Better than expected economic news turned the bears into bulls and despite an ugly start to the week the sprint to the finish was strong.
It started with China's better than expected PMI and the U.S. ISM on Wednesday and the markets gapped significantly higher on short covering. Thursday saw a drop in jobless claims, stronger factory orders and better than expected pending home sales. The markets fought to a draw after the opening gap but eventually finished up higher as shorts again were forced to cover into the close. On Friday the weaker than expected ISM Services report was ignored after the Non-Farm Payrolls came in better than expected. Those shorts that had failed to cover found themselves behind the curve once again as the clock wound down into the holiday weekend. The reversal of fortunes was dramatic after resting for six days on critical support. Not a bad start for the worst month of the trading year.
The major economic report on Friday was of course the Non-Farm Payrolls. The headline number came in with a loss of -54,000 jobs compared to the final consensus estimate of -110,000 jobs. The July job losses were also revised down to only -54,000 from their prior estimate of -131,000. While the report was not bullish it was much better than expected.
The drop in the headline number came from continued terminations of census workers. The private sector actually hired +67,000 workers and without the census terminations the report would have been positive. There was additional hiring of temporary workers, which normally precedes an upturn in full time hiring. However, state and local governments lost -10,000 jobs because of the decline in stimulus spending.
There was an increase of 550,000 in the labor force as those workers who skipped job hunting for the summer returned to look for work. The unemployment rate rose slightly as a result to 9.6%. There are currently 14.9 million workers unemployed and 6.2 million of those have been out of work longer than 27 weeks. The number of workers underemployed for economic reasons rose to 8.9 million from 8.5 million. That means they took a part time job waiting tables to pay the rent while they search for a full time job in their field.
With job gains of less than 100,000 per month it will take a very long time to put nearly 15 million people back to work. Analysts believe there are 150,000 new workers entering the job market every month. Job gains have to be over 150,000 for us to actually make some progress in putting people back to work.
In reality the payroll report was "less bad" than actually good. Since the market was expecting a much higher job loss number the shorts did not get the dip they were expecting and were forced to cover rather than face another potential gap higher on Tuesday.
Non-Farm Payroll Chart
The ISM Non-Manufacturing number came in at 51.5 and well below the consensus estimate of 53.5 and the prior level of 54.3. The headline reading was the lowest level since January. Declines in employment and new orders drove the index lower. New orders dropped -4 points to 52.4 and employment turned negative at 48.2. Order backlogs fell -2 points to 50.5 and right on the verge of falling into contraction territory.
Since analysts tell us we are now a service economy rather than a manufacturing economy the drop in the services ISM is a bearish indicator. In August the gap between the Manufacturing ISM at 56.3 and the Services ISM at 51.5 was the largest since November 2008. Since the service sector is commonly believed to be the strongest creator of new jobs this does not bode well for the next few months.
Were it not for the better than expected jobs report the market would have focused on this report and responded negatively. Instead the 8:30 release of the jobs numbers had already fueled the short covering gap open. By the time the 10:00 ISM Services report was released the direction and the race to cover was already well underway.
ISM Non Manufacturing Chart
Last week's economic calendar was stuffed full of important reports. Next week will be just the opposite. The calendar next week only has two reports that are important to the market. Really only one but the jobless claims has taken on an added significance in recent weeks.
The jobless claims fell a minute -6,000 claims to 472,000. This was far from material but the lowest level in the last five weeks. Analysts regarded the release as though it was a lost symphony by Beethoven. It was a clear case of looking for something positive to justify their trades. This week the estimate is for another drop of -7,000 claims.
The biggest report of the week is the Fed's Beige Book on Wednesday. Last month the Fed said things like overall activity "continued to increase." Obviously they were not yet seeing light at the end of the tunnel. The labor market was "mixed" and they felt manufacturing "continued to move up." All of those comments showed a Fed that was struggling for adjectives to describe an economy on life support but hopefully improving.
They will be even more stressed this month. Employment is still a problem and despite several positive economic reports over the last week the economy is still on life support. The jobs report was not dire enough to suggest the Fed will embark on another quantitive easing program so the expectations are for the Fed to continue to say hopeful things and wait patiently for the economy to improve. That means the Beige Book language is going to be a lesson in double speak that would make Greenspan envious.
The Fed is faced with a problem. If they tell the truth in the release the market could tank. At the same time they can't afford to be a cheerleader on nonexistent facts. It will be a verbal tightrope walk. If by chance the report has actually improved the market will launch into a major rally and we will be testing resistance at a new level.
The skinny calendar will be met with equally skinny volume as traders stretch the last holiday of the summer as far into the week as possible.
The better economic news lifting the global markets started with China's PMI on Wednesday. The index rose for the first time in four months. This started the global rally but there was some other news as well. India announced it was upgrading its GDP estimates significantly. The headline number remained unchanged at +8.8% for the April-June but they raised the consumption component from +3.7% to +10%. Private consumption was revised to +3.7% from +0.3%. Government expenditures were revised to +14.2% from a negative -0.7%. Investments doubled from +3.7% to +7.6%. To say this was a major revision would be an understatement. For India to revise estimates this strongly suggests India is exploding out of the recession.
Australia reported its economy grew at the fastest pace in three years in the second quarter due mostly to demand from China and Asia. Compared to India the +1.2% growth in Q2 is anemic but better than the +0.7% in Q1. Australia did not decline as much as the rest of the world due in part to Asia's voracious appetite for coal and minerals produced in Australia. Exports grew by +5.6% in Q2.
When you add in the current economic boom in South America and the global picture is rapidly improving. The U.S. is lagging the globe but the prospects for continued slow growth are increasing. The double dip story is suddenly less likely even though it was almost accepted as a hard fact just two weeks ago. This is another reason the Fed Beige Book on Wednesday is going to be so critical.
I am not writing in a euphoric cloud this weekend. I am only reporting what has changed market sentiment over the last two weeks. You may remember a couple weeks ago I said I did not believe we would see a double dip. About ten days ago I said I was on the fence because of a flurry of negative data. If we take the last week's input the pendulum has swung back in favor of the slow growth scenario.
The weight slowing down the economy is the 15 million unemployed workers. I am sure you have heard the term jobless recovery enough over the last 20 years to be sick of it. In reality there is no jobless recovery. There may be slow growth with minimal increases in employment but no real recovery. Today it looks like it could be 3-5 years before we are back to full employment and that could be a tough five years.
No employment means weak sentiment, weak housing, weak consumption, weak recovery. It does not mean the stock market will not go up. Companies have cut their expenses to the bone in anticipation of a double dip. They are highly profitable even though much of their profits are still derived from cost cutting. For Q3 earnings are now expected to be over 25% and that is an improvement from just a couple weeks ago.
We can have a year-end market rally that will probably extend for several years as long as the slow growth scenario continues. Eventually companies will no longer be able to get by with their skeleton staff and will have to start hiring again. New jobs means new spending and new consumption and companies will have to ramp up manufacturing. It is a vicious circle that will eventually take us back to prosperity but first we have to get past the uncertainty. The economic uncertainty is holding back the economy, employment and the markets.
The economic news pushed the oversold markets to the best pre Labor Day week in two decades. The Dow roared back from early week losses to post a +3% gain for the week. The Nasdaq posted nearly a 4% gain and the Transports +5%. After the week's home sales news the housing index gained +5.4% and the bank index +5.5%.
Is the market done going down? Is this the start of the new bull market? I doubt it but you could not tell it from the markets. Just remember that the volume was very low. On both Thursday and Friday volume was only 6.5 billion shares. It was a holiday week and next week will be light also.
The economics may have perked up slightly but companies are still cutting guidance and warning that revenue for Q3 will be lower. Stock prices overall are also lower. The PE ratio of the S&P was 11.8 last week. That has nearly always been considered a bargain price. This is why there are so many mergers and acquisitions being announced. Companies are looking around at the relative bargains and deciding to spend some of their cash on acquisitions. This is bullish for the market because acquisitions would not be occurring if corporations were still afraid of the dark.
I believe they are looking into the future and seeing growth. Maybe not this quarter or the next but they are seeing business trends that may be firming slightly but more importantly those trends are not declining. Banks are finally making some loans for business and private debt is so cheap any company worth their salt should be loading up on long term debt and making acquisitions with the money while corporate valuations are so cheap. If you look around that is exactly what is happening.
We know from experience that market tops come when investors are irrationally exuberant. Ask Alan Greenspan. The opposite of that trade is when markets become irrationally pessimistic and bottoms tend to form. I believe we saw that in late August. I don't believe we specifically saw a bottom but I believe the bottom is in the process of forming. It could be behind us but it could just as easily occur in the next 4-6 weeks because of structural processes that occur when fund managers rebalance their portfolios for year-end.
We also have the election factor, which I described last week. Investors will become more bullish the closer we get to the election because they believe it will produce gridlock for the next two years. The election is less than two months away so anyone planning on getting long in advance to profit from the historical +4.5% Nov/Dec gain needs to do it over the next 4-6 weeks.
Hedge fund managers plot these things out like a big Monopoly game or maybe a chess match where they can anticipate multiple moves or events and the probable reaction to those events. Right now they are plotting their expectations for economic firming and market actions to that firming. They are plotting the October portfolio shuffle and the election trade ahead of year-end. As of today I seriously doubt they are pricing in economic disaster. I suspect they are setting in motion plans to be long in early October. They may get there by nibbling at the dips through September in hopes of a normal September decline to provide a buying opportunity.
We will know if this is true by the market action on the next couple of dips. If the dips are bought on decent volume then it is time to get long. Fund managers who were trying to raise 50% cash as I reported last week probably missed the three-day rally. They can't afford to sit back and wait and hope the market comes back to them. If we don't see some weakness next week to reassure them the short squeeze was just a bear market spike then they will be forced to start adding positions. They will be forced to chase the market higher.
Another possibility that could be creating some uneasiness is the possibility of another flash crash. There are quite a few people who now believe the first crash was done on purpose. Those responsible did not mean to knock 1,000 points off the Dow and the magnitude of the damage was far more than they expected.
It appears now that there is a comprehensive attack on the electronic systems by hedge funds and high frequency traders. According to an article in the WSJ they have figured out that they can overload the NYSE system and others by flooding the network with quotes. Lots of quotes. The NYSE is rated at 20,000 quotes per second. During the flash crash those numbers hit 50,000 quotes per second. No trades, just tens of thousands of computer generated quotes.
When the NYSE system becomes overloaded the routing process for trades bogs down. Researchers at Nanex LLC, a market data provider, have analyzed the system in the wake of the crash and have proved that a latency lag can be created by quote stuffing where the official quote can be 50-cents to a dollar away from the current prices. The lag time can be several seconds while the system sorts through the hundreds of thousands of quotes being forced upon it. The term drinking from a fire hose is very appropriate.
Any computer programmer with knowledge of this latency and the ability to create it at any time by flipping a switch can make a fortune. In the space of 30 seconds they could flood the system, drive down prices, execute some trades then reverse the process and exit the trades. There does not have to be a lot of volume or a big spread to make a profit. Pick a different stock every day and scam 50 cents on a couple hundred thousand shares and you can make a nice living. Researchers claim this is now being done on a daily basis. I won't bore you with the details but they have started capturing electronic records of these mini crashes.
T3 Capital has been tracking the quotes on the Nasdaq. On one day the Nasdaq traded 1.247 billion shares but there were orders submitted to buy or sell roughly 89.7 billion shares. The majority of these orders were submitted and canceled within seconds and they were well outside the actual price. This is quote stuffing in an effort to manipulate the stock price by giving the allusion of volume away from the price and an effort to slow down the system.
Nanex reported an attack on Abbot as an example. ABT averages 38 orders per second to buy or sell shares on the NYSE. On August 17th in the span of one second there were 10,704 orders followed by 5,483 a second later. All but 14 of those 16,000+ orders were canceled within one second. Eric Hunsaker, a founder of Nanex, said there were dozens to hundreds of these attacks on different stocks every day.
The SEC is supposed to release a report next week on the flash crash and the methods they propose to keep it from happening again. Some of that is already in place with the mini circuit breakers but those kick in at too high a level. That still allows a hedge fund programmer to scam 25-50 cent increments almost at will.
If the people doing this high frequency flooding think that the SEC is going to make it illegal then they will probably want to escalate their programs to capture as much money as possible before the rules change. With all the publicity about the flaw you can bet it is not just one firm but now multiple firms, maybe hundreds of firms, all with their little high frequency scam picking up millions of nickels and dimes from the holes in the system. The next step could be another forced major flash crash, this time with full knowledge and programs ready to capitalize on the drop. You can bet that every hedge fund has already reprogrammed their computers to look for a repeat of the flash crash and act accordingly. How that will turn out is anybody's guess. When hundreds of computers start tripping over programs triggered by others and then reacting to the changes the results could be startling.
The only sure thing is that the SEC has to change the rules and do it soon in order to restore confidence from investors. How they will slow down or regulate the volume of traffic is going to be a major challenge. With a dozen exchanges and 40+ non-exchange venues including anonymous dark pools executing orders in increments as small as a tenth of a cent the amount of data flowing is enormous. Valid data must be allowed through and quote stuffing must be blocked. How to tell the difference is the key. The SEC has proposed a Consolidated Audit Trail (CAT) that would be a database of every quote and trade that moved across any exchange. The cost of this system is projected to be $4 billion up front and $2.1 billion annually. In theory they could track backwards any quote stuffing attempts or any other schemes that programmers concocted.
The worry is not that programmers can game the system. The worry for us today is the possibility of a rapid increase in gaming ahead of the rules changes that could create another flash crash and further harm market sentiment just as traders are coming back into stocks for the year-end rally. Many investors have already been scared out of the market by the flash crash and high frequency trading. We need for conditions to calm down rather than become more hectic.
One trader pointed out that in recent weeks we have had nine reversals that averaged a 7% move and each reversal occurred in less than ten days. Truly a bipolar market! If you are an average trader how do you deal with a 7% change in direction every two weeks? By the time you are comfortable with a direction change and are ready to enter a play the direction changes. I believe this volatility will end after the election and probably several weeks before the election as funds go long for year-end.
Another sign of economic recovery is the increase in Americans traveling this weekend. According to AAA 9.9% more Americans will be traveling for Labor Day. More than 34 million will hop in the family car (91% of those traveling) and head for the beach, mountains, farm, lake, etc. Five percent of travelers will be going by air. The average family will spend an average of $697, up $50 from 2009. I have been watching the gasoline prices this week and in the Denver area they have climbed more than a dime a gallon as service stations try to gouge travelers for a few extra dollars on every fill up. Normally there is a 5-7 cent range on the stations in my area. On Friday that had widened to 17-cents with the corner stations on high traffic intersections charging significantly more than those stations a few blocks off the beaten path. We can expect those prices to decline sharply next week. Notice the various prices as you drive in your neighborhood. I think you will be surprised.
I know you get tired of hearing me say it but the gains over the last three days were predominately short covering. Despite the slightly better than expected economic news the gains were mostly on the opening gap and the closing spike. Shorts cover at the open and before the close. The S&P does not rally +6.5% in three days because investors suddenly wanted to own stocks now that the ISM was slightly higher and jobless claims fell -6,000. It was the change in sentiment not the magnitude of the change. Traders were heavily short on Tuesday after a two-week slide and the change in economic sentiment forced them to cover. It is not rocket science.
The S&P-500 gapped up to 1105 on Friday and then wandered down and sideways all day only to close with another spurt that took it back to 1104. The 1100 resistance level was erased at the open but functioned as support late in the afternoon. Resistance at 1104 was solid with the 100-day average at 1106. This is also downtrend resistance from April. The 1104-1106 level should be strong resistance followed by 1130. If we move over 1106 on Monday I believe we will test 1130. The rally may have been started and fueled by the shorts but fund managers will have to chase it should the rally continue. Support should be well back at 1080.
The Dow has rebounded +500 points in three days from the 9941 low on Tuesday. The short covering was frantic on Wednesday and again at Friday's open. The ISM Services report on Friday knocked some of the wind out of the Dow's sales but shorts came back at the close to push the index to the 200-day average at 10450.
Like the S&P there are three levels of converging resistance but they are not quite as neatly grouped as on the S&P. A move over 10500 will probably run to 10700 on additional short covering. Support is well back at 10260.
The Nasdaq rallied +6.3% in three days. Yes, it was short covering. You may remember on Tuesday the Gartner Group cut their estimates for 2010 PC sale by another 2% and Dan Niles was saying short anything with chips. What a difference a short squeeze can make. The Nasdaq rallied +132 points and +118 of those points were on the opening gaps. The evidence is clear it was short covering. On Wednesday and Friday the opening gap high was the high of the day and there was only 7-point difference on Thursday as traders covered shorts at the close rather than hold over the Jobs report.
Just because all but 14 points were opening gap short covering does not mean it is not a rally. Granted there is little fundamental basis for the gains but should those gains stick on Tuesday there will be some seriously nervous fund managers. Prior resistance a 2225 was support on Friday afternoon and that is the level I would watch for a breakdown. Resistance it 2251 and the converging 100-200 day averages at 2270.
In summary the bulls were rewarded with a great three days thanks to the severely oversold conditions on Tuesday and the better than expected economic news starting on Wednesday. The news was not outstanding, just better than expected. There is very little on the calendar next week but the one major report on Wednesday is going to be critical. Since the Federal Reserve minutes last week suggested conditions were weakening there is a good possibility the Fed Beige Book could say the same thing this week. If the rally is still in progress on Wednesday that revelation could be a buzz kill.
We are still facing the historically weakest period of the year before an equally historic trend of a bullish ramp into the elections. Volume is going to be very slow because of the holiday week and that could accentuate the volatility. Tuesday should be very slow with many traders wanting to see the Beige Book data before taking any new positions. I would recommend an extended weekend and chores around the house on Tuesday like servicing the furnace and changing the filters ahead of winter. It will probably be more rewarding than trading.