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Harsh Words From the Fed

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Traders are bracing themselves for some harsh words from the Fed when they announce their rate decision on Wednesday. The markets shook off a triple digit drop at the open for a +175 point rebound on the Dow. Fear of the Fed erased most of that bounce before the close with all the indexes back in the red. The Dow is on track to have the worst month since 2002.

Chart of Wilshire 5000 Broad Market Index

The morning opened with an extremely bearish Consumer Confidence report. The headline number fell from 58.1 and a 15-year low to 50.4 and the 4th lowest ever reading since the survey began back in 1969. The present conditions component fell from 74.2 to 64.5 and the expectations component slipped from 47.3 to 41.0. These are extremely bearish numbers and the market was shocked into a major drop at the open. The share of consumers finding jobs plentiful fell to 14.1% and the lowest reading since December 2003. Those consumers finding jobs hard to get rose to 30.5% and the highest since Dec-2003. Those expecting available jobs to increase fell to 8% and the lowest level since 1980. Those planning to buy a home fell to their lowest level since 1982 at 2.2%. Consumer expectations for higher inflation remained at the highest level on record since 1987. All the same factors still apply. Higher utility costs, fuel costs, food costs and general inflation in every item were high on the list along with falling home equities and the inability to borrow on that equity or sell their homes. I would expect the same kind of trend to continue in the Consumer Sentiment report on Friday.

Consumer Confidence

The S&P/Case-Shiller monthly home price index showed a continued decline in home prices in both the 10-city and 20-city composite models. The 10-city survey fell -1.6% and the 20-city composite fell another 1.4%. On a year over year basis the 10-city composite is down -16.4% and the 20-city survey fell -15.3%. Prices fell in 12 of the 20 metro areas surveyed. The largest metro area declines were Miami -4.1%, Phoenix -3.4%, San Diego -2.6% and San Francisco -2.2%. Prices rose in Boston, Chicago, Charlotte, Cleveland, Dallas, Denver, Portland and Seattle. Despite the negativity this report was actually seen as a positive change in the trend. Prices fell overall but there were more cities showing gains and the overall declines were smaller. Credit Suisse went so far as to initiate ratings on the homebuilder sector with an overweight (buy) rating on six. CS said inventory levels should peak in spring 2009 and then begin to decline. This decline would be the first step in the final recovery process. CS put an outperform rating on CTX, DHI, KBH, PHM, RYL and TOL. Not all builders were as fortunate. HOV, MTH were rated under perform and LEN, MDC and NVR as neutral.

Case Shiller Chart

The Richmond Fed Manufacturing Survey fell to -12 for June from the -3 posted in May. This is the lowest reading since September 2003 and is consistent with the other regional Fed surveys showing an accelerating contraction in the manufacturing survey. The shipments component fell 10 points to -11, the new orders component fell 9 points to -13 and unfilled orders fell 16 points to -21. The employment component also fell sharply losing 8 points to -12. The Richmond Fed survey is very volatile month to month but the trend is clear. The most troubling data was not in a component but in the survey responses. Manufacturers said they expected prices to rise by 5.57% over the next six months and they planned to pass these increases on to their customers because they had already absorbed all they could afford over the prior months. They planned to do this even if it meant losing market share. That is a key indicator that inflation is going to increase in our future.

The remaining reports of interest are the New Home sales on Wednesday, GDP and Kansas Fed Survey on Thursday and Personal Income, Consumer Sentiment on Friday.

The most important economic event for the week will be the Fed announcement at 2:15 on Wednesday. Traders expect some harsh words from the Fed on inflation but no rate hike. Actually after some of the recent economics and revelations from the financial sector they probably wish they could cut rates again but the rising inflation has put an end to that cycle. The Fed is in trouble and it will be interesting to see if they can pull a rabbit out of their hat with some new kind of stimulus that does not involve rate cuts. The Fed Funds Futures are showing a full 50-point rate hike by October and a 3.25% Fed rate by next May. There could be a long series of rate hikes in our future but when they will start is the key question. Since nobody expects the Fed to hike this week it would be a real shock to the system. However, once the Fed embarks on their rate hike cycle it will boost the dollar and slow the climb in oil prices. A substantial hike along with harsh comments would give the dollar a huge boost and depress the price of oil. That would not be a bad scenario. Since everyone knows they are going to hike rates before October why not do it now and aggressively to really send a message to the markets? There are three more meetings between now and the elections. Aug-5th, Sept-16th and Oct-28th. We know they are not going to raise rates at the October meeting for political reasons. That leaves August and September and I would bet on hikes at both meetings. If they know they are going to hike then why wait? Why let inflation run another couple months before taking action? This is of course contrary to what the market is expecting so it would be a major shock if it happened.

There was an event today that was more important to the Fed than the Consumer Confidence and it was not even an economic event. The event was the second major price hike in the last 60 days by Dow Chemical (DOW). In May Dow raised prices by up to 20% effective June 1st. They announced today an across the board increase of another 25% effective July 1st. This is a monumental event and unprecedented in its size and scope. Dow has 2500 product families and nearly every product you buy made has something from Dow Chemical in its makeup. They are also putting a fuel surcharge of $300 on every truck shipment and $600 on every rail shipment. Dow uses natural gas and crude oil as feedstocks for its many products. Dow said it cost $8 billion for energy and feedstocks five years ago. That number rose to $13 billion three years ago, $27 billion in 2007 and will exceed $32 billion in 2008. For reference Dow's market cap is only $13 billion. So far in 2008 Dow's costs for these components are up 42% over the same period in 2007.

Dow said it had to pass on costs in order to survive and continue to supply products to tens of thousands of manufacturers around the world. Their chemicals are found in everything from antifreeze, coolants, solvents, cosmetics, pharmaceuticals, detergents, disposable diapers, water treatment, plastic, acrylics, paints, coatings and the list goes on for literally thousands of applications. For every $1 rise in the price of oil it costs the plastics industry $660 million a year. A 45% producer hike in prices over the last 45 days is a monster contribution to inflation. Dow is not going to be the only company passing on rate increases. Their high profile announcement is a green light for every manufacturer to do the same.

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The Fed has to be listening to Dow as just one of the major contributors to higher prices and thinking something needs to be done ASAP. I would not be too surprised to see a rate hike on Wednesday despite what the analysts are expecting. On the flip side an aggressive hike cycle in this weak economy could cause a deflationary recession and do more harm than good. This is seen by some as a bigger risk than inflation at the current level. Consumer prices have risen only 4% year to date and while high that is not the end of the world. One analyst commented today that the U.S. is only one shock away from a financial disaster. In that environment the Fed would probably remain on hold but either way it will be an interesting announcement.

Another signpost for the Fed would be the UPS earnings warning. UPS shares fell -6% on Tuesday after saying that higher fuel costs and lower package volume prevented them from reaching their prior guidance. UPS said it now expects to earn 83-88 cents compared to previous guidance of 97-1.04. UPS already passes on fuel expenses to customers but costs have been rising faster than prices. UPS hit a 5-year low on the news. UPS said, "The anemic U.S. economy is negatively impacting volume in the U.S. and affecting profits from the international segment." You may remember FedEx warned last week that earnings would suffer from the current environment.

If it is Tuesday there must be a Yahoo rumor. Yahoo spiked +9% intraday on rumors they were in secret talks with Microsoft about a new buyout deal. The initial news came from the popular Silicon Valley blog TechCrunch citing multiple sources saying they were in full buyout talks again. The report followed an earlier article by CNet.com that Microsoft had signaled a willingness to sweeten a previous offer for Yahoo's search business and Yahoo's board had signaled a willingness to consider that offer. The report cited a "major investor" who had been in talks with both companies. Microsoft killed the rumors saying they were not in talks on a buyout but would still consider buying the search business according to their last offer. After the Microsoft comments Yahoo declined to close at $22 for only a 3% increase. With the number of shorts piling on Yahoo it does not take much to trigger intraday short covering.

The only guaranteed trend in the market is rising sales of Toyotas in America. Unfortunately that trend just broke. Toyota said the weakness in the U.S. could cause them to miss prior sales targets. Their goal was to grow sales by 1% in the U.S. and missing it would not be earth shaking. What may be bigger news is the potential for Toyota to become the number one automaker in sales in the U.S. in June. GM sales are plunging so sharply that Toyota may actually do the unthinkable and be the top U.S. seller for the first time ever.

Almost as important as the Fed decision on Wednesday will be earnings from Research in Motion (RIMM). Their after hours report could produce some major market moves on Thursday. Expectations are very high and calls are being bought in volume as far out as $170 when the stock closed at $140 today. RIMM guided higher with expectations for 2.2 million new subscribers and a total of 16 million users. RIMM stock has a habit of making big moves after the announcement. Over the last few quarters moves of $8-$10 have not been uncommon. Analysts are worried if the economic weakness is going to make the employee Blackberry an expense that could be cut in an attempt to maintain margins. However analysts point out that with several models under $100 it is a strong consumer price point.

August Crude Oil Chart - Daily

Crude oil was flat at $137 for the second day after the Saudi meeting. There was plenty of news in the market but nothing that was a market mover. The weekend Saudi meeting was structured to push prices lower by exposing the supposed glut of oil and the impact of speculators that are pushing prices higher. Today the OPEC president negated all of that publicity with his announcement that OPEC would not be raising production. "All you have to do is look at the data to be convinced that the market is well supplied in oil and that we have enough spare capacity and that we have enough stocks in the market," Chakib Khelil, OPEC President. Last but not least, Libya's Oil Minister Shokri Ghanem announced over the weekend it may "cut" production to prevent market oversupply. Despite Saudi's energy conference on supply and prices we believe there is plenty of supply in the global market. Good try Saudi but your own cartel members are working against you. Weekly crude inventories will be released tomorrow and crude is expected to show a drop of -1.7 million barrels. It would be the sixth consecutive weekly drop.

The markets were confusing today with the early morning drop on the Consumer Confidence shock. The Dow dropped -120 points at the open to touch 11725 and test the March closing lows. Buyers rushed into the dip and the Dow rebounded +179 points to 11904. While the bulls were congratulating themselves for excellent analysis and buying at what should be strong support at the March lows the market rolled over again and erased the majority of their gains. The 11725 level on the Dow should be strong support but the rest of the indexes are not confirming. The Dow is ahead of the pack and the S&P, Nasdaq and Russell are lagging but appear to be breaking down.

Dow Chart - Daily

Nasdaq Chart - Daily

The problem for me is the Dow as the leader to the downside. I speculated on Sunday that the March lows would be a rally point ahead of end of quarter window dressing. So far that theory is holding but the window dressing has failed to show up. Actually we saw selling in winners today rather than buying. Agricultural stocks like MOS -7.69, POT -8.90 and MON -6.26 should have been moving higher as funds try to show how smart they were by stacking the deck with winners. Losers like the financials rebounded today. This is completely contrary to normal window dressing. Will it reverse as the week progresses? Who knows?

SS&P-500 Chart - Daily

Russell 2000 Chart - Daily

A big concern for me today was the Russell. When the other indexes had turned positive for the day the Russell was still down -7 points and that is a huge measure of negative sentiment for me. The Russell ended with a close at a new two-month low and a clear breakdown. As a fund manager sentiment indicator this is very bearish.

I was also especially disturbed about the sudden increase in the negativity of the market internals. In the table below look at how strongly the new 52-week lows have surged over just the past week. Volume has also increased with the majority on the downside. Note that the decliners are increasing as well. If the window dressing is going to appear it better hurry.

Market Internals

The line up for the rest of the week is going to be a battle between the Dow/Wilshire at strong support and the sdaq, Russell and S&P breaking down. The S&P closed at 1314 and has risk to 1275 and the March lows. The Nasdaq also closed at a two month low at 2369 and has risk to 2260. The Russell closed at 708 and has risk to 685. Once that 720 level broke the chart turned ugly and it will take a major change in sentiment to repair it.

EExpect volatility at 2:15 Wednesday afternoon when the Fed announcement hits the wires. Remember the initial market move is rarely the correct direction and the reversal is normally the trend that continues. RIMM earnings after the close if you want to play with fire. If you would rather play oil the inventory announcement is 10:30 with expectations for a continued decline in inventory levels. A sudden unexpected build could really create a slide in prices. I still expect window dressing to appear but it may get run over by the bears if the Fed statement is harsher than expected. After the Fed announcement volatility the volume the rest of the week is going to drop like a spent holiday rocket as traders leave for a long July 4th holiday. With the 4th on a Friday that makes the coming week the holiday week rather than the following week. I know it is still a week away but it is summer and it is a dull market. That is a perfect recipe for an extended holiday.

Jim Brown
 

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