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Market Wrap

Trick Or Treat

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The Fed gave traders a treat but it was not the treat traders were expecting. The hoped for 50 point cut turned into a dissenting 25 point cut. This is the equivalent of expecting a big chocolate bar in your trick or treat bag and finding an apple instead. A cut is a cut but the quality of the cut is still important to market sentiment.

Dow Chart - Daily

Nasdaq Chart - 90 min

The FOMC cut the Fed rate by 25 points to 4.5% and cut the discount rate by 25 points to 5.0%. The committee said economic growth in Q3 was solid and stress in the financial markets had eased somewhat. However, the pace of economic expansion will likely slow in the near term due mostly to the intensification of the housing correction. The Fed thought the cut today along with the 50-point cut in September would be sufficient to ease the adverse impact of the credit crunch and housing correction. They also said the readings on inflation had improved modestly but increases in energy and commodities could put renewed upward pressure on inflation. By putting this statement back into play they signaled future cuts would be put on hold unless conditions changed. They emphasized this again with the statement "the upside risks to inflation roughly balance the downside risks to growth." This is classic language indicating they have paused and will not change rates again unless or until conditions change significantly. Balanced risks and comments about inflation are the kiss of death to the rate cut cycle. Even further confirmation came from the dissention among voters. Thomas Hoenig voted against a rate cut in favor of no change. With dissention and a balanced risk statement the market is on its own for the rest of the year.

The Fed was likely encouraged by the surprising strength in the first reading on the Q3 GDP, which was released this morning. The GDP headline number came in at +3.9% and well over the consensus estimates for 3.0% growth. This was a monster miss by analysts and would have been even stronger were it not for the housing drag. The housing component fell -20.1% and knocked a full percentage point off the GDP, which would have been a scalding hot 4.9% had housing been simply flat. This was far from a Goldilocks number and without the housing drag the Fed would have been raising rates to cool it off. Ironically analysts are still calling the current economy "soft" and there are still claims that we are headed for a recession. Obviously there are some serious cross currents keeping analysts confused. The outlook for Q4 remains at +1.5% growth due to an expected contraction in consumer spending and the continued decline in housing.

While the GDP for Q3 was soaring the more recent economic indicators like the Chicago PMI fell into contraction territory at 49.7 in October. The report released today showed a -4.5 point drop in activity from the 54.2 posted in September. The PMI was actually very negative when compared to the Q3-GDP. The headline number fell -4.5 points, production -11.4 and order backlogs -10.6 points. As you can see in the table below the only numbers to rise significantly were prices paid and inventories. Prices paid rocketed higher on the surge in energy costs and commodity prices. Inventories spiked on the lack of demand heading into the holiday season. This was not a bullish report and suggests the ISM on Thursday is not going to be pretty.

Chicago PMI for October

The NAPM-NY report of business conditions in New York City showed growth of +0.8% and while that was a small move the internal components gave analysts reason to celebrate. The current conditions component rose to 54.7 from 35.1 and that was the first time it has been out of contraction territory in four months. The purchase quantity index spiked to 57.1 from 40.0 and regional prices fell to 48.2 from 80. Whatever is happening in New York the impact was significant. Businesses appear to be rallying into the holidays now that the August market correction is over. The New York City economic area is directly influenced by the stock market and the tens of thousands of people who work in the financial markets.

Construction spending rose +0.3% in September and that was well above the expectations for a -0.2% decrease. This was the first time in four months that spending posted an increase. Gains in private non-residential spending erased declines in residential spending. Public construction also increased +1.9%.

The Employment Cost Index rose slightly less than expected at +0.8% for Q3 and that probably removed some more of the worry for the Fed over their rate decision. As long as wage costs are declining long term the Fed will not worry about inflation. The Q2 ECI rose at +0.9%. We also saw in the GDP that the Core PCE Deflator rose only 1.8% in Q3 and that pushed the core trend close to a multiyear low.

Thursday is going to be another key day for economics with the ISM for October expected to fall perilously close to contraction territory if not into it. The ISM is expected to decline to 51.8 but whisper numbers are being heard in the 48-49 range. Personally I believe the Fed had the advance numbers and took this into account when cutting rates today. That would suggest any decline was not serious. It also suggests there will not be a large upside surprise since they would probably not have cut rates if the ISM is going to be strong.

We will also see several employment reports ahead of Friday's non-Farm payrolls. The general estimates have been rising for the Monster Report and Challenger Report. The ADP Survey today showed jobs grew in October and that bodes well for Friday's government numbers. Again, I think the Fed had access to the Friday payroll numbers and would not have cut if the numbers had been too strong. They would also have cut even deeper if the numbers were going to be very weak. The 25-point cut and move to the sidelines on their bias suggests both the ISM and Jobs numbers are going to be at tolerable levels.


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I believe the Fed had painted itself into a corner and had to cut rates to pacify the market. Because of the uncertainty in the recent data the Fed had not gone on the offensive to warn the markets about a change in bias prior to the meeting. There was not a long list of Fed speakers suggesting the Fed might wait for more data or until January to consider new cuts. The bias to cutting from the September meeting was still in place and traders were fully expecting a cut of at least 25 points. Most were expecting 50 points until this week's data had shocked them back to reality. The Fed had to cut simply because they had not telegraphed a change in bias. Bernanke and other Fed heads had recently emphasized the need for the markets to be kept in the loop on impending Fed actions and the Fed had been very quiet implying no change in bias. The Fed was trapped into a move today but they changed the bias to prevent it from happening again in December.

That means the markets are on their own until at least January. There is a Fed meeting in December but historically the Fed refrains from making changes in the rates just before the holidays. That suggests January will be the next decision point and we will have the benefit of the Q4 revisions to Q3 GDP and three more months of ISM and Jobs data for them to consider. Meanwhile the markets are going to be digesting the changes to earnings guidance for Q4. It is still barely in the double-digit range at +10.1% growth but odds are good they will fall to the lower single digits before the quarter is over. How the markets will handle the PE compression is still unknown.

Wal-Mart announced it was going to sell a $199 PC loaded with Linux instead of Windows. The Green PC as it is being called will not come with a monitor. It does come with Google Apps, all the software you need according to Google to run a home office, surf the web and download music and video. If this PC is accepted by the public it would be a giant leap forward for Linux. Typically Linux is favored by techs and the web development community with Windows the operating system of choice for the consumer. Linux is getting more and more user friendly and eventually will provide Microsoft with some serious competition for desktop users. Wal-Mart said it would offer the same PC for $299 with Windows Vista, the difference being the license fee paid to Microsoft. Microsoft is not the only PC giant being displaced since the processor will be made by VIA Technologies, not Intel or AMD. This is a bold move by Wal-Mart and it could launch a new wave of price cuts in the Windows PC environment. Microsoft investors appeared not to be worried pushing MSFT up +1.24 to $37 and a new multiyear high. Intel rose +63 cents to near $27 close to a new multiyear high.

Google put them all to shame with a +12 spike to close at $707 and a new all time high. Those $750 price targets are looking like a reality before Thanksgiving and new targets around $1000 are being whispered in the analyst community. Google is making new announcements almost daily but has yet to officially acknowledge the existence of a so-called G-Phone. However, Verizon Wireless gave the rumor more credibility when it said it does not intend to announce a partnership with Google according to informed sources. This could be another trial balloon or a balloon going down in flames but what it does is fan the flames on the G-Phone rumors. The problem appears to be Google's desire to make their phones open source and allow anyone to develop applications. This runs contrary to the carriers past practice of keeping a tight reign on what runs across their networks. Opening the carriers to thousands of applications also opens them up to hacking, virus attacks and untold misery without some very tight controls on what those applications could do and data they could access. The carriers don't seem to be willing to relinquish that control just yet although it has been confirmed by many sources that Google is in talks with various providers about hardware and carrier access. Because of those G-Phone rumors Google stock has been on a nearly vertical path since mid September.

Google Chart - 120 min

Mastercard (MA) turned in a "Priceless" quarter with a +63% increase in profits thanks in part to a booming global economy. Earnings came in at $2.31 per share compared to analyst estimates of $1.43 per share. The priceless earnings created a very pricey 21% bounce in Mastercard's stock price with a gain of +$32.76. The cheaper dollar is allowing global shoppers to profit and those cross border transactions allow Mastercard to collect more fees. Mastercard profits from the fees when consumers use their cards but Mastercard has no exposure to the debt unlike American Express or Discover. The individual banks that issue the cards have the debt exposure not Mastercard. This is the same highly profitable model Visa uses and Visa is expected to IPO in 2008 and been even stronger than the highly successful Mastercard IPO. Mastercard is already buying back stock saying it would buy back $750 million. That helped send the price even higher.

Financials were extremely volatile around the Fed announcement since lower interest rates normally allow banks to make more money on the spread. Lower rates encourage additional borrowing and bank business improves. However we saw prices on most financials return to the middle of their range by the close as conflicting opinions on future Fed direction caused buyers to pause. Those expecting a post Fed bounce and a 50-point cut bailed when it did not come to pass. While the rate cut will be good for banks 25-points were already priced into stocks. Morgan Stanley downgraded the sector on fears that the good news was already priced into stocks and the housing slump had yet to be felt in other than the mortgage companies.

U.S. traded Chinese stocks soared on the strong economic news in the U.S. and odds are good they will soar again when Asia opens for trading tonight. A strong U.S. economy is good for Asia and that helped power crude prices even higher. Crude closed at 94.53 for a +$5.61 rally off Tuesday's lows. In after hours trading today it has already surged to $95.80 and appears hell bent on hitting $100. Most analysts have given up trying to pick a top and shorts are getting killed almost daily. On Monday we saw crude hit an all time high of $93.70 even when adjusted for inflation. The prior inflation adjusted high was $93.09 in 1981 according to the Energy Department. Crude fell -3.50 on Tuesday and continued falling overnight to hit $88.92 for a -$4.78 drop from the highs. That was a 5% drop in just one day. The inventory report was released this morning showing an unexpected drop of -3.9 million barrels after an unexpected drop of -5.3 MB last week. The drop in inventory levels, the strong GDP and the Fed rate cut prompted another monster short squeeze and crude rebounded to its $95.80 level tonight for a +$6.88 rebound. These number ranges are simply unheard of even in modern times. The terms amazing or unbelievable fail to adequately describe the moves. Shorts, and there were a lot of them piling on to Tuesday's drop were simply crushed. The drop in inventory levels is due to a dramatic fall in imports over the last two weeks. Refinery utilization fell nearly a full percentage point to 86.2%. According to analysts this drop in supplies is due to the cost of holding the oil. Refineries don't want to pay $90 for oil today and not be able to sell it as refined products until a month later. Crack spreads are already close to zero and refiners don't want to buy at $90+ only to have it fall to $80 next week leaving them with a negative spread or loss on the deal. Instead refiners are buying only what they absolutely need to get by in hopes of buying oil cheaper in the future. This is creating artificial support for current prices since the refiners are bidding up prices for crude on the spot market. There are actually reports of refiners selling oil in storage to capture the high prices in anticipation of replacing with cheaper crude in the weeks ahead. This was evidenced by a large drop in stockpiles at the Cushing Oklahoma delivery point for crude futures. Storage owners at that tank farm were dumping inventory rather than hold it for future use. This has the potential for a massive problem ahead as we enter heating oil season. If the tank farms have dumped all their crude inventories to capture the $90+ prices in hopes of buying new oil cheaper in the weeks ahead any shortages in the weeks ahead could send prices even higher since the backup inventory has been drained. The demand for cheaper crude to rebuild inventories will be very brisk when or if prices ever fall.

December Crude Oil Chart - 60 min

The U.S., Russia, Iran problem is also keeping pressure on prices. The politicians are getting into the act with Barack Obama talking about it in the recent debate. He accurately explained that $30 of the current price is risk premium due to geopolitical tensions over Iran and several other hot spots. Over the last week Nigeria and Mexico reported shutdowns of production due to rebel attacks and storms but the main mover is the geopolitical turmoil over Iran and refiners not wanting to inventory oil at record highs. Eventually this is going to end badly for those long crude but as in any bubble market in the past, the markets can remain illogical far longer than those betting against it can remain liquid. The high price of oil sent retail prices of home heating oil over $2.95 per gallon and an all time high. We can expect gasoline prices to follow as higher spot crude is processed into gasoline.

Another reason for the rally in crude and the markets in general is the end of the calendar month. October is the fiscal year end for most mutual funds. They want to be fully invested by month end to dress up their year-end statements. This prompted a window dressing event ahead of the Fed over the last week or so. What better vehicle for funds to be long than oil? They look like heroes being long oil into its all time highs. This also suggests we could see some window undressing in the coming days in both oil and the broader markets.

Gold closed at $800.80 today mostly due to the falling dollar. The dollar index hit a new 40-year low at $76.46 and shows no signs of recovering any time soon. This is also impacting oil prices but it is only a small contributor to the current spike. The dollar is not expected to rebound until the recession worries ease and the Fed quits cutting rates. If the U.S. economy really did grow at 3.9% in Q3 and does not fall off appreciably in 2008 that would go a long way towards providing support. Until then it is a bear market in the dollar and companies doing substantial amounts of business overseas are going to be the prime beneficiary.

Chart of the U.S. Dollar Index

The markets rallied in anticipation of the rate cut and after a period of high volatility they rallied again after the cut. The 25-point cut was already factored in and traders had hoped for 50 but the disappointment was brief given the strong GDP. The markets figured any cut was better than none in the face of a stronger than expected economy. The Dow managed to close at a new two-week high but only after a serious struggle. 14000-14100 remains heavy congestion and the Dow has passed the lead baton to the Nasdaq. Support remains 13800 followed by 13500.

The S&P-500 is only slightly more bullish than the Dow and today's close at 1550 is only a handful of points away from resistance at 1550 and again at 1565. With the majority of S&P earnings already behind us there may be little motive power left in the S&P.

The Nasdaq is the leader by far with a new six-year high close at 2860. The big cap techs are breaking out again led by MSFT, AAPL, RIMM, DELL and GOOG. The Nasdaq-100 closed at the high of the day at 2238 and shows no signs of weakening. The chip stocks may be showing signs of forming a bottom with a three-day gain this week following Friday's test of 450 on the SOX. If the chips could find traction the Nasdaq would easily spike higher.

The Russell is still the weak link in this scenario with no material trend and fighting resistance at 830. With the fund year over today I would doubt we will see a lot of fund buying in the small caps. Anything is possible but with recession worries still making the news the large caps should remain the bank of choice for equity funds.

While I would like to be bullish tonight we are going to be faced with possible fund dumping now that their year is over. I am leery of a potential post Fed sell the news event. Funds had the best of all worlds leading into month end. Anticipation of another rate cut, booming oil prices and a recent dip to buy. Moving higher from here could be a challenge. Higher oil prices will be an economic negative, the Fed is back on the sidelines and Q4 is shaping up to be a quagmire for earnings and economics. The next major report will be the ISM on Thursday and it could show contraction. Following that will be the non-farm payrolls on Friday. Based on my assumptions about the Fed I don't expect either to be a serious problem or the Fed would have cut more and said more. It is even possible that they will produce bullish surprises and that could give the market a reason to move higher. If traders can't count on further rate cuts a stronger than expected economy and job market is always a good substitute. The last three-years have seen a very bullish start to November and I would love to see that repeat. I would remain cautiously bullish here depending on those two reports but be ready to switch sides if the S&P falls below 1530. It is time for the real year-end market direction to appear and the path of least resistance is down. That gives the bulls a nice wall of worry to climb and let's hope they have on their rappelling gear.

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