The September non-farm payroll report shocked everyone not just the bulls. The economy created only 51,000 jobs in September but the revisions for August and for the rest of the year caused the bulls to cough up some of their hard fought gains in a reflex reaction. It was still a bullish week and the outlook has not yet dimmed.
Dow Chart - Daily
Chart - Daily
The Jobs report was the major news on Friday with the +51,000 gain and the slowest job growth in 12 months. However, when coupled with the +60,000 revision for August it continued to produce an average of +120,000 jobs in a slowing economy. The August revision was a shock but not nearly as shocking as the +810,000 revision for the 12 months ended in March 2006. Each year the BLS revises the prior years numbers based on actual data compiled from the unemployment records filed by the states. The average revision is in the 0.1% to 0.2% range and this year's revision was +0.6% and the largest revision in a decade. The BLS said they were researching the very unusual change to determine why it was so large. According to analysts that revision means the economy is now slowing from a faster pace or higher level than previously thought. You may think that it is not relative since the data is 12-18 months old but it means the momentum was stronger and that underlying strength both in the economy and in inflation could quickly reappear.
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The equity market did a double take and the Dow promptly plunged -50 points on the news. The bond market recoiled in shock with the yield on the ten-year note spiking from a post announcement dip to 4.574% to an intraday high of 4.702%. In bond terms this is gigantic and roughly equivalent to a +200 point Dow day in equities. Bonds had been pricing in the next Fed move as a rate cut before March with a slim chance of December increasing with the January meeting to nearly 85% my March. Now those chances have fallen to less than 50% and worries are rising that the Fed may not be done. If the economy is stronger than analysts had previously expected it could rebound sharply now that energy prices have fallen significantly and the summer doldrums are past. We have already seen a sharp uptick in retail sales and that wave is getting stronger as gasoline prices head closer to $2. After hawkish comments from multiple Fed heads last week the jobs report put the Fed right back in the picture with a meeting only two weeks away. In reality the Jobs report was simply an excuse for the market to rest after a week of breaking records.
Ten-Year Note Yield Chart
The calendar last week was busy with several critical reports including the ISM and the Jobs report. Next week's calendar is also busy but without any really critical reports. Vying for attention will be the FOMC minutes on Wednesday and the Fed's Beige Book on Thursday. The bond market will be closed on Monday for Columbus Day but equities will still trade. The key for next week will be the beginning of Q3 earnings with Alcoa the leadoff batter for the Dow on Tuesday. Other earnings of note are DNA, INFY, LPL and SVU on Tuesday, LRCX, MON, YUM on Wednesday, GENZ, PEP, PII and COST on Thursday. This is just the beginning of the earnings wave, which begins in earnest the following week. Traders will only get a preview this week as the early reporters set the stage for what is shaping up to be a strong earnings cycle. Currently the estimates for Q3 earnings growth for the S&P-500 are +14% and only slightly less than the +15% estimate only a month ago. The Q4 earnings estimates are for +12.3% growth and only slightly less than the +13% estimate a month ago. These are remarkable given the removal of the energy sector from the leadership position of +30% to +50% growth over the prior quarters. Other sectors have jumped into the lead with financials and materials now expected to produce better than +30% earnings growth. The warnings for this cycle started off worse than normal but failed to maintain the pace. Overall the cycle is looking pretty good and that has helped push the indexes to their new highs. If the S&P can produce a minimum of +10% earnings growth in Q3 it will tie at 13 quarters the longest string of consecutive quarters of double-digit growth we saw between 1992-1995.
There are still some negative earnings surprises hitting the tape with Micron (MU) on Friday. Micron missed the street estimate of 14 cents with earnings of +8 cents after charges. Investors raced to dump the stock despite positive comments from numerous analysts. MU lost -14% or -$2.40 and closed at the low of the day. Micron said they only invested $1.8 million in capex in 2006 but planned to bump that to $4 billion in 2007. I know that difference sounds amazing but I looked it up in three different places. Micron is partnering with Intel to develop NAND memory and move out of DRAM chips. Analysts said DRAM memory should remain strong through 2007 due mostly to the memory requirements of the new Microsoft Vista operating system. Reports claim that it is a huge memory hog both in PC memory and video card memory. Pretty soon a 4GB PC will be standard and that is great for companies like Micron. S&P analysts Thomas Smith said, "PC memory needs are going to rise up to +500% to run Vista." I bought about 40GB of memory over the last six months and the going rate for DDR2-666hmz SDRAM is about $100 per GB. I view that as amazingly cheap already but with demand spiking it is only going to get cheaper. Bear Stearns felt this decline in DRAM prices made SanDisk a better investment than Micron for Q4 and they expect SNDK could have additional upside despite its weeklong rebound. The SOX was hit hard on Tuesday on the Marvel warning and had almost shaken off the losses but Micron stole the show again. The SOX is struggling to hold over initial support at 445 after three weeks of progressively lower highs.
SOX Chart - 90 min
There were lots of new highs on individual stocks led by Berkshire Hathaway (BRK.a) hitting $100,000 a share on Thursday. The internals on Wed/Thr were very strong with 563 stocks hitting new highs on Thursday alone. As you can see in the table below the enthusiasm appears to have peaked on Wednesday with better than 4:1 up volume over down. There were more new highs on Thursday but that was mostly due to a spike in the Russell. Yes, the Russell-2000 finally found a bid and it appears fund managers are finally putting some cash in the small caps. This is a bullish event since it means they are more confident in the rally having legs and less fearful the economy is going to implode. Compare the bottom table of the Russell-2000 internals to the ratios in the top table representing all the combined markets. You can easily see the strength building in the broader Russell and that represents a shift in fund manager bias. The Russell rally deteriorated slightly on Friday, as decliners were far worse than the health portrayed by the -3 point finish.
Market Internals - All Markets
Market Internals - Russell 2000
Google is reportedly in talks to buy YouTube.com for something in the range of $1.6 billion. YouTube currently boasts three times the number of video viewers than Google currently has on Google Video. YouTube users watch more than 100 million videos daily. That number simply boggles my mind when you think of all the time involved not to mention the Internet bandwidth consumed. To gain that kind of viewership I would think $1.6 billion would be cheap for Google and they could recover their investment very quickly through their advertising engine. However, YouTube is currently under the gun for copyright infringement from users posting copyrighted materials online for viewing. YouTube will remove them immediately if the copyright holder complains but they simply cannot police the volume of videos posted each month. Google is a much larger entity with deep pockets and could make a deal with copyright holders rather than fight. Google is also under the gun for its book-scanning project. Google issued subpoenas last week to the other major Internet search engines requesting information on number of books scanned, deals with authors and future plans for scanning. Google is trying to produce the largest online library of content on the planet and 8,000 writers through the Authors Guild and the Association of American Publishers is suing to stop them.
GM took a turn for the worse on Friday as Kirk Kerkorian associate Jerome York resigned from the board citing "grave reservations" about GM's ability to compete and recover from its current problems. KK also said he was abandoning plans to raise his stake in GM from 9.9% to 12% as he had recently indicated. GM shares fell -2.08 on the news. GM has been the best Dow performer recently rising from $19 in April to $34 earlier this week. Friday's close was $31. An analyst at Bank America warned that York's departure could lead to other board departures as remaining members might want to distance themselves from any potential fight with Kerkorian and the impact on GM. GM recently decided not to pursue an alliance with Renault and Nissan as suggested by Kerkorian. GM was readying for a fight earlier this week when they changed the bylaws making it more difficult for aggressive shareholders to try and force changes in the company.
The jump in interest rates on Friday did not produce a material decline in homebuilders because a former Fed head came to their rescue. Alan Greenspan spoke at a conference in Calgary on Friday and said the worst may be over for the U.S. housing industry. Citing the worst downturn in a decade Greenspan said weekly mortgage applications were flattening out after a very dramatic slump. Bernanke said the slump would probably knock off only a point of GDP this year with less impact in 2007. Vice Chairman Donald Kohn said on Wednesday he did not know how long the slump would last but doubted it would push the economy into a recession. Mortgage applications spiked +12% last week with the most apps since June as low rates prompted a +17.5% jump in refinancing as consumers bailed out of ARM loans.
It was a tough week for the energy sector despite a growing call for production cuts from OPEC. Oil tried to rebound from $60 last week to peak at $64 before inventory and weather data combined to send it plummeting again this week to a low of $57.70. That level was quickly bought but the rally ran out of steam as OPEC members voiced their disagreements on a proposed production cut. Oil closed on Friday at $59.76. OPEC has been arguing all week about making public cuts now or waiting until the December meeting. Several members have already promised voluntary cuts and several more are said to be quietly slowing production. Saudi has raised the asking price of its oil as a way to limit supplies. On Friday the Nigerian Oil Minister and OPEC President Edmund Daukoru said he was optimistic that a consensus could be formed before Monday but that no formal action had been taken. OPEC is rumored to be planning price supports at OPEC $55 which is the basket price for the 12 grades of crude they supply. The WTI or light sweet crude that is considered the benchmark of oil pricing normally trades about $5 over the OPEC basket, which would put support around $60 and it closed at $59.76 on Friday. The Financial Times had already reported that OPEC had informally agreed to a one million bbl cut on Thursday but that agreement was never officially announced. Saudi was reportedly unhappy with the unofficial cuts and wanted an official policy to be announced. Saudi had already decreased its output by -200,000 to - 1mbpd over the last month depending on whom you believe. By raising their asking price to European consumers of their heavy oil they were implementing their own brand of supply disruption. It appears the delay in OPEC announcing a cut could stem from how they allocate that cut to all members. Several are already unable to produce their full quota while others are overproducing. Deciding how to divide the quotas is the type of decision it may take a Solomon to make. Reportedly President Bush and Energy Secretary Sam Bodman do not want OPEC to cut production until prices are much lower. Bloomberg reported this week that a survey of 29 analysts predicted an average cost of crude to be $64 for 2007. That is +$2 higher than the prior estimate despite the current drop in prices. Barclay's Capital is predicting $74.60 and the highest forecast in the survey. They said, "the current decline is due to short term factors but global growth should remain strong and capacity is not expanding by much.
Natural gas rallied nearly $1 for the week to $6.42 and a +19% bounce off its lows for the week. This came despite another +73 Bcf injection into storage. That brings the gas in storage to 3,327 Bcf and matched the high set in Nov-2004, which was also a 13-year high. There was only four weeks left in the injection cycle before draws begin to appear with winter weather around November 1st. The gains in gas this week were said to be technical buying by the talking heads on CNBC. However, there were two specific reasons for the bounce. The first came from the news that the scheduled autumn refueling of several nuclear plants would be longer and larger than usual and the highest level in the last six years. Refueling normally occurs in October when the weather is mild and peaks around mid month. This year the refueling is expected to take an additional 7,000 megawatts above the five-year average offline for 2-3 weeks. That could add an additional 1BCF per day to gas consumption as long as the weather stays mild but an early cold front could spike gas demand significantly. The second reason gas spiked was an announcement by Questar that they had shut in some production from the Rocky mountain region. As of October 1st they were shutting down 70 million CF per day. We saw Chesapeake announce a shut in of production for 100 million CF per day in the prior week. Questar is a major processor, transporter and distributor of gas with storage in multiple locations. I warned everyone over the last several months this would happen as storage locations reached maximum capacity and we are right at that national capacity limit this week. By shutting in production this reduces some competition for storage and the associated drop in prices. If gas companies can hold out for three more weeks until winter begins this oversupply crisis will evaporate. Ironically, despite the production shutdown Questar raised its 2006 production guidance for the entire year to +10% to +12% over 2005. Questar also announced it had added about 40BCF of hedges through 2009 at an average price of just under $8 per Mcf and 2008 oil production at $64.30. Gas futures are trading just under $10 for Jan-2008. Gas traded at less than 40% of the price of crude on a BTU basis last week and that is only the second time since 1993 that has happened. The last was July-7th, 1995.
The website Energikrise.blogspot.com recently posted a chart of global energy production by OPEC for the last five years and despite a slight uptick in the last several months global production is still below the levels seen in 2005. The spike in prices did produce a slight rise in production and decrease in demand but analysts claim that may not be sustainable. The second chart is the global production from all sources showing the same production plateau. All data is from official IEA production reports. As long as the world economy continues to grow the -8% depletion rate on existing fields will always be a serious drag on sustaining any future production increases.
OPEC Production chart from 2001
Global Oil Production 2001-2006
Despite the drop in oil prices the Transportation index plunged -60 points on Friday after UPS announced it was making some unspecified job cuts in its logistics and freight forwarding unit. UPS said there were 2000 employees in that unit and they were going to restructure it to eliminate redundancies. This should not have been a major announcement but the transports had been on a roll over the last several days tacking on more than +200 points. It was just an excuse for profit taking on a Friday before a long weekend.
Dow Transport Chart - Daily
For next week we have a unique setup with numerous factors suggesting this rally could continue. The Dow has extended its gains from the July lows to nearly +1200 points. That three-month rebound is over extended and overbought by nearly any metric you care to use. However, it is showing no signs of fading despite the stall at 11860 since Wednesday afternoon. There are simply no sellers and every dip is bought instantly. The consolidation we saw on Thr/Fri was minimal and therapeutic. The only challenge for the Dow is approaching resistance at 11900 and the approaching earnings cycle. The Dow has climbed every wall of worry since the rebound began and it appears to be getting stronger the more extended the rally becomes. The strong potential of a positive outcome for earnings has already been priced into the tape. You have heard the term before, "priced to perfection," but this is a prime example. The lack of any material earnings warnings and the total disregard for what bad earnings we have seen seem to suggest the Dow is bullet proof. That is a term that should never be applied to the market. Whenever the outlook is too good to be true it normally is. However, the jobs report even with its shocks was still market positive when viewed long term. It suggests the economy is not collapsing and the soft landing is proceeding according to schedule. The challenge remains inflation, also not a problem according to recent reports. The Fed will not be a problem as long as inflation continues to moderate. Energy is not a problem at these levels and is actually disinflationary at these prices. Earnings don't appear to be a problem either with +14% earnings growth in an economic slowdown very market positive. Various officials are calling an end to the housing slump and there were no hurricanes to disrupt business as usual on the coasts. There is simply no bad news in the U.S. and that is scary.
However, there is a rising threat overseas. North Korea has said they could test a nuclear bomb as early as this weekend. The UN warned NK on Friday of severe unspecified consequences it if carries out its test. The UN has options under Chapter 7 of the UN Charter, which allows the UN to take immediate action to deal with threats to world peace. We obviously know who would spearhead any reprisal action the UN decided to inflict. US officials said Friday that a test would immediately evoke full-scale sanctions with the only debate being what "full-scale" means. The US is prepared to blockade shipping in and out of NK with searches of any vessels allowed through. The UN passed a resolution after the missile tests in July to allow inspection and interdiction of shipping to prevent export/import of missile technology and weapons of mass destruction. There are fears that NK would sell its nukes on the black market to terrorists for use elsewhere, preferably in the US. If a bomb goes off in NK this weekend all bets are off for market stability in the world markets.
Secondly, the Iran problem is heating up again with the six world powers negotiating with Iran agreeing on Friday to pursue sanctions against Iran for failing to halt nuclear activities. The top diplomats issued a statement saying they were "deeply disappointed" by Tehran's refusal to suspend enrichment. US Undersecretary of State Nicholas Burns said, "The decision has been made to go for sanctions because we need to raise the stakes for Iran in this confrontation. The UN will discuss sanctions under Chapter 7 next week to include non-military actions such has severing diplomatic relations, economic relations, transportation and communications with Iran. The committee also did not rule out additional measures but said it would be counter productive to discuss those measures in public. Secretary of State Rice said the committee had decided it was time to take the next step because the credibility of the Security Council was at stake. Iranian President Mahmoud Ahmadinejad was defiant on Thursday that his country would never be intimidated into giving up its nuclear program. Under Iran's system of clerical rule, Supreme Leader Ayatollah Ali Khamenei has the last word and he said last weekend Iran would never give up its nuclear right. It appears fairly certain that this event will come to a head and it is moving at a snails pace but picking up speed.
With the major problems for the market being too much good news inside the US and some fairly harsh problems developing overseas the bad news bulls may be running on a short leash. It seems almost inconceivable to the bulls that any October surprise will occur and that is the most dangerous period. Most analysts feel that the +1167 points of Dow gains were borrowed from Q4 and that while the markets may move higher from here the rate of climb may slow. The head bull Abby Joseph Cohen raised her targets for the S&P last week to 1450 over the next 12 months. With Friday's close at 1350 that does not leave us a lot of room to run and she is normally overly optimistic.
The S&P has resistance at 1365, which corresponds to roughly 12000 on the Dow. That may be the unofficial target that will cause bulls to start taking profits assuming some overseas event does not sink us first. Until then the focus will be on tech stocks and the Russell as funds broaden their horizons and retail investors jump in to surf the wave. The Nasdaq had a good week after playing the anchor for the prior month. That along with the Russell was the proof that the rally was growing legs. Hopefully not so many legs that it trips and falls. If the SPX does break 1365 the new target becomes 1425.
SPX Chart - Daily
In a nutshell I would continue to remain long over SPX 1340 but be very
observant if signs of aging begin to appear. The Dow and S&P are very extended
it may not take much of an excuse to produce some profit taking. A Dow
reversal under 11650 would suggest a bull trap springing shut. The fourth
quarter after mid October is normally a bullish period and even if the rate of
climb slows it does not mean the rally will stop. I believe any sudden decline
not prompted by an overseas event will be bought as many investors come back to
the market they have avoided for years. Nothing promotes retail investing like
new highs and after a week
of successes they should be flocking to their PC next
week. If the fist few earnings reports are positive it could turn into a rout
for the bears. There are still plenty of bears around but they are being
trampled on a daily basis as they continue to jump in front of the bulls at
every resistance point. There is nothing like continued short covering to
produce a strong bull market. Managers previously waiting for an October
surprise to the downside are being forced to chase stocks
after the surprise
breakout. Remain long over SPX 1340 but consider going flat or short on any
sudden drop below that level.