Analysts have talked a lot about the so-called "Greenspan Put" that underpinned the equity markets for the last decade. Analysts felt that Bernanke did not want to fall into that same trap and be known for rushing to the market's aid every time it caught cold. On Friday Bernanke tried to stress that the Fed was not going to come to the aid of the financial sector because of bad credit decisions. But, if those decisions were impacting the overall economy the Fed would come to the rescue. Regardless of how you phrase it the new Bernanke put is definitely taking shape.
Dow Chart - Weekly
Nasdaq Chart - Daily
There was a flurry of economic reports on Friday with mixed results. The first was Personal Income for July and the headline gain of +0.5% was above the consensus of +0.3%. It was a four-month high. Spending rose +0.4% compared to +0.2% the prior month. The PCE deflator rose only +0.1% and the slowest rate since last November bringing the headline inflation rate down to +2.1%. The core PCE deflator rose only +0.1% for the fourth month out of the last four and held the core inflation rate at 1.9%. That is just barely into the Fed's target range but not enough to press them to cut rates based on the inflation rate alone. On the flipside real disposable income jumped +0.5% in July and the fastest rate since February. Spending rose only +0.3%. The obvious dislocation between those numbers meant the savings rate to +0.7% and the highest rate since March. This means consumers are putting more money back for future bills and being less frivolous in their spending. With home equities shrinking and much harder to tap given the mortgage problem many consumers are reeling in their discretionary desires in order to keep within their budget.
The NAPM-NY report showed business conditions fell again in New York and well below the April high. The six-month outlook fell from 62.5 to 60.0 but the current conditions component spiked higher to 47.3 from 39.7. That current conditions spike kept the index from showing an even bigger drop in August. The conditions in New York are directly impacted from the current credit crunch. Money becomes tighter, layoffs are prevalent and bonuses are expected to be minimal.
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Moving to Illinois the Chicago Purchasing Manager report moved slightly higher to 53.8 from July's 53.4. The amount of the move was not important after last months sharp drop to 53.4 from 60.2. Any positive movement was appreciated. Without going into the boring details, only two components rose while four declined, the biggest moves were in the employment and inventory components. Employment fell sharply to 53.7 from 61.6 and inventories dropped to 44.6 from 55.1. The drop in employment suggests confidence is dropping and businesses are not as willing to add workers and take on new expenses. The drop in inventory could be due to shipments leaving for the holidays ahead as well as a lack of confidence in future demand.
Factory Orders were one of the bullish reports for the day rising +3.7% for the July period. This compares to an average gain of only +0.3% for the prior three months. Shipments jumped +2.6% after losing -0.5% in June. Durable goods spiked +6% and posted the second month of gains since the -2.4% drop in May. This report was largely ignored since it is a trailing indicator.
Lastly the final Consumer Sentiment Survey for August closed at 83.4 and -7 points from the 90.4 in July. Expectations fell -8 points and present conditions -6 points for the month. The continued debt wreck and the weakness in the equity markets overshadowed the decline in gasoline prices over the last two weeks. Another survey found that gasoline prices were a bigger factor in consumer sentiment than falling equity in their homes but that did not appear to carry forward into this months report.
Next week we have two major reports and the release of the Fed Beige Book. On Tuesday the Institute of Supply Management (ISM) report will tell us if last month's sharp drop after three months of gains was an anomaly or the beginning of another down trend heading into a Q4 recession. That may sound dire but that is the forecast by many analysts for the country to enter a recession in Q4 or Q1 of next year. A continued drop in the ISM would be a leading indicator. Estimates are for a flat report with a 53.8 headline number. The Beige Book on Wednesday will give investors a detailed look into the conditions in each of the Fed regions. It is also a report the Fed will use the following week to determine how seriously the mortgage/credit problem is contaminating the rest of the economy.
The biggest report for the week will be the Non-Farm Payrolls on Friday. Last month we saw job creation fall to only 92,000 jobs and well under the 135,000 consensus estimate. 92K is about as low as analysts think the market can stand. If job creation falls much under the 75k-85K level the recession fears will ratchet up sharply. This will be a key number for the Fed's rate decision the following week. Something in the range of 150,000 jobs need to be created each month to absorb the new workers moving into the job market from immigrants and graduates. A negative number next week would be a disaster for the markets and almost a guarantee the Fed would cut rates aggressively.
Everyone has been waiting for three weeks for Bernanke to speak on Friday. Now that the speech is history the reactions have been pretty much as expected. However, most praised him for being uncharacteristically blunt regarding the current conditions. He stressed that the Fed would not bail out firms that made bad credit decisions and bad business decisions. However, if the result of those decisions did spread out into the broader economy the Fed would be forced to act to support the economy. The wording of his statements changed slightly and was taken as a clue that a rate cut was coming. Bernanke said the Fed "will act as needed to limit the adverse effects on the broader economy." The change to "will" act instead of might or could act was seen as a clue. In a separate paragraph he said the impact of the credit crisis was spreading to the broader economy. This is a case where 1+1 does equal 2 and a cleverly worded indication of his plans. He also mentioned the dramatic change in conditions just since the August 7th meeting. At that meeting the primary concern was inflation. A little over a week later the Fed said there was a dramatic shift in market conditions and now economic worries were the top priority. By referencing that dramatic shift again and the shifting focus to the economy rather than inflation he also telegraphed a potential rate cut. He said the new risk adverse attitude by the financial community was causing undue market stress and the Fed would continue to act to provide liquidity. This suggests there will be another rate cut at the discount window. He stressed repeatedly that the Fed was not responsible for the consequences of actions by the financial community but was responsible for the consequences to the overall financial system. He said the outlook uncertainty was far greater than normal and the Fed would take into account not only normal indicators but also anecdotal evidence from banks and businesses. That evidence should not be too hard to acquire since nearly every CEO interviewed in the last two weeks is screaming for a rate cut to avoid an impending recession. In one series of sound bites on CNBC on Thursday they put together comments from more than a dozen high profile CEOs interviewed over the last two weeks. All of them were pleading for a rate cut to stave off impending doom. Nearly every sector was represented and follow on comments have even seemed harsher. One Countrywide official said late last week that the country was plunging into a recession at breakneck speed. That was not the exact quote because I got the info second hand but it conveys the urgency Countrywide is feeling. To sum up the Bernanke speech it was a blunt assessment of deteriorating conditions and the Fed will act but there was no commitment to specific actions. As Paul McCauley from Pimco said, "it was the best confirmation Bernanke could give that a rate cut was coming without actually saying he was going to cut rates." Bernanke does not want to appear pressured or panicked and that is why they are waiting for the meeting on Sept-18th.
The market did not know how to take the back-to-back speeches by Bush and Bernanke. It continued to wander all over the place on very light volume. It was as though traders got the message but did not believe it. Theoretically the confirmation of a pending rate cut should have put wings under the market. Unfortunately analysts started to second-guess themselves and tried to find holes in their assumptions. They also began to focus on those three critical reports next week that could confirm the current economic assumptions, prove them worse or disprove them completely. If the ISM, Beige Book and Jobs suddenly took a turn for the better then the Fed would likely provide a cautionary statement and pass on changing rates. That would be negative for the markets and produce additional weeks of wandering until the Fed's Halloween meeting in October. If the conditions proved worse than expected the analysts would begin wringing their hands over the crash and start blaming the Fed for waiting too long and begin putting out doomsday scenarios. That would also be bad for the market. That means we are right back to wishing for Goldilocks to return and find economic conditions next week as comfortably lukewarm and deserving of a rate cut to provide a gentle nudge higher.
I have started to see some light at the end of the tunnel in the various individual reports. Some areas of the country are actually seeing a slight improvement in home sales and a rise in home prices. Insiders at the builders were net buyers of stock in four of the last ten days according to TrimTabs. Since insider transactions are normally 10:1 in favor of sellers even in normal conditions the news that insiders are buying building stocks is clearly positive.
Several financial companies have also reported a loosening of the corporate paper market with several debt sales proceeding at regular rates. The key for next week will be the First Data (FDC) and Texas Utilities (TXU) deals. As of Friday the stocks were improving and values returning towards the sales price in anticipation of the deals being closed. If those two giant deals can close soon it would go a long way towards reassuring banks that business was returning to normal. Reportedly over $200 billion in corporate paper debt sales have not closed in the last four weeks. This are loans that failed to be placed and had to be eaten by the originating lender called "hung bridges." That will put a severe crimp in future deals until those loans are eventually sold. At the current rate of hung bridges at about $45 billion per week it would not take long before defaults would begin to occur as debt piled up on originator balance sheets. These would not be credit defaults but defaults on commitments to fund future deals due to lack of funds. The calendar for the corporate paper world cycles about every 45 days. While this current cycle has been avoided as though it was contaminated spinach the next cycle may get better reviews. If anything the credit profile should be better since the current change in lender appetites is to prime cuts rather than ground meat.
There are also rumors of some giant layoffs ahead in the structured finance areas. Reportedly Lehman, Bear Stearns and Goldman Sachs are preparing some monster layoffs since even a return to normalcy in the credit markets will not mean a return to subprime loans. Reportedly layoffs could exceed 20%. Those hundreds of billions in subprime originations and CDOs are over. Whatever the new lending paradigm brings with it will have to be structured as it happens. Clearly the global appetite for subprime debt has disappeared along with the loans. Bonuses for those lucky enough to retain their jobs are expected to decline by -10% to -15%. Given the massive loses some of these firms are going to take I am surprised they will get bonuses at all. Don't forget, the financial sector begins reporting earnings for the last quarter with Lehman and Bear Stearns leading off on Sept-13th. If they report massive losses it could get ugly in the markets. If they report manageable losses along with restructurings (layoffs) and provide tolerable guidance the street will probably forgive them and a bottom will form.
The Bin Laden Trade I mentioned on Tuesday has now gotten press around the world. With the glare of the spotlight some players have been discovered and more is known about the trade. Reportedly Dan Perper, a partner at Peak 6 (www.Peak6.com), one of the largest option market makers and proprietary trading firms, said Peak 6 was a counterparty to a good portion of that SPX trade. He described it as a box spread loan and a form of alternative financing. A box spread in this instance would be a short in the SPX 700 calls, 1700 puts and long the 1700 calls and 700 puts. In theory there is no risk in the trade since each option leg offsets another. Like I surmised on Tuesday it produces a giant loan on the market to whoever owns the spreads. Basically you receive large amounts of money from those options you sold and the money spent for the out of the money legs is minimal. The spread holder receives the premium in their account for the duration of the trade. Obviously as option traders we all know that the premium from selling short options or stocks must in theory remain in the account until the trade ends so how does that help the spread writer? Let's assume you had a very large stock and bond portfolio but some of the securities were underwater or illiquid. Say you owned millions of shares of Countrywide at $40 and for some reason did not sell them when they started falling or maybe some subprime bonds you can't sell. You are faced with margin calls as the values continue to drop. You can short something else, say an SPX box spread, to produce premium income. That cash sitting in your account is an offset to your margin requirements in other issues. The big question obviously on everyone's mind is what happens if the bleeding continues and the cash goes back to the market at expiration? They would then have to liquidate other positions to cover their margin requirements OR roll the spread over to the next month in hopes for a rebound in whatever it is they can't or won't sell. Perper already said this trade would probably be rolled over into December options. That market loan (off balance sheet financing) grew by 3000 contracts since Tuesday for an additional $300 million in premiums. Obviously this is a cause for concern since somebody being short $6 billion in SPX options is an expensive loan and that suggests they are in trouble and could not get the money elsewhere. It also suggests they are a credible company since you and I would not qualify for the same treatment. Should we be worried about the potential outcome? I am not as worried about a single company with financial problems taking out a loan on the market as I would be worrying that a terrorist event was headed our way. This explanation on the SPX trade does not explain why there are massive out of the money put positions being accumulated on nearly every index around the globe for the September contract. There is still an underlying cause for worry and time will tell if it is just a cautionary move by some big players.
What a week in the markets. At Tuesday's close it appeared the bears were in control and we were headed back to a retest of the August lows. Resistance had held and the bears were piling on every dip. Friday's high was nearly +400 points off Tuesday's lows and Tuesday's -260 drop was matched by Wednesday's +250 rebound. Volatility was increased by an extremely low volume week. The daily volume was nearly two billion shares below normal and five billion per day below the record volumes over 10 billion shares per day back in mid August. Note the alternating sentiment for the last four days. Welcome to whipsaw trading!
The Dow dipped almost to 13000 and rebounded right back to test resistance at 13400 and the 100-day average at 13375. I thought we were going to see an end of day short covering rally but instead there was a -80 point drop at the close. That surprised me given the steady progression higher from Tuesday's lows. In scanning some stock charts after the close there were some serious red candles right at the close in quite a few and many were the recent leaders. Evidently a fund with a large portfolio was expecting more of a Bernanke boost and exited when it did not appear. There was also a -15 point drop in the S&P futures in the last several minutes of trading. A move up from here faces strong resistance at 13700.
The Nasdaq has been a veritable pillar of strength with a close just below 2600. Since tech stocks should be immune to the mortgage problem they have been benefiting from sector rotation. Network stocks held up well and Hewlett Packard and IBM, while not Nasdaq stocks, moved back to their highs and supported the entire tech sector. Apple gained ground despite a contract cancellation by NBC for its video downloads in 2008. NBC supplied 30% to 40% of the video downloads on the iTunes site. Vivendi also declined to sign a contract for 2008 and may be looking for a better deal elsewhere. Amazon may be set to launch its new music service on Sept-17th to compete with Apple. Reportedly Amazon will have over one million tracks when they launch and they will offer them in MP3 format. Since Amazon believes in selling some things cheap to draw traffic let's hope songs are going to be highly discounted. The Nasdaq faces decent resistance at 2625 so next week could see a critical test of any move higher. Support remains 2500 and then 2400.
The S&P-500 has already returned to a critical level with a retest of the Aug-24th high at 1480. That level was tested at 12:30 and again at 3:30 on Friday and both tests were hit with a sharp increase in selling. If we can break that level on Monday the next test would be the 100-day average at 1495 followed by resistance from the June highs at 1540.
S&P-500 Chart - Daily
Russell 2000 Chart - Daily
The key for me is still the Russell-2000 and the strong resistance at 800. That level has held since it first broke on July 26th. Until the Russell moves over that level the fund managers are not comfortable with the market. If you look at the winners from the last week or two it is the big caps and a few favorite momentum stocks. The broader market has not been moving other than by the rise and fall of the overall tide. The real winners have been the highly liquid big caps. Until the Russell shows enough buyer interest to break over 800 in volume we are still in a confused market. It is good for nimble traders able to change directions twice a day but for normal traders with a job it is a tough environment. Be patient, a directional market will eventually return.
S&P-500 Chart - Weekly 2003-2007
It may not return in September or at least history suggests that is not a good bet. Historically September is the worst month in the market but you could not tell that from the trend in 2006. July 18th was the low and it was straight up from there until Feb-22nd. October was the Q4 low in 2005 and again in 2004. You have to go back to 2002 to see a normal Aug-Oct trend where we saw an average September drop. You just can't count on any particular historical trend reappearing each year. The historical averages are just that, averages over many decades. I view the rest of 2007 as dependent on the economy. Not the fed, not the subprime mess and not the yen carry trade, bonds or rates. However, we already have a rate cut on Sept-18th built into the market and it could be a problem if it does not occur. I believe the market always wants to go higher and today the road ahead is pretty clear. The Fed will probably cut rates and that will be one more reason not to sell stocks. The credit crunch will ease once the financials report earnings in September assuming there is not a smoking crater where earnings used to be. Once deep pocket lenders believe that there are no skeletons in the closet of those looking to sell debt the debt markets will quickly return. For instance State Street disclosed last week they had exposure to $29 billion in subprime debt. Nobody knew that before and that is keeping lenders on the sidelines until the earnings cycle is over. There are already dozens of new funds forming to trade in the distressed debt currently plaguing the credit sector. Sharks can reportedly smell blood from a mile away and a hungry hedge fund manager can smell opportunity and act on it before the shark can even get up to speed. A short side note, WSJ reporter Charlie Gasparino, said rumors on the street have 60% of hedge funds down -40% for the year and 30% in danger of going under. That is another problem we will face later in the year if in fact it is true. Having a random hedge fund fail is not a challenge as long as it is not as big as Long Term Capital back in 1998. We have been seeing funds fail on almost a daily basis in August and it has not yet impacted the markets in a lasting way.
Just because I think the market has less to worry about now than a month ago
does not mean we are going straight up. Normally when there is a significant
decline in July/August the month of September is not that deadly. An event
generated crash in July or August tends to take the negativity out of September.
It just accelerates fund manager portfolio shuffling forward in the year.
However, some of that September negativity comes from earnings warnings for Q3
and we are still several
weeks away from that. September is going to be a
minefield but it is possible for traders to negotiate that field without getting
blown up. It all depends on the timing and severity of the events. For traders
we just need to follow the trend and keep our stops in place. That is always
easy to say and tough to do but to be a successful trader it requires effort. I
am going to maintain my long over Russell 800 guidance and try to maintain a
short bias under 790. Between 790-800 I am
neutral. That does not mean I am not
going to make any trades unless the market is moving in one direction or the
other. There are always individual stocks that break from the trend and go
strongly directional. If you see a play on one of those don't hesitate to take
it. Just keep your stops in place. A helium balloon may rise above the crowd but
in a down elevator it still goes down. By finding these standouts in a choppy
market we are prepared to profit handsomely once the market goes
Watch Russell 800 for a breakout, the ISM on Tuesday, Beige book on Wednesday
and NonFarm Payrolls on Friday. Some volume should return next week as most
traders return to work but it won't return entirely until the following week.