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Market Wrap

Fed Wakeup Call

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It was not the type of wakeup call the Fed wanted to get on Friday. The August employment report did not just miss estimates but missed them by several miles. The unexpected drop in new job creation tanked the market and sent bonds to new two-year highs. The news produced a knee jerk reaction across all the consumer sectors and sent recession chills rippling through the markets.

Dow Chart - Daily

Nasdaq Chart - Daily

The Employment report for August surprised everyone. The consensus for new jobs created in August was running around +120,000 jobs. This was weaker than recent months but still decent. The headline number showing a loss of -4,000 jobs for the months was a serious shocker but the damage did not stop there. July jobs were revised down from gains of 92,000 jobs to gains of only 68,000. Even worse the July number was revised downwards from 126,000 jobs to only 69,000. The net result of this report was a drop of 205,000 jobs from what the market was expecting. That is calculated from the missed consensus of +120,000 for August and a downward revision of -57,000 in July and -24,000 from June. There is no way to sugar coat this report because it was a disaster in a period where the market was counting on some decent numbers to provide assurance the economy was still growing. Instead of assurance they got proof that the economy was actually much weaker than expected. The recession bears came out grinning with that "I told you so" smirk as they doubled down on their shorts. This was the first loss in jobs in four years after 47 consecutive months of gains. The record is 48 months and without an upward revision next month that record is not going to be broken this year.


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The drop in jobs caught everyone off guard because the other reports like the ISM were still showing positive growth. The unemployment rate remained near its multiyear low at 4.6% and average hourly earnings were also flat with July at +0.3%. Manufacturing lost 46,000 jobs and 22,000 were lost in construction. Service jobs posted a gain of +60,000, education/healthcare +63,000 and leisure/hospitality grew by +12,000. Those are some good numbers but they were not enough to stave off the losses in other areas.

Household employment, the birthplace of entrepreneurs and typically the leading indicator for economic growth turned negative in job creation for the year. Over the last eight months household employment is now showing a loss of -16,000 jobs for the year. The household number had been averaging about 225,000 new jobs per month. The last three months has seen a substantial drop in new startups.

Non-Farm Payrolls

The overall economy took a sudden turn for the worse over the last three months and everybody agrees the real impact from the subprime crisis has yet to appear. All we are seeing today is the leading edge of the impact from the crisis which first came to the public's attention less than three months ago. The Fed has said for the last three months that the subprime crisis was NOT spreading to other sectors and the damage was "contained." Evidently somebody opened Pandora's box and let the evil out. It is clearly spreading to other sectors as we have seen by numerous profit warnings over the last couple weeks.

On Friday Harley Davidson (HOG) warned that consumers were curbing their spending and Harley would produce and ship fewer motorcycles, a cut of up to 10% of its annual production. Harley reported that dealer sales fell off sharply in August and sales were likely to be down the rest of the year. Harley said earnings would drop -4% to -6% per share. Granted Harley Davidson is not a mainline purchase for most American consumers but they also said sales were off worldwide by -1.2% in the current quarter. This is the first time in 15 years that domestic sales had fallen in consecutive quarters.

The same problem is starting to be seen in other areas with slowing high dollar purchases for everything from flat screen TVs to motor homes. The retail sector, despite some positive sales reports last week, is taking a beating and job losses continue to mount. After the bell on Friday Countrywide said it was cutting another 12,000 workers or 20% of its workforce. This was in addition to 900 announced earlier in the week. Remember, I predicted it here several weeks ago when the trouble first started. They can't support their current staff levels on 50% fewer mortgages. Mortgage lender Indymac (IMB) also reported cutting 10% of its workforce earlier this week. Lehman reported job cuts of 850 jobs on Wednesday. It is only going to get worse. Countrywide said they expected mortgage loans to drop by 50% in Q4 and by 25% for all of 2008.

We are not even into the biggest months for ARM resets. There are $1.2 trillion in mortgages resetting in 2007-2008. Lenders are trying to restructure these loans ahead of the reset to prevent an even bigger foreclosure problem in 2008. This week the Mortgage Banker Association said foreclosures in Q2 rose +57% over 2006 and ARM loan foreclosures increased +96%. These are monster spikes and the heaviest months for resets are still ahead.

What the jobs news did for Fed forecasting was turn a strong possibility of a rate cut on Sept 18th into a slam-dunk. The only question now is 25 or 50 points? With the current rate at 5.25% the Fed Funds Futures are predicting a 4.99% rate by the end of September, 4.81% in Oct and 4.58% in November. That translates to total cuts of 75 basis points by the Halloween meeting.

Most analysts feel a Fed rate cut is not the answer. Most argue that we have a credit crisis not a rate crisis. The commercial paper market has closed until after financials report earnings later this month. Nobody wants to loan money until they know what skeletons are hiding in the closet. Banks needing to fund mortgages, corporate paper or even normal business loans have to struggle to find takers for that debt. Until time has passed and the big banks are convinced nobody is in danger of a blowup this situation is not likely to improve.

A rate cut is a Band-Aid on the credit problem and more of a token action rather than a real solution. A rate cut or more likely a series of rate cuts will only help the mortgage community, as the reset problem gets worse. If rates fall those facing a refinance to higher rates would benefit by a sharp drop in the Fed's target rate. Every little bit helps when shopping for those loans and the Fed could actually help contain the problem and keep it from getting worse by rapidly cutting rates. I am not holding my breath that the Fed rides to the rescue. They may make a token cut in September but future cuts will definitely be decided in the future on evolving economic news.

To further complicate the issue Philly Fed President Charles Plosser said on Saturday morning that the Fed may not need to cut rates to deal with the current problem. He echoed the sentiment that it is not a rate problem but a credit problem and by using other tools at their disposal the Fed could avoid changing their rate policy. Plosser put it this way: "It is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing." This type of talk next week will cause even more market volatility and increase uncertainty.

October Crude Chart - Daily

A rate cut will only push bonds higher and the dollar lower and the dollar hit a new 15 year low on Friday while bond yields hit a 2-year low. The lower dollar is great for large cap multinationals but not necessarily good for consumers. If your dollars are worth less it takes more to buy things like food and energy. That is called inflation and the Fed just pronounced inflation dead if you don't count food and energy. Oil, which is priced in dollars around the world, gained ground on Friday even with Exxon CEO Rex Tillerson saying there was no fundamental justification for oil over $70. In fact he said the fundamentals support something much less. Oil continued to move higher because the dollar was dropping like a rock. A rate cut will only make it worse but the Fed appears to be trapped between a cheaper dollar and a recession. Given the choice they will vote for the cheaper dollar to keep the economy afloat.

US Dollar Index Chart - 15-Year Low

Next week the economic calendar is crowded but there is really nothing on it that is critical. All eyes and conversation will be focused on the Sept-18th FOMC meeting. I added the 9/11 anniversary to the calendar because of the potential for a new incident. Osama released a new videotape on Friday, the first one in nearly three years and analysts say it was basically a recruitment tape. He rambled for about 30 minutes touching many topics but the real message was not spoken. By putting out a video after three years he was advertising he was in good health, aware of what is going on in the world and still pressing the fight against the West. The 9/11 anniversaries have not drawn attacks in prior years but produced a flurry of press releases by al Qaeda in attempts to capitalize on their success and convince new martyrs to join the fight. Let's hope this year is only another press release event.

I also included the OPEC meeting on Tuesday. There is a war of words being fought by all the major players and Exxon's CEO jumped right in the middle of it with his "oil over valued" claims on Friday. Oil ministers for Algeria, Iran, Libya, Qatar and Venezuela said in the past week they support keeping the quota at its present 25.845 million barrels per day until December. Of course those are countries without any excess production so raising the quota would not help them and oil prices would fall. I would vote the same way if I were in their position. It is widely believed that OPEC has unofficially raised its target price for crude to $70 according to Claude Mandil, director of the IEA, which advises 26 of the largest oil consuming nations. They won't officially say that for fear of bringing reprisals but they are definitely acting as if that is the new base. The 10 OPEC members with quotas are pumping more than their quota now by about a million barrels per day at 26.71 mbpd but they will not admit it publicly since it would drive the price down. That number came from the IEA and was gathered from individual production shipments. Iraq and Angola have no current quota and are allowed to pump as much as they can. Production from all 12 OPEC nations was 30.33 mbpd in August. OPEC leaders claim an increase in production is not necessary because the subprime problem in the U.S. will cause consumers to use less this winter and push us into a recession. Pure smoke and mirrors, they just need a reason to justify holding the price up.

Lastly I added the BSC/LEH earnings on Thursday as a potential pivot point for the markets. There are increasing rumors that Bear Stearns was in serious trouble several weeks ago and has been trying to sell itself as a merger partner or a partial takeout over the last three weeks. If it was in that much trouble their earnings report on Thursday could be the trigger that causes another market implosion. Conversely if they report stronger results than expected and no lingering, life threatening problems on their balance sheet they could explode back into health. Lehman reports on the same day and could also disappoint but the expectations are not so dire. Goldman Sachs (GS) reports on the 20th and rumors are growing that they will have a blowout quarter because of their trading desk. It might be a good idea to pick up some Goldman calls the day before LEH/BSC report because any surprise there could be felt in Goldman for a week leading up to their earnings.

Economic Calendar

Alan Greenspan was back in the headlines on Friday after a speech in Washington. He said the current financial crisis was similar in many respects to the crashes he saw in 1998 and 1987 and even those as far back as 1837 and 1907. In 1837 the collapse of the land boom was a major economic disaster and the bank panic of 1907 was also a major economic event. In 1998 Long Term Capital collapsed and their derivative book was so large there were worries they could take down the entire banking system. The 1987 crash of the stock market was blamed on many things including trading excesses and lofty valuations. He did not say how he would fix this crisis but said it was equivalent to those mentioned above. He said, "Fear is a driver, which is going on today, is far more potent than euphoria." There have been several recent comparisons of the stock charts from 1987 and 1998 and their likeness to today's charts. While I think the older charts are similar they just represent normal chart patterns where an overbought market struggles at the top before giving up. If somebody tries to convince you the world is coming to an end again I suggest you change the topic.

Dow 1929-1987 Charts

Ben Bernanke will also give a speech on Tuesday in Germany on "Global imbalances, recent developments and future prospects." That should garner its share of attention from the analyst crowd.

If the jobs report caused the chance of a rate cut to rise to 100% then why was the market so ugly? The key is simple. The market always wants a rate cut even when they don't need it. Every time the market or economy catches a cold they want the Fed to rush in with a rate cut and fix it. Friday's employment report skipped the cold stage and went straight to pneumonia. Traders were shocked back into reality that maybe the subprime virus was not contained and might have turned into an epidemic. The facts now facing the Fed are serious. The real impact of the credit crunch is still in our future. It is not over and not contained. It is spreading and will get worse as the foreclosures grow and home values shrink. Home equity is a prime source of consumer spending and that ATM is quickly running dry. Secondly the risk to the economy is now recession not inflation although a case could be made for both. Thirdly the Fed appears to be behind the curve. At the last meeting they were still focused on inflation as the biggest risk with the subprime problem contained. Less than two weeks later they were lowering the discount rate because a sudden shift had occurred and the biggest risk was now the subprime credit crunch. An entire team of supposedly educated and highly professional Fed officials doesn't miss a change of epic proportions unless they are asleep at the wheel and already behind the curve. Now, despite the fact it is not a rate problem, the Fed will have to race to catch up with the outbreak of the credit virus. The markets took about 60 seconds to figure this out once the employment report was released. The opening gap on the Dow was -165 points and that was the best level seen for the rest of the day.

The Dow continued to fall to dip below 13100 and -277 just before the close. The drop to 13100 saw support begin to firm at that level but there was no rush to buy. The Dow closed only +28 points off its lows with a -250 point loss. If it were not for the light short covering at the close there would have been no rebound at all. There was no bargain hunting and no calls by analysts on stock TV to buy the dip. There was no joy on Wall Street at the close because the future is looking grim. Of course that was the view on Friday and Monday's outlook will be different. Traders will convince themselves over the weekend that the August employment number was just a blip on the screen and September will be better. They will convince themselves that the earnings warnings last week were also blips on the screen and the majority of companies will report stellar earnings in spite of the economic decline. They may be wrong on both counts but have you ever tried to tell a drunk they are drunk? A market bull already has their mind made up and does not want to be confused with the facts.

This is going to cause some more volatility before we climb out of this mess. When newsletter writers say expect some more volatility it is a polite way of saying we could be going lower and expect some more triple digit losses. Some people can't take it when an analyst says there is selling in our future. I get emails all the time when I say something negative and people tell me I am poisoning the market. I wish I had that kind of pen power. We would be at 15,000 next week.

We will see some increased volatility next week and that is not a joke. It has been a long time since I can remember so many triple digit days and lopsided internals. This is the kind of market that chews up investors and spits out the pieces. Traders fare only a little better but also find themselves on the wrong end of a swing more often than not. The problem will get worse as the earnings warnings increase. Earnings expectations for Q3 have already fallen from just over 8% to something in the low 5% range in just the last 3-weeks. I suspect it is going a lot lower before the reporting cycle begins next month. We have seen numerous companies warn already but we are not even close to the official warning period yet. Once those earnings expectations fall below 5% it could get ugly.

Can the Fed rescue us from this downward spiral with a simple rate cut? It is entirely possible if they cut aggressively at the September meeting and move -50 points. It would not have any immediate impact on the economy but would have a strong impact to investor sentiment and could ease the worry in the market. We have 7 days to contemplate that potential and I am sure many of those days will be triple digits.

I would love to see another retest of the August lows on the Dow and S&P. I believe that would be very therapeutic for the market and bring fund managers back with aggressive buy programs. Fund managers have plenty of cash. One estimate I heard was 12% to as much as 20% from selling winners in the August dump in anticipation of redemption requests. TrimTabs said there were some outflows but mostly from hedge funds ($55B) not mutual funds. Mutual funds saw inflows last week as investors bought the rebound. If normal funds are sitting on 12-15% cash and waiting for a normal October bottom then any future dump will likely be bought and even more so if the Fed takes the lead. Those funds are not likely to enter the market until it either firms or retests the August lows. Either way that plays into the Sept-18th Fed calendar.

You may remember the internals table I posted last week with sharply alternating days where volume was heavily weighted to one side. This week was an exact carbon copy of the prior week and volume picked up only slightly as we moved away from the holiday. There is tremendous indecision in the market and that is not conducive to a strong rally. The remaining weak holders need to be flushed one more time so the big money can create a support base with heavy buying.

Internals Table

The Nasdaq is still the market leader but you could not tell it from the -48 point drop on Friday. Much of that drop was thanks to Apple and the broker who downgraded it. Apple has lost nearly $15 in the last three days and as the heaviest weighting in the Nasdaq the damage was severe. I believe the selling is overdone in AAPL and Friday's support at $130 could be a decent entry point. However, just remember a helium balloon will always rise above the crowd but will still go lower when that crowd is in a down elevator. I am not sure if this market elevator knows yet which floor it is searching for. $120 would be my preferred entry but I may not get filled if I wait for that target to be hit. The Nasdaq has strong support at 2500 and again at 2400 and has no direct subprime exposure. Network stocks, software and biotech normally do well in Q4 and especially well once a Fed rate cut program begins.

I wrote about S&P 1490 last Tuesday and how critical it was to remain over that level. Tuesday saw the S&P trade higher but still closed under that resistance at 1489. That resistance held and we are nearly -40 points lower today. The S&P is hostage to the financial sector. That is the largest group in the S&P and it is currently an anchor dragging the index back to support. That initial support is 1430 followed by 1375. A dip below 1430 produces a very negative chart and almost guarantees a retest of 1375.

S&P-500 Chart - Daily

Dow Transport Chart - Daily

The Dow Transports lost -100 points on Friday to close just over 4700. This is the lowest level the Transports have seen since the August 16th crash to 4487. With oil rising, consumers staying home and budgets getting tight a break of the August low would be a critical failure. Bill Zollars, CEO of Yellow Roadway (YRCW) said two weeks ago there was no holiday shipment surge building. Holiday buying for inventory had not been seen and truck shipments were falling. I get a daily UPS delivery and I am pretty good friends with the driver. His truck has been empty this week, literally empty. Normally it is a fight to locate and dig out my packages. On Thursday there was less than 50 packages on his entire truck. I mentioned it and he said volume was very light and UPS was going to consolidate routes if it did not pickup soon. Was it just an end of summer slowdown where people did not ship around Labor Day? I did not get that impression and it is very possible that those consumer wallets are finally slamming shut now that summer is over. Time to pay for the vacations instead of order stuff online. Ebay announced last week that there would be no insertion fees for the entire month of September. It is basically a free listing month. Ebay did not do that just because they wanted to be friendly. They needed to attract sellers back to their auctions. No sellers equals no buyers and therefore no UPS shipments. I know all this is likely unrelated but I like to try and group things together to see if there is a common thread. Getting back to the topic at hand, the transports are ailing and I believe we have a good chance of retesting the 4500 level this month. Falling transports is typically contagious and weakens the Dow and S&P.

Russell-2000 Chart

For weeks now we have been watching Russell 800 as a critical level for the rebound. A move over 800 would be bullish and buyable. Another failure there would be a strong warning signal. On Tuesday the Russell pushed just over 800 in the afternoon and closed at 800.79 and right on resistance. On Tuesday night I discussed the Russell and my pending urge to be long if we could push farther over 800. I mentioned possibly buying any dip below 800 on the idea the bottom was in. I discarded that idea and maintained my recommendation to go short under 790 and wait for the index to move over 800 to go long. On Wednesday the Russell gapped down at the open and collapsed back to support at 790. That support held for two days but Friday was another gap lower and it closed at 776 for a -2.16% loss for the day and the week. I continue to believe this is bearish for the overall market. It clearly shows the fund managers are NOT buying the small caps. They are still avoiding risk and sticking to the liquid large caps for any random buys. Until the fund managers are confident enough in the market to risk buying small caps we are not moving higher. The Russell has support at 770, 760, 750 and again at 740. Every increment of 10 is covered with 750 the most likely target. I would buy a dip to that level. Until then continue to maintain a short bias under 790.

I do believe we are about to reach a selling climax. It may not appear until after the Fed meeting but I believe we will see a lasting rebound begin soon. (2-4 weeks) Until then I would go shopping for stocks but confine your actions to window-shopping only. Traders should always plan on being late to the party. They say the early bird gets the worm but in trading the early entry is normally foiled by a retest of support. Be patient and wait for this volatility to ease. Tomorrow is always another day to trade as long as you have money to trade with.

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