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Market Wrap

Creeping Slowly Higher

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The indexes crept slowly higher for the week but progress appeared to be hampered by quicksand like moves. Volume increased as the week drew to a close but internals were almost dead even with advancers beating decliners by only a slim margin. Inflation reports continued to be tame ahead of next week's FOMC meeting and energy prices hit new lows prompting gains in retail stocks.

Economic Calendar for Next Week

Chart of Core CPI

Friday started off with the Consumer Price Index, which came in almost exactly where analysts had predicted at +0.2% for the headline number and +0.2% for the core rate. This was very positive and nearly guarantees the Fed will remain on hold at next week's meeting. The small increase in the core rate was still enough to push the trailing 12 months inflation rate to 2.8% and well over the Fed's target rate. However, this was the second month with a +0.2% increase after four months at +0.3%. The trend is moving in a Fed friendly direction just as the Fed had hoped. The main drivers for the reduction of inflation factors were falling energy prices and the weakening housing market. This trend should continue and based on the current inflation picture the Fed should be done. The Fed funds futures are showing only a 12% chance of another hike this year and longer dated futures in April 2007 and beyond are beginning to show a slight chance of rate cuts.

The NY Empire State Manufacturing Survey released on Friday showed a slight rebound to 13.8 in September up from 11.0 in August. The trend is still down but any slight uptick is a positive event. Employment jumped from 6.4 to 12.5 and back orders rebounded into positive territory at 2.3 compared to last months dip to a negative -6.6. Prices paid dropped -3.3 points and hours worked spiked sharply to 22.6 from 14.4. This report shows a decent rebound in the internals and possibly the start of a turnaround in the NY area.

Industrial Production fell -0.1% in August instead of an expected gain of +0.1%. This compares to a +0.4% gain in the prior month. This is further evidence of a slight weakening of the economy as the Fed currently expects. The majority of components showed declines with capacity utilization slipping slightly to 82.4%. This is just another report that should make the Fed comfortable to wait on the sidelines.

September Consumer Sentiment rose to 84.4% from 82.0 in August. The gain came from the expectations component, which jumped from 68.0 to 77.1. The present conditions component still showed a decline to 95.7 from 103.8. Falling gasoline prices and the perception that the Fed was done helped to provide support. Slower job growth was the drag on the current conditions component. If the Fed does remain on hold next week and give us a positive statement we could see long-term interest rates decline slightly and quite possibly the housing market could find a bottom.


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Next week's economic calendar has the PPI and Residential Construction on Tuesday followed by the FOMC meeting on Wednesday. If the PPI is lower as expected and residential construction is still declining the Fed could give us a stronger pause statement and that would setup a strong positive climate for the markets through year-end.

The Fed has also been presented with an inflation gift in the form of a -$15 drop in oil prices since the $78.80 high on the day of their last meeting, August 8th. This drop has cut gasoline prices by -50 cents with more to come. Natural gas has fallen from $8.68 on August 2nd to $4.96 at Friday's close. This -43% drop in gas prices is reducing heating and cooling costs and utility bills for everyone in the country where natural gas is the fuel for electricity generation. This drop in energy prices is a major benefit for the Fed and should give them even more peace of mind about halting rate hikes permanently for this cycle.

The decline in energy prices may be about over as it pertains to oil. Natural gas still has a rocky road ahead. Oil prices declined to $62.00 on Friday where it was met with a strong surge in buying. I personally believe the rebound was driven by end of contract short covering and option expiration pressures. I still expect further declines to something in the $58-$60 range but that is where I expect OPEC to provide price supports in the form of production slowdowns. They have become very accustomed to the flood of dollars into their coffers from high priced oil and a -21% drop is painful. Saudi has already slowed production and others may follow. This could be a good time for OPEC producers to take problem production areas offline for a mechanical refurb. They have to do this periodically and I would bet it was not happening at $75 oil prices. By taking a maintenance cycle now it would let global supplies equalize and take the surplus out of the system before the winter demand for heating oil begins. It would also provide a floor for prices and allow a new cycle to begin. OPEC producers could do this without any official directive and that would also be positive for prices.

Natural gas has more pain ahead without any hurricanes in the Gulf. Inventory levels this week saw an injection into storage of 108 Billion CF pushing gas in storage to 3.1 Trillion CF and the highest inventory level for this week in over 15 years. This is just one strong week away from hitting maximum storage levels of 3.2-3.5 TCF. When those storage locations hit their maximums they will close the pipelines and pressure will backup in the lines preventing suppliers from accepting gas from the fields. As pressure begins to build in all the pipelines the number of fields going into idle mode will increase. There will be strong gas on gas price competition for available storage space. Those with space can take the lowest bid on gas for sale thereby filling their tanks with the cheapest gas available. This gas on gas competition should send prices significantly lower for several more weeks. Once cold weather begins and inventory levels begin to drop prices will surge once again. That could be the middle to the end of October. Remember, we do not have sufficient production capacity to supply all the gas needed during the winter months. Only by filling the storage tanks prior to winter can suppliers keep the gas flowing when the weather turns cold. Once heating requirements begin to reduce storage levels it will be back to business as usual for the producers. Based on current supplies and historical winter demand it suggests a price ceiling this winter of around $8 mbtu but that is nearly double today's price. As a point of reference December gas futures are still in the $8 range. There are no hurricanes on the horizon headed for the Gulf. There has been a string of them form in the Atlantic recently led by Florence, Gordon and now tropical storm Helene. All have taken a hard right turn northward after formation and all will disappear when they hit colder water in the northern Atlantic.

Oil and natural gas do trade in tandem on a relative BTU basis but gas has broken that linkage over the last couple weeks. On a relative basis the drop in gas prices should have been equivalent to a -$25 drop in oil prices to something in the $52 range. The linkage was broken because of the remaining geopolitical concerns over oil. Gas has no geopolitical concerns holding it up. The majority of our gas is produced in the US or Canada while our oil imports come from around the globe. With Iran, Iraq, Lebanon, Syria, Nigeria, Venezuela, Ecuador and Bolivia still smoldering the future supply of oil is not guaranteed. OPEC surprised everyone on Friday by lowering their 2007 demand outlook for OPEC crude to 28.1 mbpd. This was -800,000 bpd less than the 2006 demand at 28.9 mbpd. OPEC said supply growth outside OPEC could rise by as much as +1.7 mbpd in 2007 but numerous analysts disputed that figure. New production dates and targets are very prone to being missed. Either way overall demand growth is still expected to grow by 1.2 mbpd in 2006 and another 1.2-1.5 mbpd in 2007. 92% of demand growth comes from developing countries. China's oil demand is expected to grow by +8.3% by year-end. In August OPEC produced 29.8 mbpd and non-OPEC production was 51.1 mbpd representing an increase of 1.1 mbpd over August 2005.

Fidel Castro and Cuba may end up a member of OPEC if Hugo Chavez has his way. Cuba currently imports 85,000 bpd of oil from Venezuela at a discounted rate but that may be about to change. Cuba has been very active in signing deals with the major exploration companies to drill in about 5000 square miles off the Cuban coast. Petrobras, Repsol, India's ONGC, Norsk Hydro and Canada's Sherrit Intl have signed exploration deals. Rumors are strong that China has also inked a deal but there is no confirmation. There are supposedly some major fields about to be explored and it would not take but a couple decent finds to turn Cuba into an exporter rather than an importer. Chavez would like nothing better than to see Fidel accepted into OPEC and become a major oil producer only 90 miles off our coast. It would be a nightmare for the US government, which has been hoping Castro would finally expire and Cuba opened up as a friendly country to the US. If Cuba suddenly finds its coffers bulging with oil wealth that plan could evaporate.

Individual stocks making the news on Friday included Adobe, which soared +3.35 after reporting earnings that beat the street by +3 cents. This was surprising since expectations were already lowered and earnings were below the same quarter last year. Guidance about the coming releases of Acrobat and Creative Suite 3 helped provide the boost to sentiment.

Hewlett Packard made the news again after several employees were asked to testify in the ongoing investigation. It is a sure bet now that charges will be filed in some form against the outside firm that handled the spying and possibly on some insiders as well.

Ford fell -1.07 after saying it was slashing its workforce by a third in an effort to cut costs by $5 billion. They plan to offer buyouts to as many as 14,000 workers of as much as $140,000. Wall Street thought the plan fell short of what was needed to rescue Ford from the current slump.

Dynegy (DYN) agreed to buy 11 generating plants from LS Power for $2.3 billion. DYN will increase its capacity from 12,800 megawats to over 20,000 and go from 20 plants in 9 states to 31 plants in 15 states. DYN is assuming $1.8 billion in debt with the rest a combination of cash and stock.

Daimler Chrysler (DCX) fell -3.54 after warning that profits would be about -$1.3 billion less than previously expected. The carmaker blamed operations in the US for a loss of about $1.2 billion due to excess inventories, high fuel prices and non-competitive costs for employees and retirees. DCX said health care would run about $2.3 billion for the full year. They said customer demand in Q3 shifted to smaller vehicles while inventory was overstocked with larger vehicles. Excess production capacity was also a problem since costs are incurred even when vehicles are not being produced. DCX is halting production on the Jeep Commander and Grand Cherokee for a month starting next week.

Freescale Semi (FSL) announced after the close that they were being bought for $17.6 billion by a private equity consortium led by the Blackstone Group. This is believed to be the largest leveraged buyout ever in the technology sector. FSL was spun off from Motorola in 2004. Freescale makes chips for handsets and for automotive and industrial equipment. The buyout is for $40 a share in cash. Freescale announced on Monday that it was in talks. Dow Jones said Blackstone was competing with Kohlberg Kravis Roberts, Bain Capital, Silver Lake Partners and Apax Partners. This was quite a distinguished list of suitors. Freescale must have found a way to turn silicon into gold to attract this much attention. KKR recently acquired 80% of Phillips Semiconductor and could have merged the companies had it been successful. It was theorized that Freescale will eventually be broken apart after the acquisition with the wireless division being floated as an IPO once again.

Gold fell to $576 on Friday morning to end eight days of declines from $648.60 in early September. Reasons have been flying fast and furious without any gaining credibility. I heard on Friday that one large holder was liquidating 100 tons but that cannot be confirmed. It is also a factor of falling crude prices and a relaxation of geopolitical concerns. Iran is trying to get off the front page and the Israel/Lebanon conflict is easing on schedule. Several large dealers noted that on the last drop back in July the gold funds and ETFs also saw liquidations. This time around those same funds and ETFs are seeing an influx of cash as investors add to positions. They feel it is not a retail flight from gold but something related to a major holder exiting their position. That selling triggers sell stops held by others and down we go. Gold is thought to have strong support at $560 but few expect it to test that level. But, gold bugs are historically bullish until broke so retail sentiment is not a valid indicator.

Friday was a quadruple witching expiration along with a rebalance of the S&P-400, 500 and 600. Considering the potential volatility and the extra 1.5 billion in volume over Thursday's level it was a very tame day. The spike at the open on the low CPI gave everyone interested a chance to get out at four month highs. Many did take that exit and the indexes declined to their lows around 1:PM. It was an orderly exit and once over the indexes regained some lost ground but mostly traded sideways into the close. The Dow and the S&P indexes did see a closing dip on the rebalance but all finished the day with gains.

The battlefield is set for next week. The indexes are holding near their highs and Tuesday's PPI will be the final act before the Fed takes the stage on Wednesday. Nobody expects the Fed to do anything but pass and release a statement claiming the economy is on track and inflation is easing. That is the major problem ahead. Everybody already expects this to happen and the 9/11 relief rally this week moved the indexes one notch higher to wait for the Fed's blessing. In theory the blessing should release the markets to rally into the Q3 earnings cycle. In reality the markets have already rallied to the point where gains are stretched pretty thin.

The recent moves higher have been labored and not without a struggle. That is fine as long as we continue higher since the bears are paving the path ahead with one failed short after another. The problem I am seeing is a lack of conviction on the part of the bulls. Now that summer is over, inflation is easing and the economy is slowing into a very soft landing they should be backing up the truck to load up on stocks. It is not happening and that bothers me. The broader indexes of the Russell and NYSE Composite have stalled while the Nasdaq is spiking steadily higher. Tech stocks are in favor and nearly everything else is being kicked to the curb. Chip stocks are the leading techs and the Freescale announcement after the bell on Friday should energize them even more on Monday. Unfortunately you can't build a credible market rally on one sector.

The Dow and S&P are nearing breakouts of prior five-year highs. Another way of saying that would be, the Dow and S&P are perilously close to testing double top resistance. In the monthly Dow chart below you can see why the all time resistance high of 11750 could easily be strong resistance especially in a Sep/Oct calendar period. The daily chart emphasizes that 11650-11750 range as resistance with a double top test of the May high at 11670. The bulls will see both of these tests as potential breakout attempts leading to a sprint much higher as Q4 arrives. The bears will see these levels as critical tests of bullish conviction and that conviction has been sorely lacking as of late.

Dow Chart - Monthly

Dow Chart - Daily

The corresponding monthly chart of the S&P shows strong resistance at 1325 and again at 1380. Currently it is the 1325 resistance we are concerned with. Again, the daily chart shows how critical 1325 may be for the bulls. The key here is the May/June sell off. That was a sharp drop and totally out of character for May. The three-month duration could have eliminated the possibility of a normal September dip but that has yet to be proven. Until the bulls find some conviction the bears will continue to chip away at the gains.

S&P-500 Chart - Monthly

S&P-500 Chart - Daily

The Nasdaq has been on a roll and powered by the chip stocks. The dead stop at 2235 on Friday is exactly resistance from the first quarter lows. The Nasdaq needs to hold this level, which was achieved on a gap open from the CPI on Friday. Should it slip back below 2225 it would face a tougher test the next time around.

Nasdaq Chart - 90 min

Nasdaq Chart - Daily

The Russell is not showing as much upward momentum as the Nasdaq and faces its own resistance challenge at 730. Both indexes have broken the 200-day average and that is definitely positive. The Russell took a sharper drop in the May sell off and has yet to return to its bullish ways. The congestion range from 670-730 has been a magnet that small caps have been unable to escape. Small caps are the heart of the market. Without a bullish Russell any tech rally is doomed to failure. The Russell is the incubator for the stock market and graduates hundreds of issues to the larger indexes each year. Unless the small caps are finding support from mutual funds the market will remain directionless. Recently we have seen the indexes like the Dow and S&P-100 move higher on the strength of the large caps as a defensive measure by funds afraid to invest capital in the smaller more volatile issues. Eventually that will fail as well since the smaller number of large caps eventually become overbought and managers begin to avoid them as well. Pay close attention to the Russell as the health of the market.

Russell-2000 Chart - Daily

NYSE Composite Chart - Daily

Dow Transports Chart - Daily

Two other indexes, which show the health of the market, are the NYSE Composite and the Dow Transports. The NYSE Composite is made up of all the stocks on the NYSE and indicate the underlying strength of the market simply by providing a diverse cross section of market capitalization and sectors. The NYSE Composite rallied to resistance at 8460 on September 5th but has shown relative weakness ever since. The Dow Transports should be soaring with $63 oil but instead they are limping. They saw a strong post 9/11 relief rally when there were no planes falling out of the sky due to an anniversary attack. Once that rally ended on Wednesday consolidation settled in just below the 200-day average. Were it not for Tue/Wed and the relief rally the index would be resting on 4200 and threatening a sharper breakdown. I am sure 9/11 caused the initial decline the prior two weeks but there is still no bullishness now that 9/11 has passed. The weakness is based on the potential for slowing shipments if the economy is really slowing. So far the shippers have not given any indication that business is slowing and several have actually mentioned strong bookings. Still, the transports are lagging the broader market and remain a cautionary indicator for the post Fed market.

The bottom line for me is simply the calendar, the Fed, rising complacency, lack of bullish conviction and impending resistance. I don't want to turn outright bearish at these levels but I am sure not bullish. The VXO (old VIX) closed at 11.01 on Friday. This is almost exactly the same level as the close on May 8th. It has been there several times in late August but the return on Friday could be ominous. It is strange to have this much complacency but so little conviction. I believe it is because we are approaching strong resistance highs at a time we should be worrying about normal September lows. This is unnerving for those with many years of experience in the markets.

I probably need to remind everyone that the markets tried to retest their highs in early September last year only to implode on September-20th for a -78 point S&P drop to the October lows. There is precedent for a late August, early September rally that eventually ends badly. In 2004 the September decline started on the 22nd for a -30 point SPX drop, which was bought in volume but was then followed by a -52 point drop in October. The 2004 drop came after an August rally from a correction that started in late June. This was very similar to our current August rebound. In 2003 the drop began on Sept-19th for a -40 point drop. In 2002 the September high was on the 11th and was followed by a -156 point drop into the October lows. Skipping 2001, the September high in 2000 came on the 1st and there was no relief until the -225 point low in October. In 1999 the indexes were pretty choppy but the September high was on the 8th with the October low -128 points lower on the 18th. 1998, -143 points from September high on 9/23 to Oct low. 1997 saw September close at its highs but the October decline, which began on the 7th knocked off -128 points in only 14 days. 1996 was the closest year on record devoid of a material Sept/Oct decline. One year out of ten with no decline? What does that tell you about our chances in 2006? Averaging the start dates over the last nine years gives us September-17th as the date most likely to see a decline start. Today is September 17th. Is it a coincidence that the markets almost reached their highs on Friday? I also pondered the impact of Fed meetings on the September decline and produced the following table. The last three years the decline began within three days of the meeting. Before that the results were inconclusive other than it did not make any difference if the Fed was hiking, cutting or taking a pass. The decline still appeared.

Fed Meeting Table Last Nine Years

For next week I would be very cautious of a post Fed sell the news event. I am writing on Wednesday night next week instead of Tuesday so I will get to recap the Fed meeting and the market reaction immediately after it happens. If the Fed gives us a market friendly statement anything is possible. However, given the consistency in the table above I would be far more inclined to have a bearish bias for the next week or so than bullish. They say statistics were invented to keep the bean counters busy and give historians something to write about. That is fine if you are talking about batting averages or yards gained rushing. When it pertains to money invested for retirement it might make sense to pay attention just in case lightning does strike 10 times in a row. I would continue to buy dips to 1290 and remain long over 1300.

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