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Market Wrap

All Quiet Ahead of 9/11

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A week of low volume trading saw the markets quietly decline back to initial support but buyers appeared to nibble and support held. Volume all week was slow with volume on Friday the lowest of the week. There was no rush back into the market in the post Labor Day week as traders either took a few quiet days off with kids back in school, waited patiently for the economic report cycle to kick off again next week or remained on the sidelines until after 9/11. There was no hurry to buy but dips were bought on low volume. Overall it was simply a quiet post holiday week and quite possibly the calm before the storm.

Economic Calendar

The major news on Friday was a rehash of continuing events. Lennar (LEN) joined the long list of homebuilders in warning that Q3 earnings would be substantially less than expected. Lennar said earnings would now be in the range of $1.25-$1.35 compared to the $1.81 analysts had expected. This followed warnings over the prior weeks from KBH, BZH, TOL and HOV. Reports of large land sales by the tract builders seem to be pointing to a longer period of weakness than previously expected. With shrinking land holdings it suggests builders are planning to build fewer homes for the next several years. Land is a premium commodity and giving up prime acreage is a true tell about the health of the sector. Based on the minimal -50 cents Lennar lost on Friday it appears the market has fully priced in the bad news. Stocks have declined from -40% to more than -50% in some issues. Many appear to be putting in a bottom but several analysts caution that it may be too soon to buy on faith. If a recession does appear there could be another leg down before the sector recovers.

Another rehashed event was the drop in oil prices. October crude continued its plunge to an intraday low of $66, a close at $66.28 and a loss of -1.02 for the day. The contract high had been $80 back in July with a high of $78.80 after the contract became the front month. Using either number the -$13 drop has been dramatic. It was still not as dramatic as the drop in gasoline futures from the $2.34 high in early August to the $1.60 close on Friday. That -30% drop, or -74 cents, has already equated to a -35 cent drop in prices at the pump. Based on the drop in futures this week there are more pump reductions to come.

The drop in oil prices helped to offset the continued negative news from the housing sector and the markets shook off the early weakness and recovered some ground as the week closed. The challenge facing the markets next week is two fold. The first one is the inflation problem with the CPI giving us the next look on Friday, PPI the following Tuesday with the FOMC on Wednesday the 20th. There appears to be disagreement among the Fed members about the future of inflation and the rate hike outlook. The next eight days will be full of analysis, arguments and indecision until that meeting on the 20th. The Fed is expected to pass again and possibly issue a stronger pause statement and that would be positive for the markets. Unfortunately this outcome is already priced into the market. The "R" word is getting more airtime as each day passes and that is weighing on the market ahead of the FOMC meeting. More on those recession worries in a minute.

The second thing weighing on the market this week was the coming 5-year anniversary of 9/11. The tension is rising without anyone actually talking about an anniversary event. There are hopes that the foiled terror plot for bombing airplanes headed for the US was that anniversary event and it was defeated. Despite that hope there is still an underlying fear that something will happen. Al Qaeda released several tapes lately with one showing the planning for the 9/11 attack timed appropriately to coincide with the anniversary. The other was last week's call for America to convert to Islam. While that was largely ignored it does bother me. Osama was widely criticized about 9/11 because he did not give those people in the towers the chance to convert. I am cloudy on the details but apparently in Islam if you are planning to attack/kill someone you are supposed to give them the chance to convert first. I view that conversion tape last week as a warning that something is coming. According to various reports Osama has authorized attacks for up to 10 million causalities but no more. That may just be propaganda but those comments have been making the rounds over the last couple months. I know the US is supposed to be much safer today than before 9/11 but the five-year anniversary on Monday has put an unspoken cloud over the market.

The potential for a recession appears to be growing according to various analysts. The continued implosion in the housing sector is the major culprit. Inflation appears to be slowing but the continued warnings in the housing sector are taking the focus off inflation and onto recession worry. According to most analysts we are looking at a little more than a 25% chance today. The Wall Street Journal quoted a 25% chance on Friday. Others are claiming 40% based on the inverted yield curve and the housing implosion. Liz Ann Sonders, Chief Financial Strategist at Schwab, is calling it 50:50 as of Friday. When you consider 100% of analysts did not anticipate the 2001 recession it makes you wonder about our future today.


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According to Sonders the market has already priced in the rosy scenario of a soft landing. The Fed pass, the very slight easing of inflation indicators inline with the Fed's expectations and the falling energy prices over the last month have all been priced into the market. For those who discount the potential for a recession they point to profits at +16% in Q2, a 100-year high in profit margins, abundant corporate cash, record corporate repurchases of stock and heavy M&A activity, rising income levels at +7.9% over the last 12 months, steady job market and those falling energy prices. That would be a very convincing argument were it not for the housing implosion. Housing and the jobs related to it account for 25% of the GDP. With sales in free fall, land being dumped, massive layoffs in the sector and loan requirements stiffening there seems to be no end in sight. According to HSBC current repossession rates are at a level that has preceded past recessions. According to the N.A.R. more than twice as many borrowers stretched to buy more than they could afford than in prior boom periods. Sub prime lenders are starting to join the builders in reporting losses from rising delinquencies now at 2.9%. The combination of resetting ARMS and falling housing prices could knock another -10% off housing prices by early 2007 according to some analysts. Nouriel Roubini, Professor of Economics at New York University, is very bearish on the economy saying we are not in a housing slump but a housing bust. He expects housing prices to fall into negative territory in 2007 for the first time since the great depression and even at $65 oil is a massive drain on the economy. He feels the three bears will kill the Goldilocks economy in 2007 as $2 trillion in ARMS reset at significantly higher prices. For a good explanation of the ARM problem go here: http://tinyurl.com/jkyb8 Roubini believes that imploding housing, falling commodity prices, falling interest rates, falling durable good orders, rising debt loads, negative savings rates and slowing consumer spending will produce a recession in early 2007. In a Wall Street Journal survey this week James Smith Professor of Finance at the University North Carolina had the highest estimate of GDP for Q4-2006 at +4.1% but despite his rosy outlook he still expects a negative -1.4% GDP in Q2-2007.

All of these points simply prove that putting any two economists in a room will spark hours of mind numbing debate. Getting any two economists to agree on anything would be harder than finding Osama even with a $25 million bounty on his head. What this rising debate does do is put a cautionary cloud over the markets. Add in the 9/11 worry and it is not surprising the markets lost ground in this shortened holiday week. Once past Monday the 9/11 cloud will evaporate and all eyes will begin to focus back on inflation ahead of the reports and that is a battle we should be winning.

Stock news on Friday was slim. Hewlett Packard made the news with the insider spy scandal. Apparently Chairman Patricia Dunn hired outside investigators to find a leak on the board. Those investigators illegally obtained the phone records for board members in an attempt to find out whom they were talking to. They also obtained records on nine journalists using the same pretexts and the scandal is still mushrooming as more details come to light. Dunn is not going to resign unless the board requests it and some members are on her side. The FCC asked AT&T on Friday for info into the release of information to the investigators.

McDonalds (MCD) hit a new six-year high at $37.50 after it started a stock swap offer for shares of spinoff Chipolte Mexican Grill (CMG). Holders of McDonalds stock can swap their shares for shares of Chipolte at about a 10% discount off the price of Chipolte stock. MCD owns 88% of the class B shares of CMG or 16.5 million shares.

AirTran Airways (AAI) warned on Friday that rising East Coast and Midwest capacity was putting the brakes on revenue growth in those regions. This could be the first sign that the growth surge in the industry has reached its peak. Most carriers have been adding routes and planes and running at nearly 100% capacity as airline travel resumed its steady climb after 9/11 fears abated. AirTran said it was going to curtail its capacity growth and cut the number of Boeing jets it was going to take in 2007-2008 to something less than the 19 it has on order. The company said cancellations and decreased bookings after the terror plot was announced was easing but the new security guidelines were making passengers more nervous. The CFO said the bigger problem remained the capacity increases underway at all the major airlines. Sounds like tickets are about to get cheap once again.

Broadcom fell again after announcing that it had found more irregularities in dating of stock options. Analysts are now claiming the coming restatements of earnings due to options grants could grow to a $100 billion problem at more than 120 companies now under investigation.

Cleveland Federal Reserve President Sandra Pianalto said the full impact of the Fed's two years of rate hikes had not been fully felt in the economy. She said now was a good time to pause and wait for more data before making further rate decisions. With the Fed meeting only eight trading days away further Fedspeak will quickly dry up as they enter the quiet period surrounding the meetings.

October Crude Futures Chart - Daily

Continuous Crude Contract Chart - Weekly

Weekly Gasoline Demand Comparison

Oil prices are not expected to rebound without a storm in the Gulf. Florence appears to be taking dead aim at Bermuda and then head back out to sea. It was never a factor for the oil fields and there is currently nothing else on the horizon for the Caribbean. OPEC meets on Monday and Iran and Venezuela will be calling for cuts in production to support the price at the $65 level. OPEC production has already declined -2.7% since December due to equipment problems, slowing production capability and violence. Nigeria is holding meetings this weekend in an effort to avoid another strike. Saudi has also reduced production to take stress off aging fields. The faster you produce a field the more damage you cause to long-term capacity. Since the world did not need their extra capacity for heavy crude this summer it voluntarily cut back to avoid the damage. Since almost all the OPEC members other than Saudi are already pumping at full capacity it is doubtful if there will be enough support to enforce a production cut at this meeting. $65 is support and would be a good place to make a stand but it may not happen due to the political incorrectness. $60 would be more likely for a public stand but I would bet my money on a silent slowdown. OPEC may not announce a production cut but silently slow production just enough to keep prices from falling much further. It is not what you say but more importantly what you do. OPEC accounts for 78% of global reserves, 51% of oil exports and 40% of global production.

Gasoline demand for the last week of summer soared to 9.622 million bbls, which was 600,000 bbls more than the same week in 2005. This was the last gasp for gasoline demand and we should see a significant drop off next week. That drop, although anticipated, should continue to push prices lower. The comparison was also skewed by the impact of Katrina in 2005, which cut demand considerably along the coast.

Dow Chart - 120 min

For the week the Dow ended in the middle of its range with 11400 emerging as light resistance. The Dow was influenced by gains in MCD, WMT and IBM on Friday. Wal-Mart said it saw a +2.6% jump in sales prompted by back to school buying and falling gasoline prices. IBM gained on the news it was shipping chips to Nintendo for use in the new Wii game console. Nintendo has said it could ship about six million units to be on dealer shelves by the holidays. IBM was also selected to build the new "Roadrunner" supercomputer for the DOE National Nuclear Security Administration. This will be the fastest computer in the world and capable of performing 1.6 trillion calculations per second using AMD and Cell Broadband Engine (Cell BE) chips. Cell BE chips were designed originally for video game platforms. This conjures up images of the "W.O.P.R" computer portrayed in the 1983 "War Games" movie with Matthew Broderick. The computer will occupy 12,000 sq feet of floor space at Los Alamos when completed.

The Nasdaq found support at 2150 and attempted a half hearted bounce on Friday but failed to return to Thursday's high of 2172. Techs have taken over for oil stocks with even bad techs gaining ground. This could be a symptom of future problems when even mediocre stocks find buyers in expectations of a future rally. However big caps are still king with the Russell-2000 tumbling back to 705 on Thursday and closing only slightly higher at 708 on Friday. The gains from the small cap buy program back on the 29th has been erased and we are right back in the same congestion range that has held the Russell since late May. This shows fund managers are still not buying the hope of no September decline. In their minds that decision has not been made yet.

Nasdaq Chart - Daily

Dow Transports Chart - Daily

The Dow Transports are the object of my worry today. With oil imploding and gasoline/diesel prices off substantially from their highs and promising to fall further the transports should be celebrating. Instead they are very close to testing their six-month lows at 4150 once again. Some of Friday's weakness was due to the AirTran warnings but the index has been falling all week dropping more than -120 points from its intra week highs. The decline in transports is likely due to the falling outlook for the economy and the likelihood of a recession. This should be a strong period for them with gas prices falling and their strongest quarter for shipments just ahead. The weakness in transports is a strong indicator of underlying market weakness.

The SPX finally lost traction at 1314 and the drop back to support at 1295 was swift. Using my recommendation to buy any dip to 1290 you would have had a great entry at 1292 on Thursday. At Friday's close we are right back at that 1300 resistance level that has plagued us since August 17th. The rise over 1300 was good for a few points but like the Russell we are right back in the congestion range we have seen for the last month. The close at 1300 shows the bears are content to rest on the round number ahead of 9/11 while the bulls were content to just buy the dip over 1290 and not press their luck. For next week we want to continue to use 1290 as our decision point. If that level breaks it could open up a sharp decline into a typical September correction. Remain long over 1290 and short or flat below that level.

SPX Chart - 60 min

I left you last Sunday with a different view of the Goldilocks analogy so frequently used by analysts today. That view still exists. In the Nouriel Roubini comments above he fully expects the three bears to kill the Goldilocks economy and I have to admit there are some strong points to both sides of the argument. I am not going to rehash all the points here but you can read the last paragraph again here: http://tinyurl.com/pqvw9

We need to prepare for a market move in either direction and not get married to our bias. Whether you are a bull or a bear at present you will not make any money unless you are following the market trend. Determine that trend by what the market tells us not by the constant torrent of market analysis on TV and in the papers. Remain long over 1290 and short or flat below that level and you can't go wrong.

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