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Market Wrap

Chips and Dip

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It was a strong week for the indexes until 12:30 on Friday. The Nasdaq had rallied past resistance at 2375 and the S&P made it nearly to 1390. The Dow made it to 12167 on Thursday and another new high. At 12:30 on Friday news broke in the chip sector that pulled the rug from under the bulls. The dip was typical for a Friday in an extended bull market with unexpected bad news. The drop was slow and methodical as sellers exited and buyers waiting for a dip to enter finally got a break. The question this weekend is whether this break was really a buying opportunity or a preview of things to come.

Dow Chart - 60 min

Nasdaq Chart - Daily

Friday started off with an economic shock with the first reading on the Q3 GDP coming in at a meager +1.6% growth. This was substantially below the consensus estimates of +2.2% to +2.5%. The major negatives dragging it down were a sharp drop in housing construction and lower investments into business inventories. This was a definite shock to the system and brought back fears of a hard landing ahead. The biggest drag was a -17.4% drop in housing construction in addition to an -11.1% drop in Q3. This knocked nearly a full percent off the headline number. The weakness in the housing sector is not new and everyone has known it for the last nine months. What was not known was how sharp this drop really was at the GDP level. On the bright side consumer buying rose +3.1% stretching the string of consecutive quarters to 59 for positive consumption. Q4-1991 was the last time we saw a negative consumption rate. The sharp drop in GDP caused by housing should change the outlook by the Fed and the Fed funds futures reflected that change in perception almost instantly. Just last month they were showing a 50% chance of a cut as soon as January. Based on some economics and Fedspeak that reversed at the beginning of October to a 6-10% chance of a hike all the way out to September-2007 as of just last week. After Friday's GDP report the futures rocketed back to a 50% chance of a cut by May. That is a dramatic change in a very short amount of time and represents extreme volatility.

Next week we will see several critical economic reports including the PMI, ISM and Non-farm payrolls. The PMI rose +5 points last month and another strong gain could be problematic. The bigger report will be the ISM on Wednesday, which at 52.9 in September was the lowest level since May-2005. The consensus is for a slight rebound to 53.1 but those same analysts missed it significantly last month. Another decline could really ratchet up worries of a hard landing and increase the fire under the Fed for a future rate cut. Also weighing on the Fed consciousness will be the jobs report on Friday. Official estimates are for a gain of +133,000 jobs but analysts have missed estimates numerous times recently. Last month the estimate was for a gain of +125,000 when only 51,000 jobs were created. If this month's job creation follows the prior months weakness it will add further pressure to the Fed to ease sooner rather than later.

Despite the sudden downturn in economic indicators this is along the lines of what the Fed was expecting. It may be a little sharper drop than they would have desired but it should help remove inflation pressures a little more quickly. The Fed would actually like to see the unemployment rate rise to something in the 5% range from the current 4.6% because that would relieve pressures of wage inflation by supplying more workers for new jobs. Next week will be a minefield of economics and it will be interesting to see where the Fed funds futures end up next Sunday. The sudden drop in yields sent the inverted yield curve to its widest point in this economic cycle with the 10-year yield -43 points under the 90-day T-bill.

10-year Note Yields

Economic Calendar

The report that tripped the bulls on Friday was a report from Goldman Sachs that motherboard demand is "falling off a cliff." A motherboard is the main piece of electronic hardware that forms the electronic backbone inside a PC. If motherboard sales are dropping sharply then sales of all other components will also plummet. Goldman said they cut their estimates for sales this quarter by -20%. It sounds worse than it actually is. They are cutting sales forecasts from +10.8% growth to only +8.8% growth. It is still growth however you look at it but the worst may not be over. They said shipments declined in October by -4.2% compared to forecasts for +3.1% growth. They said the "decline in demand happened earlier and more significantly than we had expected."

Just last month another firm, Think Equity, issued a report on the same motherboard makers saying they were manufacturing for +20% growth in Q3 and were targeting another +20% growth in board output in Q4. They warned that this was far in excess of demand and would lead to a surplus of inventory at a time when there was no demand. The demand they were initially expecting was to be produced by the new Vista operating system originally due out earlier in 2006. The continued delays have pushed it out to January 2007 and caused Microsoft to postpone $1.5 billion in revenue in their earnings forecast this week. The fourth quarter is typically a strong quarter for PCs but this one could be a disaster. Buyers don't want to pop for a major computer purchase only to have the software out of date before the Christmas decorations are put away. Even with the Microsoft coupon ploy announced this week there is still a strong resistance to buying a computer and setting it up with Windows XP only to have to set it up again a couple months later. We all know most will never make the upgrade due to fears of ruining the current setup and then having compatibility issues with Vista. It is much simpler to just wait a couple months and have the manufacturer deliver it with Vista preinstalled and skip all those potential problems. It is one thing to say a computer is Vista ready and another to say Vista is preloaded.

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I ran the Vista upgrade tool on a new PC I just added two weeks ago and nearly half the hardware components or software packages had compatibility problems. You can download it from here and test your own PC. From my desk I view Vista as a can of worms for an average technically inexperienced PC user and that means the average user will wait to buy that new PC until he can buy it preloaded. That could be well after January. The current Microsoft forecast for a January delivery of Vista could also be a clever ruse by Microsoft to promise it just after the holidays to tempt buyers to go ahead and make that PC purchase thinking Vista is just around the corner. Maybe not but I would not be surprised to see that January date slide once the holiday buying season has passed. Think about it. This is the biggest software company on the planet with $40+ billion in cash and tens of thousands of programmers. If Vista is really on track for a January delivery it would appear relatively simple to spend a few of those idle bucks on overtime and extra workers to move that date forward about 60 days in time for the holiday PC cycle. There are supposedly more than 100 million customers planning to either upgrade operating systems or buy a new PC with Vista as soon as it is released. That would really give tech stocks a shot in the fourth quarter arm but instead Microsoft is holding to its January target. Call me a conspiracy theorist but stranger things have happened.

Getting back to the topic of the chip weakness, the Friday tech selling was sharp. The SOX had rallied off its support lows at 445 on Wednesday and edged just past resistance at 460 before the news broke. In less than an hour the SOX gave back -2% and the Nasdaq imploded to the tune of -28 points. Intel lost -3%, PMCS -2%, AMAT -2%, RMBS -3.5%, LSCC -7%, VSEA -5% and ASYT -5%. There was already a run on chips due to some earnings problems Thursday night and those companies were even harder hit, Silicon Image lost -17%, Celestica -13%, Intersil -10% and Emulex -8%. The earnings parade has been producing some really big movers as we wade into the smaller companies with lower floats and higher short interest. I pulled a list of the top 30 winners and losers on Friday and there were some big numbers.

Top 30 Winners and Losers

The earnings cycle is quickly coming to a close. After Friday's reports 66% of S&P companies have reported. According to Thomson Financial 73% have beaten estimates, 12% reported inline and 15% have missed estimates. By next Friday's close more than 80% of all companies will have reported. The earnings cycle will be over except for a gaggle of stragglers that will drag out over the next month. That leaves investors with little to focus on for motive power other than economics and we know how fickle those can be.

Earnings Sample

There were some high profile earnings reports on Friday led by Hartford Financial (HIG). Hartford earnings rose +41% but as you know it is all about the guidance. The CEO said underwriting profits in the property and casualty industry may have peaked in 2006. He said increased competition, increased loss costs and higher reinsurance rates would pressure profits. This was a banner year with no material hurricanes and few losses. It would be tough for the industry to repeat in 2007. HIG lost -3.96 for the day and led the sector into the tank.

Next Tuesday is the fiscal year end for most mutual funds. This gives them the SEC required 60 days to produce their year-end statements. It also tends to produce some sudden market volatility as some funds make last minute adjustments to portfolios both before and after Oct-31st. Given the rally to new highs this would be a prime opportunity for funds to liquidate positions they don't want to carry forward into the coming year or window dress their portfolios. Since 1982 the plan on the street has been to buy Oct-27th and sell on Nov-1st. By gaming the fund year-end this way only one year has failed to post gains out of 24 years. Not all funds make major changes ahead of their fiscal year end but enough do to make for an interesting week. Despite the sterling record of the fund fiscal year-end rally we all know that once a trend is firmly established everybody tries to anticipate that trend by taking action ahead of it. I believe the rally over the last two weeks was due in part to traders and funds positioning themselves ahead of Oct-31st. Also, several analysts feel the current October rally borrowed significantly from later in the quarter. Last year the Dow rallied off the October lows for +800 points to the high for the quarter at 10950 on the day after Thanksgiving. It remained range bound in a 250-point range for the rest of the year. This year the Dow has rallied +1484 points since July 18th. It is due for some range bound consolidation or worse.

This year we have the election as a market motivator but that may be a negative over the next week. The apparent Democratic sweep ahead is prompting fears, right or wrong, that Democratic control will be negative for sectors like pharmaceuticals, defense and big oil. Right or wrong it may produce some selling and could make it tough to make any new highs next week. Add in the problems in the PC/chip sector and the road ahead is looking less rosy. Once past month end it could get even rockier.

The major oil companies have reported and the top five companies posted earnings of more than $20 billion for the quarter. That equated to profits of nearly $240 million a day. Analysts are coming out of the closet and beginning to recommend them again with PE ratios actually falling due to the strong earnings and guidance. Multiple major analysts like Goldman, JP Morgan, UBS, etc have reiterated expected oil prices to average between $67-$75 in Q4. Since one month of Q4 is already over that suggests they think prices will rise as the quarter progresses. However, not all earnings were met with applause. Baker Hughes (BHI) posted profits that rose +29% and beat estimates slightly. The CEO repeated the caution already voiced by others that the record surplus of natural gas today "could" slow exploration some in 2007 "if" we did not have a normal winter. According to everyone there has not been any decline in drilling, yet, but just in case it does come they want to be on record in advance. Everybody is trying to talk down expectations just in case. BHI lost -$4.16 on the comments despite the positive earnings. Investors are getting very nervous at this point on the calendar and have little patience for any cautious comments.

Oil prices rose slightly after news broke that coalition forces had moved in to protect offshore oil installations in the Middle East. It appears Al Qaeda had plans to attack Saudi Arabia installations specifically Ras Tanura. Ras Tanura handles nearly 8% of the worlds total oil exports. A successful attack there would mean instant $100 oil. Al-Qaeda has repeatedly threatened over the last two years to target oil facilities in the Gulf, most recently in a broadcast by Ayman al-Zawahiri, the second in command, on Sept-11th. Britain said they received specific and credible information that an attack was in the planning stages. With naval forces moving in to protect the installations that threat should now be over. Iran also raised the level of energy anxiety by announcing they had begun to enrich uranium in a second network of centrifuges. Iran was emboldened by the lack of material sanctions placed on North Korea and the lack of material sanctions on itself by the UN Security Council after a year of threats. I fear that once the election is over the intensity against Iran will increase sharply. The Washington Times ran an editorial a couple weeks ago saying Bush would be forced to attack Iran before his term is out. Most feel he is keeping the issue out of the US press until the elections are over. Iran has threatened to close the Straits of Hormuz if they are attacked. 40% of the world's oil flows through that strait.

December Crude Chart - Daily

Ingersoll-Rand (IR) missed estimates and warned that the housing weakness had taken its toll on the equipment it makes for landscaping and construction. The "Bobcat" division, equipment for very small contractors, produced the majority of the earnings drag. This knocked CAT back for a loss after a nice rebound from last week's earnings disaster. It should have been common knowledge since CAT had already confessed concerning this sector. Heck, IR had already taken a significant hit on the CAT earnings and then got whacked again on Friday. Terex (TEX) has no material home contractor business and it was also knocked for a -5% loss on guilt by association. This is what the rest of the earnings cycle is going to look like. If somebody stumbles it will trip the entire sector.

Next week we still have a flurry of earnings despite the cycle being nearly over. Most names you probably have never heard before. There is little to learn about the future from the lower tier players repeating what their blue chip brothers have already said. There are some blues left but they are dwindling. Next week should be more about economics than earnings. With the PMI, ISM, Productivity, Factory Orders and Jobs it will be a full week. The Fed's soft landing scenario will be tested by fire next week and then again in the mid month reports the week of the 13th. Right now it appears Bernanke and his team were correct to pause and Lacker, the lone dissenter was in error. There are some strong voices outside the Fed who feel there is a crash landing ahead not a goldilocks scenario. Nouriel Roubini, Professor of Economics at NYU, has been dead on with his economic predictions for the past year. He correctly predicted the 2.6 GDP in Q2 AND the 1.6 GDP for Q3 way back in July when everyone else was expecting much higher. He predicted the housing implosion and the continued misses in the jobs report. He is targeting a 0.5% GDP for Q4 and a recession beginning in Q1. He points to the slowing reports from the Philly Fed, Richmond Fed and Chicago Fed as warnings signs. I generally overlook the occasional interviews with an economic bear as a chicken little in analyst clothing. However, Roubini has the credibility of being right on every point I can remember for the last year. If his prediction of a 0.5 GDP in Q4 comes true the Fed will be firing off rate cuts in rapid succession but it may be too late. The Fed typically goes too far and waits too long before reversing position. I was hoping Bernanke had it right this time but we won't know for sure for another six months. That is what makes the economic reports next week so critical. If there is any signs of a rapidly falling economy in the ISM and Factory Orders or heaven forbid a negative jobs number the market will not react kindly. The Fed will have to react quickly and I doubt they will do it given their present slightly hawkish stance. The statement last week was slightly more hawkish than the one before but tame enough not to rock the markets ahead of the election. That election roadblock is going to be over in nine days and they will be free to act if they have the courage. This is why the economics next week will be critical. Personally I expect the numbers to be better than expected because it is a pre election event. While I would never accuse any party in power of outright manipulation of the numbers it would benefit the party in power if they were positive. They can always adjust them later as both parties tend to do. Anybody that follows the economics for long sees these unexplained revisions constantly. Most numbers are estimates anyway and are revised when the real data becomes available. Time will tell if there are going to be games played next week. According to several prominent analysts the GDP data on Friday was incorrect. Joe Carson, formerly a Commerce Dept Economist and now with Alliance Bernstein in New York said it should have been 0.9% not 1.6%. He claims the way auto sales are calculated actually produced a larger vehicle production number than actually occurred. Remember this was a quarter when all three automakers were cutting production not increasing it. The Commerce Dept calculates "inflation adjusted production" using the wholesale prices to project production. When automakers cut prices by 5.5% to unload extra inventory it had the opposite impact on the production numbers. Sounds like voodoo economics to me but Carson says the number will be revised down sharply. He also expects Q4 GDP to be 0.7% to 1.4% and more inline with Roubini's Q4 estimate rather than the 2.5%-2.7% consensus. According to John Mauldin stock markets drop an average of -43% during recessions so let's hope those economic bears are wrong about Q1-2007 beginning a recession.

The Friday decline did no real damage to the indexes. In fact the initial GDP shock had almost worn off before the chip news hit. The indexes had just hit their intraday highs at 12:30 when the Goldman Sachs downgrade hit the wires. The magnitude of the decline was inconsequential given the gains over the last few weeks. It was just simple profit taking on a Friday afternoon. What comes next is the key. If the Dow can hold 12075 on Monday the funds have a chance of escaping October in near record territory and will have nice year end reports for investors. There are no material economic reports on Monday. If the markets can't hold the high ground on Monday the outlook for the rest of the week could be grim. The Dow has support at 12075, 11950 and 11800 with a couple of minor tick supports along the way. If real selling developed I would expect 11800 to be the support level bought by the retail crowd and those funds looking to reinvest cash raised by dumping unwanted positions on Nov-1st.

SOX Chart - 180 min

Russell-2000 Chart - 180 min

The Nasdaq, despite it chipped Achilles heel, has decent support at 2330. This level has held for two weeks through all kinds of negative tech news. Backup support is 2300 and below that it gets ugly. We saw 2375 return as strong resistance after a higher close on Thursday. Given the chip and PC weakness now it will be even tougher to rebound back over that level. Not impossible, just difficult. The Russell was also a big loser on Friday at -1.31% and gave up its breakout gains from Thursday. Resistance at 770 reasserted control and like the Nasdaq, without chip support, it may be tough to recover. The Russell does have strong support at 760 so it is still in rebound range for Monday/Tuesday.

SPX Chart - Daily

The S&P managed to break the 1380 barrier on Thursday and I thought we were off to the races until that GDP problem tripped it up. Because of the series of weeklong consolidations since late September there is support about every ten points down to 1300. Hopefully we won't have to test them all. 1375 is the first support level followed by 1365 and then 1350. Once into November I would expect to test 1365 and probably 1350. This could be where a range develops that takes us into year-end. Many brokers have 2006 S&P targets of 1425 and that would be my upper target as well. You could make a lot of money trading a 75-point S&P range but I doubt it will be clear cut. Since any theory about market actions next week or any week is just educated speculation we want to remain with the trend until it breaks. I would continue to buy the dips to about 1363 but be prepared to go flat or short under 1360 with a new buy target at 1350. Hopefully we won't need any targets under 1350 for the rest of 2007. There is always a correction lurking in our future and as of Monday it will be 456 days without a -10% correction and the 4th longest streak in history. Like passes caught in consecutive games or a specific color turning up on a roulette table a streak will always come to an end. I once saw a streak of 27 consecutive reds that sucked in enormous amounts of cash from those betting on black. Eventually those betting on black won, at least those who could afford to keep betting until it hit. The farther we get into Q4 the better chance we have of our streak ending with a correction. It does not mean the bull market is over, just that it is time to take profits and reshuffle the deck.
 

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