The third quarter ended with a whimper instead of a roar as conflicting Fedspeak tormented the markets. Various Fed speakers discussed their views of the economy and the chance for another rate cut in October and the market did not like what it heard. Funds tried valiantly all week to keep the indexes near record territory but selling pressure increased as the week drew to a close.
Dow Chart - Daily
Nasdaq Chart - Daily
The economic reports for Friday were mixed and offered conflicting views on the economy. Personal Income rose at a +0.3% rate in the August report and while that was less than the +0.5% in the prior month it was still a gain. This suggests employment is still tight and there has not been a weakening of the positive trend despite the August employment data. Even better for the economy spending rose at a stronger than expected +0.6% rate. Inflation as measured by the PCE deflator or Core PCE rose only +0.1% causing the year-over-year inflation rate to fall to +1.8% from +1.9%. This +1.8% core rate was identical to top line inflation for the same period and good news for the Fed.
The consumer spending report is at odds with same store sales reports from various retailers, which showed falling sales trends and less demand for high dollar electronics. The consumer spending report showed a surge in durable goods spending while retailers selling things like washing machines, dishwashers, stoves, etc were complaining about weak sales. Something is amiss in the data heading into what has been described as the worst holiday shopping season in over five years.
The NAPM-NY report of business conditions in New York City fell in September for the third consecutive month with a -7.4 point drop in the headline number to 437.6. The peak back in June was at 451.5 and the index has moved down in all but one report since that high. The headline number on this report was the lowest level since Oct-2006. There has been persistent weakness in the service sector and the current conditions component fell to 35.1 from 47.3 in the prior month. That is the third month below 50 and readings below 50 indicate contraction not expansion. Meanwhile the six-month outlook component rose +15 points to 75.0 and the highest level since August 2006. The spike in the outlook is directly related to the Fed rate cut and expectations for future cuts.
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The Chicago Purchasing Managers Index (PMI) was flat in September at 54.2 and a level it has been holding since the monster dip from May's high at 61.7. The internal components were mostly flat with the exception of a sudden increase in production from 55.7 to 58.3 and a sharp increase in order backlog to 50.5 from 38.8. Prices paid fell more than 10 points to 59.0 from 71.8. Overall this was a bullish report suggesting we are starting to see signs of a rebound from the early Q3 dip. This survey appears to be contradicting weakness in other regional surveys and should have been bullish for the markets.
The PMI report correlates well with the national ISM so this upswing in the PMI suggests we will see a positive gain in the ISM on Monday.
The Construction Spending report for August saw an increase of +0.2% despite a -1.5% drop in residential spending. This gain was well over the -0.3% estimate and the -0.5% drop we saw in July. The majority of the gain came in private non-residential construction, which rose +2.3%. This suggests we could see some blowout numbers once housing begins to recover.
Lastly the final reading for Consumer Sentiment came in unchanged at 83.4 and we could be seeing a bottom form after nearly a year of declines. The Fed rate cuts, the approaching holiday season and the post Fed market rally seems to have halted the slide.
Consumer Sentiment Chart
The key reports for next week are the ISM on Monday and the September Non-Farm Payrolls on Friday. As you read above the ISM should be positive but the big wall of worry the bulls have to climb comes with the jobs report on Friday. The consensus estimate is for a gain of 115,000 jobs and a sharp revision higher for the August report that showed a loss of -4,000 jobs. Friday's report has the ability to rock the markets and move the Fed.
If the report comes in as expected and August jobs are revised sharply higher the implications for the economy are very strong. It would indicate that the -4,000 jobs last month was a bookkeeping error and the economy is much stronger than everybody thought. The Fed would be instantly knocked back to the sidelines and there would be no further rate cuts.
This would be the proverbial good news, bad news joke for the markets. Good news, the economy is stronger than we thought. Bad news the two to three additional Fed rate cuts already priced into the market need to be removed. A sharp revision higher in jobs could mean a -300 point haircut for the Dow. Over the last two weeks the market has been in hover mode after the post Fed bounce. The sudden and forceful action added about 500 points to the Dow since Sept-17th when the Dow closed right at 13400. The Dow has basically moved sideways since the Fed meeting with every dip bought but every rally sold. It is hovering just under 14000 while waiting on some confirmation that the good news is true. For the first week the market acted like it was too good to be true and actually gave up a little ground. As more news came out the bulls slowly began to accept the fact the Fed was on their side and late last week we started to see some additional gains.
Late Friday afternoon that story changed. St. Louis Fed President William Poole said fairly forcefully the market should not assume there would be any further rate cuts. Poole joined three other Fed presidents who also echoed that party line earlier in the week but his voice seemed to carry more force since he is a voting member. The Dow dropped nearly 70 points late Friday when the comments were made.
Poole also said, The U.S. economy's underlying resilience, along with future Fed actions, "should they be desirable," will most likely keep the economy "on a track of moderate average growth and gradually declining inflation over the next few years." He also cautioned "It would be a mistake for markets to bake into the cake the assumption of ongoing rate cuts." And, "The disruption seems to be declining a bit, and that's the direction we wanted to go." He said the 50-point cut was necessary to send a message to the markets that the Fed was ready to act to solve any financial crisis. Poole feels that crisis has passed and credit markets not functioning at the time have reopened for business. For instance the corporate bond market was not functioning prior to the Fed meeting. That market has rebounded and September closed with more than $110 billion in corporate issuance, a record amount! Clearly the corporate bond market has returned. The Fed's direct loans to banks hit a high of $7.2 billion on Sept-12th and dwindled to zero by Sept-26th showing that inter-bank lending had resumed. Clearly the conditions that pushed the Fed into that 50-point cut have been reversed. All four Fed presidents echoed that future rate "moves" would be data dependent.
Should the payroll report show that the August loss of jobs was a accounting blip and the ISM show a positive gain then the Fed will be back on the sidelines and the next move expected will be another rate hike if inflation continues to climb. I know that is a contradictory statement to the one I made earlier about the Core PCE deflator showing falling inflation. The core PCE deflator may be falling but prices for commodities, food and energy are exploding. That is real inflation that is not shown in the core rate. Commodity prices posted their strongest September gains in 32 years. Gold hit a new 27-year high on Friday at $753.
Food prices are rising at the fastest rate in over 17 years. Consumers spend 9.9% of their income on food. In the last year corn has risen 40%, soybeans 75%, wheat 70% and a loaf of bread +24%. Milk, meat and produce have also risen due to the higher cost of feed, fertilizer and transportation expenses. The price of oil hit a new high on the Brent Crude contract on Friday and the U.S. November WTI contract came within 34 cents of another new high on Friday. This is real inflation and the Fed will need to react to it very soon if prices don't decline quickly.
The Fed reacted to credit markets that were grid locked over the subprime crisis. As I said at the time it was only a sentiment cut not a cut that would actually benefit the economy any time soon. It was a monetary statement not economic fertilizer.
If the ISM and NonFarm payrolls show the economy is growing moderately as the Fed has been saying prior to the credit freeze then future Fed rate cut expectations will quickly be erased from the market.
Another problem the Fed needs to address is the falling dollar. The U.S. dollar index hit a record low on Friday of 77.67, the lowest price since the index was created over 40 years ago. The freefall of the dollar creates further inflation pressures since everything we purchase requires more dollars than it did before. Cutting rates and a slowing economy combine to push the dollar lower. Raising rates in a growing economy raises the value of the dollar and slows the implied inflation rate. The Fed does not want to be cutting rates in this environment. They may be forced to cut if the jobs report shows another job loss but they definitely do not want to be forced into that position.
US Dollar Index Chart
The stage is set for a monster move on the nonfarm payroll news. While nobody knows the answer in advance it definitely appears the market has already factored in a weaker job market and another rate cut on Halloween. Therefore the market is at extreme risk if that scenario falls apart with the jobs announcement.
There is still a bias by economists towards the possibility of a recession. Greenspan reiterated on Friday that the possibility of a recession was around 43%. The CEO of Freddie Mac said there is a 40-45% chance. Former Treasury Secretary Robert Rubin said there was a 50/50 chance of either a soft landing or a serious problem. The market has factored in this increasing potential for a recession by factoring in another 75 points of Fed rate cuts before year-end. Again, if the ISM and Jobs reports reduce the chance of a recession it will also reduce the chance for another rate cut.
Since all the factors are weighted towards further rate cuts there is an extreme chance of a disappointment if the ISM/Jobs data comes in positive. When the market finds itself with the majority of participants leaning in the same direction it tends to correct to balance the outlook. That possibility of a correction, the removal of a potential rate cut from the outlook, could happen before the jobs report. Quite a few traders will not want to wait around only to get blindsided by potentially unfavorable data.
Another problem the markets will face next week is the Asian markets. All the major Asian indexes either closed at record highs or very near them on Friday as the quarter came to an end. The Chinese exchanges will be closed all week for National Day celebrations and the Australian and Hong Kong markets will be closed on Monday for other holidays. Without the Asian markets for inspiration and guidance the U.S. markets could be listless. There is an even bigger problem ahead since the Asian markets are expected to correct when they reopen on October 8th. Investors are expected to take profits before China's National Congress meets in mid October on fears that the congress will take new measures to reign in the exploding markets. If they raise rates, raise transfer or trading taxes, etc, then it would be better to be out of the market before that happens. With the indexes at record highs the potential for profit taking ahead of the meeting is very strong. The various global indexes have exploded since the July lows with the Hang Seng up +40%, India +25% and the Shanghai SSE Composite +49%. By comparison the Dow only rebounded +11% from the August lows. That is plenty of profits at risk if the rules were to change.
On our side of the pond the U.S. markets are very close to new highs with the Dow's Friday close only 127 points from a record high. The Nasdaq is only 23 points below its July high and the S&P 25 points. The quarter ended on Friday and there was no end of quarter surge. There was no obvious window dressing although every dip was quickly bought in order to keep the markets only 25 points off their highs. All the recent winners like Apple, Google, Garmin, RIMM, etc flat lined all week as funds did manage to keep them pinned at their post Fed highs. They were content to hold their gains rather than battle to push them higher. This is a perfect setup for window undressing next week. Now that those Q3 statements are in the bag the funds can dump those stocks and run to the safety of cash until the jobs report is released.
Google Chart - 15 min
Apple Chart - 15 min
In my humble opinion I think the potential for profit taking next week is very strong. There are just too many factors lining up against us and funds would rather take profits on their own schedule than be blown out of the market on unexpected data. They can always get back in when the smoke clears and the market picks a direction. If you look at the chart of the Nasdaq a failure here at 2700 would be a convincing double top. If the Fed did reverse course back to a tightening bias that would not necessarily mean the markets would crash since it would also mean the economy was doing better than previously thought. It just means there would be market volatility until a balance was achieved.
Another problem the market faces is the constantly falling earnings expectations. The current expectations for S&P-500 earnings have fallen to only +2% growth for Q3. This compares to +9% in Q2 and +22% in Q3-2006. That is a significant decline in earnings from 22% to only 2% in only 12 months. This is a five-year low. This sharp decline in earnings raises the PE ratio for stocks from fairly valued to over valued in some cases. Is it the end of the world? Obviously not. If you are a fund it simply represents an opportunity to adjust your portfolio to better represent those companies that can do well in bad years as well as good years.
If we look at the charts the Nasdaq has the potential for a textbook double top. However, every new high retest always has that potential. In trading you have to trade the momentum in hopes of a breakout but always be wary of a failed retest that produces a double top.
Nasdaq Chart - Daily
For an important quarter end the volume was extremely weak. Volume on Friday was only 5.3 billion shares across all exchanges. This should have been a 7 billion share day. Volume is a weapon of the bulls and the bulls have been suspiciously absent for the last week. On Friday volume only appeared when sellers appeared. The selling was nipped in the bud every time but there was no follow through. The indexes were pushed back to the flat line and volume shrank again. This is a perfect example of stealth window dressing. They showed up with just enough volume to prevent sellers from piling on and the status quo was maintained. The sellers evidently realized the end of quarter game was in progress and stepped aside to wait until Monday. The odds are good the tide will turn on Monday and funds will be heading to the sidelines to wait for the jobs report.
This is typically a rocky time for the markets. Even Carl Icahn warned on Thursday that the next couple weeks could be volatile. Of course September is usually a rough month for the markets and the Nasdaq gained +3.7% and had the best September since 1998. You can't count on market cycles repeating exactly but it is wise to be wary of them.
The Russell 2000 had very anemic volume all week averaging only 675 million
shares daily. Back during the August rebound the Russell managed 1.2B to as high
as 1.88B shares per day. The Russell is showing absolutely no buying by funds.
The Russell has put in two lower highs and lower lows since the post Fed bounce
and has drifted back to close just over prior resistance at 800. The Russell
appears poised to break that resistance, now support, and head sharply lower
next week. I am
just not seeing any support from fund managers. This is
prompting me to be ultra cautious for next week. The recommendation for the week
is to be short under 800 and buy a dip to 780. If by chance we do move higher I
would not go long until the Russell moves over 815. Russell 820 is also
resistance but moving over 815 could generate some short covering and push over
that 820 level. I would be cautious of any longs ahead of the Jobs report on
Friday and look to follow any market move
after that report. It could be
extremely bullish or extremely bearish so consider an index straddle on Thursday
in cheap October options to capture any move on the news. I will revise this
setup again on Tuesday night from a vantage point two days closer to the jobs
event. Hopefully things will be a little clearer by then.