One more summer Friday behind us and only one more to go before traders return to sort out positions ahead of the Sept 12th FOMC meeting.
It was a typical low volume summer Friday with the markets opening lower but then rebounding on short covering after a Bernanke letter to House Oversight Chairman Darrell Issa was released. The letter said there was "scope for further action" by the Fed. Essentially the letter was a cut and paste of the most recent minutes from the FOMC but did say the Fed has room for further stimulus. The letter was dated August 22nd so it represented Bernanke's most recent position on further Fed action. It was under reported that the letter also contained the warning that "there are potential costs and risks to consider before taking action."
Even though the points reiterated were discussed in the FOMC minutes on Wednesday the knee jerk reaction was short covering and that rescued the markets from a -33 point opening loss on the Dow and pushed it to a gain of +100 points for the day. Never short a dull market.
There was so little news on Friday that even the blog sites were quiet. All eyes are on the Bernanke speech next Friday and the speech by Mario Draghi on Saturday. The two most powerful men in banking speaking back to back and the markets will be dysfunctional leading up to the event. Bernanke is expected to drop some tidbit over when the Fed will announce the next round of QE. Draghi's speech will be scrutinized for clues to his "whatever is necessary" action that has yet to appear.
The market is likely to be disappointed by Bernanke and probably by Draghi as well. Bernanke has only a few bullets left in his gun and Draghi will not want to release any specific plans before Germany votes on the ESM on the 12th. He will not want to jeopardize that vote. This means all of next week will be spent in anticipation of news that may not appear. Volume will be even lower than it was last week since it is the last vacation week before Labor Day. The market will either be extremely erratic in the low volume or extremely boring while we wait on the speeches.
The Republican convention starts on Monday so the airwaves will be full of convention coverage and any economic events or stock news will be overshadowed by that coverage. The following week is the Democratic convention.
There was only one economic report on Friday. The Durable Goods report for July saw orders rise +4.2% and well over the +1.6% increase in June. Consensus estimates were for a rise of +2.4%. However, if you exclude the +14.1% rise in transportation orders for big ticket items like planes and trains, orders fell -0.4%. Despite the large headline number the core components pointed to continued slowing in the manufacturing sector.
New orders for capital goods rose +6.7% but if you remove the aircraft orders the number fell to -5.6%. Orders for core capital goods declined -3.4% and worse than the -2.7% decline in June. This report was not a factor for Friday's market. It was ignored.
The calendar for next week includes two regional Fed manufacturing reports and the Chicago ISM (PMI). Those reports will take a back seat to the Fed Beige Book due out on Wednesday. That is the survey of economic conditions in all of the Fed regions. The revision to Q2-GDP is also Wednesday and it is expected to decline only slightly to +1.5%.
All of these reports will be new bricks in the wall of worry while traders wait for the speeches. I envision a very boring week despite a lot of events in the mix.
Adding a little drama to the convention is the approach of tropical storm Isaac. The storm is expected to turn into a hurricane after it crosses Cuba on Sunday and could make landfall in the Tampa area on Monday afternoon. While that won't halt the convention it may make life miserable for the legions of protestors scheduled to camp out around the convention center. It will also add just one more story line for the mob of reporters trying to produce a sound bite.
Isaac was followed by Joyce but late Friday that storm degenerated into an unorganized group of storms and was downgraded to junk status. Another storm is brewing farther east of Joyce and that could be named over the next several days.
Isaac, Joyce and soon to be named Tropical Storm 11
Isaac is not only disrupting convention planning but oil drilling in the Gulf of Mexico. The current storm track may favor a turn up the west coast of Florida there is also a decent chance it moves farther west towards New Orleans and right through the eastern edge of the oil patch. If weather patterns changed only minutely it could head even farther west for a direct hit. If it strengthens as expected once it passes Cuba then it could turn into a category 1 or 2 hurricane.
Oil drillers are already moving nonessential personnel ashore from the rigs and production platforms that could be impacted. There are thousands of workers on more than 100 active rigs and platforms in the gulf and whenever a storm threatens the oil companies have to start evacuation and shutdown procedures several days in advance in order to get everyone moved safely ashore.
Tropical storm Isaac only has winds of 65 mph today but forecasters remember how quickly Katrina escalated from a category 3 to a category 4 and changed its track. A category one is 74-95 mph, two 96-110, three 111-129, four 130-156, five is greater than 156 mph. Isaac only has to gain 9 mph to become a category one hurricane and once over the warm waters of the gulf that can happen quickly. Forecasters believe Isaac could possibly become a category 2 hurricane if it holds together as it passes over Cuba.
Transocean alone has 14 rigs in the gulf and they are already moving personnel ashore. If Isaac turns just a few degrees to the west it could also hit the 10 refineries in the New Orleans and Baton Rouge area. Those refineries have a capacity of 2.5 mbpd. Refineries in Mississippi and Alabama account for roughly 500,000 bpd.
Shell reported that drilling operations have been suspended on its eastern assets but no production has been shut in as of yet. BP is evacuating employees from its Thunder Horse production platform and said it is shutting down the oil and gas production there. It is also evacuating from the Na Kika, Horn Mountain and Marlin fields. Murphy Oil, Apache and Diamond Offshore also reported evacuations.
Oil prices declined on Thursday and Friday despite the potential for a decline in supplies from the storm. The reason for the decline was a story in the Petroleum Economist citing anonymous sources that the IEA had agreed to endorse a plan to release oil from strategic reserves. On Friday multiple publications had picked up the story and embellished it to claim it could be as large or larger than the 60 million barrels released in 2011. Late Friday the IEA Executive Director responded to questions about the release saying, the agency remained in close communication with member countries and stood "prepared to act as necessary in response to a physical disruption." She avoided the questions on whether there was active consideration underway of a potential release. She did say "However, as I said as recently as last week, at this time the conditions that would warrant such a response by the IEA are not present."
Analysts believe that although there are no conditions that would justify a release the IEA may be forced to react to requests from the U.S., France and Britain, countries that want a release for political reasons to lower fuel prices. If those countries acted independently then the IEA would lose credibility. The IEA could change its stance at the request of those countries under the guise of lowering prices to add to the impact of the sanctions on Iran. Currently Iran is selling less oil but the prices it is receiving are about 25% higher than June. By going through the motions of releasing strategic reserves the price of oil would decline at least in theory. In 2011 that decline lasted about a week so the whole idea of a release to lower fuel prices is purely a political exercise in an election year.
The head of the French strategic reserve agency said "I have received no official instruction telling me to stand ready to release reserves and I am unaware of such plans." He said a release would not be "reasonable" under the current circumstances and would only be "legitimate" if geopolitical tensions between Iran and Israel worsened noticeably.
The Petroleum Economist claims France, Britain and Saudi Arabia have "endorsed the strategy" as requested by President Obama. Saudi Arabia said it saw no need for a release but the decision was up to the consumer countries. Japan, South Korea and Germany continued to say they were opposed to a political release.
A story late Friday suggested there would be no announcement of the move until after Labor Day and the end of the driving season in the USA. Also, Brent prices at $115 or $120 were discussed as a possible trigger for the move.
WTI Crude Chart
Brent Crude Chart
The Apple - Samsung suit was decided by the jury late Friday. Samsung lost. The jury ordered Samsung to pay Apple $1.05 billion for copying parts of the iPhone design in the Samsung phones and tablets. Apple had demanded $2.5 billion and a halt to sales of the infringing products. The jury rejected all of the Samsung claims in their suit against Apple. Not all of Apple's claims were allowed with the jury ruling against Apple on some but it was still an Apple win.
Apple lawyers will formally demand that Samsung pull its most popular smartphones and tablets from the U.S. market. They can also ask the judge to triple the damages to $3 billion. The judge will decide on all those motions over the next several weeks. Samsung will also petition the judge to overturn the jury's verdict.
The verdict in Apple's favor will likely cause many smartphone makers to reconsider their allegiance to the Android platform on worries that Apple will become emboldened with the win and launch suits against everyone else on the same grounds that have now been proven in court. ISI Group said the verdict was as much a blow to Android as it was to Samsung. Samsung said in a statement that the verdict will be a loss for the American consumer. It will lead to fewer choices, less innovation and potentially higher prices.
Apple has filed similar suits in eight other countries including South Korea, Germany, Japan, Italy, the Netherlands, Britain, France and Australia. Some other countries have already rejected Apple's claims so it is not a slam dunk that those suits will be won. Analysts believe Apple had the home field advantage with the case being tried just ten miles from the Apple headquarters and jurors were picked from the heart of Silicon Valley where Apple is the revered technological innovator.
Samsung won a suit against Apple in South Korea on Friday. The court ruled Samsung did not copy the look and feel of the iPhone and also ruled that Apple infringed on Samsung's wireless technology.
The real result of these cases will be whether Apple CEO will want to continue the "thermonuclear war" Steve Jobs had started (his words) or whether it makes more business sense to come up with a global settlement where everyone wins a little and business can continue. Considering Apple's cash hoard and the aggravation they can cause everyone else the odds are good they will press their win and keep fighting. Unfortunately for Apple that will create tens of millions of additional Apple haters so the company had better make a careful decision. Even the best innovator can struggle if consumers start believing you are arrogant and becoming an unfair monopoly.
The news came after the close but Apple shares rose +$10 to $675 in afterhours.
The speeches next week by Bernanke and Draghi should shed more light on how the central banks plan to disperse stimulus in the future. The ECB is discussing a bond-buying program where it will set yield targets in a band in order to avoid speculators trying to cash in. If they know where the ECB is going to buy bonds then they can profit from it. The ECB is trying to develop a strategy that lets it buy bonds without a fixed limit in order to keep the program in operation for as long as needed. If the ECB said it would buy 100 billion euros of bonds it would limit its effectiveness. By having an open ended program without naming amounts it would keep speculators guessing. Essentially the ECB wants to keep yields on bonds like the Spanish 10-year at an affordable rate. Mario Draghi may reveal some of the concepts in the Sept 1st speech but the ECB is not likely to announce anything until after the Sept 6th ECB meeting and the Sept 12th ESM vote in Germany.
Analysts in the U.S. have taken recent comments from various Fed officials as suggesting the FOMC may announce a similar strategy. They may set targets like 3% inflation or 6% unemployment and then continue buying bonds (QE3) until those targets are reached. While that may sound like a plausible strategy it could result in the Fed's balance sheet expanding dramatically if growth did not begin to accelerate soon. The Fed is trying to refine its strategy and how it communicates that strategy.
In the FOMC minutes on Wednesday the Fed said "Many participants" embraced an open-ended bond-buying program for any future stimulus. Such a change would itself be a change in communications, said Barclays economist Michael Gapen: "It would, in effect, say that the Fed is in motion until the data tells it to stop." We would not have the monthly question of "Will the Fed change its policy at this meeting?" It would remove the uncertainty from the market since everyone could watch the monthly inflation and unemployment numbers and know exactly when the Fed was going to change its monetary policy.
For the last two years Chicago Fed President Charles Evans has argued the Fed should vow to keep adding stimulus until the unemployment rate falls below 7% and sticking to that plan unless inflation threatens to break 3%. His views are not in agreement with all the members. Some feel the simple rules would be limited and dangerous. Evans himself said on Friday that simple rules may not work but the Fed had to find a solution to the problem of communicating policy well in advance. While there is no clear answer at present we can expect the Fed to continue experimenting with the communications until they find a balance that satisfies the market and the economists.
St Louis Fed President James Bullard said on Thursday the expectations derived from the FOMC minutes that the Fed was going to add stimulus at the September 12th meeting was probably wrong. He believes the economic data has improved since the July FOMC meeting referenced in those minutes and the Fed will continue to remain on hold unless the situation deteriorated. He said the minutes were deliberately vague but made clear the threshold for action was high. "Continuing along at this slow pace is not enough to justify gigantic action."
Although he is not a voting member until he rotates into that position next year I think his comments are probably indicative of why Bernanke will disappoint the markets next Friday. Bernanke only has one major bullet left and that is QE3. I suspect he will not want to use that bullet this close to the election and without a significant decline in economic activity. If you only have one bullet left you don't want to be shooting at mice when there may be an alligator around the next corner.
There are alligator pits around the world and the Fed needs to save its ammunition in case of an escape. One pit is of course China. We learned last week that China can't really increase stimulus significantly because real estate prices are still elevated and inflation is still a risk in their mind. China's government leadership changes every ten years and the current leadership is preparing to hand over the reins to the new leadership in October. The fifth generation of leadership, expected to be Xi Jinping as president and Li Keqiang as premier, will take charge in October at the national congress. They will inherit an economy growing at the slowest rate in three years at just over +7% GDP and suffering from a global slowdown.
People claim China's growth is the big problem. It is not China. It is the rest of the world. If the rest of the world was consuming goods it would be China producing them. The global economy has slowed and we found out last week that inventory is backing up in warehouses and at manufacturers in China to the point where they are running out of storage space. Inventories rose faster in August than in any month since records were started in April 2004. Revenue growth for Chinese companies rose only 10% in Q2 compared to 20% in the year ago quarter. That is a three year low. China can't afford to shutter factories and see unemployment rocket higher. That would cause civil disturbances and unrest ahead of the leadership change. What we are likely to see is maintenance of the status quo until the leadership change in October and then the new leaders launching a major stimulus event as a signal of their commitment to growth. If China can't sell what it has already made then they are not going to buy more raw materials to make new goods.
The Chinese auto industry has grown 1000% over the last decade to become the world's largest. However, with cities now limiting the number of cars that can be registered in an effort to curb congestion and pollution the number of cars in inventory at dealers now exceeds their ability to store the cars. Dealer inventories of new cars have risen from 900,000 on December 31st to 2.2 million through June. Factories are now running at only 65% of capacity and it takes 80% to be profitable. New factories are being built so fast that new capacity added over the next three years will equal that of the total U.S. and Japan combined. The Shanghai Composite Index closed at a three year low on Friday.
Shanghai Index Chart
The HSBC PMI for China came in with a preliminary reading of 47.8 for August compared to 49.3 for July's final reading. If the reading holds for the rest of the month it will be the tenth month below 50 in contraction territory and the longest streak in the history of the report.
China PMI Chart
A sign of just how far global commerce has declined is the Baltic Dry Index or BDI. This is the cost to ship dry bulk goods like coal, copper, ores, building materials, etc. These are inputs into the manufacturing process so the index of shipping costs is a reliable indicator of economic activity. The Baltic index is an assessment of shipping costs across 23 shipping routes as measured on a time/charter basis. If there are 100 loads and 95 ships bidding for the loads then prices go up. If there are 95 loads and 100 ships bidding then prices go down. It is a supply-demand model that began in 1744. Today's Baltic Exchange was formed in 1823.
On May 20th 2008 the BDI reached an all time high of 11,793. By December 2008 it had fallen to a 20 year low at 663. After the recession it topped out again at 4,661 in 2009 before making a multi decade low of 647 on February 3rd, 2012. The index is heading back towards that low with a close at 717 on Friday. Since this is an actual index based on shipping activity there is no speculation involved. This is a clear indication that global economic activity is declining and reaching dangerous levels. Having Bernanke use his last bullet now will have no impact on this chart.
Baltic Dry Index (BDI) Chart
The market rebound on Friday after three days of declines was short covering with a little bit of speculative buying. The S&P dipped below 1400 at the open and that was strong support and an opportunity for shorts to exit gracefully and buyers to step in at a clearly defined support level. Unfortunately there was no conviction.
Volume was the second lowest of the year for a full trading day at 4.6 billion shares. The daily average for the full year is 6.6 billion and that is after the last five weeks of significantly weak volume otherwise it would be a lot higher.
The reason for the lack of volume is simple. This was a summer week with plenty of traders still on vacation until after Labor Day. Everyone is waiting on the Fed and ECB to announce their new stimulus plans. That means September 6th or later for the ECB and Sept 13th or later for the Fed.
The economy is trudging along at a snail's pace of +1.5% GDP and U.S. manufacturing has declined for the last four months. This is also August when market declines normally begin so there is no upside conviction.
After five weeks of gains there is no bearish conviction either. According to the AAII Investor Sentiment survey bullish sentiment rose +5.1% last week to 42% and bearish sentiment declined -2.2% to 25.9%. The long term averages are 39% for the bulls and 30% for the bears. That puts the current numbers just outside the averages and gives us yet another reason to be complacent. Investors are not overly bullish or bearish although the bulls are in control.
Last Sunday I pointed out that 1400 was the critical line in the sand and that proved to still be the case on Thursday and Friday. The failure of the bears to push us lower and the immediate rebound on the slightest news is confirmation the bulls are still in control. Until support at 1400 breaks or resistance at 1426 is surpassed we are just in a holding pattern.
S&P-500 Chart - 60 Min
S&P-500 Chart - Daily
The Dow actually broke below critical support at 13,100 on Thursday and it appeared we might be in for a trend change. That dip was bought on Friday to ease bearish speculation but the next decline below that level could be an indication of a future correction. The term correction may be too strong of a term and might be better referred to as a retracement. Dow 12,800 would be the first test but several analysts are predicting 12,600 as more likely.
Dow Chart - 60 Min
Dow Chart - Daily
The Nasdaq tried to form support at 3050 but there was a definite series of lower lows all week. Apple should help on Monday as traders capitalize from the Samsung loss but Google could decline as a result of the hit to the Android platform. Nasdaq 3085 remains resistance with 3000 as real support.
Nasdaq Chart - 60 Min
Nasdaq Chart - Daily
The Russell 2000 remains weak on a relative basis. It is far below its highs and under strong resistance at 820. At this point a move below 800 would be damaging to sentiment. Where I would normally watch the Russell for market sentiment I believe the S&P at 1400 and Dow at 13,100 are better indicators this week.
Russell 2000 Chart - Daily
Volume should be extremely light this week as the focus moves to the Republican convention, hurricane Isaac, monthly manufacturing reports, GDP and the expectations for the Bernanke/Draghi speeches and the Labor Day weekend. This is not a week to be going "all in" regardless of market direction.
With low volume and lack of market depth any program trades are going to have a dramatic influence on the market without any rhyme or reason. Watch S&P 1400 and 1422 for direction and keep your positions small.
Europe has been very quiet for the last several weeks without any deadlines to terrorize the markets. That is going to change soon. Greece is running out of money. The Greek Prime Minister Antonis Samaras visited Merkel in Berlin last week looking for more time to put reforms in place and Merkel said no. Greece is expected to run out of money in October and the EU does not want to pour good money after bad. The Netherlands, Finland, Estonia, Slovakia and Austria and Germany are against any further loans. The next EU summit is October 6th and without a major change in policy stance by the EU Greece will default again and start the entire conversation over again about leaving the euro.
In the U.S. five companies issued guidance warnings for every one company that raised guidance in their Q2 results. Only 41% of S&P companies beat on revenue and that is the lowest in three years. It is only the fourth time in ten years that it fell below 50%. Earnings estimates for Q3 continue to fall, now at -0.5%, but Q4 expectations are still in double digits. Q4 estimates have come down from estimates of 16% at the end of March to +10.3% today. Unfortunately there is no reasoning on why earnings are going to spike so significantly in just three months.
For the market to be challenging new highs with the fundamentals so bad it is clear most investors are betting on the Fed. Unfortunately they are likely to be disappointed unless you believe in the Fed's desire to propel the markets over the fiscal cliff. There is a train of thought that suggests the Fed will launch a QE3 program of sufficient magnitude to launch the markets above the year end cliff. SF Fed President John Williams, a voting member of the FOMC, has been proposing this since mid July. By announcing an open ended QE3 the Fed could power the stock market, the sentiment indicator for the masses, across the cliff and to a calm landing at some point in the future. Boston Fed President Eric Rosengren seconded Williams's comments in an interview on August 7th. By putting further downward pressure on interest rates it would provide additional support for the recovery and improve market conditions according to Rosengren.
We know that Bernanke sees the market as the sentiment indicator for the consumer. He has said so multiple times in past speeches. For instance in November 2010 in an op-ed in the Washington Post on QE2 he explained that "Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending." With the CBO now predicting a recession in 2013 as a result of the fiscal cliff it is possible the Fed will take action to accelerate the equity markets in hopes of avoiding a cliff dive at year end. However, it would seem that the Fed would want to wait and see who won the election before using their last major bullet on a last ditch effort to stave off the recession. If Romney and the republicans win they have already pledged to kick the cliff can another year down the road to give them time for major tax and spending reform. Surely with rates already near record lows the delay in announcing a new QE program for 75 more days would be justified. Who knows what thoughts are lurking in that Fed head but hopefully the next three weeks will reveal the Fed's plan.
Bill Gross said on Friday that QE3 was "almost a certainty" because the Bernanke Fed likes to telegraph moves in advance and "I can't remember such explicit hints such as this without follow through." With those kinds of statements from people like Bill Gross headlining the airwaves it is not surprising the markets are testing recent highs. Let's hope he is right about the Fed adding to the punchbowl or the hangover is going to be ugly.
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