The markets continued their losing ways as the debt debacle drones on. However, the economy is about to become the main headline once the debt deal is done.
Late Friday night a new chapter began in the political theater in Washington. The House passed a modified form of the Boehner bill and sent it to the Senate for a vote. The Senate and the President had said the bill would be dead on arrival because it forces a repeat of this process in 2012 after a committee suggests some new spending cuts. Secondly the bill requires the passage of a balanced budget amendment to the constitution to be approved and sent to the states for ratification. That has a zero chance of happening in the Senate.
The Senate tabled the Boehner bill two hours after it passed in the House. Reid then formally submitted his plan to the Senate for debate. House members returned the favor and voted down the Reid bill.
Nothing can pass unless it has bipartisan support and that seems to be impossible to achieve today. The president, Harry Reid and Nancy Pelosi met at the White House on Saturday and nothing was resolved. Reid said there is no progress and no deal.
On Thursday night I wrote about the governments dwindling cash balance of less than $80 billion as of Monday. We saw some more specificity Friday with the Treasury disclosing what payments would be made over the next week. The Treasury burns through about $9 billion a day but there are some big payments several times a month.
To put that $80 billion in perspective these are some S&P-500 companies with cash on Thursday.
Goldman Sachs $805 billion
JP Morgan $764 billion
GE $136 billion
Apple $76 billion
U.S. Treasury $55 billion (Friday)
Subtracting -$9 billion through Tuesday would put the balance at $19 billion next Tuesday. The Social Security checks will be paid on Wednesday and that would put the balance $13 billion into the negative column on Wednesday and it would continue to decline by $9 billion a day if no deal is signed into law except that writing checks with no money in the bank constitutes a debt to pay and the debt limit currently prevents those checks from being written. There is also a big debt sale planned for Wednesday that would have to be canceled if the limit is not raised.
Once the artificial debt limit crisis is resolved the focus for investors will immediately return to economics, earnings and Europe. On the economic front we got some bad news on Friday. The first reading on the Q2 GDP came in at +1.28% growth. That was well under consensus estimates of +1.80% but that was not the real problem. The GDP for Q1 was revised down from +1.9% to ONLY +0.4% and just fractionally away from a return to recession levels. This was so shocking that reporters actually did double takes to confirm the number was correct before reporting it on air.
Here is the really bad news. Remember, the economic reports didn't really start diving until April with significant drops in May. That means the economy was actually stronger in Q1 than Q2 and that suggests we are going to see a major revision to Q2 GDP and it could be ugly. The early estimates are usually optimistic and we saw conditions worsen significantly in May and June. Corporations are telling us with their earnings guidance that conditions sharply declined just in the last 2-3 weeks as the debt debacle ruled the news.
The biggest booster to Q2 GDP was a +5.9% increase in fixed nonresidential expenditures. That added +0.7% to the Q2 GDP. This was likely a one-quarter boost that will not continue in Q3 but we can always hope. However, Q2 was also hit by the sharp slowdown in auto manufacturing due to the earthquake in Japan.
The Q1 numbers were seriously impacted by a slowdown in government spending that subtracted -1.2 points from the GDP. (In the current version of the Senate bill the spending cuts are expected to reduce GDP by 0.5 per quarter through 2015.)
The consensus estimates for Q3 and Q4 are still in the range of +3.5% growth but individual analysts are slashing predictions after Friday's report. Deutsche Bank cuts its Q3 estimate from 3.5% to 2.5% and Q4 from 4.3% to 3.0%. The banks said the country was facing a protracted period of slow growth and high unemployment. IHS Global said Q3 GDP would likely be less than 2% and possibly less than 1% compared to its prior estimate of +3.4%. Capital Economics is now expecting 2% or below for Q3 and they were already low at 2.5% before the report.
Another weak report was the Chicago ISM (PMI), which fell to 58.58 for July from 61.1 in June. Analysts blamed the drag on auto production since this is for the Chicago region and it is very dependent on auto manufacturing. In the table below I highlighted the cycle highs in green and lows in orange. Note that the cycle highs were mostly in Q1.
However, only two lows were in July. Most of the components rose in July with the exception of deliveries and employment. The employment component came very close to falling under 50 and back into contraction territory. This is not encouraging for the nonfarm payroll report next week.
ISM Chicago Table
ISM Chicago Chart
The New York ISM was also released on Friday and it continued its climb to new highs. The index was nearly flat in June rising only 1.1 point to 535.1 but it added +3.7 points in July to 538.8. The index has been rising about 8 points a month for the prior six months so +3.7 is good but not back to its prior form. The recovery in New York since the recession has been spectacular.
Moody's NY-ISM Chart
The final reading on July Consumer Sentiment was flat with only a -0.1 point decline to 63.7 from 63.8 in the initial reading. However, that is a -7.8 point decline from June at 71.5 and the lowest level since March 2009. Once the debt debacle is over that should improve as long as the stock market is not crashing because of all the lowered guidance.
Consumer Sentiment Chart
The economic calendar next week has some high interest events. The national ISM Manufacturing on Monday was expected to be flat but after last week's unexpected decline in the GDP and Chicago ISM the whisper numbers are dropping. Some are now speculating the ISM could fall into contraction territory and that would not be market friendly.
Wednesday is the ADP employment report, ISM Services and Factory Orders. All have the potential to be market negative.
Lastly the Nonfarm Payrolls on Friday could be a real market mover. The consensus estimate is for a gain of +85,000 jobs (wink, wink) but the odds are a lot higher that we will see job losses instead. In June the economy only added +18,000 jobs and the estimate was for a +125,000 gain. Given the sharp decline in economic conditions in July I think expecting a gain of 85,000 jobs is extremely optimistic.
If the jobs go negative analysts will immediately start talking up QE3 again. However, four different Fed presidents were interviewed on Friday and all said the bar was set very high for approving QE3. They really don't want to add any further accommodation unless the economy weakens significantly. The Fed's newly adjusted view is for 2.0% to 3.0% growth for the rest of the year. The Fed has two mandates. The first is price stability and low inflation. The second is full employment. If jobs went negative again the inflation worries would decline and the Fed could come back into the market even with the negative sentiment towards the QE1 and QE2 programs.
The equity market was not the only market seeing selling last week. Investors withdrew $37.5 billion from money market funds. That was the largest one-week withdrawal since Dec-15th 2010. Reportedly it was institutions pulling money out of U.S. bond funds ahead of an expected ratings downgrade. Gold funds gained +$1 billion and German stock funds saw inflows of $3 billion. That was the most since 2008. Money market funds total $2.6 trillion. The potential downgrade of the AAA rating has caused significant agitation for institutions. Fidelity was forced to issue a note saying they would not be required to liquidate U.S. debt if the rating changed from AAA to AA. However, the note said they had taken steps to ensure the safety of its funds even in the event of a "severe disruption" in the markets.
Surprisingly the yield on the ten-year note fell to the lowest level since November 30th at 2.80%. Apparently quite a few investors still believe the U.S. Treasuries are a safe haven given the suddenly declining economic picture.
Ten-Year Note Yield
Late Friday Moody's softened its downgrade comments saying the likely outcome of its current review would leave the U.S. with a AAA rating but keep the negative outlook. You have to wonder if somebody in the administration leaned on them or they just decided on their own that the U.S. remained the best credit in a global sea of sovereign weakness.
Cyprus was cut by S&P on Friday to BBB+ or three notches above junk status and warned the country would not meet its austerity targets for the next two years. Debt is expected to rise to 80% of GDP in 2011, a +19% rise over 2010. Bailout comments are increasing.
Spain was warned of a possible downgrade by Moody's by one notch from its current Aa2. They also put five of Spain's top banks on review as well. The pressure on Spain is increasing the risk of a future bailout for Spain and that would be a major problem for the Eurozone.
Italy sold debt on Tuesday but they were forced to pay the highest interest rate since November 2008. Spain also sold debt for yields that hit three-year highs. The rising rates show that the relief from the new bailout package was short lived and the pressure on these countries is returning. Italy is going to try and sell another 10 billion euros in debt on Tuesday and Wednesday so you can bet their rates are going higher.
The European debt tensions, U.S. debt debacle, falling dollar and negative economics combined to push gold to another record close at $1631.50. The chart below shows 1623 but that includes some after hours activity. A new nominal high was also reached intraday at $1637. The Newmont Mining CEO was interviewed on Friday and said inflationary pressures and continued uncertainty in U.S. and European economies would combine to push gold prices to $1750 in 2012. Given Friday's close at $1631 that target is not very far away. After rising +$160 over the last month is another $119 gain to $1750 too much to expect?
There were only a few earnings reports of note on Friday. Chevron (NYSE:CVX) posted record earnings of $7.73 billion or $3.85 per share. That was +23 cents higher than analyst estimates. Chevron received an average of $107 per barrel of oil sold outside the USA compared to $71 in the year ago quarter. Chevron is forecasting $111 for a full year average on crude oil. Chevron produces 74% of its oil in countries outside the USA.
Production declined -1.9% to 2.69 mbpd and they lowered their forecast for the full year to 2.73 mbpd. When oil prices are higher some host countries have contracts that allow them to keep more of their oil. Chevron is planning on spending $26 billion in 2011 on exploration and construction of production facilities. Chevron is building two mammoth gas projects and LNG terminals in Australia called Gorgon (40 TCF) and Wheatstone (5 TCF) with a total of seven LNG trains. This will increase their global production by 4% to 5% starting in 2015. The upfront costs are huge but Chevron is going to be printing money when these projects go into operation. Chevron is a long term buy in my book.
Drug giant Merck (NYSE:MRK) reported earnings of $2.02 billion or 65-cents a share but the outlook was not good. Merck has a lot of drugs going off patent soon and the company said it was planning on cutting an additional 13,000 workers or 13% of its workforce. Last year MRK said it was cutting 17% of its staff after it acquired Schering Plough for $41 billion. The company said the additional cuts would trim another $1.5 billion in costs. Merck said up to 40% of the savings would come from cuts in the U.S. and those workers would be replaced by lower cost workers in other countries. The moves by Merck are not unusual with drug companies in the U.S. cutting 61,109 workers in 2009 and 53,636 in 2010.
The earnings cycle is almost over with the majority of major companies already reported. Last week was the biggest week of the cycle and the volume will only decrease from here. The big names for next week are MasterCard, NYSE and AIG.
The guidance for Q3 has been less than exciting with dozens upon dozens of companies lowering guidance and warning of sharply declining economic conditions. Personally I believe it is due to the debt debacle that has filled the headlines and airwaves with negative news for the last six weeks. Consumer confidence has fallen sharply and consumers and businesses have been hoarding cash. That was the constant comment from businesses interviewed about the declining economy and debt worries. "We are increasing our cash position and postponing our hiring and expansion." Corporations have never been through this type of disaster in recent memory and coming so soon after the Great Recession they are being extremely cautious.
I wrote last week that perception is a dangerous thing. If enough people perceive a thing to be true then it can be self-fulfilling. If enough people believe we are about to fall into an economic crisis and respond by halting spending and raising cash then they will create that economic crisis they feared. I believe that is what we are seeing today. There has been so much negative press that consumer and business confidence has been severely damaged.
In theory a resolution of the debt debacle would end the crisis in confidence but a new problem has appeared. That is the potential credit rating downgrade and its impact on interest rates. If we can get through next week without a default and lawmakers pass enough spending cuts to at least satisfy the ratings agencies in the short term then the crisis may pass. Moody's has already said they will likely leave the rating at AAA so that will provide political cover for S&P to do the same. They don't want to downgrade the rating because it would cause them significant grief and condemnation from investors as well as the public. It would not be a popular move. It would cause the associated downgrade of hundreds of other states, local governments, government institutions and corporations. It would be very messy and create some serious financial ripples. I don't believe the ratings agencies want to take that step so they will find an excuse to put it off as long as possible.
Much has been said about the damage to the economy from the spending cuts. While I am sure there will be some collateral damage you have to remember we are talking about pocket change. The plan that will probably be passed will include about $2.5 trillion in cuts over the next ten years. That is $250 billion a year and many of the cuts are symbolic like cutting a budget increase for XYZ agency from $20 billion in 2012 to an increase of only $19 billion. A billion is a lot of money to us as individuals but to these big agencies it is pocket change. The amount of money they would receive would still increase but by a smaller amount.
Assuming they were really going to cut $250 billion a year out of existing spending, not future budget increases, it would be about $20 billion a month. Since we are currently running a deficit of $125 billion a month that just means the debt will increase by $105 billion a month instead of $125 billion.
Lastly, the current Senate plan includes $1.1 trillion for cessation of the Iraq and Afghanistan wars. How exactly is that a "new" spending cut? The president has already put a schedule into motion to end both of those conflicts. This is not "new" spending cuts. It is a decline in spending that has already been scheduled.
Both the House and the Senate are relying heavily on accounting gimmicks like the cut in war spending as the basis for their total cuts. I don't see a major hit to the U.S. economy from spending cuts related to accounting tricks.
It will take a few weeks for the headlines to disappear and consumers shifting back into football mode, back to school schedules and what new is on the fall TV lineup but it will happen.
The problem for us as investors is how to get past Halloween without a major market crash. August is not normally a good month for the markets and September has been the worst month of the year since 1950. The one-two punch of August-September always leaves the market reeling but ready for a major rebound in October. The month of October has seen some of the biggest crashes but those drops are normally capitulation events leading to an even bigger end of month rebound.
Monthly Market Movement Chart
The markets have seen some serious volatility in 2011 but it remains to be seen if that volatility will continue after the debt debacle is solved. We did just see two attempts at new highs in July so there is (was) some bullish optimism present.
The challenge is three fold. Corporation earnings for Q3 could be weak as a result of the halt in spending by businesses and consumers. Secondly, the economy could post another month of declining activity until the debt crisis is a distant memory. Lastly the European debt crisis appears to be worsening rather than getting better. Just like Jason in the Friday the 13th movies the EU/IMF keeps killing the sovereign debt crisis but it keeps coming back to life.
Those three problems could combine to give us a weak August and September. With analysts and the Fed slashing economic forecasts for the rest of the year we don't have that "growth will rebound in the second half" scenario to power the market higher. We may have just moved into a period where investors will wait for the economy to show signs of life before returning to investing as usual.
The S&P dipped to support at the 200-day average at the open on Friday at 1284. That is as close as we want to come to a bearish breakdown. That is our line in the sand we do NOT want to cross. Breaking below the 200-day is a normal sell signal for funds and indicates a new bearish trend. The 200-day was support in June at 1265.
The S&P and Dow declined -4% last week, Nasdaq -3.6% and Russell -5.3%. That was the largest weekly losses for the indexes since last summer. With the earnings cycle losing momentum and more negative economic and political headlines than positive ones it will take a brave investor to venture back into the market. Richard Bove told investors last week to go to cash. That will either turn out to be the pivotal point in the market where the rebound began or an outstanding call that will make him famous. We won't know which for 6-8 weeks.
There is usually some end of month buying as funds adjust allocations and put monthly cash to work. Unfortunately there was no sign of buyers at month end for July and the month ended up being historically perfect. Highs for the month in the first ten days and the lows for the month at month end. That is the normal July pattern and I thought we were going to break the trend around the 25th when the Nasdaq 100 was making new highs. How quickly things can change.
I would like to think the long-term fundamentals of owning stocks at this level will provide enough buyers to keep us afloat but without some positive economic news that could be a false hope. If the S&P breaks below 1284 the storm warning will sound. A break below 1265 would be a signal to abandon ship.
That is true for the weekly chart as well. The longer term trend since the March 2009 rebound is in danger of failing. A break to 1265 would dent the trend but a move below 1265 would be a material failure.
S&P Chart - Weekly
Traders were selling everything in sight on Friday and big caps on the Dow were no exception. The drop in oil prices pushed Exxon and Chevron into the top three Dow losers with Hewlett Packard rounding out the list. MRK, CAT, DD and KO were next in line on the losers list.
The Dow broke though the 12,200 support level without even a minor pause. The next material support is round number support at 12,000 and Fib support at the lows for June at 11,925. The 200-day average at 11,977 is not expected to be an issue. The Dow is not very respectful of moving averages because of its thin 30-issue composition. Changes in only one or two stocks can cause significant moves in the Dow. However a break below the 200-day will still be a psychologically negative event.
Dow Chart - Daily
Dow Chart - Weekly
The Nasdaq Composite actually held up better than the non-tech indexes thanks mostly to minimal selling in Apple, Google, Priceline, etc. Those big caps showed amazing relative strength and suggest any future rally could be led by tech stocks.
The Nasdaq 100 was especially strong with only a -2.7% decline and the smallest loss of any of the other indexes with the exception of the Oil Service Index at -2.2%. The NDX set a new high on Monday and Tuesday with the selling in only the last three days.
The NDX has support at the 50/100 day (2317-2325) and I would be surprised to see that level break without a complete washout in the market.
Nasdaq Chart - Daily
Nasdaq Chart - Weekly
Nasdaq 100 ($NDX) Chart - Weekly
The Russell broke below the 200-day on Friday but quickly rebounded to close back above it. I have no confidence this is going to hold but very strong support at 775 should not break unless the entire market implodes.
On the weekly chart I believe it is significant that the Russell can decline to strong support at 775 without breaking the longer uptrend. The other indexes are in danger of breaking below their long term trends to reach horizontal support.
The Russell is encouraging despite the -5.3% decline last week. Most of that decline came on Wednesday with lighter selling towards the end of the week. The Russell only lost -2 points on Friday when the Dow lost -97. That means it has good relative strength and fund managers or bargain hunters were buying the dip in expectations of a rebound next week.
Russell 2000 Chart - Daily
Russell 2000 Chart - Weekly
To say the market direction next week is dependent on the resolution of the debt debacle would be a gross understatement. The indexes are very oversold after the biggest weekly decline in nearly a year. If lawmakers can avoid a disaster on Tuesday I believe we will see a significant rebound. How long that rebound lasts given the new set of economic numbers is a different story. Conversely a technical default on Wednesday could be extremely ugly.
The potential for some further negative economics with the ISM on Monday and Nonfarm Payrolls on Friday is pretty good. Should those reports surprise to the upside amid a resolution in Washington the results in the market could be dramatic. However, I am not holding my breath on the hope for a positive surprise.
I believe we are entering a new phase in the recovery. A phase that will be led by slower growth and higher unemployment. I am not in the double dip recession camp but I do see at least another month of weak economics and then a slow rebound as consumers and businesses regain their confidence.
I would watch the S&P 200 day at 1284 as a directional indicator and then the Russell 2000 as a relative strength indicator for making play decisions. As of 10:PM Saturday night there is no progress in Washington and the debt clock is ticking down to expiration. Monday should be exciting.
Please click like, thank you!
Send Jim an email
"Not everything that can be counted counts, and not everything that counts can be counted."