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Market Wrap

Fed Sees Balanced Risks

HAVING TROUBLE PRINTING?
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The Federal Reserve left rates unchanged and walked the line between downside risks and rising inflation in their statement. The statement seemed to please everyone with the Dow gaining over 300 points. Falling oil prices helped start the market gains after dropping to $118 overnight. It was a good day for the bulls but will it stick?

Wilshire 5000 Chart - 180 Min

The big economic event for the day was of course the Fed meeting. After some mixed economics over the last two weeks almost everybody expected the Fed to leave rates unchanged. The Fed did exactly that and skillfully crafted a statement that confused everybody and suggested rates will remain unchanged for the rest of the year. Confusion is always the goal so the markets will remain balanced. They want to avoid painting a picture too bright or too gloomy but guide slightly in a positive direction.

The central theme of the Fed's statement was a Fed on hold and possibly on hold for the next two months. The statement specifically said the economy faced downside risks for the next couple of quarters but also stressed again that inflation, although a rising concern, is still expected to moderate over the coming quarters. I highlighted the key points in the statement.

FOMC statement:

Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.
Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.
Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

The key point in the first paragraph is the "next few quarters." This is the Fed telling investors they do not expect any improvement in growth any time soon. According to several analysts this is the Fed saying we do not intend to raise rates this year.

The next two highlighted sentences seem to be contradictory. One has inflation moderating while the other sees a significant concern over inflation risks. This is the Fed trying to play both sides of the same coin. They want us to know they are watching but still betting inflation falls. They have been handed a significant gift with the drop in oil prices. Energy and commodities were the main driver for rising inflation and now those drivers have imploded.

Here is how to tell if the Fed is "really" concerned about inflation. Two weeks ago before oil cratered three Fed members were calling for rate hikes to slow inflation. In today's vote there was only one dissenting member, Richard Fisher. If the Fed was really concerned those other two members who stirred up the bond traders two weeks ago would have sided with Fisher and voted for a rate hike.

The Fed's concern for inflation is strictly vocal at this point. They are not going to raise rates because the country is in a recession despite the GDP saying otherwise. Jobs are falling, unemployment rising, credit crisis increasing, banks are failing and home values falling. The Fed never raises rates in a recession. The Fed needs to continue to provide cheap credit to banks until the financial crisis passes.

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Two weeks ago the Fed funds futures were calling for a 100% chance of a rate hike by year-end and a 40% chance of a second quarter point hike. Two weeks ago there was an 80% chance of a hike over the next two meetings (Sept/Oct). That dropped to 62% before today's meeting and fell to 52% after the meeting.

The way I interpret the Fed statement in light of continued record borrowing at the discount window is the Fed telling us there is not going to be any changes. This could be construed both positively and negatively. It could be negative because they are not seeing enough economic strength to support a rate hike. Because they added the "several quarters" comment it is almost a warning that the road ahead could be a minefield. Also, the Fed just extended its term auction facility for banks until Jan-2009. Why would they make it easier for troubled banks to raise money but then raise the rates on that money? I heard three different respected analysts already this week suggesting the next Fed move could be a rate cut. Obviously that would mean the economy worsened but everyone seems to think the decline in the global economy has accelerated rather than firmed and that will take us lower. There is never a shortage of opinions when it comes to economic direction.

Fortunately we do not have to place bets tomorrow on what anybody thinks the Fed actually said. As long as we trade what the market gives us the actual Fed statement is immaterial. The FOMC meeting turned into the Fed equivalent of tropical storm Edouard. It had all the appearances of becoming a hurricane but after all the huffing and puffing there was nothing of substance left.

The other economic report for the day was the ISM Non-Manufacturing Index or services index. The headline number rose slightly to 49.5 from June's 48.2 reading. This is still in contraction territory and the internal components were far from bullish. New orders fell slightly suggesting further weakness but employment rose to 47.1 from 43.8. This could be hiring ahead of the holiday season. The prices paid component fell to 80.8 from 84.5 and that is good inflation news and a confirmation of the trend we have seen in the recent reports. Based on the regular ISM and the ISM services most analysts expect the GDP to decline to only 1% growth.

The last economic report for the day was Cisco earnings. You would not normally think of Cisco as an economic report but that is the way it turned out this quarter. Cisco earned 40 cents per share and analysts were expecting 39 cents. CFO Frank Calderoni said Cisco's earnings in a "quarter of uncertain macroeconomic conditions" demonstrated the strength of Cisco's business model. However, CEO John Chambers said future economic uncertainty meant the company would NOT provide a full-year outlook as it has in the past. Ordinarily this would be an automatic trip to the woodshed but traders appeared unfazed and CSCO stock rose +1.50 in after hours trading. Chambers did say he was comfortable with the long-term revenue growth of 12-17%. Chambers also said many of Cisco's customers see the economy picking up late in 2008 and early 2009. It almost seems as if Chambers has been taking notes from the Fed in how to word the guidance statements. Give no specific guidance and speak in broad general terms.

Cisco Chart - Daily

MasterCard reported today that the first three weeks of the back to school spending cycle has shown the biggest drop since they began keeping weekly records in 2005. This is not just school supplies and apparel but also covers electronics stores and office supplies. This reflects all payment forms including MasterCard data. The electronics category is normally the earliest of all buying with apparel the last to rise. MasterCard said the ten states that held tax-free holidays last weekend did see a dramatic boost in apparel buying. It does not look good for retailers this year.

MasterCard Spending Pulse Table

In the cheapest government bid ever the Treasury Dept said Morgan Stanley won a competitive bid to conduct a "sensitivity analysis" of Fannie and Freddie and provide an assessment of appropriate capital structures for the two firms. The fee for this task is $95,000. Correct, not 95 million but 95 thousand dollars. The review will run until January 17th and will help the Treasury Dept understand how to backstop Fannie and Freddie if the Treasury Dept is ever called on to support them after the rescue legislation passed next week. The $95K was for "expenses" and would not charge any fees for their work.

Helping kick the markets out of their slump this morning was a sharp drop in oil prices from $121 to $118 overnight. Support levels were falling like dominoes and expectations for a continued drop were running high. The touch of $118 was a drop of $30 off the $147.90 high and exactly a -20% drop. The bulls were hoping the dip into bear market territory, regardless of how brief, would trigger some buying but that was also brief. There is no love in the energy sector this week.

I believe the oil/commodity sector implosion this week was not the result of some geopolitical news or falling demand but simply an asset allocation event ahead of the Fed meeting. Every hedge fund worth its fee has been invested in commodities and short financials for most of the last year. Many analysts were calling a bottom in financials after the panic selling of July 15th. We saw another decline from that bounce that ended with the Merrill Lynch announcement last week. That Merrill announcement was seen by many as the beginning of the end. Quite a few were saying that it only heralded more write-downs by the other big banks but others were saying it established a floor in the sector. Obviously the proof is in the market and after John Thain's grilling on CNBC on Monday the financials moved higher on Tuesday. Merrill sold $9 billion in stock but their stock price is up +$6 since that sale. If this week's commodity implosion was an asset allocation move then we should see an extension of the gain in financials on Wednesday.

Every day after the market closes I review the charts for the major indexes and discuss them with others in the office. Today we were all impressed with the duplication across all the charts. Every major chart rallied exactly to resistance and screeched to a sudden stop. We all agreed we are either going to explode over this resistance or fail hard. Today's rally was the first in four days and just one more in a long line of short squeezes. Each one failed but will this time be more of the same or different?

Index Charts

The Dow chart did not change even after a +331 point spike. Resistance remains 11650 but we did get a higher low. That did change the short-term trend but it did nothing for the consolidation pattern since mid July. A triple digit move over 11650 would go a long way towards convincing the bulls the bears have gone.

DDow Chart - Daily

The Nasdaq rallied exactly to resistance at 2350 and exactly where it has failed twice before. I actually feel a little more positive about the Nasdaq today and the Cisco gains should give the Nasdaq a little momentum at tomorrow's open. We have been here before but we have a good series of higher lows since July 21st. Current initial support is now 2285.

Nasdaq Chart - Daily

S&P-500 Chart - Daily

Russell 2000 Chart - Daily

The Russell is again the most bullish of the charts with an actual close just over resistance at 720. I can't emphasize this enough that the Russell is leading the market and a breakout here would be very bullish. The Monday dip to 700 came within three points of my buy the dips to 697 recommendation from Sunday. That same recommendation works for the rest of the week but I would be concerned if we made that trip again. Eventually the bulls will step back on repeated dips just to see where it stops. I would rather hope for a breakout than dwell on reasons for a support break.

There were other earnings after the close with PriceLine (PCLN) losing -$18 in after hours trading after warning that airline capacity cuts and higher fuel prices would have a negative impact to PriceLine earnings. Whole Foods Markets (WFMI) lost $5 after posting lower earnings, slashing the outlook and halting their dividend. Obviously not everything was positive after the close but hopefully Cisco will overshadow those losers.

We knew the Fed statement would be balanced and there would probably not be a rate change. There was no surprise in the statement so by all rights the short squeeze was extremely overdone. If by chance that was the beginning of the asset allocation move I discussed then tomorrow could see more gains. However, after a +331 point gain it would not be unusual for a consolidation day. It would be a coin toss at the open so continue to buy the dips and keep your fingers crossed.

Jim Brown

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