We have seen this pattern many times before. Equities rise based on hopes for an optimistic Fed outcome then cautious bulls began to get nervous and move to the sidelines to avoid an unpleasant surprise. Add in the sharp increase in inflation in this morning's reports and there is even more reason for caution.

Market Stats Table

The economic calendar today was not kind to investors. The biggest pothole for the market was the explosion of inflation in the Producer Price Index on the day that the FOMC is meeting to discuss inflation and rates. Prices at the producer level rose by a whopping +1.8% due in part to rising food and energy prices. Excluding food and energy the core rate still showed a +0.5% jump. For an indicator that normally moves in .1% to .2% increments this was a major spike. In the chart below for 2009 you can see that inflation at the producer level is rapidly increasing.

Producer Price Index Chart

Gasoline and other energy products were responsible for much of the headline gain. However, food prices also rose with vegetable, pork and milk prices rising sharply. It appears that the economic slack the Fed was hoping would restrain inflation is not working. Now that the economy is in rebound mode the cost of living is going up again. This is a mixed message. If the market can support rising prices that suggests the economy is strengthening. On the negative side this also means the Fed's timetable for raising rates may be accelerating. The timing and content of this report was troubling to the market even though nobody expects the Fed to make any changes to their announcement on Wednesday. Despite these rising prices there were several economists that still believe we are at risk for a deflationary trend because of slowing demand. They believe this is a temporary blip in prices and prices will turn down again.

Another negative for the market was the sudden drop in the NY Empire State Manufacturing Survey. The headline number for December fell sharply to 2.6 from 23.5 and missed consensus estimates by a mile for a rise to 24.5. This was the second monthly decline from the high of 34.6 in October. This significant drop of 32 points over only two months is very disturbing to economists and increases fears of a double dip recession. The December reading was the lowest level since July.

In the table below I marked the high levels from October and the serious changes in only the last 60 days. Most notable is the drop in unfilled orders to -21 in December from 2.6 in October and the drop in new orders from 30.8 in October. Moody's believes this is the result of post stimulus depression where the economy got an initial boost from the stimulus including the cash for clunkers and now is going into withdrawal as the initial programs begin to wind down.

Empire State Manufacturing Chart

Empire Survey Table

The NAHB Housing Market Index fell for the third month, as homebuilders grew more pessimistic during December. The headline number fell to 16 from 17 and now -3 points off its high of 19 in September. Expectations were for an increase of 1 point to 18. The prospective buyer traffic component was unchanged at 13. This is nearly twice the low of 7 seen last December and the all time low for this survey. Analysts were surprised to see the declines since Congress extended the buyer incentives and mortgage loans are becoming easier to get in some areas.

NAHB Housing Market Index Chart

While all the consumer reports were negative today the Industrial Production report for November posted a gain of +0.8% and well over the +0.5% consensus estimates. The increase in manufacturing output was +1.1% and the largest since August. The strength was broad based with durable goods increasing +1% and nondurables +1.1%. Metal production rose +6.3% and that is an input for later stage manufacturing of finished products. Business equipment production rose a minor +0.4% but computer equipment production fell -2.6% for the 19th consecutive monthly decline. Capacity utilization rose to 71.3% from 70.6%. That is the highest level since December 2008 but still well below normal levels of 80% or better. With inventory levels still very low this suggests we will continue to see improvements in the manufacturing sector.

Industrial Production Chart

The economic elephant in the room today was quiet and invisible but everyone knew it was still there. That is of course the FOMC meeting, which started today and concludes tomorrow with the 2:15 announcement. The Fed has a lot to consider. Inflation is rising but is not yet a problem. Employment is improving but it could be just a seasonal bounce. The economy is improving with a sharp increase in business inventories suggesting the Q4 GDP could be over 5%. On one hand the Fed has to be concerned about an economy that could move into overheat mode very quickly but on the other hand there is the potential for the post stimulus depression.

Despite all the conflicting indicators Bernanke has to deal with his comments during his confirmation hearing last week that the Fed will continue to remain on hold for an "extended period." That should mean the Fed is on hold this week and will remain on hold. Most analysts still don't expect the Fed to begin raising rates until the second half of 2010 although some of those are starting to favor a move in the second quarter. How they word the announcement on Wednesday will determine how aggressively analysts change their forecasts.

The morning started out negative after Austria nationalized a troubled financial institution, Hypo Alpe Adria. That is a unit of German bank BayemLB. Austria took over the bank to keep it from sliding into bankruptcy after making lots of bad loans in Eastern Europe. BayemLB said Austria took a 67.08% stake in Hypo Alpe Adria for the symbolic price of one Euro or $1.46 dollars. Both BayemLB and Austria said the move was necessary because of the systemic importance to Austria and to southeastern Europe. BayemLB lost $3.75 billion Euros with the takeover by Austria. There are also rising worries about a default on sovereign deby by Greece, Ireland and Spain.

Why the bank takeover news is relative to the U.S. markets is because of its impact on the Euro and the dollar. The Euro plunged on the news and the dollar rallied to a new 3-month high at 76.96 on the dollar index. With that kind of spike in the dollar I am surprised the U.S. markets did not trade significantly lower. This is a bullish event because it shows that investors are beginning to increase their confidence in the U.S. economy and are becoming less worried about the impact of the dollar abroad.

Wells Fargo (WFC) completed its secondary offering of $10.65 billion in common stock at $25 per share and the offering was 15% oversubscribed and actually netted Wells $12.25 billion. Wells issued the offering to raise money to exit the TARP program. That should have been good news for the banking sector but the dilution factor is weighing on the banks. Two weeks ago Bank of America raised $19.3 billion with a secondary offering at $15 and adding roughly 1.3 billion shares to its outstanding total. Citigroup is expected to price a $20.5 billion offering late tonight or early Wednesday at roughly $3.25 per share or 6.2 billion shares. Talk about some massive dilution! The already have 22.8 billion outstanding and this will get them very close to 30 billion shares. I can't even comprehend these numbers and the odds of a reverse split soon are about 100%. The government owns billions at $3.25 per share and Citi closed today at $3.57 so the Citigroup offering has got to be somewhere between those numbers. All together that is over $51 billion in new shares coming to market in the last two weeks and there are numerous other banks preparing to do the same thing. That is a lot of cash taken out of the market to support a handful of banks.

Look up in the sky, is that a bird or a plane? No, it is not just a plane it is the super plane from Boeing. The long awaited 787 Dreamliner finally took off today for its maiden flight. The flight was cut short because of weather in Seattle but from all appearances everything went according to plan. There were hundreds of people on hand at the runway to see if it would actually fly and it did with the chase planes following it through every maneuver. Boeing has spent $13 billion developing this plane with the focus on fuel economy. Supposedly it will consume 15% to 20% less fuel and that is an airlines greatest expense. Boeing has orders for more than 800 and even before it flew today it was one of the most successful new models in aviation history. It will still be years before most airlines will actually receive their planes but today was a good first step.

Boeing 787 Taking Off

The airlines are going to need help with fuel costs according to the International Air Transport Association. The IATA predicts that airlines will lose $11 billion for all of 2009 and another $5.6 billion in 2010 do mostly to the rising cost of fuel. Passenger traffic declined -4.1% in 2009 but is expected to rise +4.5% in 2010. The IATA represents 230 airlines carrying 93% of international traffic. They project that fuel costs will be 26% of all operating costs in 2010. They are projecting the average price of crude to be $75 in 2010. The IATA said that fares would continue to decline because of the increased competition and the new larger planes like the 787 and the Airbus A380. Air traffic is due to plunge again once oil demand returns and the next price cycle pushes it back over $125 by 2012.

OPEC released its latest demand estimate for 2010 and called for oil demand to rise by +800,000 bpd to 85.13 million barrels per day. That was a +70,000 bpd increase from their November forecast. They believe the first half of the year will remain weak but escalate sharply once the global economic rebound finds some traction. Crude prices rose today breaking the 9-day losing streak. Considering the dollar was up sharply the gain in crude prices was even more startling. Crude rebounded to just over $71 after trading as low as $68.59 on Sunday night. The current crude futures contract expires on Monday and OPEC meets on Tuesday to officially confirm they are not changing production targets. Since they are already producing two million barrels per day over their "official quotas" the entire process is a sham anyway. The meeting and the announcement is only for show because they will pump whatever they can get away with and not crush prices.

Crude Oil Chart

After the bell today Adobe Systems (ADBE) reported earnings that beat the street and said demand was growing. Adobe said they were "hopeful" the increase in business would continue in 2010 but refrained from issuing a full year forecast. Adobe will release a new Creative Suite and Acrobat in 2010 and those two products account for 90% of Adobe's revenue. Adobe released CS4 just as the economy crashed and the timing could not have been worse. Adobe posted earnings excluding items of 39 cents and beating the 37-cent estimate. They projected Q1 revenue of $800-$850 million and ahead of the $798 million estimate. Shares were unchanged after the release.

Best Buy reported earnings that beat the street but the shares were crushed after it said margins would suffer. You may remember in my weekend commentary I cautioned that should Best Buy whine about lower margins it would not go well for the retail sector. The damage started with Best Buy with an 8% drop today and that tanked the retail index. Every retailer I checked was down with the exception of Ross Stores, which was up on their inclusion in the S&P-500 at the close on Friday. Best Buy reported earnings of 53-cents compared to 18-cents in Q4-2008. The consensus estimates was for earnings of 43-cents.

You would think that a 10-cent beat would overcome some of the weak margin worry but there is little "margin" for error. Best Buy said gross margins would decline from 1% to only .8% in the current quarter. That is so absurdly low it is ridiculous. They would make more money by putting in a snack bar and soda fountain in each store and charging for parking. Less than 1% gross margin on sales of $12 billion is a lot of work and a lot of risk. If only one thing goes wrong they could be back in the loss column.

Best Buy Chart

Next up on the earnings parade are DRI, FDX, NKE, PIR, RIMM, PALM, RAD and WGO on Thursday. FedEx and RIMM will be the key ones to watch with DRI and NKE another read on the retail trends. I saw today that Nike has offered to help Tiger Woods out with his desire to disappear for an indefinite period. They offered an idea for plastic surgery that would change his appearance. Do you think it makes him less recognizable?

Plastic Surgery for Tiger?

GE made news today with their guidance for 2010. They expect to record flat profits across their industrial segments because of sluggish demand for jet engines, electric turbines, locomotives and other heavy equipment. They believe the worst is behind us but the immediate future is still not bright. GE said it was ready to invest in growth now that the recession was over. Considering Jeff Immelt is normally overly optimistic and most GE forecasts are eventually lowered the outlook for GE's stock price is flat. Analysts had expected earnings of 89-cents in 2010 compared to 99-cents in 2009. With GE competitors forecasting solid growth you wonder why GE is so glum. UTX predicted +10% growth last week. 3M predicted +9% growth the week before. GE Capital is still a drag on GE and the parent is still trying to scale down that business but it is a slow process. GE shares were flat for the day with only a fractional decline.

We knew in advance that Tuesday was likely to be a lackluster day in the markets. The surprise spike in inflation during a Fed meeting was an added weight on equities. Volume was surprisingly strong at 8.2 billion shares although that is not a strong day under normal conditions. I was expecting something in the high 6B range as we waited for the Fed announcement. I suspect the inflation news scared a lot of traders to the sidelines and the impending announcement on the Citi secondary offering created nearly one billion shares of volume there alone. That was nearly five times Friday's volume on Citi. Citi was down more than 10% for the week just before the close.

The Dow declined to 10,450 to wait for the Fed decision. After trading over 10,500 yesterday for the fourth day since December began, it was an easy opportunity to take profits ahead of the Fed. Today's trading had nothing to do with the markets or market sentiment. It was simply a throwaway day while we wait on the Fed. The closing level was immaterial in that there was no big decline. 10450 has been initial support since November 23rd but it has also failed every support test. It is more like a bus stop than a train station. The market pauses there whenever it passes but only briefly.

The only two numbers that matter this week are 10,500 and 10,265. Both have been visited multiple times and both remain unbroken for more than temporary intraday spikes. Once the Fed announcement is behind us the markets are going to pick a direction and I suspect one of those levels will be broken before the holidays. Considering the inflation news today and the relatively small decline I think the market is poised for another attempt at new highs if the Fed does not spoil the party.

Dow Chart

The S&P, like the Dow remains stuck in its recent range between 1085 and 1115. The 1115 level is the 50% retracement of its loss from the 1561 high close on Oct-7th 2007. This level has been solid resistance with traders using the 1110-1115 range to take profits and establish new shorts since Mid November. The decline to 1107 today was a non-event. As I said earlier traders were just passing time today and taking some cash off the table in case of a Fed surprise.

S&P-500 Chart

The Nasdaq is a slightly different story. The 2200 level had been strong resistance since Nov-16th and we closed 12 points above that level on Monday. Today's decline to close just over 2200 was bullish since that establishes prior resistance as new support. At least that is the theory. Like in the case of the Dow and S&P we really can't apply too much logic and interpretation to today's trading. On the surface the Nasdaq appears cautiously bullish but at 2:15 Wednesday afternoon it will be an entirely different picture. Support is 2160, 2140 and 2120. Overhead short-term resistance is 2125 and long-term resistance is 2150 and the 61% Fib retracement of the bear market drop.

Nasdaq Chart

Like the Nasdaq the Russell broke over strong resistance at 606 and then returned to use that resistance as support on Tuesday. The combination of the Nasdaq and the Russell doing exactly the same thing in the same week is very bullish. However, there is still the cloud of the Fed meeting. I would revert to short-term bullish mode if these two indexes can close over support again on Wednesday after the Fed announcement.

Russell Chart

The canary in the coalmine is still the NYSE Composite. It has failed to return to resistance and continues to show greater weakness than the other indexes. Where the other indexes are breaking out to new highs the NYSE is showing weakness. This is a reason to remain cautious on the positive signs on the Nasdaq and Russell.

NYSE Chart

In summary, everything hinges on the Fed announcement. Despite the bullish signals in the Nasdaq and Russell the NYSE is still flashing caution. However, a continued breakout on the Nasdaq/Russell would negate the short-term caution on the NYSE but it would remain a longer-term caution for the first week of January. We can't predict how the market will react to the Fed announcement other than there will be volatility. It is what happens on Thursday that counts. Once the news has had time to settle the real market should return on Thursday. This is also expiration week so there will be pressures to pin stocks to their max pain points after the meeting. This could restrain any move or create a massive short squeeze if the Fed news is better than expected.

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