The market gave back all of its midweek gains as the anticipation over the fiscal cliff talks appeared to be fading.

Market Statistics

The shooting in Connecticut put a cloud over the markets even though it was not market related. The news flow on the shooting overshadowed the news about the fiscal cliff and the result was a very low volume Friday and no meaningful market movement.

There was barely any fiscal cliff news despite John Boehner and president Obama holding an hour long meeting at the White House on Thursday night. Both sides said there would be no comment on what they discussed. It was the second face to face meeting in the last five days. The only adjective used to describe the talk was that it was a "frank" meeting. This suggests both parties stuck to their positions and there was no material deviation.

The week ahead is going to be critical for cliff discussions. Up until this point most analysts believed we would see some progress just before the Christmas holidays. That belief is starting to fade. Recent comments from some lawmakers suggest we will be lucky to get a deal done on the tax portion by December 31st. President Obama is scheduled to leave for a vacation in Hawaii on Monday and not return until Jan-6th. If he leaves on that trip without a deal the message to the markets would be negative.

The problem is on the republican side. The president does not have to do anything by Dec 31st and taxes will go up on everyone. That is his trump card. The republicans are struggling to extract some kind of spending cuts to go along with agreeing to tax hikes on the top 2% but are coming up empty. There is no urgency on the side of the democrats to do anything because they know the deadline works in their favor. Once the tax cuts expire any new deal will be a "new" deal and they can structure it any way they want and the republicans will get the blame for not accepting the president's earlier tax proposal. I would hate to be John Boehner next week. He has a tough job and no real weapon in his arsenal.

The "doomsday" option is still being held as a last resort. The republicans can allow the existing Senate bill to come to a vote in the House. If this happens the republicans would vote "present" instead of opposed so the bill would pass as written. That way they can't be blamed for voting for a tax hike. I know, it is just semantics, but that is how politics is played. By doing this they would not be blamed for letting taxes rise on everyone.

However, even if the House passes the bill the president still has to sign it. He has said in the past he would but recent comments suggest he will want to get something in addition to the tax bill like an agreement to kick the rest of the cliff well into next year by postponing the other deadlines on the cliff.

The main detail that should concern investors next week is simply the countdown clock winding down. The initial deadline from Harry Reid was "before Christmas" and once it is apparent it will be missed the markets may begin to react badly to any cliff headline that suggests there will be no agreement. House leader John Boehner went home for the weekend so no meetings with the president this weekend.

The economic reports on Friday were positive but they failed to support the market. The Consumer Price Index (CPI) declined -0.3% and slightly more than the -0.2% drop analysts had expected. The main driver was a -4.1% decline in energy prices overall and -7.1% decline in gasoline prices. Inflation has disappeared and we could see further declines in the near future.

The potential for deflation is what the Fed is trying to guard against with the new QE4 program.

The core CPI, excluding food and energy, showed a minor +0.1% gain. Core prices have moderated this year for the longest streak since 2009. Food prices rose +0.2% led by dairy prices. Meat and poultry prices declined slightly.

The 12-month CPI is +1.8% with the core rate +1.9%. This is below the Fed's target of +2.0% and well below their toleration level of 2.5% where they would begin raising rates to slow inflation.

Consumer Price Index Chart

Industrial production for November rose a much better than expected +1.1% compared to analyst estimates at +0.4%. However, October was revised down from -0.4% to -0.7% as a result of hurricane Sandy. The rebound in November was the result of the hurricane depressed activity coming back online. This will be a temporary bounce. December will require another big gain or production will decline for the quarter.

Manufacturing production rebounded +1.1% after a -1.0% decline in October. Manufacturing received a boost from a +4.5% jump in automobile output. That was the largest increase for the year. Cars destroyed by Sandy were being replaced by insurance and that spiked vehicle demand.

Industrial Production Chart

Next week has a lot of economic data with housing reports and several manufacturing surveys. The NAHB Housing Market Index on Tuesday is the most watched of the housing numbers. This is basically the sentiment indicator for home builders with sales expectations and traffic estimates.

The Philly Fed Manufacturing Survey for December is the most important of the regional reports because it tracks well with the national ISM the first week of January. The Philly Fed headline number fell off a cliff in November with a decline from +5.7 to -10.7. The expectations for the December headline number will be a rise to -1.2 and still in contraction territory.

Don't forget the world will end on Friday the 21st according to the Mayan long count calendar. The calendar is normally believed to be invented by the Mayans but it was most likely invented by the Olmec. That was the people who preceded the Mayans from about 2500 BC. They were the first Mesoamerican civilization and flourished in the area now filled with Mayan artifacts. The Mayans flourished from 250 to 900 AD. The long date calendar that ends on Dec-21st has been interpreted by pseudoscience practitioners as the end of the current age. The Mayans believed there were several prior ages. At least if the end of the world comes on Friday we will not have to worry about the fiscal cliff.

Economic Calendar

In stock news, oil field services company Schlumberger (SLB) warned that Q4 earnings are expected to decline by 5 to 7 cents because of slowing activity in its two largest regional units. The company said weaker than expected drilling in the U.S. and Canada along with contractual delays in Europe and Africa were to blame. SLB said the Europe/Africa segment produced the second highest regional sales with $2.99 billion in Q3 but local delays and slow start-ups for rigs were responsible for missed targets. The U.S. and Canada region had the highest sales in Q3 of $3.29 billion but active rigs declined by -2.8% in Q4. They blamed the slowdown in the U.S. on lower natural gas prices. SLB had been expected to post $1.14 in earnings for the quarter. Shares of SLB declined -5% on the news.

SLB Chart

Baker Hughes said active rigs declined by -1 to 1,799 and the lowest level since April 2011 as falling natural gas prices forced companies to cut back on marginal wells. The number of gas rigs declined to 416 and well off the August 2008 high of 1,606. Oil rigs declined -1 to 1,381 and they are in a declining trend as well because of weak oil prices and a large number of shale wells that are failing to deliver oil at commercial rates. The wells are expensive and the initial decline rates are in the 65% to 75% range. This does not allow the producer to recover the initial drilling costs before production falls to a fraction of the initial rate.

Oil inventories rose last week by +843,000 barrels compared to an expected decline of -2.5 million. Inventories are now 11.5% over year ago levels. Crude prices gained on Friday as a result of better economic news from China and the jump in U.S. industrial production.

Natural gas prices have collapsed back to $3.30 after hitting $3.93 in late November. It would take gas over $4.00 to grow the number of gas rigs in operation.

WTI Crude Oil Chart

Natural Gas Chart

Apple (AAPL) shares fell another $20 to close at $509 on a long list of problems. A Jefferies analyst said component suppliers had received large order cuts as the assembly bottleneck of the iPhone 5 continues. He said the continued bottleneck in production could impact sales numbers until March.

Another story making the rounds was the lackluster iPhone 5 launch in China. There were only two people in line when the Apple store opened in Beijing on Friday. The story made headlines but the background did not. Buyers were able to reserve a phone online and did not have to wait in line. Also, there was a snowstorm in Beijing that kept buyers indoors. You may remember there was a riot in January during the launch of the iPhone 4S. Apple wanted to prevent a repeat so there was a strict "pre-order" rule online.

However, China Mobile has not yet blessed the iPhone 5 and said it could be late next year before they accept it. Apple may have to produce an iPhone 5S with TD-SCDMA instead of W-CDMA for the Chinese market in order to be accepted by China Mobile. TD-SCDMA is a proprietary transmission method developed in China to avoid being dependent on Western technology and prevent payment of billions in patent fees to Western patent holders. Meanwhile Nokia is an accepted phone and sales are exploding in China where more than 700 million people have phones.

Analysts are slashing iPhone sales targets for Q4 and Q1 by 5-7 million units on average. However, it is not because of lack of demand. This is strictly a manufacturing problem delaying deliveries. Spot checks show no excess inventory so Apple is selling all the phones they can make.

Analysts are also cutting profit estimates because the iPad Mini is selling so well. The cheaper Mini is eating into sales of the regular iPad and that means a smaller profit margin per unit sold because the Mini is cheaper and the retail price is squeezed to compete with the Kindle Fire and others.

The Mini is rumored to be getting an upgrade to a Retina screen of 2,048 x 1,536 pixels in the next generation. That will cost more money and Apple may not be able to increase the price.

UBS analyst Steve Milunovich cut his earnings and price targets for the next two years. He cut his target from $780 to $700 and reduced sales targets for iPhones by five million a quarter for the next three quarters and iPads by two million each. He said the iPhone build rates at suppliers had declined from 40 million to 25 million for the March quarter.

Apple is also falling because investors have given up on a special dividend in 2012. Time has expired on that option. Apple has already announced a flurry of new products and there is nothing in the pipeline in the near future. Analysts still expect strong earnings but they claim the bloom has faded.

Apple closed at a new 10-month low on Friday and pulled the Nasdaq down with it.

Apple Chart

Stocks in the Apple food chain also took a hit on Friday as the sales estimates plunged. QCOM, BRCM, SWKS and AVGO to name a few, all declined on the Apple hysteria. The problem with selling the component suppliers is that several of them have chipsets in all the major phones. If Apple sales slip by five million units then Nokia, Motorola and Samsung will see sales improve. Qualcom and Broadcom are still going to sell roughly the same number of chips regardless of which phone is leading.

Qualcomm sales to Apple represent only 6% of the company's total sales. If Apple iPhone sales slip from 40 million to 30 million that is just 2% of QCOM revenue and some other companies will sell more phones.

QCOM shares fell -5% on the Apple bashing.

QCOM Chart

Facebook (FB) shares declined -5% after the lockup on another 156 million shares expired on Thursday. Lately nothing seems to faze Facebook and investors have gone from hating the stock to loving it. There is still solid resistance at $28 but that is well off the post IPO lows of $17.50. Even noted tech analyst Dan Niles is now a Facebook fan. He said the company has gone from one revenue stream when they IPOed to multiple revenue streams.

Facebook Chart

Adobe (ADBE) shares rallied +6% after the company reported earnings of 61 cents on sales of $1.15 billion. Analysts were expecting 56 cents and $1.1 billion. Adobe is moving to a subscription model rather than a purchase model and the move is happening faster than previously expected. The subscription model also cuts down on the amount of counterfeiting and increases revenue. Through November Adobe signed up 326,000 paying customers for its suite of Creative Cloud tools, which include Photoshop, Dreamweaver and Illustrator.

Adobe lowered Q4 estimates to a range of 26-32 cents with the street expecting 57 cents. However, the company said you could not compare the numbers. They said by 2014 Adobe's sales would be much stronger because the subscription model will force customers to stick with Adobe rather than "skipping" releases and then coming back later for an upgrade. Investors liked the commentary and the stock surged +6%.

Adobe Chart

Mining stocks soared on Friday after HSBC reported a stronger than expected PMI of 50.9 for China. That is a 14-month high, up from 50.5. The Euro zone composite index rose to 47.8 from 46.7 and the best in five months. German ZEW investor confidence spiked unexpectedly to +6.9 from -15.7.

The Markit flash PMI for the U.S. rose to 54.2 from 52.8. That is the best reading since April. New orders hit an eight-month high.

The sudden burst of decent economic news caused steel, coal and copper stocks to rally on hopes for a global economic rebound in 2013. Coal producer Peabody Energy (BTU) said Q1 should be the bottom for earnings and then rally from there. Prices are expected to decline -5% as high dollar contracts expire. Companies contract for coal for months or even years in advance. The final contracts from 2008 when prices were high are now expiring. However, coal prices have bottomed and are trending higher. If global economics improve we can expect higher demand for coal, copper and steel. Peabody said coal volumes from Australia should rise to 34.5 million tons in 2013 from 32 million in 2012.

U.S. Steel (X) shares rallied +7% on the better than expected global economics.

US Steel Chart

Sturm Ruger (RGR) and Smith & Wesson (SWHC) both declined sharply on the Connecticut school shooting. Coming so close after the Oregon mall incident the odds are pretty high for stricter gun control in 2013. That would eventually impact future sales from these manufacturers even though sales in the coming weeks will soar.

Ruger Chart

GE (GE) announced it was raising its dividend by +12% to 19 cents and the company authorized the buyback of another $10 billion in shares. The dividend will be paid in January. They did not follow the example of others by accelerating it into December. Prior to the financial crisis the dividend was 31 cents. GE is trying to buy back the extra shares it had to offer in 2008 to raise money in the face of the financial crisis. GE shares were flat for the day.

Hostess Brands has received serious bids from about two dozen parties interested in purchasing its assets. Wal-Mart and Kroger were two of those parties. Some bidders want the entire company and some just want a specific cake or bread business. The company is going to have initial bids by early January and the final auction will begin. Hostess has $900 million in secured debt and about $150 million in administrative claims.

Best Buy (BBY) shareholders were left at the altar once again. Founder Richard Schulze initially claimed he was putting together an offer for $26 a share earlier this year. Shares spiked to $21.60 on the news but quickly faded as analysts expressed doubts about his ability to finance a deal of that size. He has continued talking to Best Buy, partners and private equity firms. He has amassed an impressive list of potential executives if his bid is successful. That bid has been "forthcoming" for weeks but it never seems to appear.

Shares have been very volatile as the buyout rumors circulate in the market. Shares declined from $17 to $14.50 in early November on news he was having trouble getting financing and Best Buy's patience was wearing thin. In late November shares declined even more to $11.50. On Thursday BBY shares spiked +19% on news Schulze was expected to submit his formal offer of $5-$6 billion before the Dec-16th deadline.

On Friday news broke that Best Buy and Schulze had mutually agreed to extend the offer period to Feb-1st to Feb-28th. The board agreed to act on any offer within 30 days. Shares of BBY crashed back to $12 and a -15% decline. Many analysts don't believe Schulze will be able to garner the necessary financing to take BBY private. The company is struggling in the retail sector and the outlook is not good. Same store sales on Black Friday were down -5% for what should have been a banner day for the company.

By waiting until February to make an offer Schulze will have the benefit of knowing how holiday sales ended. He will know if they made any money or fell further into the abyss. Clearly his initial $26 bid is history and it is not coming back. BBY had a $4 billion market cap at Friday's close so a $5 billion offer would be 25% over the current price. If holiday sales go badly for Best Buy their shares could sink even further before February. The lower they fall the more likely Schulze will be able to put together a deal because the amount to be financed will be less. Schulze currently owns 20% of BBY shares.

Given the potential impact to retails sales from the fiscal cliff worries I would bet BBY shares are going to be under $10 by February and Schulze may actually be able to rescue BBY shareholders with at least a small premium. Whether he can actually rescue Best Buy from retail oblivion is a different question. Electronics retailers are acting as showrooms for Amazon, Newegg.com and others. However, with the recent addition of sales tax to the online prices plus shipping expenses the playing field is narrowing. The biggest problem for electronics retailers is the massive glut of models of things like TVs. Every manufacturer has a dozen models and sizes and there are dozens of manufacturers. Newer models are being announced before the previously ordered models are even delivered to the dealers. Prices and profit margins are declining so fast that markdowns on any model in inventory more than 30-60 days turns it into a loss. I would not want to be an electronics retailer today. Shareholders better hope Schulze does not change his mind or Best Buy could go the way of Circuit City.

Best Buy Chart

The Shanghai Composite Index ($SSEC) rallied +4.32% on the China PMI news. That was the biggest one day gain in 30 years and the highest level since August. China is far from "recovered" but at least there has been significant progress in recent weeks.

Shanghai Composite Chart

The "scratching my head chart" for last week is gold. The Fed announced QE4 with another open ended $45 billion a month Treasury purchase plan and gold declines -$20. In theory QE cheapens the dollar and makes commodities more expensive. That theory ran into a bout of profit taking on Thursday but I suspect it will be temporary. Silver followed gold and closed at a four-week low but I believe it is a buying opportunity. I am adding to my hoard of physical silver on any fiscal cliff dip.

The dollar index declined to a two-month low on stronger economic news overseas, the Fed announcement and expectations for lawmakers to kick the fiscal cliff can well into 2013. I expect new relative lows for the dollar in the weeks ahead.

Gold Chart

Silver Chart

Dollar Index Chart

On Tuesday the National Federation of Independent Businesses (NFIB) published their latest study of business sentiment. It was not a good report. The Optimism Index fell -5.6 points to 87.5. That brings the index back to one of the lowest points in its history and very close to the 2010 levels just after the 2009 recession.

The NFIB excluded survey results from states impacted by Sandy to prevent any weather related skew. The survey was sent to 3,938 businesses.

NFIB Optimism Index

Only one component showed improvement from October and that was employment. The biggest hit to optimism was the decline in those who expected the economy to improve over the next six months. That component declined a whopping -37 points. An incredible 49% of business owners now expect conditions to be worse in six months.

NFIB Component Changes

I don't know how to interpret the NFIB report. The changes in November were dramatic and the only two major events were Sandy and the elections. Since they eliminated the responses from states impacted by Sandy it leaves only the election as the pivotal point for small business owners. That is not exactly a confidence builder for 2013.

The market has been held aloft over the last several weeks on hopes for a fiscal cliff resolution and expectations for the Fed to announce QE4. The Fed did its part so that is no longer a support for the market.

The odds are increasing for the fiscal cliff battle to drag into 2013. With no resolution on the horizon by next weekend the market could quickly change direction. Since any resolution will require days of work between the agreement and the voting the time to actually get anything done and passed into law by year end is rapidly decreasing. Investors understand the political theater up to this point was the required posturing so that both sides can claim they did the best they could and stood on their principles as long as possible.

The countdown clock only has about six days remaining in the negotiations in order to get a law passed by year end. As each of those days tick off the calendar without any progress the market could become more unstable.

Some analysts are expecting a 3% to 5% pullback once it is evident we are going to hit the cliff. Passing the tax package alone could eliminate that decline since that is the biggest immediate impact to consumers and investors. Let's hope lawmakers understand that fact and get with the program next week.

The S&P levitated well past resistance at 1430 last week to hit 1438. Unfortunately the hang time was measured in minutes not days. The index gave back -25 points to close the week at 1413 and right in the middle of the congestion we have seen over the last three weeks.

Apple was a big part of the S&P decline with its 4% weighting but it was just a part of something bigger. Financials, energy, technology and even housing lost ground as the week progressed. The broad decline across all sectors suggests the year end outlook is dimming for investors. The hopium is fading.

The S&P has decent support in the 1400-1407 range and without a serious meltdown in the fiscal cliff negotiations we could see that level hold. However, if president Obama gets on that plane on Monday for his scheduled 21 day vacation in Hawaii, all bets are off. That would signal the end of negotiations for the year. I do not expect that but we are facing some deadlines that will weigh on the markets.

Below S&P 1400 the 200-day average at 1387 should be strong support. There are some analysts predicting S&P 1500 by year end if a cliff deal is announced so there is a wide range of possibilities. I would be cautious about buying a dip to 1400 unless there is some positive cliff news. I would buy a dip to the stronger support at 1387 unless we enter meltdown mode. You will know the difference between dip and meltdown mode if the stronger version appears.

S&P Chart

The Dow failed the resistance test at 13,279 on two consecutive days before fading away late in the week. Without some news headline to power it higher the retest of support at 13,000 is likely.

The Dow benefitted from the dividend announcements of the big blue chip stocks. Those announcements are over for 2012 and quite a few stocks are going ex-dividend between now and year end. That will pressure the markets since stocks decline ex-dividend.

Dow Chart

The Nasdaq rallied on Tuesday and Wednesday simply because Apple was not in dive mode. The index tested resistance at 3030 and failed. When Apple declined again the Nasdaq barely closed above a three week low. It was a failed rally in every sense of the word and a break below 2960 could setup an even steeper decline.

Nasdaq Chart - 30 Min

Nasdaq Chart - Daily

The Russell 2000 breakout to the upside on Monday was very promising. Unfortunately it failed along with the big cap indexes to close back in the prior week's range. A retest of 820 is likely. A breakdown below 817 would be very negative and target 800.

Russell 2000 Chart

I am still in buy the dip mode but I would suggest being more cautious this week. With all the holiday vacations scheduled for the President, House and Senate, all parties will be in a hurry to either get something done and get out of town or simply resign themselves to accept the cliff for a few weeks in 2013 and restart negotiations in January. Obviously the first option rallies the markets and second option puts us in dive mode.

Commentary

Some investors were surprised when the market faded after the Fed's announcement of QE4. There has been a lot written since that announcement and I believe the fade was just the result of profit taking BUT there are bigger problems ahead.

The Fed set itself on track to expand its balance sheet by $1 trillion in 2013 to $4 trillion dollars and possibly $5 trillion in 2014. The Fed assures us it will halt the QE programs if unemployment falls below 6.5% or inflation rises above 2.5%. The Fed also gave itself an out by saying they would only look at the core rate of inflation and ignore global commodities. That is basically a blank check for the Fed to continue printing forever. Secondly, Bernanke said he would only look at real unemployment and not take into account a falling unemployment rate from people dropping out of the workforce. Again, that is an open ended commitment that is subject to future interpretation.

The Fed had to continue the QE program so the government can afford to continue financing its $100 billion a month deficit at a ridiculously low interest rate. With the Fed monetizing the debt there is little need for other central banks to buy our debt. Thank goodness because the global appetite for our debt is shrinking fast.

The elephant in the room is the Fed's eventual exit plan. Since the Fed is trying to stimulate the economy and spending trillions to do it we have to assume they will eventually succeed. Once the economy is rebounding they will not only have to halt new purchases but to slow inflation they will have to sell their treasuries back into the market. This is going to create a total catastrophe because not only will the Fed be dumping debt back into the market but the government will still be running massive deficits that will involve selling tens of billions of debt every month.

Investors everywhere understand the laws of supply and demand. When JP Morgan's whale trade became public knowledge the market for those particular securities exploded higher as every hedge fund on the planet began to front run JP Morgan as they tried to close out the trade. Instead of losing $1 billion as anticipated I think they were up to losses of $4 billion or more because the market knew they were trapped.

The same thing is going to happen to the Fed. Once they are forced to start dumping treasuries the bond market is going to implode. Every hedge fund with a pulse will be shorting treasuries ahead of the Fed. With $4 to $5 trillion in inventory there is NO buyer in the world able to takedown a sizeable chunk. And to make it worse no buyers will want to buy treasuries with the market betting against the Fed.

The Fed is building up the biggest whale trade position ever conceived and there is no rational exit plan. This disaster will make the financial crisis of 2008 look like a Sunday picnic. This is going to be made worse by the need for the U.S. to continue selling debt into an imploding bond market. Interest rates are going to soar as will the annual payments on the U.S. debt.

I can't believe lawmakers on both sides are not in panic mode over the disaster headed our way. Instead they are still adding to the debt every day and arguing over a couple hundred billion here and there. They are truly rearranging the deck chairs on the U.S.S. Titanic with the iceberg dead ahead.

Definitely, enter passively and exit aggressively over the next few weeks!

Jim Brown

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" The trouble with the rat race is that even if you win, you’re still a rat."
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