Window dressing by funds with an October 31st year-end overcame the late day selling and powered markets to the best weekly gain in years. However, even the strong weekly gain could not erase the worst monthly loss for the S&P since 1987.
The Dow ended October with a -1525 point loss despite the +946 gain for the week. It was the first time since Sept-26th that the Dow and S&P posted gains on two consecutive days. It was the best weekly gain for the Dow since 1974. The Nasdaq closed positive for the fourth consecutive day and that is the first four-day gain since May 30th. I would love to ramble on about the new bull market but I believe everyone reading this commentary understands this was just a window dressing event from severely oversold conditions. We may continue higher but I doubt it will be without some rocky sessions. We have had some record setting economic reports recently and I believe there are some more records to be made before conditions begin to improve.
On Friday there was a new multi-year low on the Chicago Purchasing Manager Index (PMI) with a drop to 37.8. That was the lowest level since the 2001 recession. This was a drop of 18.9 points from September's 56.7 level. The business conditions coming into October were very restrictive to business with credit lines cut off leading to layoffs, cancelled orders and limited production. The new orders component fell to 32.5 from 53.9 and order backlogs fell to 39.0 from 54.9. The production index fell to 30.9 from 71.4 for a whopping 40-point drop. This is the lowest production level since 1980 and the largest monthly decline in the 62-year history of the index. With orders and order backlogs dropping this sharply it suggests that production and employment are going to suffer even more in November. The recent numbers on the various manufacturing surveys suggest that Monday's national ISM report is going to be very ugly. Analysts are lowering their expectations for the economy and the GDP. Moody's is now projecting a decline in GDP through Q1-2009 and no real economic rebound until 2010. Even worse they are projecting a global recession to be unavoidable.
Chicago PMI Chart
The National Association of Purchasing Managers (NAPM) report for New York posted the fifth consecutive month of contraction and ninth drop in ten months with a drop to 396.8. The downturn in the financial sector is especially hard on New York and the index reflects this pressure. However, the six-month outlook component jumped sharply to 51.6 from 39.3 as evidence of government programs beginning to work lifted spirits. Tens of thousands of layoffs in the sector have increased unemployment significantly and most are facing limited job opportunities in the area. With hundreds of people applying for any meaningful job in the sector it is going to be a cold winter for many.
Personal income rose +0.2% in September but it was primarily due to hurricane adjustments, additional unemployment insurance benefits and stimulus payments. Real income did not go up, only the government's way of calculating it.
The most surprising report for the day was the Consumer Sentiment survey. Sentiment fell sharply in the initial data two weeks ago to 57.6 from 70.3 but the final revision for the month only showed a minimal 0.1 change. When Consumer Confidence fell over 20 points to 38.0 only a couple days earlier most analysts expected confidence to decline as well.
Consumer Sentiment Chart
I don't normally report on the ECRI Weekly Leading Index but the index is at a serious inflection point. The index has gone into a steep decline over just the last several weeks and is threatening to break lows set back in 2001 during the last recession. The smoothed, annualized growth rate number derived from this index has fallen to a -21.9% and suggests there is serious trouble ahead. In theory this is a "leading index" and it projecting a serious economic decline in our future. This index contains things like unemployment, manufacturing, stock markets, interest rates, etc. This index, although normally meaningless in the weekly reporting cycles, has suddenly turned into a dire forecast for the U.S. economy.
ECRI Weekly Leading Index Chart
The economic calendar for next week is peppered with some high profile reports. The ISM fell to 43.5 in September after clinging to the breakeven expansion/contraction level at 50 for several months. With the various regional economic reports all showing sharp drops in October the outlook for the October ISM is grim.
On Tuesday the Factory Orders report will show us if the monster -4% drop in August was an anomaly or a preview of coming attractions. With credit lines cancelled and orders/backlogs/production all plummeting the outlook for factory order output is not looking good.
The ISM services on Wednesday should not be as grim as the ISM manufacturing on Monday. The service sector is easing but nowhere near the decline in manufacturing.
The next biggest report for the week is the non-Farm payrolls on Friday. The report is expected to show a loss of 175,000 jobs but whisper numbers are running as high as 350,000. Obviously everybody should understand that the economy is tanking and jobs are being lost but it always takes an actual announcement of a specific number to galvanize people into action. A loss of more than 300,000 jobs would be a normal monthly loss during a recession and so far we have been lucky. However, with the economic decline rapidly gaining speed over the last six weeks this could be the month where our luck runs out.
Bernanke was on TV again Friday speaking on housing finance reform. He started off the talk saying the mortgage market was frozen. The process of securitizing mortgages had for all practical purposes stopped. Unfortunately the securitization process is how banks and mortgage companies sell their mortgages to recover capital so they can make more loans. The banks are basically mortgage originators, which are packaged as securities and sold to investors. The process died when investors found the AAA mortgages they were buying were actually subprime slime and over a trillion dollars has been lost in the market blowup. Investors are rightfully wary and today they only want to buy mortgages from Fannie and Freddie with the government as the backstop. That leaves the retail banks and mortgage companies with a limited amount of capital and they are being very picky whom they take on as a mortgage client because they might have to keep the loan for several years. Bernanke said the government might have to backstop mortgage backed bonds as a method of freeing up the market. If the government were going to guarantee the debt then investors would rush to the table to load up.
Bernanke mentioned covered bonds as a way to free up mortgage capital. This is done in Europe in place of the Fannie/Freddie entities. Over $3 trillion in covered bonds are outstanding in Europe. A bank would write X dollars in mortgages. Let's say $100 million. They sell debt in the market secured by the mortgages and by the bank. The amount of debt on the bonds must always be less than the value of the mortgages, say $90 million. The bank retains the mortgages on their books and handles all the servicing. If a mortgage fails they are required to replace it with another one so bond investors are always covered by performing loans. They are considered to be overcapitalized investments. If the bank fails the investors have a priority lien on the mortgage assets. If the assets are insufficient to pay off the bondholders they become unsecured creditors of the bank with claims against the banks other assets. In anticipation of this vehicle being used the Treasury and FDIC have already issued guidelines to promote their use and make sure the banks don't go overboard and assume too much risk. The FDIC regulations require that covered bonds make up no more than 4% of a banks debt. The Treasury requires they are all fully documented loans with a maximum loan to value of 80%. The downside to the program is the transfer of risk from the private investors to other creditors, the FDIC and ultimately the taxpayers if the bank blows up. The investors have a priority security interest in the bank so the FDIC has fewer assets to sell if the bank goes under. That leaves the government holding the bag and backing the debt to the bondholders. Of course you are also going to have to find investors who want to loan billions to banks where financial health may still be an issue. So far only WaMu and BAC have issued covered bonds in the U.S. but JPM, WFC and Citi have said they are going to issue them.
Intel blunted the Nasdaq rally on Friday when it warned that the credit crisis could hurt demand for its chips and lead to the insolvency of key suppliers that would result in product delays. Intel gave no forecasts but shocked the street with their economic warning. Intel said, "Current uncertainty in global economic conditions poses a risk to the overall economy as consumers and businesses may defer purchases in response to tighter credit and negative financial news, which could negatively affect product demand and other related matters." This warning was hidden in a 10-Q filing with the SEC. It was not in the last filing and that suggests Intel is already seeing these factors come into play and that was their heads up for when the details are made public. Numerous manufacturers, not just in the chip sector, have already warned that customers were canceling large orders because the banks were canceling their credit lines and letters of credit. Intel dropped sharply at the open taking the Nasdaq with it. Fortunately the Nasdaq recovered and Intel closed only fractionally lower. UBS said on Friday that PC sales for Q4 were expected to drop by -2.4%. Given the apparent severity of the recession I would be surprised if it is only 2.4%.
SunMicro (JAVA) was knocked for a 13% drop on Friday after an analyst at BMO Capital Markets warned on the outlook for Sun's products. He believed that Sun was stuck with negative product mix issues and a weak economic environment, neither of which is expected to change over the coming quarters. Sun reported a quarterly loss of $1.68 billion or $2.24 per share on Thursday. Gross margins dropped -8.3% for the quarter. Sun refused to give a forecast for the rest of the year.
The commodity sector rallied with the broader market over the last three days but still suffered the largest monthly drop since 1956. The combination of volatility in the dollar, decreasing expectations for global demand and forced liquidations by hedge funds was a perfect storm for commodities. Eventually the volatility in the markets will ease and hard commodities will return to favor but we are not seeing those signs yet. The commodity sector is valued at $1.9 trillion and hedge funds normally control about 45% of that market or $954 billion. Needless to say they were killed over the last three months. It may take a while for their confidence to return.
Morgan Stanley Commodity Index
You already know October was the worst month on record for the S&P since 1987 and TrimTabs confirmed why on Friday. TrimTabs said investors pulled $70.7 billion from mutual funds during the month of October. The previous high was $56 billion in withdrawals in September. Together it was an outflow of funds that was unprecedented in history. After the 1987 crash it took four years for trading to return to pre-crash levels. The S&P fell -18% in October and the MSCI World Index fell 20% and the most in its 38-year history. Morningstar said the average U.S. stock fund declined -23% in value through Oct-30th. That is a horrible month in anybody's book. In October the $157 billion Growth Fund of America fell -19% and the $62.8 billion Fidelity Contrafund lost 17%. Both are down 35% for the year.
Now that we are finally out of October is the bear market over? I would not be the one to make that claim. Despite the massive declines of the last couple of months the recession is still not priced into the market. The minor 0.3% decline in the Q3 GDP was like a mosquito bite in recession terms. The velocity of the current economic decline suggests it could be revised down sharply and the Q4 GDP could be really ugly and in the range of -3% or even lower. The labor market has seen job losses for the last nine months but the average has been only about 75,000 jobs per month. Again, that is akin to another pesky mosquito interrupting your barbeque. When the economic reports start flying in late November that intensity could escalate to the level of yellow jacket stings and that should really capture the attention of picnickers. It may be a really nice sunny day with perfect weather but knock over a yellow jacket nest in the middle of the party and the picnic is over.
I really want to think the lows are behind us given the forced liquidations by hedge funds and the $127 billion extracted from stock funds. This has been the ugliest and most persistent decline I can remember. I would also agree that most investors have bought into the coming recession story but we can't tell if they really believe it or not. On the flipside we know that the stock market normally rebounds 6-9 months before the recession is over. If economists are projecting Q2/Q3 of 2009 as the start of a lasting recovery then the markets should be getting ready for a rally. That is a long-term view not a view for next week. There are probably some serious news events in our future including the presidential election.
The short-term view is cautious. The broader markets rallied an average of 11% last week. Many years we don't move 11% in an entire year. I believe the rally was generated by the Oct-31st fund year-end. I told you last week that year-end fund selling was likely over and I expected window dressing as the week closed. That was exactly what happened with volume decent but lackluster on Thr/Fri. When the market opens on Monday with an 11% gain under its belt those funds will be free to take profits and return to cash at the slightest hint of negativity. Even with the window dressing we still saw strong sell programs late in the afternoon each day last week. Selling into the window dressing means some funds are still raising cash. That suggests to me that we could see a resumption of some selling next week.
I would still be in buy the dip mode if that selling appears. The key for me was the Russell 2000. The index gained nearly 100 points from its Tuesday low of 441 to its Friday high of 540. That is nearly a 23% rebound from trough to peak in only four days. Odds of profit taking are very strong. However, I view the return of fund managers to the small cap market as a strong signal the bottom may be behind us. I doubt the right side of that chart will look like the left but I do believe we will regain some of that ground over the next couple months. If the Russell moves over 550 it would be very bullish.
Russell 2000 Chart
The Dow rallied +11% for the week but reached only to 9350 before running out of steam. There is a line of reasonable resistance at 9500 and that is the line in the sand keeping the gains from being just a bear market rally. If the Dow can find traction and break over 9500 on strong volume then the bottom behind us. if the Dow falls back below 9000 we will see the bears loading up again and the bulls heading for the sidelines. This will be a critical week for market direction and the strength of any early week profit taking will be critical.
The Nasdaq rebounded right to the top of its downtrend channel and closed Friday at exactly where it should fail if the window dressing rally fades. The warning by Intel, the UBS warning on PC sales and the warnings with earnings by several chipmakers over the last couple weeks suggests the Nasdaq is going to need some help to survive next week's expected profit taking. However, the bad news bulls were alive and well last week so anything is possible.
The S&P-500 came to a dead stop right under 985 on Friday and a resistance level analysts feel is the key to any future rally. I also believe 1010 is going to be crucial but we have to cross 985 first. The clear stop at that level on Friday suggests sellers are waiting patiently for the window dressing to be over. The banks have been improving slightly along with the energy sector. Those are the two biggest sectors on the S&P representing nearly 38% of the index. Either one can hold the S&P back and both would need to be in rally mode to more the S&P over 985.
Friday marked the end of the year for mutual funds, the end of the worst month since 1987 and the end of the "sell in May and go away" strategy. Monday marks the first day of the "best six months of the year" strategy and historically there are a lot of investors that subscribe to that theory. Whether or not they have any money left to invest is an entirely different question. I would love to see Nov-3rd blast off over resistance but I seriously doubt it will happen. I think it will be a fight until the election is over and we get the non-Farm payrolls next Friday. Investors will be watching to see if the end of day sellers are still with us or they packed up and left town. Another date to watch is Nov-15th. That is the last notice day for investors wanting to take money out of hedge funds on Dec-31st. Most analysts think the redemptions have run their course and I hope they are right. Also just receiving a notice on Nov-15th means the funds need to plan to have the cash on Dec-31st. It does not mean they are going to sell on Nov-15th. Either way the fund activity after that date should give us a clue as to which way hedge fund investors voted. Nov-15th is also the Washington meeting of the G20 and a global response to the credit crisis could mean sweeping currency changes. This could be a serious market mover or a complete dud. Large meetings of heads of state rarely produce much real agreement but this one could be different given the current crisis.
If you are reading this letter in your email this weekend then we were successful in our weekend website conversion. We have been working on returning the look and feel of the old Option Investor website for several months. You will be able to find any newsletter, Traders Corner or Option 101 dating back to 1997. I encourage you to visit the new site and the wealth of knowledge you will find there. I am sure there will be some bugs we have not found yet so be the first to venture in those undiscovered pages and let us know what you find. Starting the following week we are going to bring back the intraday updates on the website and by email. Watch for a notice about the free sign up. I hope you enjoy the website as much as I do when I look back in the archives at all the wonderful articles written over the years. I have tasked all the writers to produce some more Options 101 and Traders Corners and on the new system they will show up in your email the instant the writer posts them to the website. They will no longer be in the nightly newsletter but sent to you as stand alone content. We have also put a new system in place to get the newsletters to you earlier every evening. It may take a couple weeks to get it functioning perfectly but the goal is faster and better. If you have any comments, questions or complaints just click on the "Email Jim" link at the top of this commentary and I promise you will get an answer.