Better than expected economic news soured market sentiment on worries it would keep the Fed on the sidelines.

Market Statistics

For a day with better than expected economic news the market action was disappointing. This was strictly a function of Fed expectations and traders walking away from the market before the long weekend.

The biggest report was the national ISM Manufacturing for August. The headline number declined from 50.9 to 50.6 and that was not just better than expected but a shock to some analysts. The consensus view was for a drop into contraction territory at 48.5. To dip only -0.3 points is nearly miraculous and it suggests the actual state of the economy is not as bad as expected and maybe the concerns over a double dip are overblown. The ISM has not been below 50 since July 2009. However, it did rise as high as 61.4 in February but it has declined five of the last six months.

Unfortunately the components were less than impressive. The new orders component rose slightly from 49.2 to 49.6 but remained in contraction territory. Backorders also rose slightly from 45.0 to 46.0 but remained in contraction. Employment declined to 51.8 from 53.5. The biggest decline came in the new export orders, which fell to 50.5 from 54.0. This may track with the rising view that Europe has a 50% and rising chance of falling into recession as a result of growing austerity.

The odds are good the ISM could dip below 50 in September but analysts claim just dipping below 50 does not mean the economy is crashing. Historically it takes a number in the 45 range to indicate a recession.

ISM Chart

Jobless claims declined to 409,000 from a revised 421,000 from 417,000 in the prior week. This could be related to the Verizon employees going back to work. Analysts had estimated there were 8K-12K of Verizon claims represented in the prior week. Hiring remains anemic although there is historically a weak hiring period over the last few weeks of summer. The report that will matter will be the one for the second week of September.

Jobless Claims

Chain store sales for August rose by +4.6% and flat with the July gains. Some retailers reported Irene helped their sales and others reported Irene cost them sales as consumers were focused on storm supplies rather than things like apparel. Saturday would have normally been a big back to school shopping day but many stores in the northeast were closed at least half a day on Saturday.

Despite the store closures as a result of Irene and excluding fuel and international sales the growth was still a decent +3.6% although the slowest core rate since March. The ICSC is predicting total sales growth to continue at a 4% to 5% in September. The back to school shopping will just be deferred into September. Consumer spending is not showing any material weakness and that suggests there will not be a double dip. Consumer spending is 70% of GDP. This is confusing to some extent since Consumer Confidence and Sentiment are both at two-year lows.

Auto sales for August came in at 12.1 million units on an annualized basis. That was only a minor decrease from the 12.2 million rate in July. Sales were up +7% over the same period in 2010. Sales would have been higher except for the shortage of Japanese models and U.S. vehicles delayed by a lack of Japanese parts. The shortage of models led to lowered incentives and that also limited sales. Overall this was a good report and again suggested consumers are alive and well.

Chrysler was the big winner with a +30.6% increase. GM saw +18.2%, Ford +11%, Hyundai +13%, Nissan +19%, Toyota -12.7% and Honda -24%.

The big report for Friday is of course the Nonfarm Payrolls. The official consensus is now a gain of 80,000 compared to +117,000 jobs in July. There are still estimates in the +25,000 range and a few whispers suggesting we could have lost jobs. Morgan Stanley still expects a gain of 75,000 jobs. The ADP report on Wednesday predicted a gain of 91,000 jobs on Friday. The ADP report has a terrible record of accurately predicting the actual Nonfarm numbers but analysts still adjust their estimates based on the ADP prediction.

The Challenger Layoff report said layoffs fell -23% in August to 51,114 and that suggests the jobs picture may not be as bad as some predict. Layoffs were significantly below the 66,400 reported in July.

There may be good news in the nonfarm payroll report but it remains to be seen if the market will see it as a reason to buy stocks. The economic reports this week have been "less bad" than expected and that suggests the Fed may have second thoughts about incurring political wrath by announcing new stimulus on the 20th. If the payroll report is mediocre to decent at 50K to 80K of new jobs then the Fed may deem it wise to wait for another month of data before taking action. However, since one of their mandates is jobs a number much below 50K could stimulate them to act.

The National Federation of Independent Businesses (NFIB) said the "prospect for a good jobs report are slim." Their survey showed small business owners cut an average of .08 workers per firm in August. That was down from .15 in July and .23 in June. More than 14% of owners reported cutting an average of 2.7 workers per firm. That compares to 12% who added an average of 3.1 workers. The remaining 74% of owners made no change in employment for the month although 48% had hired or tried to hire. Over the next three months 11% plan to hire, up +1 point, and 12% plan to fire, also up +1 point.

They will have the added benefit of hearing what the President is going to recommend in his jobs speech next Thursday. Since almost anything the president is going to suggest will take at least several months to possibly years to have any impact it will still be a framework they can model.

The market decline today in the face of decent retail sales including auto sales plus the positive ISM number was a reaction to Fed expectations deflating. With the highly volatile jobs report on the Friday before the last summer holiday weekend means many traders simply took cash off the table and left the building.

Stock news was relatively light with retail sales at various chains getting the most attention. The Limited (LTD) was the sales leader with +11% increase in same store sales. JC Penny (JCP) and The Gap (GPS) were the losers with weak reports. JCP said same store sales declined -1.9%. The Gap said sales declined -6%. Checkout the losers in this table. They are sure to have some great sales over the next couple weeks.

Same Store Sales

Qualcomm (QCOM) was added to the "Top Picks Live" list at Citigroup as the best large cap chip pick. The analyst said the smartphone market for Qualcomm is one of the few areas with upside instead of downside. The analysts said new iPhone orders, BlackBerry orders and reportedly big orders from Nokia for a product based on Microsoft Windows Phone 7 will all help Qualcomm sales. He said Qualcomm backend suppliers were all posting record sales to Qualcomm. Shares of QCOM rallied sharply at the open but faded with the market to end down 40-cents.

Goldman Sachs (GS) was cut to a hold from buy by ISI Group saying earnings will be weaker on lower trading and investment banking revenue. IS expects Goldman to have market to market losses on its $15 billion equity portfolio and its stake in ICBC. There is also litigation risk on GS on multiple fronts. The Fed is leaning on Goldman hard for changes in its mortgage handling. They were forced to write down mortgages by 25% on any loan that was 60-days past day in order to get approval for its sale of Litton Loan Servicing. The Fed cited "a pattern of misconduct and negligence" at Litton. Goldman also agreed to halt robo-signing of foreclosures.

Goldman Sachs Chart

NetFlix was crushed after the bell when Stars announced it was ending its content arrangement with the company. Stars Entertainment is controlled by Liberty Media and they said they ended negotiations over streaming content and streaming will halt on Feb-28th when the current contract expires. Starz has exclusive rights to first run content from Sony Corp and Walt Disney so this is a big deal for NetFlix. The initial contract four years ago was thought to be in the $30 million range. The renewal contract was expected to be in the $300 million range due to the increase in NetFlix subscribers. They currently have 22.8 million subscribers. NetFlix said it was confident it could use the money earmarked for Starz to maintain or even improve the quality and quantity of content to replace the loss of Starz. NetFlix shares declined about 10% in after hours.

NFLX Chart

Crude oil prices are holding over $89 and nearly touched $90 intraday on worries the storm in the Gulf will turn into a hurricane right in the middle of the oil patch. The storm has not developed enough to be named and only carries the label Tropical Depression Thirteen but it is a threat to the offshore oil patch. At this late date in its life cycle it would only be a minimal hurricane at best but it is headed right for the busiest and most populated portion of the Gulf oil patch. More than 6% of oil production has already been shut in and 2% of natural gas production. Some workers have already been airlifted to shore.

Tropical storm Katia is moving closer to the Leeward Islands but is expected to miss the Caribbean and head north into the Carolinas. Katia is no threat to the Gulf unless there was a significant change in direction.

Gulf Storm Map

The European debt crisis continues to roil the markets but investors appear to be immune to the daily dribble of news. The ECB has been buying bonds to keep interest rates low for Spain and Italy but that impact appears to be wearing off. The German president, Christian Wulff, accused the ECB of violating its treaty mandate with the mass purchase of southern European bonds. Article 123 of the EU Treaty prohibits the ECB from directly purchasing debt instruments from governments in order to safeguard the central bank's independence. The ECB has purchased €110 billion in bonds in the secondary market to keep those countries from imploding.

There are new concerns coming out of Italy, which votes on its austerity program next week, and Greece. Greek officials are making noises about missing targets and inability to pay on their existing bailout loans.

Pimco's El-Erian now expects the ECB to cut rates because the chance of recession in Europe is now over 50%. The ECB has raised rates twice this year, which took rates to 1.5% in order to keep inflation in check. However, the austerity programs and worries over country solvency and bank defaults have restrained growth. GDP growth in the 17-nation euro area slowed to +0.2% in Q2 from +0.8% in Q1. The IMF claimed this week the European banking system needed €300 billion in additional capitalization. A Goldman analysts said that number was more in the range of $1 trillion. El-Erian said the ECB has gone from being part of the solution to part of the problem with the purchase of bonds with a questionable future. He said the ECB may need to be recapitalized if conditions worsen.

He said the European crisis is the equivalent of rolling a snowball down a hill. As the snowball grows in speed and size the problems get bigger and the dynamics get more disorderly. The rescue bill in Europe has grown to $518 billion in official loans to Greece, Portugal and Ireland plus the creation of a €440 billion fund plus the €110 billion in ECB bond purchases. Pretty soon there will be some real money at risk and the problem is continuing to grow.

This will continue to weigh on our markets and El-Erian believes it could end up being the EU version of the 2008 subprime crisis. This is weighing on EU sentiment with the biggest decline in sentiment in August since the December 2008 decline after the failure of Lehman.

I believe this is going to keep cautious U.S. investors in cash but this is more of a distraction at the current label rather than an impending crisis. We have reacted to the news headlines so often that institutional investors have grown numb to its effects. They will likely keep a wary eye on Europe but they have to generate some investment profits by year-end or lose bonuses and customers. This should keep them buying the dips in the weeks ahead even though September is historically the worst market month of the year.

The markets rallied at the open on the better than expected economics but the selling started almost immediately. Volume was about normal at 7.6 billion shares but it was 4:1 negative. The S&P lost -14 points to close at the low of the day at 1203. This should be reasonable support in a normal market but Friday will not be normal because of the payroll report and the long holiday weekend.

Trading should be very volatile at the open but any remaining traders will pack up and hit the streets as soon after the report as possible. Once the initial volatility ends the markets could go dormant for the rest of the day. The exception would be a significantly larger or smaller number than expected and the resulting change in investor sentiment. If 1200 breaks the next support level is 1160.

S&P-500 Chart

The Dow gave back -119 points in a bit of minor profit taking to close just under support at 11,500. This is exactly where you would have expected it to rest after a strong run since August 22nd. Nothing goes straight up and you would expect profit taking ahead of a critical economic event. This was tame and would suggest institutional traders are holding their positions.

Dow Chart

The Nasdaq hit a brick wall at 2600 and what should have been decent resistance dating back to November. This appears to be a solid psychological level and the implosion in NetFlix tonight means that even a good jobs number on Friday could see a decline in the Nasdaq. Support should be 2500 but that is well below the close so tech stocks could be weak on Friday.

Nasdaq Chart - 90 Min

Nasdaq Chart - Daily

I am not applying too much worry to the decline on Thursday. We had a nice rally since the retest of the lows on August 22nd and it was time to rest. With the payroll report likely to create some serious volatility at the open the majority of cautious traders simply cashed in their chips and headed out for the weekend. There was no rush to the exits and volume was average. It was an orderly bout of cautious profit taking and nothing else.

Predicting the market reaction on Friday to a positive or negative jobs report would be a fool's errand. Who knows how a positive or negative number will impact sentiment and Fed expectations and how many traders will actually be around to see it. If a number is reported in a dead market with nobody around does it make a sound? My advice is to watch the morning open while enjoying your morning coffee and then close your charts and turn off the TV. Enjoy the weekend without a confusing dose of conflicting sound bites causing you worry over your existing positions. They will still be there on Tuesday.

Jim Brown

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