The market crashed on Friday not because of an earnings disaster or a warning from a high profile company. The market extended its decline to three days because politicians are trying to distract you.
This is going to be a tough market commentary to write. Some of our readers don't want politics mentioned when discussing the market. Unfortunately this week politics crashed the market and I can't in good conscience write a puff piece and avoid the hardball facts. I will try and make it brief and you are more than welcome to skip the next few paragraphs if this topic offends you.
On Tuesday republican Scott Brown did the unthinkable and won the Massachusetts Senate seat held by the Kennedy's since the 1960s and did so with anti Obama campaign pledges. One of the most liberal states in the country where democrats outnumber republicans by more than 3:1 voted for a republican and for a change to the current administration's policies. It was the shot heard round the world and meant that no democrat seat in the country was safe in 2010.
The democrats immediately went into reaction mode and returned to populist politics that have worked so well for them in the past. By immediately blasting the "fat cat bankers" and calling for more regulation on major financial institutions they created a firestorm of controversy and succeeded in refocusing American attention on them instead of the voter revolt. This is not a new tactic. It has been used since the time of Aristotle to distract attention when current events turned against those in power. It is NOT a purely democratic ploy and has been used by both sides many times. It is called populist politics.
According to the dictionary populist politics is a political tactic that creates conflict between "the people" and "the elite" and urges social and political system changes. It is normally deployed by members of political or social movements. The Cambridge dictionary defines it as "political ideas and activities that are intended to represent ordinary people's needs and wishes."
Populists use derogatory terms like fat cat bankers, Hollywood elite, big oil, etc. Whenever politicians need a scapegoat they demonize whatever elite may be appropriate in order to become a hero to the masses. This week it was fat cat bankers and next week it may be big oil and so on depending on how their opinion polls are improving.
What I am trying to get across here is that this is business as usual. It is a common political trick to distract you from other events that were in the spotlight. I believe what the administration is proposing has little or no chance of becoming law but that does not matter. What matters is the distraction factor to take voters minds off the now dead health care bill and the potential to lose another 10-12 Senate seats in the fall. Banking analyst Meredith Whitney does believe it will become law and that is why the severe market reaction.
How many readers on Friday actually heard the comment from the president that lawmakers should table the health care bill until later in the year and then start over? This is the same president that was trying to force it through a week before the Massachusetts elections by calling all the holdouts and trying to cut additional deals. His comments on Friday came after Nancy Pelosi said they no longer have the votes in the House to get it passed but of course it was spun in the media as his idea.
Unfortunately for those of us in the market these political games impact the lives of real people. Every investor in the U.S., about 90 million people, lost money this week because of populist politics. Unfortunately probably 89 million don't understand the problem and actually believe fat cat bankers are at fault because of the media spin on the new banking rules the president is proposing. The S&P-500 lost more than $400 billion in market cap for the week according to Rich Peterson at S&P. There are real consequences to class warfare.
There are growing rumors that Treasury Secretary Tim Geithner is about to be fired as part of the populist shakeup. Geithner is seen by the masses as being favorable to Wall Street and his bank bailout plan has failed. Banks are not lending again even though they paid back the TARP. Geithner has been tied to some cover-up scenarios at AIG and that is linking AIG to the current administration. His too big to fail policy is linked to the current Wall Street bonus outrage. Analysts think he is the next scapegoat for the administration and suggest president Obama floated a trial balloon for his replacement last week.
In president Obama's opening paragraph in the new bank rules speech hs said: "Good morning, everybody, I just had a very productive meeting with two members of my Economic Recovery Advisory Board: Paul Volcker, who is the former chair of the Federal Reserve Board, and Bill Donaldson, previously the head of the SEC, and I deeply appreciate the counsel of these two leaders and the board, that theyâ€™ve offered as we have dealt with a broad array of very difficult economic challenges." Geithner was on the podium with the group but he was not mentioned and spent most of the speech looking at his shoes.
Basically president Obama said I just had a meeting with two new advisors and based on what they said, I am launching a new policy I am calling the Volcker Rule. Note that Volcker is just an advisor and Geithner is Treasury Secretary. So it appears Turbo Tax Tim may be next up on the sacrificial list as the administration tries to project a new get tough on Wall Street fat cats image.
Every single analyst I heard or read over the last week is dumbfounded that the administration is suggesting these changes because the changes they are suggesting have nothing to do with what caused the financial collapse. They are pure knee jerk populist politics used to inflame the public. For someone who ran on the platform of uniting America he has done more to divide it. I am sure the State of the Union speech on Wednesday evening will contain more populist remarks to further endear the masses. I am hostile this weekend and I hope every investor in the U.S. is also hostile.
The new political news on Friday was a canceled vote on confirming Ben Bernanke for another term as Fed Chairman. This is pure political theatre to distract from the other events. Senators Boxer and Finegold, both up for reelection this year and suddenly vulnerable, spearheaded this effort. By all accounts from economists, analysts, bankers and anyone who really understands how close we came to a complete meltdown they all say Chairman Bernanke should be confirmed by unanimous acclamation. Some claim there should be a statue of him on Wall Street as testament to his efforts to bring us back from the brink. Nobody claims he is perfect and there were mistakes but these were extraordinary times that required extraordinary measures in a very short time frame.
Several analysts thought there could easily be a 10% sell off if Bernanke is not confirmed. There is only a week left in his term and should he not be confirmed for a second term Donald Kohn, a Fed banker since the 1970s, would temporarily fill his seat until a successor could be named and confirmed. Analysts claim this sudden rousting of Bernanke is meant to show that our lawmakers are taking action on the banking crisis by throwing out the old guard.
The Bernanke problem is not going to simply disappear. There is a Fed meeting on Tue/Wed and his confirmation problems will be on every news channel and every newspaper. This will be the big story next week with the term countdown clock going to zero at month end.
I heard late Saturday that President Obama called several key senators from the White House in an effort to support Bernanke. He said later aboard Air Force One that he has "a great deal of confidence" in Bernanke. An Obama spokesman followed up with "The president has a great deal of confidence in what chairman Bernanke did to bring our economy back from the brink. The president thinks he is the right person for the job and believes he will be confirmed." Obviously the possibility Bernanke would not be confirmed and the potential for a market meltdown suddenly became a top priority for the president and he made the right call in moving to assure the confirmation. Let's hope his actions were enough to insure the confirmation.
For the next ten months there will be no status quo. Every topic touched on by politicians will have only one goal and that is avoiding a repeat of the Scott Brown revolution in their own states. Republicans are not safe either. The mandate from Massachusetts was smaller government and lower taxes and those republicans who have voted to tax and spend are also in trouble. They need their own distraction points to refocus voter attention towards them in a positive light.
On the economic front there was nothing of note on Friday and had there been it would have been ignored. Next week has several events that will be of importance even if the demonizing of banks and banking officials has not gone away. The most important is the FOMC announcement on Wednesday. No changes are expected but we are hoping not to hear that conditions have weakened since December. Several economic reports have softened and you heard from two banks last week that the worst may not be over. I doubt the Fed is going to want to spread doubt so even if there have been signs of weakening they will probably phrase the statement to avoid any negativity.
The second biggest event is the Q4 GDP on Friday. GDP is expected to have risen by +4.4% in Q4. Yes, you read that correctly, +4.4%. It is a technical bounce only that has to do with inventory depletion and is not a clear indication of a surge in economic activity. However, I am sure the less intelligent talking heads in the media will be bubbling over with excitement as they report the numbers. Don't be fooled. The Fed is only expecting the GDP for all of 2010 to be in the range of 2.4% to 2.7%. Friday's number is a statistical anomaly to be ignored. If by chance the number comes in dramatically lower we could see a strongly negative reaction since 4.4% is already baked in the cake.
There is also a flurry of Fed surveys, Richmond, Kansas and Chicago as well as the NY and Chicago ISM reports. These are all preludes to the Non-Farm payrolls on Friday of next week. This week has a busy calendar but the Bernanke confirmation will be the overhanging cloud.
This is the last week for material earnings reports. The cycle will drag on for several more weeks but after this week the majority of the big names will have reported. The following week is when I expected a sell off on profit taking but given our -4% drop already and the negative tone in the market I am not sure investors are going to wait another week.
Headlining the earnings next week are Apple, Amazon, Yahoo, CAT, MMM and UTX. Apple reports earnings on Monday and hosts its unveiling of what is expected to be a tablet PC on Wednesday. Bernstein Research warned on Friday that expectations for Apple's iPhone sales could be too high. Bernstein expects Apple to announce sales of roughly 8.5 million phones compared to the 10-million consensus estimate. Apple earnings are expected to be $2.07 per share and a miss there could be partially offset by the impending tablet announcement. The Bernstein warning helped knock $10 off Apple on Friday
So far this quarter 92 of the S&P-500 companies have reported and earnings are up +193% over nearly zero earnings of Q4-2008. However, if you take out the financials that drops to only a +7% gain. 78% of companies beat by an average of +21%. Only 17% missed earnings but more than 50% struggled with their guidance. S&P says the bottom line earnings are still improving due to continued cost cutting but the top line growth has been minimal. Next week there are 12 Dow components and 130 S&P stocks reporting.
Not on the economic calendar but definitely a scary sequence of events is a massive debt auction of roughly $178 billion. On Monday $48 billion in T-Bills, Tuesday $12 billion in monthly notes plus $44 billion in 2-years. Wednesday has $42 billion in 5-year paper and another $32 billion in 7-year paper on Thursday. The rate at which we are adding debt is nothing short of phenomenal. The current administration is on track to add more debt in the first 20 months of this term than George Bush did in his entire 8-year term. By 2013 the interest on the debt will be the largest single item in the Federal budget.
The problem with constantly adding debt is that we can't repay the debt that we
already have. There is a new book by Carmen Reinhart and Kenneth Rogoff called "This Time is Different." They researched over 250 financial crises in 66 countries over 800 years and analyzed them for differences and similarities. They found that debt kills countries and excessive debt kills them quickly regardless of the reason for the debt.
Quote from the book: "As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked."
Debt to GDP Chart
Borrowing $178 billion in short term paper next week is a pure example of being forced to refinance short term because long-term confidence is weak. As I have said many times before we are eventually going to see one of these debt auctions fail and all hell will break loose.
We are seeing a higher demand for our debt since the Dubai debt warning. Add the current problems in Greece, Spain, Portugal and Italy and the potential for a Euro implosion if something does not change and the U.S. still looks like a safe place to park money in short term debt. We are still the highest rated paper although that could also change soon. As long as we can keep running debt auctions to pay the interest on existing debt the house of cards should not fall.
That is like getting a cash advance on one credit card to pay the monthly payment on another. Eventually your available credit lines run out and you are left with a mountain of debt you can't pay and no credit. When an auction fails it will be the equivalent of running out of available credit on that last credit card.
Speaking of credit cards American Express got a haircut of nearly 9% on Friday after FBR Capital Markets cut estimates for credit card companies due to the new Credit CARD Act, which goes into effect on Feb-22nd. After that date companies will no longer be able to change rates and fees on a whim. There are rules they will have to follow and it has resulted in the cancellation of hundreds of billions of dollars of credit to consumers.
American Express (AXP) lost $3.50 or -8.46% on Friday after the CFO said yields on credit cards could drop to 9.7%. Capital One (COF) was also cut by FRB and their yields are expected to drop to 15.5%. COF is expected to undergo the most pain since they have a large number of subprime cardholders. AXP said they lowered their provision for loan losses by -47% to $748 million for the current quarter. COF posted an even bigger drop to $843 million from $2.1 billion. This is a clear sign that the banks have cleaned up their books and are working to prune off less than desirable clients. Meanwhile Fitch Ratings warned that charge offs of consumer loans could become more widespread in coming months as higher interest rates and unemployment push more consumers into trouble.
Capital One Chart
Oilfield services giant Schlumberger (SLB) reported earnings on Friday and promptly lost -4.5% in its share price. SLB posted better than expected profits but lower margins since the company had cut rates to remain competitive. SLB CEO Andrew Gould said international margins should bottom out in the middle of 2010 but warned that natural gas production presented few growth opportunities outside the U.S. over the next few years.
The CEO said the amount of activity scheduled in Iraq over the next three years was huge but it required a new election and passage of a new oil law. He said the ramp up could begin late in 2010.
AMD posted better than expected earnings but lost -12% anyway. Most of the profit came from the end of the dispute with Intel. AMD had no real impact on the sector but a downgrade on chip stocks by Citi sent them all sharply lower. The downgrade by Citi analyst Timothy Arcuri was on chip equipment makers to sell from hold. Companies cut were KLAC, ATMI, BRKS and ENTG. He kept a sell rating on ASML and LRCX. He also cut NVLS to hold from buy and removed AMAT from the "top picks" list. Arcuri did keep a buy on FORM. He said he saw the potential for chip stocks to fall -30% over the next 3-6 months. The SOX lost -5% on the downgrades.
Semiconductor Index Chart
Google reported earnings on Thursday that beat the street but failed to beat the whisper number. Paid clicks did not accelerate as hoped and the growth plan seemed a little fuzzy. Investors are beginning to worry that the easy money has been made in Google and now it has evolved into just another tech company where product penetration has peaked. Google lost -$32 on Friday.
Google also reported that founders Larry Page and Sergey Brin plan to sell about 10 million shares over the next five years. This will reduce their holdings to less than 50% and technically they will be giving up control. In reality nobody else can even come close to amassing a block big enough to have control so despite their less than 50% ownership they will still be making decisions and wielding absolute power. After the sale the pair will still own 47.7 million shares, only around 15% of the outstanding, but they will have voting rights on 48% of the stock. Currently they have voting rights on 59% of the stock.
Oil prices imploded over the last week as the year-end commodity fund rally fizzled. Comments from China about slowing growth by halting lending suggested oil demand growth might also slow. Gasoline inventories in the U.S. rose by 11.5 million barrels over the last three weeks and refinery utilization fell to 78.4% from 81.3% the prior week. Crude prices fell from $84.22 on the March contract to close at $74.09 on Friday. That is a $10 drop in two weeks. All things being equal this is support for crude but we have to get past the weakness in equities and worries about a double dip before we can expect a return to that $84 level.
Crude Oil Chart
Next week is going to be difficult. Earnings are peaking and after the week is over there will be little left to provide lift for the markets. The political process is running amok and there is a big list of events next week that could be impacted by a continued attack on capitalism and Bernanke's confirmation vote.
We got word after the close that the UK just raised their terror alert status to "severe" on worries about attacks from terrorists in Yemen. This is equivalent to the current U.S. status of "high" for domestic and international flights. We have heard for the last couple weeks that information from the Christmas bomber has led investigators to uncover evidence of other plots in progress from Yemen.
The Dow lost -4.12% for the week and closed below support that had held since early November. Closing at the lows on Friday is never a good sign and closing below support is even worse. Without a cessation of the political attacks I believe the Dow could easily test 9500 over the next month. Dow 9650 would be a 10% correction but given the fragility of the current market we could slide all the way to 9500. I know this sounds drastic but the Dow has fallen -562 points in just the last three sessions. The markets are in rout mode from their own version of a terrorist attack.
The next Dow support level is 10,100 but we could easily overshoot that if nothing changes in the news over the weekend. Volume is off the charts with 12.2 billion on Thursday and 11.5 billion on Friday. This is the equivalent of screaming fire in a crowded theater. Somebody better turn on the lights and give the all clear signal soon or it is really going to get ugly.
The S&P-500 is our hope for a halt to the market drop next week. The 1085 level has been strong support since early November. It will probably be tested on Monday and should it hold it might give the bulls some incentive to buy the dip at least temporarily.
A 10% correction would be a drop to 1035 and that would be a logical stopping point according to the chart. The ascending megaphone wedge crosses exactly at that 1035 level. This will be a make or break point for the markets. Over 1.5 million SPY puts traded on Friday.
The Nasdaq ended a month of consolidation around 2300 and collapsed with a 3.6% drop to 2205. This support must hold or the S&P may not be able to support the markets at 1085. With Apple on Monday there could be a serious challenge if Apple disappoints. A break of 2200 could target support at 2040.
The problems facing the market are policy issues not fundamental issues. The earnings have not been great despite the +193% record so far. There were no earnings in Q4-2008 so any earnings are an improvement. Earnings were not weak enough to cause this kind of selling. This is news driven panic and not related to equity valuations.
The qualification is that most analysts expected a decline in February so the stop losses were in place. When the downdraft began those stops began to get hit and the sell off became self-perpetuating. Stocks go down faster than they go up because traders are rushing to capture remaining profits rather than patiently wait for stocks to move higher.
The market closed with a strongly negative bias on Friday. If the right people say the right things over the weekend the policy problem could fade by Monday. I am not expecting that because the politicians have us exactly where they want us, focused on them rather than on their election problems. We are at their mercy if they want to keep feeding these flames. President Obama's Saturday comments expressing confidence in Bernanke is a major plus. He is doing the right thing and it may calm tensions before Monday's open.
Fortunately time heals all wounds. Several days from now the market will lose interest in the current problems and hopefully will be focused on GDP and ISM and Microsoft earnings. The president's support of Bernanke on Saturday was a good first step. If he can give a calming speech on Wednesday and avoid using the term fat cat bankers again then the worst may be over. You can bet he is taking heat from his advisors about crashing the market and would like to avoid being blamed for a full correction.
However, now that this sell off is up to speed it may continue to be self perpetuating until the sellers run out of stock. I doubt many investors are sticking their hands out to catch these falling knives. They will want to see them hit the floor first before they start picking them up.
I would be patient about going long next week. There may be a rebound day where all the shorts get squeezed again but I would wait until sentiment improves before picking up some bargains.