The markets closed down for the second day but despite the decline there is still no change in trend. The indexes only retreated to initial support and the profit taking was very orderly.

Market Stats Table

The big economic report for the morning was the Productivity and Costs for Q2. Nonfarm business productivity rose at an annualized rate of +6.4% in the second quarter. This compared to +0.3% in Q1. Unit labor costs fell -5.8%. Hours worked fell more sharply than output, which led to the gain in productivity. Earnings barely rose by +0.2%, which should lead to greater profitability. Obviously the high unemployment rate is providing cheap labor and raises are being eliminated and in some cases workers are being asked to take a cut in pay, forced vacations and rotating layoffs. Averaged hours worked has fallen to just over 33 hours per week. This is great for manufacturers as long as they can sell the products. Unfortunately all of these forced cutbacks are due to the lack of product sales.

I believe the spike in productivity, normally a positive event, is actually the opposite this time around. This is clearly a factor of lack of demand and the harsh remedies the manufacturers are forced to implement in order to survive. If you cut your workforce by 50% your productivity per employee would spike sharply but the number of items you could produce would also drop sharply. Today's number is not bullish despite the seemingly positive spin.

To further confuse the issue the BLS issued an alert late this afternoon saying the report had errors in it and it would be corrected as soon as possible. The errors were in the compensation per hours and labor costs and did not include the +6.4% headline number.

The Wholesale Trade report showed a -1.7% drop in the inventory to sales ratio. This exceeded expectations for a decline of -0.9%. Sales rose +0.4% but that was due to stronger oil prices. Sales also benefited from a sharp +4.8% gain in auto sales. The inventory to sales ratio fell slightly to 1.26 and that remains 16 basis points above the 1.10 level seen in June 2008. This compares to the 1.34 high seen in January 2009. The higher the number the longer it will take to deplete inventories. This is a seriously lagging report and is normally ignored. However, this will be substantially negative for Q2 GDP when we get the next revision. Analysts believe it could remove half a point from the headline number.

Wholesale Trade Inventory Chart - 3 years

Reports due out on Wednesday include Mortgage Applications, International Trade, Job Openings, NAR Metro Real Estate Prices, Oil & Gas Inventories, Treasury Budget and of course the FOMC announcement.

The FOMC meeting, which began today, will end on Wednesday with the rate announcement at 2:15 ET. There should be a lot more information in Wednesday's announcement than we saw after the June meeting. The Fed is being pressed from all sides for timing and methods the Fed will use to remove all the monetary stimulus from the market. The Fed's balance sheet has exploded with debt as they sought to eliminate some of the uneasiness in the market. Sometime in September the Fed will max out its $300 billion purchase of treasuries and other agency securities. They had purchased $243 billion through the March 18th meeting. The TALF program is expected to continue in an effort to free up bank funds for lending and to address the commercial mortgage problems. In June the Fed added $100 billion to the TALF specifically for commercial mortgage asset purchases.

The current Fed stimulus is at record levels. We have seen inflation explode in past cycles after much less stimulus was applied. The Fed has said that there is no inflation in the foreseeable future and should continue to say this in order to keep rates low until the last minute. If the Fed is still seeing no inflation then they will probably keep the "rates will remain low for a considerable period" phrase in their statement. This is what the market wants to hear.

However, we are coming to a point where the Fed is going to have to start telling investors how and when they plan to begin removing this record monetary stimulus. Once that dialog starts the market is not going to react well because it represents a shift in policy from easing to hiking even if the hikes are still months away. Because of the record levels of stimulus the pace of the retraction, once the real economic recovery begins, could be sharp and fast. This is the real fear for the markets. If the Fed said we are going to raise rates .25% every 60 days starting Jan 15th until rates hit 4% I think the market would be fine with that plan. Unfortunately that has almost zero chance of happening. The Fed may want to remove it that slow but once signs of inflation begin to appear the Fed will be forced to accelerate the process and that worries the market. Rapid removal produces maximum pain for the markets. Analysts are not expecting any rate moves until mid-2010 so ANY mention of rate move potential before then could turn ugly in the stock market.

In this statement the Fed will hopefully acknowledge the improvement in the economy and in the labor markets. They should also increase their estimates for growth in Q3 and Q4. In order to provide balance they should also continue to warn that downside risks remain. The Fed has nearly 70 years of U.S. economic history starting with the mistakes made in 1937 and we know Bernanke is a student of the Great Depression and the wrong moves taken by Japan in 1997 and 2000. There are plenty of examples of the wrong moves so hopefully he will be ready with a game plan to avoid any economic and market disruption. Investors want to know what those moves will be but not necessarily see them put into operation.

The Fed may talk about the current problem in the commercial real estate mortgage area. Those problems are deflationary and will give the Fed more than enough reason to withdraw stimulus over a very long period. Bernanke is up for reappointment in 2010 and if he wants the job to continue he has to deal with the political risk of taking steps contrary to what the administration would like to see.

The Fed will likely temper its outlook for Q3/Q4 growth by discussing the lack of consumer demand. With home prices still declining and mortgage rates rising the Fed may have to continue to keep rates artificially low through its various stimulus programs to offset that drag on consumer demand. Until consumers can again see and access equity in their homes the demand for big ticket consumer products will remain low.

Obviously the Fed statement on Wednesday afternoon is going to be critical for the stock market. The Fed has a minefield of issues it will have to address in the statement and any one of them could explode in their face and take the markets down sharply if not handled correctly. It will be a serious stumbling point for the market since nearly all the points to be discussed include removing some form of incentive for the markets. It is like a doctor addressing an irate patient holding a loaded gun and trying to tactfully tell him he has cancer and possibly only a few weeks to live unless every painful treatment the doctor suggests is concluded carefully, correctly and completely. Let's hope the Fed's prognosis for the economy is delivered in Bernanke's best beside manner on Wednesday.

Oil prices fell again today to trade at $68.71 after OPEC said the lack of demand due to the global recession would cause demand for OPEC crude to decline by 480,000 bpd in 2010 to 27.97 million bpd. This was a decrease of -100,000 in the decline from their prior estimate for a decline of -380,000 bpd. OPEC said prices would decline further unless there were some signs of increased demand soon. OPEC said if the current market expectations for an economic recovery did not come to pass the current price levels would come under pressure.

Separately the US Energy Information Agency (EIA) cut its 2009 demand forecast. The EIA now expects 2009 demand to decline by -1.71 mbpd compared to their prior estimate for a drop of -1.16 mbpd. Meanwhile China's imports increased by 42% in July to 4.62 mbpd.

The decline to close at $69.50 was actually muted given the double estimate declines. The reason for the muted response was the appearance of three tropical disturbances. Two of them are headed into hurricane alley but there is less than a 30% chance today that they will turn into a named storm. The third storm, currently called Two, has already developed and is heading towards the U.S. but is currently on track to head up the East Coast rather than into the gulf. Just the appearance of these three storms was enough to keep oil prices from falling farther from the two downgrades.

Storm Chart

Storm Track Chart

The CEO of XTO Energy was interviewed at the Enercom Energy Conference here in Denver today. He said the majority of his oil production was hedged at $96 and about 40% of gas production at $9. That was old news since XTO is normally a strong hedger. The news that caught my attention was his expectations for natural gas to double sometime next year. According to Simmons there were 1500 rigs drilling for gas in 2007 in the U.S. and less than 700 in 2009. He said that explosion of drilling increased U.S. gas production by only 14%. The majority of that new production came from the four shale gas plays, which are quick decline wells. He said production has declined -3% from the 2008 peak and could be down by -10% this winter. By next year he expects production shortages to push gas prices back into the $7 to $9 range. He is not the only one with this mindset. Baker Hughes has reported more than 100 rigs have gone back to work in the U.S. over the last five weeks. I glanced at Chesapeake (CHK) and it is very close to a breakout over $25.

CHK Chart

After the bell today Applied Materials (AMAT) reported a loss of 2-cents that was much better than the analyst consensus for a loss of 8-cents. For the current quarter AMAT expects to breakeven or even make a small profit of 4-cents thanks to rising orders and deep cost cuts. Revenue was $1.13 billion compared to analyst estimates for $955 million. AMAT shares gained slightly in after hours trading.

AMAT was seeing some weakness in its solar orders and research firm iSupply said on Monday that nearly half of all solar panels manufactured in 2009 may not be sold until 2012. This glut is due in part to a decision by Spain to cut subsidies. AMAT said in early Q2 that full year revenue from solar installations could fall -40% from the year ago period of $18 billion.

The record $37 billion sale of three-year notes went off without a hitch today and saw the largest demand ever from indirect bidders at 2.89. This compares to the average demand of 2.52 over the last seven auctions. Indirect bidders include foreign central banks and their appetite for U.S. debt appears unabated. Indirect bidders bought 62.5% of today's notes and 54% in July and 48% in the prior auction. Average over the last seven auctions was 40.96%. Foreign banks like the three-year note as the best compromise between term and yield while being able to escape early if conditions change. $23 billion of ten-year notes will be auctioned on Wednesday. These could see a little lighter bidding as we have seen in other recent longer-term auctions. The equity markets rallied off the afternoon lows once the auction outcome was announced. Equities are running scared that an auction will eventually fail.

GM announced the mileage estimates for the new Chevrolet Volt. GM rocked the press with a 230 mpg claim for the mainly battery powered car in the city. The car's fans and detractors were all over news arguing the claims. The detractors claim that mileage is only valid if the user travels less than 40 miles per day. That is the threshold where the gasoline engine kicks in to charge the battery once the trip exceeds the 40-mile initial battery life. Essentially if you drive less than 40-miles per day and plug it in every night the gasoline engine never runs or runs only slightly. Over a week of commuting less than 40-miles per day with a minor trip increase for shopping, GM says you will get 230 mpg.

This is totally bogus since the cost to plug it in every night should be considered somewhere in the equation. Secondly, if you simply get in the car and drive the total range is only 300 miles before you have to stop and charge. That poses a question of how good the gasoline engine is to recharge the battery. Evidently it will not keep it charged while under use and may function as more of a battery booster during normal use and should not be relied upon for power on its own. Tack on a $40,000 price tag for a car that would take four full charges to go from Denver to Las Vegas and you have to wonder who is going to buy them and in what quantity. Obviously anybody who has to park on the street is going to have a charging problem so this appears targeted to those living in the suburbs with driveways and garages. Unfortunately those are the ones who have the farthest to drive. Time will tell.

Bernie Madoff's CFO, Frank DiPascali, pleaded guilty today to ten counts of various charges that will garner him 125 years in jail. However, in a deal with authorities he will tell all he knows in an effort to get a lighter sentence. He began working for Madoff when he was 18 and he is 52 now. The key to his comments in court today was his implication of others in the scheme. He said that from the early 1990s he had helped Madoff "and others" carry out the fraud. He said he recorded fictitious trades and under the direction of Madoff lied to the SEC. He said he helped Madoff avoid detection of the scheme by designing, developing and overseeing a wide array of fictitious books and records to conceal the scam.

He admitted producing fictitious trade records to match returns requested by various feeder funds. Reportedly these funds knew about the scam to some extent but as long as Madoff could produce the paper returns they could show their investors they looked the other way. The FBI is investigating more than ten others for their role in the scam. Sentencing of DiPascali is not until next May in order to allow authorities to extract every ounce of knowledge from him before the judge issues the sentence. In theory the judge will respect a plea of clemency for a light sentence in exchange for the years worth of incriminating evidence. Prosecutors are also asking for $170 billion in restitution from DiPascali. Since I doubt he has $1 billion, much less $170B, so that appears to be dramatic overkill by prosecutors.

Banks continued their decline today after noted bank analyst Dick Bove said bank stocks were running on fumes and recommending selling. Bove said the rally had been on a change in investor psychology and not a change in the profit potential. He now believes that bank earnings will not improve in Q3 or even in Q4 and many will continue to show losses. Bove believes that the bank sector will come back and be a very good place to invest but only if you have 3-5 years before you need the money. For those with a shorter time horizon he is recommending taking profits now.

Goldman Sachs (GS) is down more than $12 from last week's $171 high but they are not alone. The entire sector has been bleeding red ink since last Thursday's opening spike. The worry over commercial real estate mortgages is starting to overcome the optimism we saw over the prior week.

Chart of XLF

My comments in the weekend newsletter concerned the weakening market internals and the strong converging resistance. So far this week the selling has been muted and on light volume. Only 8.6 billion shares were traded on Monday and only a few million more today. This is a far cry from the 11+ billion on each of the last three days of last week.

With volume light and financials giving back less than 10% of their prior three weeks of gains this is not a correction, at least not yet. This is a simple buyer boycott and some light profit taking. I welcome it and hope it continues but historically the market rallies into the Fed announcement as shorts cover. After the announcement the volatility increases and the day after is typically down even when there was good news.

I don't believe the market action so far this week has told us anything. The Dow has declined to just over initial support at 9200 and has shown no indications of testing that support. The majority of the Dow's losses today came from TRV -1.49, JPM -1.45, CVX -1.29 and IBM -0.91. The IBM 91-cent decline on a $118 stock should give you some idea of how lackluster the selling was. It was nearly all driven by the financials and some weakness in oil.

Obviously this can change at a moments notice with the wrong Fed statement or even a lack of excitement at a lukewarm statement. The internals were 3:1 negative but new 52-week lows at 8 were at the lowest level since June 18th. I can't say it much clearer other than so far this is just a pause. I would love to see some fear come back into the market and a Dow drop to support at 9000 so we can see how much conviction the bears have. That would be a -400 point drop from Friday's high and about a 4% move. Definitely not even a decent bout of profit taking but a retracement that is really needed. Just look at the monster bounce from early July in the chart below and you can see how seriously overextended we are. A dip back to 9000 or even 8800 would just be a decent bout of profit taking and not a material event.

Dow Chart

The S&P could not hold over the 1000 level but it remains in striking distance. The 20-point decline from the Friday high is barely a decent pause when you consider the +140 point rally from the July lows. The S&P could easily retest 970-980 and not cause any material damage to market sentiment. Most traders are hoping for a continued decline for another entry point.

S&P-500 Chart

Google, Microsoft, Intel, RIMM, Apple and even QCOM all finished lower today. Qualcomm was upgraded after a court rejected a class action lawsuit and news broke about more orders from a new Intel product. Even the double dose of good news could not keep QCOM positive or the Nasdaq from losing more than 1%. Still a quick glance at the internals on the Nasdaq showed that decliners were barely twice the number of advancers. The leaders may have taken a hit for the team but the troops were still moving forward to some extent. The Nasdaq rallied nearly 300 points from the July lows and has not even returned to initial support at 1950. As with the other indexes this was just a buyer boycott rather than the beginning of a summer smackdown. Support at 1950 is key. If we do break that level I would expect the decline to extend for several more days. Until then I see 1950 as a buying opportunity until proven wrong.

Nasdaq Chart

I am not going to bore you with a recap of everything above. I simply view this decline as a buying opportunity and hope we get at least one more day before the buyers return. The FOMC announcement at 2:15 is guaranteed to be a volatility event and lacking any noteworthy change in the FOMC announcement we could be looking at another down day on Thursday. I would love to see support tested on Thursday and a rebound into Friday as shorts cover into the weekend. We are rapidly running out of summer and volume should pickup for real after Labor Day. Until then traders are probably going to be trying to pack in a few more days of sunshine instead of trading as we head into the holiday.

Jim Brown