If you expected me to be shocked that the markets sold off for the first three days of 2008 then you did not read my commentary last Sunday. I warned for the last two weeks that the first few days would be rough and for me the first real market day for 2008 would be Tuesday the 8th. I warned that funds would be free to take profits now that we are in a new tax year and that is exactly what they did. 75% of the entire Nasdaq gain in 2007 was on the back of GOOG, AAPL and RIMM. Those profits were at risk for selling and so far GOOG has lost -8%, AAPL -10%, RIMM -10% and AMZN -10%. I was not surprised that the winners were sold hard but I would be surprised if it lasted past next Tuesday.
AAPL Chart - Daily
Network analysts were blaming the market meltdown on the Jobs numbers on Friday and while that did help accelerate the selling it was not the cause. The Jobs report was a shocker to some but I warned you last weekend that the whisper numbers were under 50K with many nearing zero. Jobs for December came in with a gain of only 18,000 and well under the "official" consensus for a gain of 70,000. Fortunately gains reappeared in November with an upward revision from 94,000 to 115,000. The total for Oct-Nov rose to +274,000 and offsets the meager 18,000 gain for December bringing the 3-month average to 97,300 new jobs. This was actually higher than the 3-month average for Q3 at 76,600 jobs. It is the way these numbers appear on a monthly basis that creates the consternation in the markets. Having only an 18,000 job gain in December sounds significantly worse than averaging 97.3K for Q4. December was not expected to be a strong month for jobs so this should have been even less of a surprise. We are still on a downward slope regardless of how you view it. I charted the monthly jobs in the first graphic and then the trailing 3-month moving average in the second graphic. Both paint a picture of slowing job gains but the pace appears manageable in the 3-month chart. Average monthly job gains for all of 2007 were 111,000 per month but that is well below the 2006 average of 189,000.
Nonfarm Payrolls Chart - Monthly
Nonfarm Payrolls Chart - 3-month trailing average
There were sharp drops in construction jobs (-49,000), manufacturing (-31,000) and retail (-25,000). The job diffusion index fell to 48.4 and the lowest level since 2003 suggesting the tide has turned and more companies were cutting back jobs than adding jobs. The unemployment rate spiked by 30 basis points to 5.0% and the highest rate since Nov-2005. This is a major red flag for the economy if it is true. The rate bottomed at 4.4% back in Oct-2006. The jobs report will increase the chances of the Fed cutting rates at or before the Jan-29th meeting.
The jobs data is not what it appears on the surface and that could have caused some additional background selling. The Non Farm Payroll (NFP) report contains an estimate called the birth-death ratio. In December 66,000 jobs were added as a result of this estimate. Basically the Bureau of Labor Statistics (BLS) does two surveys per month. One is the NFP and the other is called the Household Survey. For the NFP the BLS calls 160,000 businesses at random out of their database of 9 million. They ask a few employment questions to get the base for the NFP numbers. The BLS knows the method is flawed since larger corporations tend to stay around and get called repeatedly while small companies tend to disappear, move around or simply get passed over in the census. New companies are normally small and don't show up on the radar for years. The BLS has found that by averaging prior years of data they can compensate for this by adding in the birth-death ratio of new jobs as an average of prior periods. The BDR added 66,000 jobs in December of which 17,000 were supposed to be in the financial sector. Do you really think the financial sector added 17,000 jobs in December? Of course not, this was about the number from 2006 and 2005. When the economy is expanding this BDR will underestimate jobs and when the economy is shrinking it will over estimate jobs for about 12 months in both directions. That means while the economy is sinking into recession it will appear we are doing better in employment that we really are. Since February the BDR added over 1,239,000 jobs to the NFP. Since January the NFP has only shown a gain of 1,208,000 jobs. Does it seem right that the BDR added more jobs than we actually counted? I don't think so but the household survey goes even further into fuzzy logic.
In the Household Survey the BLS calls 60,000 homes at random and asks them employment questions. In the December household survey they showed a loss of -436,000 jobs for the month. This is where the unemployment percentage is derived and that sharp drop in jobs is why the unemployment rate spiked +30 points in one month while the NFP was still showing a job gain. The Household Survey is rarely discussed since the numbers vacillate so widely. In just the last month we went from a gain of +631,000 jobs in November to a drop of 436,000 in December. The variations come from large changes in the population numbers. For instance the civilian population rose from 232,939,000 to 233,156,000 in December. They assume 66% of the population were employed based on the responses received from their 60,000 phone calls. That equates to employment of 146,211,000 in December. It is hardly a precise method but it is the one used to calculate the unemployment rate. They calculated that the number of unemployed rose to 7,655,000 (+474,000) or 5.0% of the 153,866,000 currently employed. You can see why this data is not reported. It would cause the general public's eyes to glaze over. Instead we get the sanitized version of the non-farm payrolls as our beacon of sanity in the job market.
HHousehold Survey Chart
Also helping to increase those chances of a rate cut was the drop in the ISM Index on Wednesday into contraction territory at 47.7 for December. This was a drop of -3 points from the barely positive 50.8 in November. This was the sixth consecutive month of declines in the index. The last time that happened was in 2001. The headline number of 47.7 was the lowest since 2003. This is as close to a real time number as we get on the state of the manufacturing economy.
The ISM Services was released on Friday at 53.9 and it was nearly unchanged from the November reading of 54.1. The services sector is not healthy but it is holding just over contraction level and roughly where it has been since July. Employment rose a point to 52.1 but that could have been related to holiday jobs like catering parties and handling holiday events. January's ISM employment number will be more critical.
The ISM Manufacturing did break under 50 but the 4th quarter is not historically a strong quarter. In 2006 the low for the year was Q4 and we could be seeing the same cycle trend in Q4 2007.
The Fed got a strong dose of exposure to recession flu last week but it remains to be seen if they caught a fever. The Fed funds futures are projecting a 160% chance of a 25-point rate cut when they meet again in a little more than 3-weeks. Goldman Sachs and JP Morgan already jumped into the fray on Friday with their forecast for a 50-point cut to 3.75%. Goldman also suggested we could see an intermeeting move before the regularly scheduled Jan-29th meeting. They believe the Fed will want to fight the recession fears rather than focus on inflation during Q1. Recessions are more damaging than inflation and should be at the top of the Fed's priority list. Once the economy begins to show growth again they can shift their focus back to inflation. The Fed announced late Friday they would offer another $60 billion in TAF loans (Term Auction Facility) similar to their first offering of this type. They will increase the amount offered to $30 billion on each of the next two auctions. Those auctions will be on Jan-14th and another on Jan-28th, the day before the FOMC meeting. The Fed saw its last auction of $20 billion oversubscribed by 300%. The Fed announcement said they were planning on continuing the auctions every two weeks for as long as it takes to address the pressures in the short-term funding markets. The prior two auctions brought in bids of 4.67% and 4.65%. That is more than the current Fed target of 4.25%.
On the economic calendar for next week there are not any events that I deem as critical or as market movers. Those that are material are lagging indicators and already factored into the equation. The most important event may be Treasury Secretary Henry Paulson's speech on Monday on how the markets are recovering from the credit crunch.
I believe the most important quasi-economic events for next week will be any further earnings warnings for Q4. Dow component Alcoa officially kicks off the earnings cycle when they report on Wednesday but the real earnings calendar does not fill up until the week of Jan-21st. That gives everybody planning on reporting after Jan-21st another full week to warn if earnings are going to be less than expected. This should happen next week if we are going to get an earnings dump. So far warnings have been very light except for financials.
Earnings estimates for the S&P for Q4 have declined to an expected loss of -9.5% and ending decisively our long string of earnings growth quarters. The earnings damage is almost entirely due to losses in financials. If you remove the financials from the S&P equation the earnings would still be expectations for +12.5% growth. By themselves earnings estimates for financials are expected to drop -66%. Earnings for energy and techs are still rising. The economy can't be too bad if tech stocks are still raising estimates but now the fears are starting to appear that even those bulletproof sectors may be in trouble. Consumer discretionary and Industrials are the only other sectors to show material estimate declines. Financials and Materials are the only sectors with negative expectations.
Earnings Expectations Table
The problem remains the subprime induced gridlock. In the FOMC minutes released last week for the Dec-11th meeting the Fed noted the risk of an "unfavorable" feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit. The Fed said such a compounding cycle of ever tightening conditions could require "substantial" further easing of Fed policy. Currently banks do not want to lend to other banks because they are not comfortable with the credit quality of those banks. There is simply too much subprime damage still unknown and other banks need to restrain lending to maintain adequate capital. This is keeping the pressure on financial earnings estimates on fears that there will be even more write-downs to come. This fear on the part of the Fed along with the sudden weakening in the ISM and Jobs should cause the Fed to react strongly to the changing events.
The financial stocks are still declining with analysts expecting the mother of all write-down cycles ahead of Q4 earnings. Citi (C), Bank America (BAC), Countrywide (CFC), Bear Stearns (BSC), Wachovia (WB) and Wells Fargo (WFC) among others all hit new 52-week lows on Friday. Fear is rampant in financials and that is rubbing off on the rest of the market. That also suggests we are nearing a bottom in the financial sector but it could take several more weeks for it to appear. S&P expects financial earnings to fall -66% in Q4, -11% in Q1 and then be up +25% by Q4-2008.
John Mauldin brought a company to my attention this week named ACA Capital Holdings. (ACA) ACA wrote credit default insurance on CDOs, $70 billion worth. After losing over $1 billion in Q3 and having their debt-rating cut to nothing they are in default and have to come up with nearly $2 billion in cash by Jan-18th or be deemed insolvent. On Dec-27th the company entered a consent order with the Maryland Insurance Commission giving control of the company to the commission. The New York Times reported last week that Merrill, Bear Stearns or possibly another large firm could take them over. The reason is simple. If they go under the $70 billion in CDO default insurance becomes worthless and those CDOs become worthless. It might make sense for somebody big with lots of ACA exposure to step into the gap just to save their own positions. The problem is that they would take on the risk of the other $70 billion in positions that was not theirs. This same ACA scenario could be happening to the other dozen or so firms that dabbled in this market. Odds are good there is more pain to come for the financial sector in January.
The chip sector was knocked for a 10% drop after both JP Morgan and Bank America cut Intel to neutral. Intel itself fell -15%. The JPM analyst cut Intel on concerns over slowing orders and rising inventory levels. He said processor growth had been rising at an annualized rate of 16-20% for the last two quarters and the highest level since the Y2K surge in 1999 and double the historic average of only 8% growth. He said order weakness was appearing in Europe and could be spreading. AMD hit a new 5-year low at $6.25 after a Wachovia analyst warned that Intel was well ahead of AMD on quad-core processors. Intel has been shipping the fastest quad-core processors for well over a year while AMD is still struggling with design problems. AMD hopes to have the design problems with its quad-core chip code named Barcelona fixed by March. That is nearly a 2-year head start for Intel and Intel is ready to announce faster versions in the coming months. Any day the market is open is a good day to sell AMD.
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Next week the Computer Electronics Show (CES) opens in Vegas with 140,000 attendees and over 3,000 exhibiting companies across 1.8 million feet of floor space. This is the largest electronics show in the world and all the new toys will be exhibited. Home theaters, gaming, cameras, phones, home networking, vehicle electronics and dozens of other categories will be on display. This should give tech stocks a boost simply from the hype surrounding the new devices and their components. The Macworld convention comes the following week from the 14th to 18th and Apple is expected to make even more announcements that could spur buying in tech stocks.
One jump-start to the CES show was an announcement late Friday that Warner Brothers was going to support the Blu-ray format for high definition DVD technology. That major win in the studio wars will be touted by Sony (SNE) at CES next week. There are some thoughts that Apple Computer will also pick a favorite the following week at MacWorld. Sony is the major developer behind Blu-ray. The battle lines appear drawn since Microsoft is expected to announce in its high profile keynote address at CES that it will support the competing HD-DVD in its Xbox 360 product. This brings back visions of VHS vs BetaMax and the videotape format wars. Many analysts are claiming it will not make any difference since the future appears to be a downloadable HD product rather than a flat disk. Apple is rumored to be announcing a new DVD component (HD or Blu-ray) to its Apple TV product at MacWorld but that may just be speculation. Warner Brothers said consumers had spoken in choosing the format rather than an internal WB decision and WB would cancel plans to distribute videos on both formats. Sony already has exclusive deals with Disney, 20th Century Fox and Lions Gate. HD-DVD has exclusive deals with Universal and Paramount/Dreamworks. The WB switch may be just enough weight to end the battle but the two main proponents of HD-DVD remain Microsoft and Toshiba and they have deep pockets. Just how much money they will want to spend to remain on the outside of the mainstream remains to be seen. Had WB made the announcement a month ago there would have been a lot more Blu-ray DVD components sold ahead of the holidays and a lot of HD-DVD players heading back to distributors today.
BoBond rating agency Fitch cut YRC Worldwide (YRCW) investment grade debt rating to junk status on Friday citing a weakening credit profile and tough market conditions. YRC (Yellow Roadway) fell -9% and hit a new 2-year low at $12 on the news. Fitch said the less-than-truckload market in the U.S. had weakened significantly in the past 18 months. According to Fitch poor pricing and over capacity was a result of slumping demand. Fitch expects earnings to come in under expectations for the near future. FedEX (FDX) also slumped to a new 2-year low at $84 due to the guilty by association rule. UPS was impacted less but still fell to its 2-year lows. The Transports are just a handful of points away from a major breakdown under 4100 and the bottom set in August 2006. High fuel prices have been dragging on the transports and specifically airlines for months.
YRCW Chart - Daily
Dow Transports Chart - Weekly
The markets roared off to the worst start since 1932 with a -565 point drop in the Dow and -170 point on the Nasdaq. I warned you last weekend to expect selling in AMZN, AAPL, RIMM and that even Intel and Microsoft were at risk. Those first three I mentioned were down -10% for the week. That should have been no surprise. I believe the majority of this decline was due simply to tax selling by funds now that 2007 is over. They can take profits now on 2007 positions and not have to pay taxes for a year. Secondly we are seeing billions in funds leaving the U.S. market and heading overseas through funds and ETFs. With the U.S. market apparently heading into a recession many investors want to shift money to an economy still growing. Russia funds were seeing strong inflows of cash as were Taiwan, Brazil and even China. The combination of tax selling and money movement was too much for the markets to bear.
Going into next week I am setting up to be bullish. I believe the tax selling is basically over given the severity of the drop. I only projected three days when I warned you last week. Monday will be a cleanup day where remaining positions are dumped and margin calls covered. Traders coming back from an extended holiday will do a gut check and hit the flush lever. I told you last week that I considered next Tuesday the first day of 2008 and I have not changed my mind. There are qualifications to my bullish stance but I am looking for an entry point for at least a trade.
Here is my qualification. The S&P started 2008 with the worst performance since 2000. The S&P-500 has to hold 1400 on any further drop. That is the 100-week average and right at the closing lows from August and November. We are setting up for EITHER a triple bottom low/rebound OR a major breakdown from that level. A break of 1400 could find support at 1375-1380 but a break there would be a game changer.
S&P-500 Chart - Weekly
S&P-500 Chart - Daily
The Nasdaq lost -170 points for the week and plunged to 2500 at Friday's close. This is major support from August and the majority of the drop was in the major names. It was clear tax selling ahead of CES and MacWorld. Now those waiting for an entry point in those same names should be jumping into the gap early in the week to establish positions. The Nasdaq has risk to 2350 if current support and Friday's close at 2500 does fail. RIMM is expected to be a big winner at CES with a number of new devices to feed off the popularity of the BlackBerry. As long as RIMM holds $98-$100 I would still be a buyer. I am not that positive on AAPL and feel it could have further to fall. An ideal entry on AAPL would be somewhere in the $165 range but there may be too many people ready to jump the gun to see a continued dip to that level. Apple will get a boost from MacWorld before Jan-18th. That means we should see a bottom sometime next week.
Nasdaq Chart - Weekly
The biggest worry for me is the Dow and the potential for a confirmed head and shoulders failure with a break of 12800. The Dow closed at a nine-month low on Friday and right at critical support. On a closing basis the Dow has broken a 6-month head and shoulders. On an intraday basis it is right at the neckline. Either way 12800 is critical support and a break here almost guarantees a retest of the February lows at 12000. Let's hope this does not happen.
Dow Chart - Weekly
Nothing says ugly better than the Russell-2000 chart. I warned you last week that the Russell would telegraph fund manager sentiment and judging by this telegram it is extremely bearish. Friday's close was a 16-month low and there was no attempt to buy the dip. This is purely recession related rather than tax selling. Small caps do terrible in a recession and Friday's Jobs numbers scared the dickens out of any fund holding small caps. This could be the failure point for any SPX 1400 rebound. The bulls may show up to buy 1400 only to be devoured by the small cap bears.
Russell 2000 Chart - Weekly
Wild cards for next week will include the JP Morgan Healthcare conference, a major event that could generate interest in any number of health related stocks. The New Hampshire primary on Tuesday will be another lightning rod for healthcare with half the candidates against nationalized healthcare and the others for it. Whoever comes out of NH with a vote lead could influence investor votes on those same stocks.
Something else I expect to see would be the influx of year-end retirement contributions. All those billions in contributions hitting funds last week will be cleared and ready to put to work next week. This is tens of billions of dollars and they have the perfect dip to buy. Since a lot of that money goes into index funds this is a market-lifting event in normal years. The problem here is the recession worries generated by the ISM and Jobs reports. Fund managers don't really have a lot of discretion on those index funds and they will have to put the money to work very soon even if the market continues to fall.
I wrote about the earnings and that only two sectors are in the negative category for estimates. That suggests to me the health of most sectors other than financial and maybe transportation are fine. The vast majority of analysts at Friday's close were screaming sell but that can also be a contrarian indicator. If we are not yet in a recession, earnings are still decent and the Fed is expected to ride to the rescue at the end of January or sooner then this becomes a buying opportunity. Tax selling was anticipated and the bears got help from the jobs report. End of story. At least I hope it is the end of the story. With CES, the JPM Healthcare Conference and MacWorld over the next ten days we should see buyers reappear.
Here is my best guess at a scenario for next week. Monday becomes washout day as traders on extended holiday come back to work and barf all over their charts. Margin calls are covered and the flush ends. On Tuesday buyers appear and the bulls get a running start heading into mid-week. A battle forms when the bears try to short the rally. If support holds the bulls charge ahead and into mid January, MacWorld and the meat of the earnings cycle. If support fails after Monday we go back to bed and set the alarm for the following week and try again.
You should be short from 1490 if you followed my suggestions. I would look to exit that short around 1400 and look to buy any bounce from that level. Should 1400 fail I would look to buy 1380 as a fall back position. If 1380 breaks the market has imploded and we load up on shorts and look for something in the 1235 range for a bottom. If we do go into implosion mode then Russell 675 would be a potential bottom for fund managers to buy in the small caps. I would look to pickup some IWM calls at that level should disaster strike. Initial Nasdaq support is 2400 if Friday's close at 2500 fails. If the Dow fails at 12800 it has risk to 12000. At face value the market appears headed deeper into the red. If that face value is wrong, as it has been so many times in the past, we will be ready for it next week.
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