The Fed committed to create $600 billion in new money and use that money to buy government bonds and keep interest rates low for "an extended period."
The Fed announcement today was no real surprise. The move had been telegraphed since Bernanke's Jackson Hole speech on August 27th. There had been some competing rumors in the market as to how much the Fed would actually commit to spending. The general estimate was between $500 billion and $1 trillion with some estimates as low as $100 billion and as high as $2 trillion.
The Fed came in right in the middle of the range with a commitment to create $600 billion in new electronic money and then spend it on U.S. government debt at the rate of $75 billion per month through June 2011. In addition to the investment of the newly created money they also committed to use money received from the payment on past investments to purchase the same 3-5 year maturities. This is expected to provide another $250-$300 billion in purchases. That raises the total on the new QE program to something in the range of $850-$900 billion over the next eight months.
This amount of quantitative easing in addition to their prior program is unheard of in U.S. history. In theory it will keep interest rates near zero for a very long time. The Treasury sold 2-year inflation protected notes last week with a negative yield. That means the interest rate was so low that the real yield was negative. With bonds the higher the price the lower the yield. The demand was so strong that the calculated yield was less than zero.
The Fed statement did contain an escape clause. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
If the Fed decides the economy is improving sufficiently they can scale back on the size of the purchases or eliminate them completely. They can also increase the purchases if they believe conditions are deteriorating.
The Fed sees the $600 billion in new money purchases as the equivalent to a 75-basis point in the Fed funds rate. Under normal conditions this would be extremely aggressive policy accommodation. Can you imagine the market reaction to a normal Fed rate cut of 75-points? Unfortunately these are not normal times and over the last 60 days the market has already priced in the move. Bernanke telegraphed the program starting on August 27th and then continued to provide additional hints over the last two months. The S&P is up +12% since that August speech.
As justification for the move the Fed said the pace of recovery had slowed and employment remained constrained. Housing wealth and tight credit continued to weigh on consumers. Business spending was still rising but at a slower pace than earlier in the year. The Fed reiterated that inflation remained low and had trended even lower in recent quarters. The PCE CORE inflation number last week was zero. You can't get much lower than that without slipping into a depression and this is what the Fed is fighting.
With interest rates already zero the Fed is taking direct aim at the stock market. Over 50% of consumers have investments in equities. By inflating the stock market this produces a wealth effect that boosts consumer confidence and stimulates spending. Since the election slammed the door on any new government stimulus the Fed is the only player left in the game that has the power to move the economy.
The Fed is in a unique position. To use a Texas Holdem term the Fed can go "all in" by betting all of its available cash in an effort to boost the economy. If they lose that hand they can simply create more money to replenish their bankroll and go all in again. They have the power to outlast any other player at the table because they can keep creating money until they eventually bankrupt everyone else.
In this case they can continue creating money and pushing rates so low that banks, businesses and investors will eventually have no choice but to make loans, spend money and buy stocks in an effort to get a return on their investment. You can't leave trillions in cash in the corporate mattress forever. During the recession non-financial corporations have accumulated $1.845 trillion in cash a near record. If that money was put to work the impact on the economy would be huge. This is what the Fed is trying to accomplish.
There is also about $1 trillion in corporate profits sitting in accounts overseas in hopes of a tax holiday or some kind of tax discount for bringing those profits back into the U.S. This has been done before when the government wanted to stimulate growth at home. Now that the election is over companies are hoping for a friendlier Congress that will pass a repatriation bill. Currently they would incur a 35% tax rate and the highest rate in the world.
The next step up in the escalating war on the recession is to charge banks for money they have on deposit at the Fed. Banks currently earn interest, .25%, on money deposited at the Fed. If the Fed suddenly turned the tables on the banks and began charging them say a quarter point in interest those banks would immediately be forced to put that money to work somewhere else.
The Fed also said it could reactivate the various loan facilities like the TALF if conditions warranted.
Even though the market did not post any sizeable gains today and this has been telegraphed for months in advance that does not mean the rally is over. Over the long term we know not to fight the Fed. They will eventually accomplish their goals and it is best if we don't bankrupt ourselves trying to second-guess the market direction. We could still have a sell the news event but we have to believe it will simply be another buying opportunity. Do you really want to beat against an entity that has an unlimited bank account?
There was a heavy economic calendar today in addition to the FOMC statement. I will skim through the highlights because the Fed was the big story.
The Factory Orders for September rose +2.1% and the biggest gain in the last eight months. This is a lagging report but it was still good news. However, when you remove orders for transportation equipment that number fell to +0.4%. The transportation component rose +15.8%. Nondurable goods shipments rose by +0.9% and durable goods was raised to +3.5%. Core capital goods rose +0.5% and the ninth consecutive monthly increase.
The October ISM Non-Manufacturing Index (Services) stretched its rebound to two months with a small gain to 54.3 from 53.2. It appears from the ISM Manufacturing and the ISM Services that the economy is rebounding from the temporary summer slump. If this kind of increases through year end we could be set for a significant ramp higher in 2011. These are still just green shoots and not a blossoming economy just yet. The business activity component shot up to 58.4 from 52.8 for the biggest gain in the report. That one component accounts for 25% of the index so we are making progress. We still need to see the index move over the 55.4 plateau we saw back in the spring in order to break the long-term downtrend.
ISM Services Chart
The Challenger Employment report was neutral for October. The number of announced job cuts remained low at slightly less than 38,000. The number of layoffs has remained under 40,000 for six of the last seven months. July saw a small spike to 41,700 and August was the low at 34,800.
The ADP report earlier this week predicted an increase of +43,000 jobs in Friday's NonFarm Payroll report. This was pretty much inline with estimates although there are some as high as +100,000 jobs. Moody's is predicting a gain of +70,000 jobs.
The NonFarm Payroll report on Friday is the last of the big economic events for the week. Since the Fed has already made its announcement on QE the jobs report should not make a big impact on the market as long as the numbers are inline. However, an unexpected loss of jobs or a much better than expected gain could still produce some extra volatility.
Vehicle Sales for October spiked another 500,000 units to an annualized rate of 12.3 million units. This was better than expected and was boosted by a pickup in fleet sales. That is a positive economic signal for me. If companies are increasing their purchases of fleet vehicles they must be positive about the economy. This was the highest sales rate since September 2008 and with the exception of the artificial cash for clunkers spike in August 2009. We still have a long way to go because average sales rates before the recession were in the 15-15 million unit range.
Stock news was almost nonexistent today with the election results and the FOMC meeting hogging all the airtime. There are still some earnings occurring and Qualcomm was one of those reporters. QCOM reported earnings of 68-cents and well above the estimates for 59-cents. Revenue rose +10% o $2.95 billion. The company raised its guidance for Q4 to an average of 72-cents where analysts were looking for 64-cents. QCOM shares spiked +$3 in after hours. Analysts believe QCOM would benefit from a Verizon iPhone in 2011.
Chesapeake (CHK) reported earnings of 70-cents compared to estimates of 64-cents. The beat came from a 23% increase in natural gas production. The big news was not the earnings but statement they will stop pumping gas until prices go up. All the gas producers are struggling under the current price of gas in the mid $3 range. Gas prices have gone down 31% this year.
Chesapeake said it would begin to ramp down production by mid-2011 if prices did not rise. CHK and other gas producers are shifting their drilling programs to search oil and natural gas liquids rather than shale gas. The cost to drill the horizontal wells are about equal but the relative price between gas and oil has broken down. Typically there was historically a 6:1 ratio of gas to oil on price but that is now roughly 24:1. It takes 6,000 cubic feet (mcf) of gas to produce the same amount of energy as a barrel of oil.
It does not make sense to continue drilling for shale gas at $3.50 per mcf. This is a lowing proposition for many drillers. Chesapeake said they expect to produce around 1 trillion cubic feet in 2011 but expects 80% of its production growth to come from liquids. Over time this will produce a decline in gas production and push prices higher. Producers need prices in the $6 range to make it worthwhile to continue drilling at the current cost. Those costs have shot up over the last 24 months and will continue to rise as the landowner war over damage from hydraulic fracturing makes its way through the courts.
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The earnings cycle is winding down but the earnings growth numbers are still rising. With 404 of the S&P-500 companies reported the average earnings growth was 33.3%. Over 313 companies beat estimates and 82 missed estimates. The average surprise was 46.5% and the average miss was -21%.
GM priced its IPO between $26-$29 and they expect to raise about $12.2 billion. The government will still own 43.3% of GM after the deal. GM still has about a $50 billion operating loss carry forward and the government funded that loss. The UAW will sell 25% of its shares in the IPO to reduce its holdings from 19.93% to 15.33%.
The major indexes saw about five minutes of volatility after the FOMC announcement. The statement was so inline with what most people expected there was no major sell off or rally. The bears were waiting for the official announcement to start a selling frenzy but the buyers were also waiting just under the market and the sell off was very short.
I was expecting a sell the news event since this announcement has been priced in for a month now. Just because it did not happen immediately after the announcement did not mean the danger has passed. We could still see it tomorrow or Friday.
However, after looking carefully at the charts tonight I am leaning towards a breakout instead of a breakdown. I believe if we did get a dip in the markets it would only be temporary.
The Nasdaq is leading the other indexes into the promised land above the early 2010 resistance. The Nasdaq has broken out over strong resistance at 2520 and is now testing resistance dating back to June 2008 at 2540. This is a strong signal that investors are moving into higher risk assets. While the Russell is lagging the Nasdaq it did close at a new five month high at 715 and apparently on the verge of a significant breakout. This is going to be key. Managers had been neutral on the small caps since Oct 13th. If they suddenly start piling into the Russell stocks in the days ahead it will be the starters gun for the end of year race.
The S&P closed at 1198 and ever so close to the psychological 1200 level. With no economic events other than the NonFarm Payrolls in the immediate future the bulls could stampede once over the 1200 level. The payroll report should be ignored if the number is roughly inline with estimates. Support is solid at 1180.
The Dow came to a dead stop at resistance at 11,215 but we did not get the instant sell off that we saw in the prior three touches of this level. The Dow appears poised for a breakout assuming that sell the news event does not appear. The dips are being bought so quickly that the fear of a sell off is dissipating. Should the Dow break over 11,215 the next material target is 11,650. That would be a strong run but all the warnings lights are turning from red to green. Support remains 11,100.
The Nasdaq closed well over 2520 for the second day and that qualifies as a confirmation of the move. Granted the rally from August has been incredible but once retail investors and money managers find themselves chasing price and performance this trend could actually accelerate. Before you start sending me bearish hate mail I am not wildly bullish. I just believe the green shoots are sprouting and the FOMC is leading the charge. Don't fight the Fed! I would love to see a decent sell off to give us an entry point but I am not holding my breath.
The Volatility Index collapsed today once the FOMC announcement hit the airwaves. The addition of another $900 billion Fed put completely killed the VIX. Traders who were long puts in case of a change in direction by the Fed immediately sold those puts and drove the VIX back to lows from late October.
In summary the bears are going to want to sell the open on Thursday but the Fed is our new trading partner. Whether you believe in the program or not is immaterial. The Fed wants the market to move higher to create a wealth effect on consumers and businesses so they will feel more comfortable about spending money. By pushing the stock market higher they can create a speedier recovery. With the Fed put protecting our portfolio we need to continue buying the dips.