The markets struggled to hold their gains all week as we wait to see if the Fed is going to give us a treat or a trick.
Friday was a strange day with more emphasis put on a couple of bombs from Yemen than the handful of meaningful economic reports. Volume was mediocre and the Dow traded in a very tight 55-point range. Despite a couple of sharp intraday declines fund managers were able to close the Dow over support at 11,100 and the Nasdaq stretched its string to eight consecutive days of gain. Okay, it only gained +0.04 points on Friday but it still counts. The Nasdaq gained +28 points for the week but most of that was on Thursday. Managers just wanted to close it over 2500 and near the highs for the year at 2520. They held off the bears all week and Monday starts a new fund fiscal year.
The economics were mixed with the headline GDP number for Q3 coming in at +2.0% compared to growth of +1.7% in Q2. However, if you remove the inventory-rebuilding component the GDP would have been only +0.6%. Investment growth slowed dramatically from +2.1% to only +0.1%. Government spending accounted for +0.7% of the overall GDP. That means government spending is the only thing that kept the ex-inventory GDP positive. Exports improved to a -2.0% from -3.5% in Q2. That offset a +1.8% gain in personal consumption.
The inventory rebuild phase is nearly over. Inventories were allowed to decline to very low levels during the recession. When the rebound began last March it took several months for wholesalers to feel better about future demand and begin placing orders to replenish inventories. That replenishment cycle has run its course but consumers have not stepped up their buying as they have in previous rebounds. That means future quarters will not have the inventory crutch to keep them positive. When that inventory is sold in Q4 it will detract from GDP. Building inventory adds to GDP, declining inventory detracts from GDP. Also, this is for Q3 and you may remember that most of the stimulus spending ended at the end of Q3. The government will not be nearly as big of a contributor as in Q3.
Recently we have been plagued with multiple downward revisions. The Q2 GDP started out at 2.4% but was revised down repeatedly until the +1.7% final. This will probably happen to the Q3 number as well. Some economists are predicting a +1.6% final of which government spending will be nearly half and ex-inventory would be almost flat.
Until employment picks up the GDP should remain at or below the 2% level. This is not expected until late in 2011. For reference, normal GDP at this stage of an average recovery would be around 5%.
On the positive side we have seen some upside guidance with the recent earnings reports so there is economic activity. It is not the consumption graveyard many analysts would have you believe. Businesses are still reluctant to invest until the growth begins to accelerate. It is the basic chicken and egg story. Consumers can't consume until they have a job. Businesses won't hire until consumers begin to consume.
We are creating what could be a massive explosion of pent up demand but it is well out into the future. Just because consumers are not spending today does not mean they don't want to spend. They have to be cautious until jobs improve. Once the economy does start to improve significantly there will be a release of all that pent up demand and it could be explosive. However, it takes a GDP of around 3.5% before decent employment numbers will appear.
The GDP numbers are one more guarantee the Fed is not going to raise rates for a long time. Most analysts are now expecting the Fed to be on hold possibly until 2012.
Reinforcing the gloomy outlook by consumers was an 11-month low in October Consumer Sentiment at 67.7 compared to September's 68.2. The decline was driven by a three-point drop in the current conditions component from 79.6 to 76.6. It will be extremely interesting to see how the November sentiment changes after the elections.
Consumer Sentiment Chart
The ISM Chicago surprised to the upside with a 60.6 reading. That was only a +.2 improvement over September's 60.4 but analysts were predicting a decline to 58.5. New orders improved to 65.0 from 61.4 but backorders were flat at 49.2 and slightly in contraction territory for the second month. Employment improved better than a full point to 54.6. The biggest gain was the production component, jumping +5.5 points to 62.8.
Regional manufacturing reports have been weak and the Chicago ISM was a real surprise. Obviously it was buoyed by auto manufacturing in the area while other regions don't have that support base.
ISM Chicago Chart
The ISM New York was also up strongly with the headline number gaining 7 points to 477.9. This was the largest gain in the ISM-NY since June. The current conditions component spiked from 58.3 to 64.7 and the six-month outlook rose from 64.8 to 69.8. The employment component gained a point to 54.4 and consistent with the employment gain in the ISM-Chicago.
The ISM New York is more of a services index where Chicago is a manufacturing base. New York has added 60,000 jobs this year and 40,000 were in the services sector. Hotel occupancy rose to 85.7% in September and the highest level since September 2006 according to Smith Travel. Room prices are also rising with a +12% gain for the year. There are green shoots in the economy but they are scattered and not yet turning into a lawn.
The national ISM will be released on Monday and it is expected to rise from 53.3 to 54.5.
The economic calendar for next week has some major events. The first group is the ISM Manufacturing followed by Factory Orders and ISM Non-Manufacturing.
The biggest event for the week is the FOMC meeting and the statement on monetary policy on Wednesday. In theory this is when the Fed will outline its new quantitative easing program the market is all hyped up about. This could be a seriously pivotal event for the markets. If the Fed announces a big program the market will probably breathe a sigh of relief the hype was valid and eventually move higher.
If they announce some minor program with incremental purchases based on economic indicators at the time, the market will probably go into short-term free fall. Eventually it will recover but with less emphasis. This is not the option the market prefers.
Regardless of what they announce I expect a sell the news event. I could be mistaken but I think there could be a bunch of fund managers looking to take profits now that they are in a new fiscal year.
Lastly we have the Non-Farm Payrolls on Friday. The consensus estimate is for a gain of 62,000 jobs compared to the loss of 95,000 in September. I am actually leaning towards a higher number and possibly in the 100,000 range. We have seen the employment components improve slightly in the regional reports and the large-scale census terminations should be over.
I may be overly optimistic but the JOLTS report showed an improvement, as did the Mass Layoffs report. All the improvements have been minimal but they show a rising trend.
Employment is about to get a lot worse but it won't show up in the payroll report. After multiple emergency extensions to state and federal unemployment benefits the crows are coming home to roost. Currently a person can qualify for a total of up to 99 weeks of unemployment compensation when combining state and federal programs. Those extensions end on November 30th. Nearly one million people will quit receiving checks in December and another 3-4 million will lose benefits by April. Roughly five million people will no longer get their weekly checks. Since the average check is about $300 that equates to a loss of $80 billion in spendable income over the next several quarters and could knock another sizeable chunk off the GDP.
Most analysts doubt the lame duck Congress will extend the tax cuts although most consumers expect that to happen with a republican win. They don't understand the process and the animosity that may restrict any bipartisan agreements. They may get another round of unemployment benefits passed but I am not holding my breath on that either.
In stock news Chevron reported earnings that disappointed with profits down -2%. Chevron said costs related to the drilling moratorium and monster currency charges were the reason for the disappointment. Chevron reported earnings of $3.77 billion or $1.87 per share. That compares to $1.92 in the year ago quarter. Analysts were expecting $2.15 per share. Revenue rose +7% to $49.7 billion.
Chevron took a charge of $367 million on currency translation issues related to the drop in the dollar. That has cost them $600 million over the last two quarters alone. Chevron said production in the Gulf fell by 10,000 barrels per day due to the moratorium. Every well suffers production declines as time passes. If you are not drilling new wells to replace that lost production your profits will suffer. Total U.S. production fell -7% or 53,000 boe per day. The company said the drop was due to "normal field declines."
Chevron said exploration costs jumped +74% to $420 million for the quarter because of expenses in the Gulf and dry holes in Canada and Turkey. Chevron is forced to continue paying leases for its nine rigs in the Gulf even though they are unable to work. The company said it could be months before drilling resumed in the Gulf because of new permitting rules.
Chevron did warn that the refining business still faces difficult years ahead with "tepid" growth in the demand for refined products. The reasons given were the global recession, government mandates for alternative fuels and increased fuel efficiency for new vehicles. Chevron shares lost -2% for the day.
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Merck (MRK) reported disappointing sales and took a $1 billion charge related to its Vioxx arthritis drug. Merck had already agreed to pay out $4.85 billion in damages to people who had taken the drug. Despite the weak sales and charges the company still beat analyst estimates for profits. Merck reported profits of 85-cents excluding items and analysts were expecting 82-cents. That minor beat did not help the stock with a -2% loss for the day.
Nasdaq (NDAQ) reported earnings of 50-cents compared to analyst estimates of 47-cents. That was still a 2-cent decline from the comparison quarter. Gains in market data fees and new products were offset by lower overall volume after the flash crash. Nasdaq raised its estimates for operating expenses and the guidance was not exciting. After an opening spike shared of NDAQ closed with only a fractional gain.
Blended earnings growth for the S&P-500 rose to 30.1% on Friday. This compares to the estimates for 23.8% growth back on October 1st. Of the 335 (67%) of companies reported 77% beat estimates and 17% missed estimates. This pushed the earnings growth rate for all of 2010 to +32%. For a recessionary low growth environment I don't see how we could have asked for much more other that a little better revenue numbers.
With 67% of the S&P already reported we know how this cycle will end. The few major companies left to report will not change the outcome significantly. The bloom is off the earnings rose for Q3 and it will be increasingly harder for a positive surprise to move the market.
The market handled the Yemen bomb news with barely a hiccup. Despite wall-to-wall cable TV news coverage the volatility was minimal and the Dow remained in its 55-point range. As of late Friday night the devices are still being called bombs although there appears to be considerable confusion. In a news conference President Obama said the packages contained explosive material. One was setup to be triggered by cell phone and the other had a timer. The New York Times reported they were printer cartridges filled with PTEN, the same explosive used in the underwear of the Christmas bomber over Detroit. After the scare both UPS and FedEX announced a cutoff of shipments from Yemen. In return Yemen closed down the FedEx and UPS facilities in the country. Several European nations were also canceling all airline flights involving Yemen.
Trimtabs.com reported on Friday that investors put $759 million into U.S. equity funds in the week ended on Tuesday. That may not seem like a lot of money compared to the $4 billion on average they have been taking out every week but it marked a special event. It was the first week in over six months where fund flows went into U.S. equity funds instead of exiting those funds. Think about that. The market is at the highs for the year and the retail investor has been taking out an average of $4 billion a week from equity funds and putting it into bond funds and emerging market funds. If that trend were to reverse the impact on our markets would be huge.
Portfolio managers claim the phones started ringing about ten days ago and with the market about to make new highs clients are asking if they should get back into the market. Clearly the herd is always wrong but that does not mean we can't profit from that trend.
Since Ben Bernanke announced QE2 on August 27th the S&P is up +13%. The QE2 roller coaster has not only left the loading ramp but has reached the top of the first major hill. What next is the key question? The QE trade is very overbought and we have not had a decent bout of profit taking since August. Conventional wisdom suggests we should see a sell the news event that knocks 5% or more off the indexes. Conventional wisdom is normally wrong when it comes to the stock market.
A 5% decline would be an ideal scenario because it would give everyone waiting on the sidelines an opportunity to buy. I believe we will see a sell the news event next week and there are plenty of news events to sell. The biggest of course is the Fed statement. Since it comes after the election we will know what the next two years is going to look like in the House and Senate and be able to project the political and regulatory environment and its impact on the markets.
Business owners will be able to project how the changes will affect their businesses and act accordingly. You may remember last week when the Job Openings and Labor Turnover Survey report showed an increase in job openings. The openings spiked significantly but there was no material increase in hiring. I theorized at the time that businesses were planning for a specific election outcome and maybe the impact of QE2 and had authorized the new positions but were waiting for the results of the two events before actually hiring anyone. They have been accepting resumes and doing interviews so actually hiring people could occur very quickly. Well, next week is the week where the rubber meets the road. The economic and political outlook should be very different by next Friday. Hopefully it will be a positive change.
Yes, the market has now priced in the election, a new Fed QE2 program and some pretty decent earnings surprises. Conventional wisdom would suggest it is time to take profits. That assumes of course that you are in the market. For the millions of investors who pulled their money out of the market they are seeing those three things as signs they should go back into stocks. With the conventional wisdom traders shorting the market next week the sidelined investors could be their worst nightmare. Remember, the market can remain irrational far longer than we can remain liquid.
There is also a historical factor pushing those market timers back into the market. Since 1942 in the 12 months following a midterm election the market has averaged a 24.7% gain. That is a hefty average considering some years did significantly worse. The normal Q3 to Q3 gain is only 8.9% so there is something to be said for buying into the election.
Taken another way the average annual market gains since 1942 work out to 6.3% for the first year of a presidency. The second year averages 4.9%, third year 17.1% and fourth year 5.7%. We can see in those numbers that the post midterm year is three times stronger than the other three. Those averages cover booms, busts and recessions so more often than not the historical trend repeats.
I personally have some very strong views about the financial mess the country is in with rampant spending and debt and I worry that we are in for some really tough times before the decade is out. I know a lot of readers also feel that way. However, I do believe we are going to see a continued rally if the Fed announces another QE program as expected. They have to force the dollar lower to stimulate inflation and the economy sooner rather than later. The cheaper dollar and the surplus of cash will force people out of bonds and money market funds and back into the market. This will eventually create a wealth effect and investors (consumers) will start feeling prosperous again and spending money. Eventually it will end badly but in the short term we could see an explosive market. I can't tell you how many times I heard S&P 1300 even 1350 for a year-end target last week. I hope they are right.
The S&P slammed into resistance at 1185 the prior week and after a week of trying was unable to move back over that level. I think it is remarkable that fund managers were able to just hold it at that level given the couple serious intraday declines. Every time they fought point-by-point to push it back to that resistance but the bears mounted a successful goal line stand and would not let them pass.
Even the golden cross of the 50-day average back over the 200-day average was not enough to give the bulls an edge. OR, maybe it was the edge that helped them recover the high ground day after day.
The term bad news bulls has never been more appropriate. Time after time the economic news, currency spike or earnings surprises produced a temporary decline but nothing seems to keep them down more than a few minutes. You can imagine them repeating their mantra day after day, "Don't fight the Fed!"
I am kidding about the bull's impact here but I am sure they helped. In reality I believe it was more year-end window dressing by the funds than a new stampede by the bulls.
For next week initial resistance is 1190 followed by 1210. Initial support is 1175 followed by 1160. A 5% correction would target support at 1120 and I would be extremely surprised if that level broke.
The Dow actually spiked over 11,200 for a few minutes last Monday and that was it for the week. We closed on Friday after four consecutive days of lower highs. The bears are sitting on resistance and that resistance was slipping lower every day. This is called a heavy market by the bears and consolidation by the bulls. Fund managers did not care what you called it as long as they could end the month over 11,100.
Support is pretty solid at 11,025 but I would be very surprised if we didn't see 10,925 in early November. After 3M lost $7 I am surprised they could push the index back over 11,100. I scanned all 30 Dow charts and 11 of them are pretty ugly.
The Nasdaq came to a dead stop at just over 2500 but has managed to extend its string of positive gains to eight consecutive days. I don't know if you could actually call this formation a cup and handle but the outlook is clear. After several months of profit taking from the recession low rebound the Nasdaq is poised to break over fib resistance and the two prior resistance highs at 2519. If it succeeds in breaking over 2520 the resulting short covering and price chasing could be explosive. There is no immediate resistance over 2520 and we could be in for an amazing run if it happens.
Initial support is 2490 followed by 2480 then 2420. Dragging on the Nasdaq is Apple at 7% of the Nasdaq Composite and 20% of the Nasdaq 100 ($NDX). Apple declined to $300 on Friday and has been in steady decline since their earnings report. With new tablets coming to market almost every week there is plenty of competition and margins are shrinking. The Nasdaq will have a tough time moving higher if Apple does not break out of its slump.
Nasdaq Chart - Weekly
Nasdaq Chart - 15 min
Powering the Nasdaq over Apple's decline is the remarkable recovery in the semiconductor sector. The SOX gained a whopping 4.4% last week when most of the indexes were flat. This is surprising to me since several chipmakers warned about future sales and the slowdown in PC growth. Offsetting those worries were a few chip companies that are producing chips for phones and things like the new tablets coming to market. Business is good for them. The bad news bulls obviously picked what information they felt was relative and jumped on the chip express.
If the SOX breaks through resistance at 375 we could see some short covering and a race to 400. That level will probably prove tougher to overcome. Support is well below at 350 and I would be surprised to see a dip of that magnitude.
Semiconductor Index Chart
The Russell 2000 has encountered some serious congestion between 700-710. For two weeks now the index has been unable to break out of that range and resistance at 710 is proving formidable. This is due to the age-old problem of window dressing. The majority of the cash goes into the highly liquid blue chips in the last couple weeks of a quarter or in this case of the funds fiscal year end. Small caps get the leftover change.
Once we are past any sell the news event next week I expect that to reverse. Big caps will be sold and that money will find its way into the small caps in expectations of that big post midterm election rally.
At least that is the theory. In the 60 min chart there is a pattern of higher lows on each succeeding dip and I believe that is telling us which way the pattern is going to resolve once the news volatility is over.
Russell Chart - Daily
Russell Chart - 60 Min
Last but not least the Dow Transports are also poised for a breakout over 4800. We see a similar pattern of consolidation after the post recession rebound and now the transports are poised to breakout of that consolidation period and start a new trend higher. Next resistance is 5400-5500 but once out of this consolidation pattern we should also conquer those 2008 highs.
I am hearing stories of a severe lack of drivers and trucks. As the recession deepened the marginal drivers were sent home and the marginal equipment was retired. Now that business is improving those companies are short. Drivers are being offered bonuses to switch companies and rates are rising. This is another green shoot that is going unnoticed by the general public but based on the solid string of green candles on this chart somebody got the message.
Dow Transport Chart
In summary I expect a sell the news event next week. "IF" we get a dip on other than a deficient QE2 program I would be a buyer. I believe the Fed is going to flood the system with money now that the stimulus programs are over. How they will do it should be clearer after Wednesday's announcement. I believe the combination of cheaper dollars and the end of election uncertainty will eventually push the markets higher. I want to buy the dips with expectations of a longer-term hold.
There are only 64 days until Christmas. Did you know that Black Friday sales have already started? Yes, stores like Sears and Target have already started advertising sales as Black Friday sales even though they started last week. It is going to be a bitterly competitive shopping season as the majors try to coax shoppers off the couch and into the mall. I believe the early holiday shopping hype will help to improve consumer sentiment and add to market sentiment.
So, what are you giving as gifts this year besides an iPad?
The pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.