There is still no real direction in the markets but the underlying sentiment is improving despite numerous hurdles.
The major indexes are still negative for the year with the exception of the Russell 2000 and the Dow Transports BUT those are the indexes that provide long term sentiment for the market.
The Dow was the only major index to lose ground for the week but I see that as fund managers rotating out of their large cap window dressing plays from late December. The market has faced some serious hurdles over the last week with negative economic surprises and a flood of negative earnings reports and guidance. Despite the strong headwinds the Nasdaq, Russell 2000 and the Transports managed to power ahead and close at the highs for the year. In the case of the Russell and the Transports it was record highs.
When you consider the magnitude of the various challenges for last week those new highs are a remarkable accomplishment. The biggest shock of the week was the Nonfarm Payroll report on Friday. The headline number showed a gain of only +74,000 jobs for December compared to consensus estimates of +205,000 and whisper numbers as high as +250,000.
This was the lowest number since April 2012 when we added +68,000 jobs. There was a small positive with November revised higher from +203,000 to +241,000. Unfortunately the rest of the report was so bad that gain in revision was ignored.
Of the 74,000 new jobs a whopping 40,000 were temporary jobs. I don't have enough lipstick to make that pig of a number respectable in any way.
The unemployment rate dropped from 7.0% to 6.7% and that should have been a good change but it was caused by a massive drop of -347,000 in the labor force as people quit looking for jobs. The broader and more accurate U6 unemployment rate remained unchanged at 13.1%. The labor force participation rate dropped from 63.0% to 62.8% and the lowest level since March 1978. Dallas was the new show on TV and Saturday Night Fever was winning at the box office.
In 2013 the population of the U.S. grew by 2.4 million but the labor force shrank by -550,000. That gives you a real clue that the economic trends are not healthy.
Private payrolls added +87,000 compared to +226,000 and +217,000 in the prior months. There is no way to sugar coat this decline.
The Economic Policy Institute (EPI.org) has a chart series where they track the missing workers not included in the BLS monthly employment report. The BLS drops people from the unemployment rolls if they are no longer receiving unemployment benefits and they have not looked for a job in the last four weeks. By removing these "discouraged" workers from the rolls the unemployment number is much lower.
EPI said there were 5,990,000 "missing workers" as of the end of December. If those workers were included in the calculations the unemployment rate would be 10.2% instead of 6.7%. You decide. Which is the real unemployment rate?
Initially analysts tried to blame the drop in jobs on the weather because of a -16,000 drop in construction jobs but weather did not cause the -12,000 job decline in information technology, -13,700 at motion picture companies, -24,700 in accounting and -11,600 in performing arts. Retailers added +55,000 and bad weather keeping crowds away would have slowed that gain. Government payrolls declined -13,000.
Barclays said, "We do not find it plausible that adverse weather accounted for the decline in the participation rate to 62.8% from 63.0% in November. To be counted as in the labor force, one needs to be employed or have looked for work during the four weeks preceding the survey week. Therefore, it is unlikely that weather would significantly disrupt estimates of the size of the labor force in the same way it might for workers with weekly pay periods."
December did go down in the record books for weather. It was the coldest December since 2009 and snowfall was 21% above normal. The second week of December was the coldest for any comparable period in more than 50 years according to PlanAnalytics. The first week of January was even colder and more disruptive so there could be a weather related impact to the January payrolls as well.
This causes a lot of problems for the Fed. The unexpected drop in the unemployment rate to 6.7% will be a shock for the Fed. The FOMC has said they would begin considering a hike in interest rates when the unemployment rate hits 6.5%. However, the rate is falling for the wrong reasons. It is falling because people are dropping out of the labor force rather than surging employment. It is possible we could see 6.5% rate with the January employment report and the Fed is several years away from raising rates. That means they are going to be forced to change their guidance or possibly even remove that guidance to keep from facing this problem again in the near future.
Secondly the sudden plunge in hiring means the Fed could pause the recently announced taper at the January meeting. The Fed wants to end QE but if the economy suddenly hit an air pocket they may have to pause the taper and wait until there is clear evidence of an economic recovery rather than hopeful expectations over a few green shoots.
We are facing a secular employment problem. Job creation is growing at the slowest pace of any prior recession in the last 100 years. There are multiple reasons with the biggest relating to productivity from technological growth. This helps companies do more with fewer workers. Secondly, the shift to a higher educated workforce utilizing the technological advances means more workers are unable to find jobs because of their older blue collar skill sets. This means workers unwilling or unable to upgrade their skills are finding it very hard to get a job. The frustration level of 40-50 year old people being passed over for 20 somethings because of their greater acceptance of things like social media, mobile computing and ability to adapt is causing those older workers to give up looking for jobs and file for disability and whatever government assistance they can get. It is easier than pounding the pavement every day and being told "we will call you."
This means the employment problem is not going to improve significantly in the near future. It means the Fed is faced with trying to remove stimulus while the number of people unemployed continues to fall. This will not end well. The fed has said the taper process will be gradual and could be reversed if circumstances warrant. It remains to be seen if other economic reports confirm the downturn in payrolls before the Fed's next meeting in two weeks but it is clear the potential for an acceleration in tapering has been substantially diminished.
Narayana Kocherlakota, president of the Minneapolis Fed, said this week the Fed should reverse course and provide more stimulus to the economy because of the weak job growth and low inflation. "By easing monetary policy relative to the current stance, the FOMC could facilitate a more rapid fall in unemployment and more rapid return to 2% inflation."
Others, including Bernanke, believe the impact of QE has slowed to the point of being ineffectual and contains more risk to future inflation than reward to the current economy.
This employment report just two weeks before the last FOMC meeting with Bernanke at the helm has thrown a monkey wrench into the Fed's plans. You can bet the analyst community is going to be spending some long hours trying to decipher the Fed's plans and the FOMC members are in for a heated discussion at the next meeting. Yellen will be forced to assert herself since she has to live with whatever decision and statement that is released.
Along that same thought process the president nominated Stanley Fischer for Vice Chairman of the Fed. This rate hawk will offset Yellen's extremely dovish bias but the real challenge is in the communication. Yellen favors high levels of communication and guidance to the market and Fischer does not. He believes excessive communication can leave the Fed trapped or at the least show that the Fed has no clue of what the future holds. Stating that they are looking to review interest rates when unemployment hits 6.5% is a prime example. Now with that level only 0.2% away and possibly hit in January the Fed will have to revise that guidance and that is always a thorny process. Fischer said we don't know what will happen 12 months from now so we should not be giving guidance predicated on a potential outcome.
Fischer, a former Bank of Israel governor, has taught economics at MIT to students including Ben Bernanke, ECB President Mario Draghi, Treasury Secretary Larry Summers, Harvard economists Kenneth Rogoff and Greg Mankiw. I personally think Fischer is an excellent addition to the Fed and so did Yellen since she asked Obama to nominate him and personally talked Fischer into accepting the position. My opinion of Yellen rose when I read that. Most people in authority don't want strong opinionated personalities as their second in command. They want somebody that will back their positions rather than push conflicting ideas. This means Yellen is confident and not afraid to have strong people on the team.
The bond market did not appear convinced the Fed was going to continue the taper. The yield on the ten-year Treasury fell from 3% on Thursday to close at 2.86% on Friday. That is a monster move and suggests a mountain of money suddenly moved into treasuries.
The economic calendar for next week has a lot of reports but the two most important are the Philly Fed Manufacturing Survey on Thursday and the Retail Sales on Tuesday. The Philly Fed is the proxy for the national ISM in early February. It is our first real look at the current manufacturing conditions.
The retail sales for December could be ugly. The consensus is for a gain of +0.4% which is very light but we could easily see a seriously negative number for December. Shopper traffic was down significantly. Heavy discounting was rampant and even 50% off sales were unsuccessful in attracting buyers. Dozens of retailers have already warned about falling same store sales and weak results in Q4. This could result in a weak number for December sales.
The PPI and CPI reports are normally important but with the lack of any inflation for months they are going to be ignored unless inflation fell even farther.
On Thursday Bernanke will speak on "Challenges for the Central Bank" and that will draw a lot of attention. It is likely it will turn into a history lesson rather than a forecast but you never know. I would be surprised if he poisoned the market ahead of Yellen's takeover but you never know when an official is focused on his legacy. He may want to "adjust" the history on some of his past problems in an effort to clean up his legacy.
Another economic indicator we follow has posted the worst start in 30 years. The Baltic Dry Index has declined -35% over the last two weeks. It is the biggest drop since Christmas Eve since 1984. The index shows the cost to ship dry bulk products on the common ocean routes. The index had been up significantly since early 2013 and dramatically since November. Those November/December gains were completely erased.
The index fell 11.27% in one day for the biggest percentage drop on record. On the surface what this would seem to indicate the inventory buildup in Q4 had no follow through.
However, things are not always what they seem. The real cause was a restriction by Columbia on some exports by Drummond Co that slashed the number of cargoes being exported from Columbia. Columbia is the second biggest coal supplier to Europe. Columbia said Drummond is restricted from exports until it finishes some overdue construction work on the port.
The rate for a Capsize ship, which can carry 150,000 metric tons of coal, iron ore and other cargoes, fell -27% to $17,452 per day. That was the biggest drop since October 2008 BUT it is going to be temporary. Once Drummond completes the port work the demand for ships will immediately return.
However, Rio Tinto, BHP Billiton and Fortescue Metals booked fewer cargoes to China over the last week and that also contributed to a sudden availability of ships. There was no reason given why those three miners would suddenly cut their cargoes to China.
The moral to this story is to not take everything on face value. Look for the reasons behind the moves.
Earnings begin in earnest next week and the outlook is fading. Alcoa (AA) is normally considered to be the first of the major companies to report and they kicked off the cycle with an earnings miss. Adjusted earnings were 4 cents compared to estimates of 6 cents. Without the adjustments they lost -2.19 per share or -$2.3 billion. Analysts called it a kitchen sink quarter with $1.7 billion in write-offs. Alcoa has idled 17% of its capacity and the prices received for the year were -7% below 2012. Since October Alcoa shares have rallied from $7.85 to nearly $11. On Friday shares lost -5% of that price to close at $10 with analysts expecting a further decline to $9. More than one analyst recommended buying this dip since all the bad news is supposedly priced into the stock. Losing $2.3 billion in a quarter when your market cap is only $11 billion tends to clear quite a few things off the books.
Sears Holdings (SHLD) dropped -14% to a two year low at $36.72 after the company warned of a big loss for Q4 and gave retail comps that were terrible. Overall same store sales at Sears fell -7.4%. That breaks down to a drop of -5.7% for Kmart and -9.5% for Sears. The company said it would lose -$250 to -$360 million for the quarter. That equates to -$2.35 to -$3.39 per share. The loss for the same quarter in 2012 was -$489 million or -$4.61 per share. They will report earnings on or about February 27th. CEO Eddie Lampert has been selling off assets to produce cash flow. They are planning on spinning off Land's End and the 700 auto service centers in 2014. Moody's downgraded the corporate debt rating from B3 to Caa1, citing the accelerating negative performance. Lampert is under pressure from investors to his fund. They are giving up and requesting withdrawals. Lampert's ownership in Sears has fallen from 55% to 48% as a result of stock sales to raise money for redemptions. In December he gave Sears stock to investors in his fund in lieu of cash for redemptions.
Other retailers disappointing the market included American Eagle Outfitters (AEO), which said same store sales fell -7% and forecast profits at the low end of its prior range. Pier 1 (PIR) reported sales that fell -5.7% and they cut forecasts from 63 cents to 50 cents per share. L Brands (LB) warned that sales rose only +2% and they lowered estimates from $1.75 to $1.60 per share. Gap Stores (GPS) reported flat same store sales compared to estimates of +1.5%. Old Navy sales fell -2%. The Buckle (BKE) said same store sales declined -2.8% in December. Zumiez (ZUMZ) said sales fell 2.4% compared to estimates for a +1.6% gain. The company cut guidance for earnings to 57 cents from prior estimates of 63 cents. Stein Mart said same store sales rose +4.5% but total sales fell -2%. American Apparel (APP) said same store sales declined -6%. Bed Bath and Beyond (BBBY) fell -$10 after reporting comps that rose only +1.3% compared to estimates for +2.7% and warning on earnings for Q4.
Discount retailer Family Dollar (FDO) reported same store sales that declined -2.8%. Earnings were 68 cents compared to estimates for 69 cents. FDO said there were many problems in Q4, including a challenged consumer and intensified promotional environment. FDO said they responded to the competitive environment by leveraging promotions more than originally planned. They said the market would likely remain challenging in the near term. FDO shares fell -$5 on Thursday but rebounded to recover all of that on Friday.
Not all retailers were negative. Costco said sales rose +5%. Walgreens (WAG) reported a +6.1% rise in December comps and beat the estimates for +4.2% gain. Rite Aid (RAD) posted a +2.9% gain in sales and beating forecasts for +1.7%. The very active flu season in December probably helped those drug stores increase sales.
Moving away from the retail area Twitter (TWTR) has become the stock to hate as the analyst parade has turned into a riot. On Friday Cowen and Co initiated coverage of Twitter with the equivalent of a sell rating on worries that advertising revenue will falter as Facebook and LinkedIn offer better platforms and can attract more advertisers.
In a survey of advertising buyers only 5% thought Twitter had a compelling return for investment spending compared to 60% for Facebook and 25% that chose LinkedIn.
The Cowen analyst said user engagement growth is decelerating with a drop from +30% in Q1 to only 8% growth in Q3.
Cantor Fitzgerald downgraded Twitter to sell from hold saying "valuation is excessive and currently see materially more downside than upside."
Twitter now has the equivalent of 11 sell ratings, 11 holds and six buys according to Bloomberg. Twitter will report earnings on Feb 5th.
There used to be a TV series called 7 Days where the government could send one person backwards in time for seven days and then he would be returned to the present. The project was called Backstep. I would love to have that capability today. I would take my life savings back in time and invest it in Intercept Pharmaceuticals (ICPT) last Monday. The stock was trading for $68 and in a steady uptrend but nothing spectacular.
Fast forward to Thursday and the company announced it had stopped a clinical trial of a liver disease drug early saying there was clear evidence the drug worked better than expected. The drug, obeticholic acid, was being used to treat a form of nonalcholic steatohepatitus (NASH) or fatty liver. It is the leading cause of liver transplants. Approximately 30 million Americans are afflicted with this disease. Over 8 million are in the advanced stage and there are no drugs approved for treatment. Citigroup claims this is a $30 billion market.
The announcement caused shares of ICPT to spike from $72 to $275 on Thursday. On Friday they gained another $169 to close at $445.75. Merrill Lynch raised its price target from $81 to $872. Shareholders of ICPT hit the equivalent of the Mega Millions Lotto with their investment. SAC Capital owned 1 million shares at the end of November. That equates to about a $360 million gain in two days.
If I ever wanted to go back in time this was it.
The Citigroup biotech analyst was interviewed about ICPT and asked if there were any other stocks out there that could possibly be lottery winners. He suggested Clovis (CLVS) and Exact Science (EXAS) as potential candidates based on drugs in development.
Target (TGT) went into the confessional again and announced another 70 million customers could have had their data stolen. This data contained their names, addresses, phone numbers, etc but not card numbers. They said there was probably some duplication with the 40 million credit card numbers they already reported stolen so it was not a total of 110 million but some number less than that. This makes it the largest data theft in U.S. history.
Target warned that although sales were good before the first announcement they did decline sharply after the news. They cut earnings guidance for Q4. It could be a long time before they know how much the security breach will cost them so expect a constant stream of charges over the next several quarters.
Nemian Marcus also reported a data breach in December and the full extent is not yet known.
Canadian based CGI Group (GIB) was the company that built the main Obamacare website. The Obama administration announced on Friday it was replacing CGI with Accenture (ACN). The administration announced it will sign a contract with Ireland based Accenture for $95 million to complete the website and correct the errors still plaguing the site. Accenture is the second largest technology consulting company behind IBM and they built the health exchange website for the State of California, which has had very few problems and worked from the first day. CGI's role in the healthcare.gov website was already diminished after United Health (UNH) was brought in on an emergency basis in late October to oversee emergency repairs. The government has already paid CGI $319 million for work on the website and the backend automation to track and report subsidies and payments to providers is still not functional and according to some estimates could take another 6-9 months to complete. There is some talk about the government demanding a monster refund from CGI for shoddy work and nonperformance.
CGI also built the state exchanges for Massachusetts and Vermont. Those states have also complained about the company's performance and quality of the work. Vermont is disputing millions of dollars in payments to the firm and is deducting $5.1 million in damages from payments owed to CGI. Officials at the Massachusetts Health Connector told the board of directors on Friday that most people applying for insurance at the exchange have not been able to use the website because of CGI's poor performance. "Incomplete and inadequate IT functionality as a result of an under-performing vendor has made it difficult for users to complete the application process." Governor Deval Patrick instructed the exchange "to consider all our legal rights related to CGI's failure to perform and the cost of remediation."
I am betting the future is not bright for CGI. With multiple governmental customers withholding payments, cancelling contracts and considering legal options for recovering damages, not only is the company going to lose money but what new customer in their right mind would hire them for a major project? We tried to play them as a short back in December but they kept rallying as the website operation improved. Most investors did not know that United Health was the company actually doing the emergency repairs. This time I think the bad news will stick.
Tesla (TSLA) declined slightly on Friday after the company said it was upgrading the wall-charger adapters following reports of overheating in garages. The charger adapters which connect to wall outlets will be mailed out in the next two weeks. Tesla said we have found that many homes were not wired correctly and the volume of current flowing through the charger will heat up the wires in the walls of an improperly wired house.
The new adapters will have a sensor to detect overheating and shutdown the system. They also supplied a new software update for the cars to trigger a 25% reduction in charge current when it senses conditions that could lead to overheating. The software update was done in December and Tesla said it was not aware of any overheating incidents since the update.
I can imagine the various wiring environments in the garage walls around the USA. Garage wiring in prior decades was normally an afterthought or something that was added later. Many times home wiring was done by laborers and then spot checked by electricians. A home inspector I know claims 35% of the homes in Colorado would not pass a comprehensive inspection due to loose connections, improper grounding and faulty wiring as a result of using wires too small for the load because heavy gauge wire was more expensive. Builders cut corners on wiring all the time. Nobody ever expected homeowners to plug a $100,000 car into the garage wall and suck more power than the rest of the house combined. It is no wonder there have not been more garage fires as a result of faulty wiring.
Tesla shares have held their rebound gains since December and negative news is having less impact.
Next week begins the real earnings parade and it is heavily weighted toward the financials. We will get earnings from all the heavyweights including JPM, WFC, BAC, C, AXP and GS. By next Friday we should know how the financial sector sees the rest of 2014 as a result of their guidance.
Intel slipped into the week on Thursday as the only major tech stock reporting. With Gartner Group saying on Friday that 2013 saw the worst decline in PC sales in history at -10% the earnings from Intel could be tough. Gartner said holiday shopping was weighted to smartphones and tablets and away from PCs. Global PC sales fell -6.9% in Q4 according to Gartner. U.S. shipments fell -7.5% in Q4 to 15.8 million units. This sharp decline in PC sales means Intel's guidance is going to be critical for all the chip companies that will report later.
Remember, we had 10 times more earnings warnings than positive guidance for Q4. This means the bar is set very low and we could see some actual beats of the lower numbers. It also means a flurry of earnings misses could be ignored by the market.
The market may have turned in a mixed performance last week but I view it as slightly bullish that it is consolidating at record highs without a material dip. I view the Dow's decline as more of window dressing being unwound than a dumping of big cap stocks. We saw the Dow rally in late December as fund managers parked excess cash in the blue chips. They are now withdrawing that cash and putting it to work in small caps and tech stocks.
The S&P has been consolidating in a very narrow range just below 1,840 and succeeded in pushing above that resistance at the close on Friday. The recent high close was 1,847 and only 5 points away. After seven days of consolidation and base building a breakout over that 1,847 level could be explosive assuming the earnings parade does not force a detour into a dead end due to a series of bad reports.
Support has appeared at 1,830 and is slowly rising in a pattern of higher lows. However, the range has been so narrow that any of these observations are more wishful thinking than any material technical events.
There is one warning. Volume throughout the consolidation has been decent at about 6.7 billion shares on average. This is significant given the very narrow trading ranges. Some analysts would call it distribution where current holders are dumping shares into the year end fund flow buying. That remains to be seen but it is a concern that volume has been this high without any material forward progress.
The Dow is showing the opposite from the S&P. The Dow has a solid downtrend pattern in place with lower highs and lower lows. However, the range has been very narrow and I believe this is big cap window dressing being unwound. The 16,400 level has emerged as support and 16,500 is resistance.
I am wondering if we might be looking at one more triple digit decline just to test the next support level at 16,300 and then a rebound can begin.
Stocks dragging the Dow lower last week included CVX, GE, IBM, KO, MMM, MSFT, NKE, T, TRV, and VZ.
The Nasdaq has also been consolidating in a very narrow range between 4,140 and 4,175. The close on Friday was right at the top of that range and very close to a breakout to a new 13 year high over that 4,175 close on Dec 31st.
The Nasdaq consolidation is showing the same uptrending signals as the S&P and suggests we could see a breakout next week. We have been at these levels since December 23rd along with a decent dip in the middle as the traders took profits from 2013 gains.
Support at 4,140 should hold on any light selling.
The most bullish indicator for next week was the Russell 2000 closing at a new historic high. After two weeks of consolidation the Russell is showing solid signs of an impending breakout. The Russell reached higher levels back in December but could never close at those levels. The intraday tracks still cloud the Russell chart but a more above 1,165 could be explosive. Quite a few traders are waiting for confirmation of a breakout before putting money back in the market.
Assuming no earthshaking news over the weekend and at least mediocre earnings from the early week reporters I think we are poised to move to new highs and begin a short term rally. However, once the real earnings begin a continuous flood of misses and guidance warnings could blunt any 2014 enthusiasm. This is going to be a critical week for market direction and hopefully the green shoots on the charts will turn into a decent move higher.
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