The economic reports this week showed increased levels of weakness and analysts are worried that the economy is headed for a harder landing than previously expected. The combination of the declines in the ISM, PMI, Durable Goods and Construction Spending overshadowed the upwardly revised GPD at 2.2%. The GDP is a backwards-looking indicator reflecting conditions in Q3 while the rest of those reports are current readings. The yield on the ten-year imploded to hit a low of 4.4% when the ISM number hit the wires. This is a new 10-month low for rates and analysts expect it to go lower, possibly to 4.0% over the next couple months.
SPX Chart - Daily
Nasdaq Chart - Daily
The big news on Friday was a drop in the ISM from 51.2 to 49.5 and into contraction territory. Consensus estimates were for a gain to 52.1. This is the first drop below 50 since April 2003. The internals were much worse with New Orders, Back Orders, Inventories, Production and Employment all under 50 and showing contraction. This is an acceleration of weakness that began with the September report. The third consecutive month of declines in order backlogs suggests future production will continue to be weak. Some analysts feel this is another sign of an impending recession while others claim this is just solid evidence of a soft landing. Obviously both can't be right. The bears are yelling fire and stock traders are unsure of which way to run. The markets reacted sharply to the release with an -80 point drop in the Dow to the low for the morning. That was not the low for the day. More on that later.
Construction Spending for October fell -1.0% for the sixth straight month of weakness. Private residential construction fell an even sharper -1.9% to -9.4% year over year. However, this may be close to a bottom with many indicators suggesting a bottom may be forming. Interest rates fell sharply over the last several months making it much cheaper to build and finance. In the housing sector mortgage applications are rising and home sales and prices are firming and in some cases beginning to rise. The appearance of a bottom was strong enough to convince Bill Gates to invest $241 million in homebuilder stocks over the last couple months. JP Morgan, Bank America and numerous other brokers have upgraded the sector and recommended a buy of home stocks. Investors were quick to go bottom fishing with the Homebuilder SPDR (HBM.x) rising +30% since the July lows.
Homebuilder SPDR Chart - Daily
10-Year Note Yields Chart - Daily
I believe the weak ISM on Friday was actually a positive event for the economy. It confirms the soft landing scenario and continued to push bond yields lower. Historically whenever the ISM turns negative the Fed is forced to cut rates. This is highlighted by the yield on the 10-year note falling to 4.4% intraday and a ten-month low. Falling interest rates are very good for the housing market and I am already seeing for sale signs disappearing from yards in my area. If the housing market is really firming ahead of the spring selling season then the broader economy should also firm. It is not expected to improve in December, which should give us another month below 50 on the ISM and put further pressure on the Fed. The Fed funds futures rocketed to an 80% chance of a rate cut in March after the ISM release. This was well above the less than 50% chance before the report. The chance of a cut at the January meeting rose as well but to only a 25% chance. The Fed needs additional months of weakness to convince them to reverse course and the January meeting is just too close. March gives them three months of data, which should be more than enough to tilt the scales in favor of a new rate cut cycle.
Not all Fed watchers see it this way. One very close to the Fed was responsible for the afternoon implosion on Friday. Chicago Fed President Michael Moskow said late Friday "Some additional firming may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time." Moskow has consistently said he wants inflation in the 1-2% range. Using the Fed's preferred method of calculating inflation by subtracting food and energy from the consumer expenditures, the core PCE deflator, the trailing 12 month inflation rate was +2.4%. He also said the risk to higher inflation is still higher than the risk of a slowing economy. Currently Moskow is not a voting member of the FOMC but will become a voting member in 2007. Philadelphia Fed President Charles Plosser also spoke on Friday saying he was also more worried about inflation than economic growth. The combination of those two Fed heads caused an afternoon plunge on Dow to a low of 12090, down -130 for a short time. That dip to support at 12100 was quickly bought and the rebound added +102 points to bring the Dow back to a nearly respectable -27 points for the day. Jeffery Lacker and Donald Kohn were also scheduled to speak but fortunately after the market closed. If Lacker, Moskow and others manage to force through a tough rate policy in 2007 the odds are very good they will force the US into a recession and produce yet another Fed too far historical statistic.
The dollar fell to a 14-year low against the pound and a 20-month low against the Euro. This produces yet another quandary for the Fed. If they are forced to cut rates it will weaken the dollar even further forcing higher prices on commodities and energy. This puts them between the proverbial rock and hard place if the economy continues to weaken with prices showing a resilient inflation rate. Instead of the Goldilocks economy we could be seeing the first stages of a return to stagflation. It is far too early to start predicting that but unless inflation takes a sudden turn lower it is definitely a possibility.
In stock news Google received an upgrade from Stanford Research with a new price target of $615. It failed to provide any lift and GOOG lost -$4 for the day to close at $480.
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In the Ripley's Believe it or Not category Home Depot (HD) spiked nearly +$2 at the open on rumors that KKR and Texas Pacific Group were considering a leveraged buyout worth something in the range of $100 billion. Apparently somebody believe the group could pay as much as $46for HD, currently at $39, and still make a profit. Somebody pinch me I think I am dreaming. If this trend continues there will not be any stocks left to trade. Of course all the parties in question refused to comment during market hours. After the close HD CEO Bob Nardelli denied having any discussions about a leveraged buyout or recapitalization. HD traded 47 million shares and triple the normal daily volume. If HD is in play then nobody is safe from the LBO crowd and we can expect to see some serious poison pills adopted by boards very soon.
Microsoft officially released Vista for businesses this week on exactly the 20th anniversary of the Microsoft IPO. There was no rush to buy and no long lines of shoppers waiting outside Best Buy to grab a copy of the business version of Vista. Only corporations with volume licenses were able to buy Vista business, Vista Enterprise or Vista Ultimate. OEMs and system builders all announced Vista PCs but they can't ship them until Jan-30th. Nearly all businesses surveyed by reporters this week were NOT planning on taking the plunge for quite sometime. This is the most massive rewrite of Windows ever and the most resource hungry ever. It takes a minimum of 1GB of ram for the OS alone making a current level processor and a 2GB PC about the minimum configuration according to Dell's CEO. It will require users to add roughly $17.5 billion in memory alone according to Samsung Semiconductor marketing director Tom Trill. I bet Trill is thrilled with that number. According to Microsoft the minimum disk requirement is 15gb but rumors are circulating that it requires a lot more in practice. PCPitStop.com ran tests on numerous computers and nearly 70% of currently installed desktops and 80% of portables do not meet the minimum specs as published by Microsoft. That includes things like compatible drivers, which 90% of computers more than two years old do not have. SoftChoice conducted a similar survey of 110,000 PCs from 500 corporate customers. They found 50% of those corporate PCs could not handle Vista's minimum requirements and half of those would need to be replaced rather than upgraded. I would bet it is many more than that once you get past the minimum requirements. The study found that 95% of installed PCs could not run Vista Premium. Accordign to Forrester Research only 34% of corporate decision makers planned to start Vista deployment within a year of its release. Of those running Windows XP, nearly two-thirds of those surveyed, will wait to upgrade until they are ready to support only one operating system. That could be up to two years after the initial release.
Ballmer said this Vista release would drive a monster upgrade wave in the PC sector as users stepped up to pledge their loyalty to the new Vista standard. Ballmer said they expect to sell 200 million copies of Vista in 2007 with as many as 400 million new PCs shipped with Vista over the next two years. Eventually we may look back at our Windows XP and laugh at its simplicity but I doubt it will be very soon. Windows XP software is still going strong with a discounted price today of $79.99 on the Internet. I suspect many users will hear the horror stories about the Vista product and elect to stick with XP for the foreseeable future. Did you know there are now two icons and seven options for turning off your computer? On a laptop installation there are 15 ways to shutdown your computer. When you consider the iPod does not even have an on/off switch it makes you wonder if Microsoft designers are allowed to interact with the outside world.
Vista Shutdown Options
GM appears to have found a bottom at $29 after captain Kirk elected to dump his holdings of nearly 10% of the total outstanding shares. That was before GM announced that sales for November rose +5.8%, which powered GM to a +46 cents gain on Friday. Actually while overall sales rose only +6.1% it was sales of trucks and SUVs that really shined at +16.6% while autos slipped -8.9%. GMC trucks jumped +30.1%. Since trucks and SUVs are the most profitable it appears GM is on the right track back to profitability. Ford was the ugly duckling with overall sales that fell -9.7% with a -13% drop in truck sales. Toyota surged for +15.9% in total sales with a gain of +17.8% in truck sales. Chrysler managed a plodding gain of only +4.7% but they topped the list in incentives per vehicle at $4,224, with Jeeps soaring to $5,398 each. Edmonds said incentives across all manufacturers fell to $2,237 with compact cars dropping to only $689 per vehicle. Obviously offering the most incentives on your most profitable vehicles makes sense and the public seems to have taken the bait. The gullible consumer fell right back into the SUV trap only a few months since gasoline was well over $3 at the pump. Those who swore off big cars were reversing their decisions faster than a smoker on the second day of quitting. This will continue to push long-term oil prices higher and OPEC will eventually be struggling to pump more oil than cutback. Auto sales in the USA since 2003 were 16.7 million units in 2003, 16.9m in 2004, 17m 2005, est 16.3m in 2006 and current estimates are for 17m in 2007. That is just in the USA! Current estimates claim more than two billion vehicles exist worldwide with nearly 70 million produced each year.
January Crude Oil Chart - Daily
While on the topic of oil the January crude contract closed just over $63.50 on Friday only two weeks ahead of the December 14th OPEC meeting. OPEC President, Edmund Daukoru, said another cut of -500,000 bpd is likely at the December meeting. He said I don't expect anything less than 500K. Actually another 500K cut would finally get them to the -1.2 mbpd they claimed to have cut on Nov-1st. According to a Reuters survey the actual cut was only -785,000 bpd and most of that in the less desirable high sulphur oil. Nobody is buying this product so let's cut it. 785,000 may sound like a lot but in reality OPEC production is only -300,000 bpd below last years production at this time. The demand decline is due primarily to price destruction from the spike to $3+ gasoline and a slowing US economy. With a +16% jump in November SUV sales that demand destruction appears to have ended. Energy Secretary Samuel Bodman said Friday there was no need for a cut and OPEC needed to keep the markets well supplied. At the same time Saudi's Oil Minister said the cartel needed to remove 100 million bbls from the market to restore balance. Remember, this balance they want to achieve appears to be oil over $60 despite comments to the contrary. Chavez, who is up for reelection this weekend, said on Thursday OPEC had reached a consensus to keep prices for the OPEC basket of crude above $50. That basket is currently selling for $56 with light sweet crude at $63. OPEC must be doing something right because Angola, Ecuador and Sudan are thinking about joining the cartel. Evidently belonging to OPEC is a status symbol for those without an economy.
I had a laugh on Friday when one astute commentator said OPEC was a sham for the gullible to allow Saudi Arabia to control the price of oil while appearing to be politically correct. In practice Saudi is the only OPEC country with any material surplus production and it has always fallen to Saudi to make the harsh moves when the situation demanded. Saudi nearly single handedly bankrupted Russia in the 1990s by flooding the market with oil at a time when Russia needed high prices to fund further development. Their tactics cost Russia 10 years before they could recover from that blow. Russia has significant amounts of oil but the lost decade prevented them from being able to use that oil to grab a larger share of the global market. Now 15 years later much of Russia's capacity has been used up and oil they could have used to fund development 15 years ago is needed to cover production from declining fields. In short Saudi stole their thunder at a time it would have mattered and Russia has never been able to regain that position.
NATO has warned Europe that Russia may be planning on forming an OPEC like cartel for natural gas and LNG. Russia's state owned entity Gazprom controls 25% of the world's supply of natural gas and wants to be the LNG exporter to the world. That is all we need another unfriendly world power selling us life giving supplies of natural gas that can be turned off in a heartbeat like they did to the Ukraine last year. It would be the equivalent of being a patient in ICU with OPEC responsible for our oil IV while GPEC led by Russia responsible for our oxygen/gas mask. You may be laughing but that is exactly where we are heading. Gas supplies in North America have already peaked so we cannot save ourselves.
Dell Computer remains under pressure despite the +2.50 jump back on the 22nd. On Friday Friedman Billings Ramsey said warranty problems appeared to not be reflected on their books and could lead to further profit warnings and restatements in the future. Dell has been hit with a plague of problems with the exploding battery recall the largest. They are also under investigation for accounting irregularities.
GM completed the sale of its GMAC subsidiary this week and the CEO was speaking on CNBC on Friday. He said the mortgage market was in trouble with delinquency rates climbing and foreclosures at a decade high. He said numerous smaller firms were battling for every deal and for survival making it impossible to increase margins. He expected failures in the sector and consolidations as those smaller companies give up the battle. GMAC operates under the name Ditech.com in most markets. H&R Block has also been taking heat from their sub-prime lending division. LEND is another sub prime lender trading near a two year low.
Despite the Dow rebound on Friday there appears to be a cold front headed for Wall Street and it is not atmospheric. Nearly every sector lost ground last week with the Brokerage sector leading the list with a -4.65% drop. The Semiconductor Index came in second with a -3.11% drop followed by the Transports with a -2.85% drop due to rising oil prices and a weakening outlook for package shipping. Nasdaq big caps fell -2.23%, Nasdaq Compx -1.91% and the Russell 2000 -1.40%. Energy, Housing and Health Care were the leaders on the upside with the Oil Service Index gaining +5.53%.
November finished with the worst performance in three years and the markets are looking rather toppy. That is an obscure technical term used by Colorado analysts. Volume has increased significantly over the last week with a monster day on Thursday where volume hit 6.6 billion shares. If you recall the Dow only gained +6 points on Thursday. This could be a perfect example of distribution, high volume at a lower high and no movement after a rebound from initial support. Thursday produced a lower high for the Dow and were it not for the end of day rebound on Friday I would be predicting a washout ahead. The Dow returned to strong support at 12100 and the bulls arrived to save the day. Or maybe I should say some fund manager with a decent buy program rescued the Dow on a snowy Friday.
Market Internals Table
The Nasdaq also returned to strong support at 2400 but the rebound was less spectacular. The Nasdaq also posted a textbook lower high at 2440 on Thursday. The negative reviews on Vista and comments from hardware managers about postponing implementation until there is enough history to support their decision could be depressing the SOX and the hardware sector. Symantec and McAfee imploded on Friday on worries that their virus programs were not compatible with Vista. Both issued press releases promoting complete compatibility on Thursday but that failed to keep them from getting slammed in the post Vista slump. The wireless sector is still reeling from the lowered Nokia estimates. Techs are simply not showing a lot of spark heading into December.
The SPX is slightly more bullish with a nice rebound on Wed/Thr that took it back to 1405 before being sold hard on Friday. If you recall on Tuesday I said I was neutral in the 1380s and bearish over 1400. That worked out well for me when I went short the futures at Thursday's close. Now that we are back in the middle of the range, actually towards the high side near 1400 again I am ready to get short again next week on any weakness.
However, my feelings about a market dip are less confident this weekend. Friday's rebound could have been a single buy program, short covering, dip buying at support or a combination of the three. It was NOT convincing but had just enough strength to cause me and probably thousands of others to question further shorting. I listened and read analysis from dozens of respectable market strategists on Friday and quite a few bulls are starting to waffle and many more are turning short term bearish. Many are expecting a -5% dip in December, some even more. The topic of fund distributions came up repeatedly. Nobody wants to contribute money to a fund only a week or two before they make distributions. It is simply not prudent and sometimes expensive. It is better to wait until January to make your contribution. That suggests funds will be on a cash diet for the next three weeks and many could be reducing positions to cover portfolio adjustments, tax sales, etc. That did not seem to deter investors last week where $2.17 billion flowed into funds for the week ended on Wednesday.
Don Worden from TC2000 felt the Dow rebound on Wed/Thr was the classic goodbye kiss. The Dow had been in an uptrend channel since August and that channel broke on Monday. The Dow rebounded to touch the bottom but failed to penetrate for two consecutive days. Don is normally correct in his views and I have reproduced his chart below. If the Dow does continue lower I would expect 11975 to produce another pause but below that we could easily see a freefall.
Dow Chart Uptrend Channel Kiss
Longer term I believe everyone agrees the market is headed higher but we could be in for a continued trading range until January. An S&P analyst was discussing four-year cycles on Friday and pointed out that the four-year cycle low was in 2006. He claimed that over the last 18 cycles dating back to 1934 we saw the S&P rise an average of +18% the following year for 16 of those cycles. He predicted a S&P high between 1550-1600 for 2007. You should not place large bets on cycle history but it always tends to color my outlook. Since most fund managers are cycle followers to some extent it is entirely possible this one will be self-fulfilling.
I spent about 14 hours researching and writing this commentary. I changed my outlook several times over that period, which proves nothing other that I had no strong conviction when I started. At the end I am left with several observations that I doubt will be lost to fund managers. Regardless of what year-end mechanical moves they must make to adjust their portfolios, square with investors and get ready for 2007 four things will be on their mind long term. The probability of a rate cut in March, the rebound in the housing sector due to falling rates, the upward revision in the GDP and the strong corporate earnings. We have seen the Fed funds futures whipsaw numerous times over the last year so a cut based on those numbers is never guaranteed. However, once the ISM goes negative like we saw on Friday the Fed normally reacts once that contraction is confirmed. If December confirms and then January it should be a rate cut lock for March. I believe Moskow and Plosser are trying to talk rates back up rather than actually hike them. They know they can't actually hike again but nothing prevents them from using the verbal hike to slow the decline in bond yields. Even if they don't actually cut in March there will be the perception they will cut and the markets should rise on that perception. As long as real rates remain low the housing market should continue to strengthen and that will be an all-clear signal for the equity markets. It would also provide support for the Q4/Q1 GDP and help guarantee a soft landing. Corporate earnings have been strong for 13 quarters and despite a few guidance warnings for Q4 they are still expected to be strong in Q4. Liquidity is at the highest level in history with buyouts and buybacks announced daily.
None of this guarantees a bull market and it is a long-term view rather than short term. We could take a -10% dump over the next couple weeks and those talking points could still push us to new highs over the next 90 days. What I can predict for next week is increasing volatility. We saw more triple digit swings last week than we have seen since July. The VIX finally broke out of its lethargic mood and spiked +25% to 12.50. High market volatility is another symptom of a market top but it is also a symptom of indecision. That indecision can produce entry points for those willing to take a chance on the long-term outlook. Until a new trend appears I would advise sticking to the plan. I will continue to short weakness above 1400 and plan on buying a dip to 1360. Any wandering in the middle of that range could grind positions to dust so be careful to only enter at the outside extremes. Playing in a range bound market is like walking down the middle of the freeway at rush hour. It can be either extremely boring if all the cars are crawling bumper to bumper or extremely hazardous if their speed suddenly increases. The width of the road stays the same but the chances of getting hit increase significantly. Should the S&P breakout to new highs I would gladly reverse to a long. As of 11/30 we have gone 486 days without a correction in the S&P. That remains the 4th longest streak since 1900.
Economics next week are not particularly exciting until Friday's Non-Farm Payrolls. The consensus estimate is a little lighter at +110,000 and only slightly higher than last months 92,000 job gain. It will be very hard for the report to surprise investors since most are already expecting a weaker number. If we do have a big number well over estimates it could derail the entire scenario I outlined above. A very strong jobs report would put the Fed back into the picture and could delay a rate cut by several more months. It would suggest the economy is stronger than the ISM and PMI were reflecting. That would be good for equities in general but bad for rates. The dollar would strengthen and housing should firm further on a stronger employment outlook. As an investor continued flat employment is Fed friendly. Strong employment growth is market friendly. It would be hard to disappoint unless jobs turned negative. That could rekindle the recession discussion.
Housing Debt Bubble Chart - from Yardeni.com
Several well known analysts are increasing their predictions for a recession in
2007. Most base their forecasts on a continued bursting of the housing bubble.
According to the Yardeni chart above Americans have been using their home equity
as an ATM since the boom began back in 2000. As long as home prices continue to
go up the Ponzi scheme can continue. New purchasers
buy your house for a higher
price and your debt is erased and you buy a new house and start over. Once
prices burst consumers will be faced with monstrous debt loads and no way out.
We have seen housing prices fall in 2006 but so far it has not been a disaster.
If rates continue lower and the housing market continues to firm we may escape
the final accounting for several more years. Should the housing rebound fail and
more consumers are trapped in loans they can't pay then the
entire house of
cards could collapse very quickly. Obviously the Fed does not want this to
happen and several Fed heads, including past Chairman Greenspan have comforted
investors recently with claims the worst is over. That will be the key. As long
as the worst is over in housing everything else will not matter. If housing
begins to weaken again it could get really ugly and it could last a long time.
As long as the recession bears remain on the outside growling at the moon the
investor will ignore them. Once the bears get inside the house the
urgency to exit may be overwhelming. According to Gary Shilling regarding the
housing bubble, "Gigantic levels of speculation remain and speculations never
end voluntary or in orderly fashions." John Mauldin said in his recent letter
that 3.3% of sub-prime mortgages made in 2006 are already delinquent by more
than two months. What does that say about lenders who could not see the future
only six months
in advance or their desperation to make any loan to remain
afloat at least temporarily? According to Bear Stearns 38% of the most common
sub-prime mortgages in 2006 were for 100% of the value of the home. The data
gets even worse the farther you dig into it but I need not elaborate. The bottom
line is we have a lot of negative press and a major wall of worry for the
markets to climb. So far they have been doing pretty well. However, it may be
time for them to pull back a little
so they can get a running start at the next
hurdle. As long as that hurdle is not a sharper decline in housing the good
times should continue.