will be surprised when you read the next paragraph. I don't believe the +1.4% growth in the Retail Sales headline number is relative for the Fed. There were two components that produced 50% of the jump in sales. Those components were autos, +0.4% of the total and gasoline sales at +0.3%. Without those components the headline number would have been right in line with estimates at +0.7%. Automakers pulled out all the stops in July to dump inventory ahead of the new model year. The return of monster incentives drew some extra buyers off the sidelines and into the showrooms. It was simply a one time event and not relative to the overall consumer profile. With the rise in gasoline prices over $3 it was not surprising that gasoline sales spiked so severely as vacations hit high gear. Gas stations reported a +2.5% jump in sales due mostly to the rising price of gas. This is also not discretionary spending with more than 95% of gasoline purchases simply normal daily travels. It should not be seen as a sign of increased consumer spending due to an abundance of free cash. I doubt anyone rushed to the gas station last week just to buy the latest version of reformulated gasoline. Have you heard anybody brag last week that they bought premium instead of regular so the guys at work would be jealous? I doubt it.
The components that did produce cause for concern were a +1.8% jump in sales at building material dealers and +1.9% jump in electronics sales. This is the season for home building projects and with fewer people trading homes this summer it is not surprising to me that they are improving their current homes. The electronic sales are rising on the sharp drop in flat screen TV prices. I get email spam almost daily from places like Circuit City, Microcenter, NewEgg.com, Buy.com, etc advertising new lower prices on flat screens. With dozens of models at 42" or smaller under $1000 it is not surprising purchase activity is increasing. I am sure many families opted for a new TV rather than an expensive driving vacation in the heat.
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There were some challenges in the retail sales report. Year over year sales growth slowed to +4.8% but that was mostly due to slowing auto sales in prior months. If you take out autos that number jumps to +9.2% growth over the last twelve months. That number was available to the Fed before it's meeting so despite being strong the Fed was not worried. The Fed is convinced the economy is going to slow as a direct result of the high energy prices and the slowing housing market. The current economic cycle has run its normal course according to the Fed. They feel the lagging impact of their recent rate hikes will provide a soft landing to the unsustainable gains we made over the last two years. The Retail Sales report does not bother me and I doubt it bothered the Fed. The talking heads on stock TV were just looking for an excuse for the selling.
Personally I think the foiled terror plot this week will add to retail sales in the future. Americans have already slowed their overseas travel and this should make even more rethink that desire to travel into places where terrorists are active. Officials tell us air travel is safe but I am skeptical. For at least the next decade I believe airplanes will continue to be the target of choice for terrorists. This foiled plot will cause many people to vacation at home in the US rather than expend the money and risk to travel abroad. We saw it after 9/11 and I expect to see it again. Much of the money, which would have been spent overseas, will be spent at home. Just replacing the millions of trashed bottles of shampoo, toothpaste, hair spray, makeup, sunscreen, moisturizer, etc, should produce a bump for consumable sales. The US warned on Friday that US citizens in India were at risk next week due to information about a plot to attack the country's financial and entertainment hub around independence day on August 15th. Americans traveling to India were advised to avoid New Delhi and Bombay. With the five-year anniversary of 9/11 only a month away it is likely we will see an escalation of attacks. A top leader in Al Qaeda has said they were planning a major attack by the anniversary. Officials are hoping the foiled airline plot was that attack and there are no others in the works.
Next week we will get some reports that will impact the Fed in September. Those reports are the PPI, CPI, Industrial Production and the two housing reports. They will be looking for the current reading on inflation (PPI/CPI) and the strength of the manufacturing sector in the Industrial Production report. The housing reports will update us on the state of the housing sector decline.
Weekly Economic Calendar
Although the earnings cycle is about over there are still some major companies left to report. Next week we will see Computer Associates (CA), Agilent (A), Applied Materials (AMAT), Home Depot (HD), Wal-Mart (WMT), Hewlett Packard (HPQ) and Dell (DELL). Dell has already warned and the focus will be on how much market share HPQ has stolen from Dell. On Friday Analog Devices (ADI) missed estimates by a penny and guided lower for next quarter. The stock was knocked for a -$5 loss or -16%. Kohls rode the retail wave with better than expected earnings and raised their guidance. KSS gained +2.57 on the news. Kohls departed from the pack with some recent retail reporters down between -2% to -4%. Those losing ground since July included Target, Federated and JC Pennys.
The stock option problem took a turn for the worse on Friday after Apple Computer warned that restatements of financials would now contain "significant changes" in last quarters results and they cannot provide a reasonable estimate at this time. The investigation into options grants is continuing and could be lengthy. Apple also reported it had received a delisting notice from Nasdaq due to its failure to file its 10-Q. Juniper also acknowledged it had received a delisting notice. Nvidia posted better than expected earnings but then lost ground after telling investors it found option grant problems dating all the way back to its IPO in 1999. According to one analyst over 120 companies have now delayed financials due to the options problem and over 80 companies are under review by the SEC. Based on the charges filed against the Brocade ex-CEO the bar appears very low and we could see hundreds more face charges. The University of Michigan did a survey and found more than 2000 companies that had suspicious options activity. 24% of those companies reported options grants well after they happened raising the flag even further. Other names in the news this week on options were VTSS, RMBS, OPWV, ZRAN, VRSN, MFE, KLAC, INTU and CMVT. The poster child for options problems is still United Health (UNH), which is reviewing 45,000 grants to 15,000 people over the last seven years. This could continue to depress the markets as more charges are filed.
BP announced on Friday that they were going to try and keep the west side of the field open and continue producing 185,000 bpd through an alternate pipeline. They received approval from regulators on Thursday but were still running tests on Friday. There were conflicting reports late Friday that they had made the decision but I could not find any hard documentation. BP said the repairs would cost $170 million and could take six months. After the bell Exxon declared force majeure on deliveries from the Prudhoe field. Conoco, 36.1% owner of the field, had already declared force majeure earlier in the week. By declaring they are relieved of the responsibility to deliver the oil to current contract holders. This means those expecting delivery will have to replace the oil on the open market. BP has already contracted for delivery of 4.5 million barrels from the Middle East for delivery to refineries on the west coast. It will take 30 days for the replacement oil to begin to arrive. BP is losing $3.5 million per day from the halt in production. Exxon and Conoco will also take a hit but it will be smaller. BP is the operator of the field for the partners and is fully responsible. Unfortunately Exxon and Conoco will have to pay a portion of the repair cost despite the corrosion being the fault of BP. I am sure there will be some heated discussion in boardrooms about this. The state of Alaska is losing over $6 million per day in tax revenue and they claim they will sue BP for any losses. I saw an interesting statistic in one of the BP interviews. They feel the majority of the corrosion came from excess water in the pipe allowing microbes to survive. It is supposed to be removed before entering the pipeline. During the interview the BP spokesman said the mixture pumped from the Prudhoe field was 75% water and only 25% oil. This is a sure sign that the field is nearing the end of its life. A water cut that large becomes a very tough problem and separating it requires a lot of extra effort. This excessive water cut is probably why extra water made it into the pipe.
Unless we see a sudden flurry of hurricanes I think the peak for oil is behind us for 2006. We could see another attempt to rally next week on the Exxon force majeure but inventories are at high levels and the peak demand from driving season is nearly over. Late Friday there was news of a resolution at the UN to end the war and the vote was unanimous. Israel and Lebanon are both expected to accept the cease-fire. If the war is going to be over it will remove worries of eventual involvement by Syria or Iran. That should weaken oil prices despite the Alaskan problem. Some of the Nigeria oil is also coming back online and that will offset some of the Alaskan loss.
September Crude Oil Chart - Daily
Oil prices dropped -$2 on Thursday and the drop was blamed on the terrorist plot. This is ridiculous. The theory was an expected decrease in the number of fliers and therefore less demand for jet fuel. Since most flights are full there is a very slim chance that enough people would cancel trips to cause entire flight cancellations. The planes may fly with a few empty seats for a while but scheduled flights will continue and fuel demand will remain the same. What really tanked oil prices was the reallocation of gasoline positions by Goldman Sachs in the GSCI index. They announced they were changing the weighting allocations for gasoline in the September and October GSCI futures contracts and the herd stampeded to the exits. Note the weighting changes for the HU contract highlighted in blue in the table below. The drop in oil prices had NOTHING to do with terrorists and was simply a figment of imagination by the talking heads on TV who had no clue about the change in futures.
Unleaded Gasoline Chart - 60 min
The futures price for unleaded had been hovering in the $2.25 range for four weeks in anticipation of a hurricane that never appeared. With the summer driving season rapidly coming to a close it was the right time to exit and I believe the Friday's close at $2.07 could be just a pause point. We could see a further decline by as much as -25 cents if no hurricane appears. The price of gasoline exerts significant pressure on the price of oil when gas is declining. Oil prices pull gasoline prices higher when oil prices are climbing. The dump in gasoline contracts on the Goldman Sachs news simply kicked the props from under the price of oil. Despite all the news and paranoia the gasoline inventories are +300,000 bbls above the five-year average for this time of year. We saw a sharp decline last Wednesday of -3.2mb but we were already over supplied. Gasoline demand continued to rise with demand of 9.697 million barrels for the week ended on Aug-4th. That was +2.2% higher than the same week in 2005 and the strongest demand week for the year. $3 gasoline is definitely not slowing demand regardless of what the news sources are telling you. That demand should come to a screeching halt over the next four weeks as summer vacations come to a close.
GGas Demand Chart
The Cisco rally was short lived and the Nasdaq succeeded in hitting a new three-week low of 2048 once the Cisco bounce was over. This does not mean the market is heading south at a high rate of speed. The post Fed decline has returned to support levels that need to hold if the bulls have any hope of preventing the seasonal decline. Earnings next week from Dell are not expected to be pretty and it will be up to HPQ to save the day for techs. However, the focus will not be on earnings but the inflation data in the PPI/CPI and the housing surveys.
The PPI on Tuesday is expected to rise by +0.6%, which would be the largest gain since April. The CPI on Wednesday is expected to rise +0.4% and inline with prior levels for the last four months. The core rates will be the key. The Fed has pinned its hopes on a slowing economy putting the brakes on inflation. Three days after the Fed meeting very few, if any, analysts actually expect their hopes to come true. Martin Feldstein commented in the WSJ "although this optimistic outlook is possible, experience suggests it is unlikely." Feldstein is an economics professor at Harvard and the ex-chairman of the Council of Economic Advisers under Reagan. His thoughts count in the economic community. According to Feldstein, "A mild slowing of economic growth is generally not sufficient to reverse rising inflation." Mickey Levy, a member of the SOMC or Shadow Economic Market Committee, agreed with Feldstein saying, "Inflation is above the acceptable range and there is strong risk it will rise further. More importantly we would disagree that a moderation in growth will lower inflation." In the last 30 years there has been six lengthy Fed rate hike cycles. A recession appeared after four of those cycles with a soft landing in only two. The Fed does not have a good record of avoiding going too far regardless of who is at the helm. If the PPI and CPI continue to show rising inflation next week the analysts are sure to start preaching rate hike again and this time they will be using the R word as the eventual result. Most feel the economy at present is still growing rapidly and not declining as the Fed claims. That 9.2% retail sales rate I mentioned above is the fastest pace of growth in 15 years. The preliminary GDP for Q2 came in at 2.5% and based on the recent economic reports it appears we could see a revision to over 3.1% when it is revised on August 30th. That is far from a slow economy although well off the 5.6% rate in Q1. A 3% GDP will NOT slow inflation and that suggests the Fed erred when it took a pass last week. With the Fed funds futures currently at 46% chance of another hike in September any strong inflation data in the PPI/CPI or strong growth indications in the Philly Fed survey or Industrial Production and the market will be back on Fed watch once again.
I would say the odds of that happening are about 100% in some form or another. The recent reports have not shown a sharp downward move on the economy and some have been stronger than expected. If this trend continues it is almost a sure bet the Fed will have to come back harder and faster to put the inflation monster back in the cage. That could easily mean another full point or more. This is why analysts are divided on the market outcome. Strong growth, decent profits, +16% in Q2 and no sign of gasoline prices slowing consumer spending means the bulls are predicting a monster year end rally. I heard one major analyst on Friday predicting a +20% move in the indexes. The bears are pointing out the chances for a more aggressive Fed in September and the potential for a Fed induced recession in 2007. From the looks of the internals below traders are not buying the bullish case. New highs are well below new lows and Friday's decline was a downward acceleration from the Tuesday high.
The bullish case is strong and even Charles Biederman from TrimTabs.com was beaming with excitement on Friday. He said there was over $6.3 trillion in cash in money markets, cds, and brokerage accounts. Over $700 billion was added in the last 12 months alone. He feels with corporate buybacks and mergers and acquisitions at record levels along with huge hoards of corporate cash and rising dividends investors should be backing up the truck. Biederman said once the tide reversed on the cash flowing into money markets the equity markets would explode higher. That was a key word there, reversed. What we are seeing is more cash going into money markets now than into equities because 4% on cash is a decent return ahead of a potential recession. The bears claim investors are going into bunker mode despite the Fed pause. I heard the catch phrase more than once this week. Since the Fed paused despite rising inflation "what do they know that we don't know?" I told you it would happen and it only took three days for that question to begin making the rounds. Don't forget that 23 of the 28 central banks around the globe are still tightening. The global boom will eventually slow in the face of that concerted effort.
For next week I believe we are data dependent to steal a phrase from the Fed. Any material signs of inflation and we will be setting new lows. Any signs of slowing inflation and the bulls will be back. Dow 11050 appeared as support once 11100 broke. I told everyone on Tuesday to watch for Dow 11100 to break as a sign investors were concerned about slowing growth. We saw an immediate breakdown in CAT -$6.50 from Tuesday's high, UTX -$3, BA -$5 as examples. This could have been simply a sell the news event from the widely anticipated Fed decision but there are signs it is not over. I would say the market has an overwhelming downside bias today. This is good because a sudden burst of good economic news could produce a monster short squeeze. If that news does not appear then I believe the markets are setup for a swoon into September and the seasonal autumn dip. I do believe that a retest of the lows in September would be about all the bulls could stand before mortgaging their homes and families to buy the many bargains.
I would watch Dow 11050, Nasdaq 2050 and SPX 1265 as current support and
continue to remain short on any further drops. Remember to watch the inflation
data on Tue/Wed as
the next clue to market direction. I would not jump into a
lot of long positions until we either retest the lows or move back over SPX
1280. This is period of historical seasonal weakness and there is no reason to
fight the trend.