Worries over Eurozone economics, rising U.S. debt levels, slowing economics, rising inflation and the end of QE2 appear to be changing the dynamics of the market.
The European Central Bank warned that the likely restructuring of Greek debt would create massive harmful effects for the Eurozone as a whole. Juergen Stark warned against underestimating the damage from a restructuring saying it would risk the financial stability of the entire Eurozone. Greece and the various EU finance ministers continue to claim a restructuring of debt will not be necessary but the numbers don't lie. Almost every analyst believes a 50% to as much as a 75% haircut on Greek debt will be necessary in order for them to eventually pull out of their economic mess. This would sink the banking system of multiple countries that hold hundreds of billions in Greek debt. There is no way in the foreseeable future for Greece to make all the payments required to service their existing debt plus the 160 billion in bailout debt. Greek debt is currently 158% of its GDP and will jump to 166% in 2012. Greece can no longer borrow in the open market because the interest rates in the market are now 25% for its two-year bonds.
This resurgence in the uncertainty over the European debt crisis and another drop in the euro caused commodities and equities to weaken. There is a meeting or Eurozone finance ministers scheduled for Monday and worry over that meeting caused the Euro to fall and the dollar to rebound as traders reduced their risk ahead of an unexpected result. A rising dollar causes equities and commodities to decline.
It was a Friday the 13th but it was not black cats or broken mirrors that caused the markets to decline. The economics were positive but they failed to move the market. The Consumer Price Index (CPI) for April rose only +0.4% and only half of the consensus estimate of +0.8%. That was less than the +0.5% increases over the prior two months and inline with the gains for the two months prior to that. The report suggested that inflation might be peaking and this would be confirmation for the Fed. Bernanke has claimed the impact to inflation from rising commodity prices would be temporary and with the declines in commodities over the last couple weeks he could be right. He also points out rather reluctantly that the high unemployment and lack of spending capacity by consumers will make it nearly impossible for companies to raise prices.
Excluding food and energy the Core CPI rose +0.2% and also inline with the last three months of gains. On an annualized basis the core CPI is up +1.3% over the last twelve months. That is very tame and well below the 2.5% Fed target range. The CPI for food and beverages rose +0.4% and is up +3.9% over the last 12 months thanks to the rise in grain prices. For example corn is up +86%, cotton +80% and soybeans +46% over year ago levels.
Until the labor market improves we are probably not going to see any significant rise in inflation. This should have been good news for the markets but they were focused on other things.
Consumer sentiment for April rose +2.6 points to 72.4 after a sharp -10 point dip to 67.5 in March. The rebound was smaller than expected since the elimination of Osama occurred at the beginning of the survey period. The rebound was powered by a significant bounce in the expectations component from 61.6 to 67.4. The present conditions component actually declined from 82.5 to 80.2. Inflation expectations declined from 4.6% to 4.4%.
At the time of this survey the gasoline prices were closing in on $4 and the events in the Middle East were intensifying although the worry over Japan's nuclear problem was receding. The next reading on sentiment should show another gain. However, the coming debate on the U.S. debt limit and the budget fight will likely weigh on sentiment as funding for favored programs like social security and Medicare are argued in the headlines.
Consumer Sentiment Chart
Next week the biggest reports are the FOMC minutes on Wednesday and the Philly Fed Survey on Thursday. The FOMC minutes will be scoured for clues on future Fed stimulus like a QE3 or the end of the QE1 payoff reinvestments. Fed governors appear to be equally divided over the need for continued policy accommodation and analysts will be trying to weigh the comments in the minutes for clues.
The Philly Fed survey imploded last month from 43.4 to 18.5 in a very surprising decline that shocked analysts and forced a downgrading of economic activity estimates for April. If this week's report shows conditions worsened in April it would be very ugly for the stock market. Estimates are for a minor rebound from 18.5 to 20.0 so clearly expectations are subdued.
The Philly Fed and the NY Empire (Monday) are the two earliest reports for the monthly cycle and they will set the tone for the rest of May.
Another problem for next week is the flood in Louisiana. At 4:PM on Saturday the Morganza Floodway was opened in an effort to prevent serious flooding in Baton Rouge and New Orleans. The spillway was built in 1954 and can release 600,000 cubic feet of water PER SECOND into central Louisiana. That is the equivalent of filling ten football fields ten feet deep every second. It has not been open since 1973. When opened it will create a new 100-mile long tributary of the Mississippi to the Gulf.
The problem comes from the damage that will occur when the gates are opened. There are 2,500 people and 2,000 structures in the immediate spillway area and another 22,500 people and 11,000 buildings farther down stream that will be flooded when the water rises.
Several hundred thousand acres of farmland and crops will be wiped out and 10% of Louisiana's oil production will be flooded. There are 2,264 wells producing 19,278 barrels per day that will be underwater. The Alon refinery will be closed and they are rushing to build dikes around the facility. Exxon has said their docks in Baton Rouge are already under water. Crews are working around the clock to build dirt levees around critical installations but the rising water in the Mississippi forced the opening of the spillway late Saturday.
Morgan City is right in the middle of the flood path and that is the home base for most crews servicing the Gulf of Mexico wells. All of the major companies like Transocean and Oceaneering International have extensive offices there. It will take three days for the water from the spillway to reach Morgan City. The city is rushing to complete a 10,000-foot long fortification in an effort to divert water away from critical areas like power stations.
The opening of the spillway will force the closing of the roads and railroads across the three million acres that will be flooded. It will also close portions of the river to barge traffic. The last time that happened it cost $275 million a day. Barges filled with rocks and broken concrete are being sunk on purpose in specific locations in order to divert water around strategic structures that would be damaged by the full force of the river.
By opening the spillway and causing all this damage that will require months to dry out and repair it will only lower the crest of the Mississippi at New Orleans by a foot. The river is expected to crest at 19.5 feet and the levees are only rated for 20 feet. Even with the spillway open there is still a chance of levee breakage and serious flooding downstream.
Colored areas will be flooded.
Flood Plain from Corps of Engineers
The Colonial Pipeline, which carries more than 100 million gallons of gasoline, kerosene, heating oil, diesel and jet fuel to terminals in 12 states over 5,519 miles, is located in the flood plain. The pipeline transports fuel from refineries in Houston, Louisiana and Mississippi to the northeast. Officials are worried the pipeline could suffer structural damage by the raging floodwaters. That could cause months of delays and impact the price of fuel all along the east coast. If it was damaged to the west of the Mississippi there would still be a large number of refineries on the east side that could still feed fuel into the system so there would not be a complete shutdown, just a decrease in the amount of volume. Louisiana has 17 active refineries and nine are in danger of flooding.
Exxon said it had already shutdown three pipeline segments in the danger zone and they were in the process of purging oil from the lines to prevent spills in case of damage. They are refilling the lines with fresh water to reduce the chance of empty pipes becoming buoyant and tearing away from their foundations. Magellan Midstream partners discontinued operations at two of its terminals on the river because of the flood. Magellan said it had no estimates when it would reopen the 2.8 million barrel terminal in Marrero.
Colonial Pipeline System
Even without a serious crisis developing in the flooded region it will remove tens of billions of dollars from GDP and impact prices of multiple commodities. The flood higher up the river and into the Ohio river has already flooded hundreds of thousand of acres of farmland and wiped out crops and stalled barge traffic of ore, grains and oil products. This is another hit to the U.S. recovery that we did not need.
The impact of the flood upriver is a disaster to the agricultural community. The rains and flooding have caused 2.3 million acres of cropland not to be planted. More than 1.1 million acres of that was scheduled for corn. Currently only 40% of the nations anticipated corn crop has been planted compared with 80% in the same week in 2010. Only 22% of the wheat crop has been planted compared to 65% in 2010.
On the flip side the severe drought in Texas and Oklahoma has caused 35% of the crops already planted to be abandoned. Some areas have seen no rain for up to 60 days and the heat has been scorching for new crops. That 35% had just sprouted and then died for lack of moisture.
The Waterford 3 nuclear plant is also in danger of being flooded. Currently the plant is offline for refueling and they are taking precautions to prevent a disaster. As in Japan, a country that stupidly built plants in tsunami zones, you have to wonder who approved building a nuclear plant in Louisiana in flood zone?
The Louisiana region is used to getting hit from the south by hurricanes, the season starts June 1st, but they have not had a flood from the north of this magnitude since 1927.
The flood will be the headline topic all next week and will completely overshadow the dwindling earnings calendar. The other headline for next week will be the debt ceiling. The $14.29 trillion debt ceiling is expected to be reached as early as Monday according to Treasury estimates. The Treasury Dept has already begun to take emergency measures that will let it operate until August 2nd with no change in the limit. On August 2nd the government would have to shutdown in order to conserve cash for debt payments.
Temporarily they have suspended payments and transfers for some services from state and local governments. They have also halted some borrowings for the civil-service fund. As the days drag by they will have to continue to limit other spending measures. Senators have pointed out that 67% of all government spending comes from tax revenue and debt service only accounts for 6.5% of all government spending so there is plenty of cash to prevent a default. That is not the problem even though some politicians and public officials would have you believe a default is imminent.
The government could also sell assets like student loans ($400 billion) or pare down their gold reserves ($400 billion). It also has giant equity stakes in GM and AIG that are worth billions and the administration would love to see those go away before Election Day.
The coming debt limit battle is going to be ugly and it is sure to depress consumer sentiment and investor confidence. Based on the latest estimates the ceiling will have to be raised by another $2 trillion to keep the government running until after the next election. That means the current administration and the Congress is going to have a heated battle that will take place in sound bites and headlines and that battle is going to increase in intensity beginning next week. It is likely to weigh on the market simply because of the uncertainty around what programs will be cut and what taxes will be raised.
In stock news Yahoo (YHOO) continued to decline on Friday by another -4% after the company disclosed a problem with Alibaba.com earlier in the week. Yahoo is a 43% shareholder in Alibaba.com and the company's various businesses. Earlier this week Yahoo disclosed that Alibaba had transferred ownership in Alipay, a payment processor like PayPal and a key asset of Alibaba, to another company owned by the CEO of Alibaba. This not only significantly weakens the $1 billion investment in Alibaba but it also reveals a problem in the partnership. Alibaba claims the transfer took place over a year ago but Yahoo did not find out about it until March 31st. Furthermore Yahoo did not disclose the information to shareholders as a material event when they reported earnings on April 19th.
The asset sleight of hand by Alibaba's CEO also highlights the problems of trying to do business in China where there is no rule of law. It is pretty much anything goes and buyer beware. Even Google, the most powerful Internet company, was unable to successfully do business in China. Analysts believed Yahoo's investment in Alibaba was worth $8-$10 per share and roughly half of Yahoo's stock price last week at $18.50. Now analysts are revising their numbers to eliminate the Alipay asset. A Gleacher analyst said he believes Alipay was worth 65-cents per share to Yahoo or $850 million. Yahoo said they "hope" to be compensated by the loss of the Alipay asset. Without Alipay and with the apparent internal feud brewing the value of Alibaba to Yahoo may be significantly lower. Yahoo CEO Carol Bartz, often known for her fiery and profanity laced speech, probably needed to have her office repainted after she learned of the transfer. The office would have been scorched from the inside out from the resulting tirade. Bartz will have some explaining to do when Yahoo holds its analyst meeting on May 25th.
AIG announced its plans to go ahead with a 300 million share offering with 200 million to be sold by the US Treasury and 100 million by AIG. The Treasury has committed an additional 45 million for over allotments. The decision was made to go ahead with the offering even though the stock price has been falling since January. The breakeven price for the Treasury Dept shares is $28.72 per share. The government has repeatedly said it would not sell its shares for a loss and can still pull out if the price falls below their breakeven level. The offering is expected to raise $9 billion with $6 billion going to the Treasury Dept. AIG would get $3 billion and will use $550 million to fund part of a litigation settlement with the remaining balance to be used in operations.
AIG paid the Treasury Dept $7 billion in March to lower its debt to $60 billion. The government owns 92% of AIG with that expected to decline to 77% if the offering is successful. The outlook for AIG has soured since January. The company has sold off some key assets and very profitable businesses. This has weakened their potential performance. Investors are also worried about AIG's ability to perform once the government removes its financial support. AIG currently has $37 billion in an undrawn credit line with the government. That will likely end before the election. I would say the odds are good the Treasury Dept will own a substantial part of AIG for a very long time. Having AIG owned by the government and dependent on government credit lines will be a critical issue in the coming election. Voters were strongly against bailouts and having this one lingering in the background will give opponents plenty of ammunition.
Rambus (RMBS) was kicked to the curb after an Appeals court determined the technology company destroyed key documents in patent suits with Micron and Hynix Semiconductor. Rambus had won a patent suit and $397 million settlement against those companies. The Appeals court threw out the settlement and sent the case back to the lower courts. The district court will now try to decide if Rambus acted in bad faith and if those actions ruled the settlement invalid. Rambus said they were very disappointed by the court decision. This is the third time Rambus has been to court to prove it did not destroy documents. Shares of Rambus declined by 18% on the news.
Market sentiment took a serious hit the last two weeks. The new highs on May 1st eroded on what was initially thought of as normal profit taking but now it appears there are more problems than just profit taking. For the last three years the market has declined in May and unless something changes quickly it looks like this will be the fourth.
The basic problem is the suddenly weakening economics. I think I must have read or heard the word stagflation at least ten times last week. I think we are far from a stagflation event as evidenced by the PPI/CPI last week but the stagnant part could be upon us. The sudden decline in the last round of regional economic reports suggests the economy is still growing but the pace could have slowed by more than half. The first reading on the Q1 GDP dropped to +1.75% growth from +3.1% in Q4. That number could decline when it is revised on May 26th. Even worse that is for Q1 and the sudden decline in activity did not happen until April and won't be reflected in the GDP until the first report at the end of July. Q2 will also bear the brunt of the flood impact and the break in the supply chain from Japan so Q2 GDP could be under +1.0%.
Employment is the key and employers are no longer that confident about hiring because lawmakers are talking about new taxes and lower deductions and the economy appears to be slowing. They don't want to over commit to hiring and then have the recovery stall. Housing prices are still falling and credit is becoming harder to get as each day passes. The double drag of housing and employment is going to be tough to overcome.
The ECRI Weekly Leading Index appears to have topped out at downtrend resistance and is struggling to hold its gains. This composite index is reportedly a leading indicator of key turning points in the economic cycle. The dip in 2010 was what caused all the worry over a double dip recession. Fortunately it did not come true but that is when the growth in GDP growth dipped back to +1.7%. The WLI pointed the way but the move was not completed. It is time we started watching this weekly indicator again. If it dips below 128.0 it would be an early warning signal. Last week was 129.7.
ECRI Weekly Leading Index Chart
The Q1 earnings cycle started out with the number of companies beating the estimates up around 76% and very high compared to the normal 67% beat rate. However, with more than 1800 companies now reported the beat rate has fallen to only 60% because the recent reporters have been turning in quite a few misses. This is the lowest beat rate since 2008-Q4 when the recession was in full bloom.
Apparently investors are picking up on these facts and we hear a lot in the press about the "risk off" trade. That means investors are moving to cash or cash equivalents like TIPS, treasuries and money market funds to wait out the storm. There was never a lot of confidence in the market in 2011 to begin with. Volume since January has been very low and that shows a lack of conviction. We know for a fact that QE2 provided the majority of the gains since August. Now that QE2 is coming to an end investors are confused about direction. Evidence of the move from risk assets can be seen in the drop in interest rates. The chart below is the Treasury 13-week T-Bill with a yield of a whopping .02%. The flight to quality is in full swing.
Treasury 13-Week T-Bill Chart
Interest rates are also falling because of a sudden flurry of analysts claiming the Fed will have to resort to more stimulus to keep the economy from falling back into a recession. Former Fed Vice Chairman Alan Blinder told Bloomberg last week the U.S. needs "somewhat more" fiscal stimulus once again in order to boost employment. He believes the current austerity program being discussed by lawmakers should be implemented but not yet, otherwise the fragile economy will suffer. Put the plans in place for 3-5 years down the road but wait for an actual recovery to start the budget trimming.
Obviously Blinder is on the "spend ourselves to prosperity" program. Given the current makeup of the House and Senate there will be no material budget cuts or spending increases for the next two years so Blinder does not have to worry about austerity getting in the way of the recovery. Since lawmakers are not going to pass any further stimulus programs it will be up to the Fed to follow through on its dual mandate of "low unemployment and price stability."
On Friday Goldman's Sven Jari Stehn released a paper titled "Fiscal Adjustment without Fed Easing: A Tall Order" in which he compares the two paths to austerity and concludes it will be up to the Fed to provide more monetary policy accommodation (QE3) in order to keep the economy from backsliding. Stehn compared the two proposals to achieve trillions in budget reductions and concluded neither would work. Republicans want spending cuts and democrats want tax hikes. Neither is going to happen in the current political environment. He analyzed 29 efforts to cut the budget by 1% of GDP or more over the last several decades based on U.S. data and studies produced by the IMF on similar events in other countries. Stehn found that on average the spending cut model was more effective but it only truly worked when done in parallel with monetary easing. Since interest rates are already zero the only option available to the Fed is more quantitative easing.
Stehn also argued that in either fiscal case the drag on economic growth will be substantial. In our current reality Stehn found regardless of the austerity method the economy will slow dramatically but without additional monetary easing it will crash. Based on his analysis of our current situation he expects the Fed to remain on hold or to be even more accommodative to keep rates at low levels for a long time. Translated that means some form of QE3.
That would be positive for commodities and equities if it appeared the Fed was going to continue pushing the dollar lower. Commodities were hit again on Friday after China hiked reserve rates by another half a point effective May 18th. They announced the hike after their inflation rate for April remained high at 5.3%. This was the fifth hike this year as China tries to slow inflation to the official target of 4%. Oil, silver and copper finished with gains but well off the highs for the day. Gold declined $12 to $1494.
Oil prices are struggling to hold support at $98 with the dollar closing at the highest level since April 5th. The dollar spike will not hold. The worry over Greece will eventually fade as the EU applies Band-Aids to the problem. When the dollar begins to slip again the price of crude will rebound. We are moving into the high demand driving season and prices normally rise.
Dollar Index Chart
WTI Crude Oil Chart
The Russell 2000 declined -1.4% on Friday compared to the OEX at -.7%. The Russell is the small cap index and the OEX is the top 100 stocks in the S&P. This seems to confirm some traders are becoming risk averse and are moving from the higher beta small caps to the safety of lower beta big caps. They may not be leaving the equity market for the safety of zero percent bonds but they are altering their risk profile.
The S&P-500 posted another lower high on Thursday and unfortunately the new pattern looks bearish with a potential break below support. That support is 1333 and a print below 1328 would be a lower low to confirm the current pattern of lower highs. We could dip to 1295 and hold but I would read that as a break in the trend and worry it would mean we were going a lot lower over the summer.
Remember, when we hit 1365 on the S&P we filled quite a few analyst targets. There are still higher targets in the 1375-1425 range with one all the way up at 1525. However many analysts were more conservative and in the 1350 range. When their targets are hit they have two choices. They can change their target to something higher and appear to have been wrong on the first target or they can advise their clients to start taking advantage of any additional advances to exit positions at a profit. That way they look smarter and they can use any future advances as an exit ploy rather than "I was wrong."
There are still plenty of analysts calling for higher highs but their voices have softened a lot over the last two weeks. Now we are hearing the terms soft patch, profit squeeze and uncertainty a lot more often. Repetitive phrases eventually become accepted as reality and traders begin to take action on those phrases.
S&P-500 Chart - 90 Min
S&P-500 Chart - Daily
The Dow chart is similar to the S&P only at a higher level. The blue chips in the Dow have been benefiting from their better earnings performance and the move into lower beta names. So far support has held but the Dow is still over extended from its +700 point rally in late April. A break below 12,550 could easily test 12,400 or even 12,200 if sentiment continues to deteriorate.
The Nasdaq has been struggling without the help of Apple and Google. I showed the Apple chart last week and the shares broke out of the downtrend channel on Friday. Google also broke below a recent consolidation pattern and helped drag the Nasdaq lower.
The Nasdaq closed on critical support at 2825 with a break there targeting 2800. Unless the selling in Apple suddenly ends I doubt 2825 will hold.
The longer term chart of the Russell is showing increasing weakness despite a new historic high on May 1st. The momentum has slowed and even though the Russell actually posted a gain for the week it was the biggest percentage loser on Friday. I fell like it was running on hope on Monday and Tuesday but that hope faded quickly after a couple triple digit losses by the Dow.
All is not lost yet. As long as the Russell holds 820 as support, yes it would be a lower low, it would still be in a longer term uptrend. Under 820 could see investors flee ahead of the summer doldrums.
The Dow Transports have been very bullish in the face of high oil prices. They set a new historic high in early May and then retested that high last week. Friday did see a lower low but given the relative out performance they could decline to 5200 and still maintain a bullish trend.
In summary I am cautious about market direction. I am not ready to switch into summer bear mode but with several of the indexes on critical support we may only be a day or two away from making that change in trend.
If economics continue to weaken we could be in trouble. Several weeks ago we had strong earnings to capture investor attention and make them ignore the weaker economic reports. That has changed. Earnings have turned negative and now anyone looking for another reason to buy stocks for a summer rally may have trouble finding one.
The conversations about pending Fed action are going to heat up and it will be tough for the Fed to do anything positive for the market. At this point even additional stimulus could be seen as a sign of a weakening economy and a signal to head for the exits. The Fed almost needs to let QE2 end on schedule and the economy weaken so they can make a case for some new monetary policy. None of that would be good for equities.
Add in the uncertainty over commodities, the flood and possible pipeline disruptions that could send gasoline prices soaring and there are some definite potholes ahead. If the bad news bulls want a wall of worry to climb they got their wish.
I would be cautious. Enter passively, exit aggressively.
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"If you can count your money, you don't have a billion dollars."
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