The economic reports last week were right in the groove with the economy moving down the yellow brick road but not fast enough to get a speeding ticket from the Fed. The Goldilocks economy grew jobs right on track, saw manufacturing expand for the 40th consecutive month and consumer sentiment is beginning to rebound in time for the coming holiday. The heat wave is over, Ernesto brought only needed rain and not hurricane winds, kids are back in school to the relief of parents and for traders we are finally out of the dog days of August. Life is good, or is it?
Dow Chart - 30 min
Nasdaq Chart - Daily
The major report out Friday was the employment report for August with the headline number coming in at +128,000 and almost exactly where analysts had predicted at +125,000. The lower than expected numbers in June and July were revised up slightly by +18,000 jobs. Not too hot and not too cold with jobs growth just right. The unemployment rate fell back to 4.7% on a strong jump of +250,000 jobs in the household survey. Average hourly earnings rose only +0.1% and well below the torrid rate of +0.5% in July and +0.4% in June. Wage inflation appears to be slowing as predicted by the Fed. Manufacturing lost -11,000 jobs, trade/transport -15,000, retail -14,000 but construction gained +17,000, finance +10,000. The tame jobs report almost guarantees the Fed will remain on the sidelines on Sept 20th.
The ISM Manufacturing Index came in at 54.5 with only a -0.2 drop from the July reading and almost exactly where analysts had expected. This shows the manufacturing sector is still expanding for the 40th consecutive month but not fast enough to attract additional heat from the Fed. The prices paid component fell -5.5 points to 73.0 while employment rose +3.3 points to 54.0. New orders eased only slightly to 54.2. The index is right in the slow growth sweet spot needed to keep the Fed on the sidelines.
ISM Index Table
Construction Spending fell -1.2% as the drop in homebuilding led the index lower. The prior two months were also revised lower. The homebuilding component fell -2.0% and the biggest drop in five years. Rising interest rates were seen as having a moderate impact but it was condos and homes that really knocked the support from the sector. The chart below shows the sudden drop over the last month. It would have been a lot worse had it not been for a boom in office construction.
Chart of Construction Spending Changes
The final reading of Consumer Sentiment for August came in at 82.0 and up strongly from the 78.7 in the initial reading. During the survey period for the first reading the foiled bomb plot was the big news. During the survey period for the last half of the month there was a truce declared in the Middle East and gasoline prices were plunging. One contrary indicator was the National Association of Realtors pending home sales number released on Friday. The index fell -7.0% for July following a sharp downward revision in June. The July drop was the largest drop on record since the index was created. This pushed the index to -11% for the year and -16% over the same period in 2005. This change in sentiment should reverse soon with falling interest rates a major driver to home sales. The expectations of a permanent pause by the Fed and the potential for cuts in 2007 has sent bond buyers into a frenzy. The yield on the ten-year note fell to 4.72% on Friday with the 30-year at 4.87%. These are multi-month lows and suggest home mortgage rates will be following very quickly. This will bring those looking to refinance back into the market. A quick check of mortgage rates showed several lenders in the 5.85% range for a $250k 30-year mortgage. This is not a bad rate and an easy out for those with option ARM loans about to reset. This looks to me like the housing sector may be close to a bottom but we need to see a couple more months of data before that assumption can be proved.
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After the bell on Friday the Semiconductor Industry Association released the semiconductor billings, which rose by +1.8% in July to $20.1 billion. This is calculated on a three-month moving average basis. This should give techs a boost at the open on Monday. Sales have risen over $2.1 billion over the same period in 2005. Sales growth in the Americas has risen +17.7% and +13.4% in the Asia Pacific region. Capital spending has risen in 2006 to 22% of chip sales. The summer months are typically a weak period for semiconductors and this strength is especially gratifying given the state of the economy. As we head into Q4 sales should continue to rise as cell phones and consumer electronics benefit from the back to school ramp and the coming holiday sales period. Computer sales amount to 40% of chip sales and the growth in laptop acceptance due to lowered prices is producing another chip boom. The average price of PCs has fallen -7% so far this year. Sales of chips by price is expected to be under pressure as the year progresses and Intel continues to dump excess inventory. Unit sales will grow but price pressures will make sales comparisons difficult. Intel is expected to announce job cuts of as many as 20,000 workers next week as it continues its reorganization plans. The first 10,000 are scheduled to be announced after the close on Tuesday according to industry sources. Intel is trying to cut $1 billion in expenses by the end of 2006.
The economic calendar for next week is lackluster compared to the flurry of major reports we saw over the last three days. The major events for next week would be Productivity and Beige Book on Wednesday. The calendar is not expected to be a detriment to the markets but there are no material reports expected to help it either.
Oil prices continued their fall on Friday after comments from UN members made it evident that any material sanctions against Iran would be months away. Russia, China and now France are talking down immediate sanctions in favor of further talks over the next month. Gasoline demand for last week was 200,000 bbls over the same week in 2005 and stretching the consecutive weeks of higher demand to eight. This should be the last week of strong demand with 35 million people taking to the highways for the holiday.
Ernesto has withered into a rainstorm and there are no other storms in sight in the Atlantic. With gasoline demand about to drop off a cliff and supplies of crude surging two months before winter heating oil demand begins it is a bearish setup for energy prices. The price of crude closed at $69.25 and below support at $70 and below the 200-day average at $69.75. The next material support point is $65 and baring a sudden Iran event or a new hurricane in the Gulf we should test that level soon. The breakdown in oil is relieving the pressure on the transportation index and support at 4200 appears to be holding.
Gasoline Demand Chart
October Crude Chart
Falling gasoline prices won't help falling consumer interest in gas-guzzler autos. The major manufacturers released sales numbers for August on Friday and it was not pretty. GM managed to post flat sales for the month but Ford sales dropped -14.8% and Chrysler fell -6.8%. Toyota posted a gain of +12.6% led by their hybrid models. GM also announced they would be cutting production -12% in Q4 in an effort to reduce inventory levels. Ford said truck sales fell -23.6% in August.
TrimTabs reported total equity outflows in July of -$4.3 billion from mutual funds. Outflows from May-July totaled -$19.5 billion and the highest three-month period since 2002. Ironically the markets ended the quarter only slightly below their 4-year highs in the case of the Dow and S&P. This was due to the strong corporate buyback activity of nearly $3 billion per day and on institutional and insider buying. New offerings over the last month averaged only $605 million per day with many cancelled due to market volatility. You have to go back to 1998 to find a lower period where new offerings averaged $433 million per day.
The Dow turned in its best month since 2003 and the Nasdaq had its best August since 2000 with a +4.5% gain. The S&P closed Friday at 1310 only 16 points away from new four-year highs. The Dow closed at 11464 only -206 points from its four high. Despite the strong August performance for the Nasdaq its 2192 close is still well below the 2375 high made last April.
Considering August and September are historically the two worst months of the year is this rally too good to be true? Are we going to continue higher from here? I would never be the one to say never but the odds of us getting into the October earnings cycle without a serious correction are not very good. BUT, it is just those low odds that may give us a decent chance of moving higher.
After the markets failed to breakout all week I was beginning to have my doubts but I knew traders were waiting for the Jobs report as confirmation the Fed would stay on hold. It was a holiday week, the last week of summer and volume was very low. I said last Sunday everyone just wanted to get into September without any material event. Vacations are over and the economics are excellent. The soft landing appears to be on track and investors should be losing their fear of the Fed and of a recession. There is actually little investors have to fear now but fear itself. I know that is corny but it is true. Even without any material minefield ahead the memories of prior fall corrections looms large in our collective consciousness. I listened and read numerous commentaries last week where fund managers and professional traders were talking about increasing short positions on any post Jobs rally. The Sept/Oct dips are too cyclical to be shrugged off simply because traders feel good about the economic future.
It may come to pass as many fear but just maybe this fear is what could keep us moving higher. I saw evidence of several sell programs on Friday afternoon and I chalked it up as hedge funds trying to get short ahead of September, historically the worst month of the year. If we have enough bears shorting the tops it could provide us with new rounds of short covering if the herd wakes up and wants to stampede into Q4. The hedge funds have tried to push the indexes back for two straight weeks without any conviction or success. If the cash on the sidelines, I heard it was as much as 20% in some funds, 5-7% in others, suddenly decides there is not going to be a September dip we could be off to the races. Should the S&P actually break that four year high at 1325 it would trigger a flood of buying and short covering.
That is a big "IF" and next week will be crucial for market direction. If we continue to see the inch worm creep higher above the 1310 close it will attract more and more attention and begin making those funds still sitting on cash very nervous. They can't afford to miss any Q4 rally or risk losing investors and bonuses. Normal September corrections are caused by earnings warnings coming out of the summer slump. We really have not see any indications that will occur this year from any sector other than autos and homebuilders. We already know those sectors are bad and that is already discounted into the market. Falling energy prices will ease pressures on profits at manufacturers and retailers are already seeing a surge in new buying. Wal-Mart said they saw a +2.7% jump in sales in August, Target saw a +2.8% gain and Federated got a +3.8% boost. Falling gasoline prices will continue to boost consumer spirits. We saw from the jump in semi billings that tech stocks should continue to see profit gains. Cisco has already risen +29% off the August lows while HPQ gained +14%. Those are some strong numbers and should produce a strong case for profit taking soon. That is exactly what the September bears are counting on. However, it is not just tech stocks moving higher. We are seeing industrials, cyclicals, commodities and finance stocks moving higher. Proctor & Gamble (PG) gained +10% to a new high along with Dow components MO and PFE. Rate hikes appear to be over and the smell of a soft landing is floating down Wall Street. Going long after the Fed ends a rate hike cycle is never a bad idea and could easily trump the historical September weakness. However, the highest risk timeframe for traders is the next three weeks as we approach the Sept-20th FOMC meeting. Since almost everyone expects the Fed to pass at that meeting and a growing number of analysts think the Fed will confirm that pass with a stronger pause statement that would be the starters gun for a Q4 rally. This means any funds, which have not already jettisoned unwanted positions will need to do so quickly and position themselves for that possibility. It also makes any economic reports between now and the 20th very crucial to confirming that soft landing scenario. If any of them suddenly begin to show a strong growth spurt or a renewed spike in inflation all bets would be off and we could head south at a high rate of speed.
S&P-500 Chart - Daily
Russell/SPX Comparison Chart - Daily
Since we don't know what the future holds we need to base our decisions on what the market tells us. The S&P closed at 1310 after two weeks of chipping away at resistance at 1300 and then 1305. It has been very slow progress but market internals have been improving almost daily. New 52-week highs for the last three days have been at levels not seen since the May 9th highs. That alone should make any bear drool with anticipation. While I would have liked to see more conviction as we chipped away at the S&P resistance it did occur over the dog days of August on very low volume. We should be grateful for our many blessings instead of looking our gift horse in the mouth. For next week I would remain long and buy any dip above 1290 but never doubt the damage, which could occur if that level is broken. Another indicator to watch would be 700 on the Russell-2000. The Russell has not participated in the rally and continued to trend sideways with a slight uptick only visible over the last few days. This means funds are not committing enough new money to small caps and until they do any future rally will either be excruciatingly slow or doomed to failure. A move over 740 could confirm a strong rally in progress and a dip back to 690-700 would be a buying opportunity. I would still use the S&P as the primary indicator but keep the Russell in view as confirmation. Despite all the warm and fuzzy feelings about the economy and where the markets "should" go do not forget that the market exists solely to prove the most people wrong at any given time. Follow what the market gives us not what we expect to happen. Remain long, buy any dip to 1290 and go short or flat below that level.
S&P-500 Chart - September 2000 Retest of Market Highs
I started this commentary with a Goldilocks analogy. You might remember in the
end of that fairy tale the three bears scared Goldilocks off and she ran into
the forest and ran and ran until she could run no more always fearing the three
bears were still chasing
her. While everyone points to the center of the tale
for various analogies the ending is not so pleasant. If you look back at the S&P
in September 2000 you will find an almost exact duplicate of today's conditions.
The yield curve was inverted by 0.59% and bond yields were falling while
analysts were praising the return of the S&P to its highs at 1525 as evidence
the market was shaking off the slowing economy and was going to rally to new
highs. Fed funds rates had just topped
at 6.5% and the Fed had just shifted into
pause mode. We all know what happened. A recession did follow within two
quarters and the three bears chased the Goldilocks market all the way back to
950 on the S&P by Sept-2002. The Fed started cutting rates by 50 points per
meeting beginning on Jan-3rd 2001 and continued cutting until June-2003 where
rates hit 1.0%. The only thing really different this time is the imploding
housing market. That did not exist to this extreme in 2000.
In 2000 it was the
Internet bubble bursting and today it is the housing bubble. Which do you think
impacts the American consumer more? This should be another reason to wonder, "Is
this time really different?" This is why we always need to trade what the market
gives us, not what we expect to happen. Remain long, cautiously buy any dip to
1290 but go short or flat below that level.