Caterpillar issued an ugly profit warning after the close on Monday and that proved to be one too many for the markets.

Market Statistics

Caterpillar (CAT) warned that earning would be "anemic" through 2015 because of slowing global economies including China and the emerging markets. CAT shares fell -4.2% on the news. CAT added its name to the list of high profile warnings from Intel, FedEx, Norfolk Southern, etc. This may have been one major warning too many.

Adding to the earnings worry was headlines out of Spain where crowds protesting austerity measures and demanding a halt to any new reforms. The pictures of the crowds reminded everyone of the protests in Greece and the downward spiral in that country. Spain's prime minister is scheduled to release the 2013 budget and a new set of reforms next week. Spaniards are already complaining loudly about past austerity measures and the 25% unemployment rate.

Spain has been a focal point for the last several weeks on whether they will ask for a bailout from the ECB, EU and IMF, otherwise known as the Troika. The prime minister claims he may "allow" a bailout if the terms were acceptable but would not accept any outside interference in Spain's spending. That dog will not hunt. There will be no bailout without strict conditionality and Germany reminds the other countries in the eurozone nearly every day that strict conditions will be required to obtain any future loans. So, the parties continue to dance around the issues while the Spanish protests increase.

Greece is also coming back to the forefront with the Troika poised to release a report showing the country has failed to implement the required reforms from the first two bailouts and it is going to need a third bailout of as much as 25 billion euros and a further forgiveness of debt. Since the EU, ECB, EFSF and IMF now own the debt it means Germany and the other countries would have to agree to the debt forgiveness and that is not likely to happen in the near future.

The markets have been climbing a wall of worry over since May with economics and stock fundamentals declining. Eventually there would have to be a return to reality but investors were hoping the announcement of QE3 would be enough to fuel a continued rise into year end. Unfortunately multiple analysts have surfaced since the QE3 announcement to warn the unlimited duration $40 billion a month plan was either not enough or the wrong kind of stimulus to power the markets and the economy higher.

Philly Fed president Charles Plosser, roiled the markets today when he said QE3 probably won't boost economic growth or hiring and may jeopardize the Fed's credibility. Plosser said QE3 would be unlikely to lower interest rates by more than a few basis points and the impact on hiring would be negligible. Plosser said QE3 is neither appropriate or likely to be effective in the current environment. "Every monetary action has costs and benefits and my assessment is that the potential costs and risks associated with these actions outweigh the potential meager benefits." The risks to the economy would be a significant increase in inflation.

Plosser added his name to the list opposing QE3 along with Richmond Fed president Jeffrey Lacker and Dallas Fed president Richard Fisher. Lacker claims QE3 will increase inflation and have little impact on employment. Fisher also believes QE3 and the Fed's zero interest rate policy through 2015 is telling the market to expect higher inflation as a tool to reflate the economy. He is afraid the potential for a sharp spike in inflation to scare the market and crash the economy.

Contrasting the negative comments by Plosser and others San Francisco Fed president John Williams said on Monday he expects the Fed to expand QE3 in 2013 and end it by year end 2014. Currently the Fed is buying $40 billion in mortgage backed securities each month (QE3) and they are continuing Operation Twist ($45 billion a month in treasury swaps) until year end. Williams believes the Fed will increase its buying of treasuries after Twist expires at year end. Because unemployment is unlikely to change significantly in the coming months Williams said, "A strong case could be made" for continuing the current level of mortgage backed securities and expanding into treasuries in January. He believes the unemployment rate will decline from the current 8.1% to 7.25% by the end of 2014. He said the Fed would need to start raising interest rates once unemployment fell to 6%. Williams expects inflation to rise to +3.25% in 2014.

Morgan Stanley said the same thing last week. They expect QE3 to be expanded in 2013 and the addition of a QE4, which would likely be treasury purchases.

The conflicting Fed opinions all had one thing in common. None of them expect unemployment to improve significantly for a long time and all believe QE3 will have a limited impact on the market and economy. We are not suffering from a lack of liquidity. We are suffering from a fiscal crisis where spending is growing faster than our ability to pay for it, consumers and businesses will see the largest tax increase ever on January 1st, businesses are being buried under a mountain of regulations and the new healthcare law is so onerous that businesses are cutting employees to avoid the costs when the law becomes effective.

Every businessman wants to make money and grow their business. That is why they are in business. However, when the government burden becomes too great those businesses are forced to cut back and shrink rather than expand. This is economics 101. Regulations and taxes have consequences. Regulations impose higher costs that reduce profits and reduce the amount of funds available to pay for employees. Taxes have the same impact. The Fed can't fix this. Congress and the president are the only people who can fix this problem.

Regardless of the long term benefits of QE3 the comments from the Fed presidents helped to tank the market.

On the economic front it was all good news and that helped to power the Dow to a +61 point high at the open. The big news was the Consumer Confidence for September, which rose to 70.3 from 60.6. That is the highest level since February and a dramatic reversal from the trend since February. We saw the high for the year in February at 71.6 and the low for the year in August at 60.6 and suddenly we are back at the highs in just one month. Conspiracy theorists would wonder if there was an election connection here.

The present conditions component rose from 46.5 to 50.2 but the big gains came in the expectations component with a jump from 71.1 to 83.7. This is the first confidence report since the political conventions and the Fed's QE3 announcement. Clearly something has impacted expectations considerably.

Those expecting jobs to be more plentiful six months from now rose sharply to 18.5% and a 2.7 point gain. That had to be related to the convention speeches and the Fed action. The jump in confidence did not really translate into buying plans with home buyers declining from 5.5% to 5.0%, auto buyers rising from 11.6% to 12.1% and appliance buyers from 48.3% to 49.2%. Those increases were minimal compared to the jump in the headline number.

Consumer Confidence Chart

The Richmond Fed Manufacturing Survey rose to +4.0 from -9.0 after three months in contraction territory. This was the first expansion in manufacturing in the Richmond area since May. New orders spiked from -20.0 to +7.0 and a dramatic rebound after being in contraction territory for four months. They declined to -25 in July. Backorders rose from -25.0 to -9.0, up from the cycle low at -27.3 in July. Employment remained unchanged at -5 and the fourth month in contraction territory.

This was another stunning reversal from rapidly declining conditions. Analysts had no specific indications on why manufacturing suddenly turned positive other than the end of summer vacations may have sparked the restarting of processes shutdown or slowed over the summer.

Richmond Fed Manufacturing Survey

The Case Shiller home price indexes rallied into positive territory for the second month with a +1.2% reading. That means home prices are up +1.2% over the same period in 2011. This data was for July and should not be a surprise to anyone.

The FHFA Purchase Only Home Price Index increased slightly from 3.7% to 3.9% for July. This exceeded expectations but was slower than the +0.6% gains in each of the prior three months. The housing market is still improving but the late summer period did see a slowdown in buying as the U.S. economics began to deteriorate. This is lagging data and was ignored.

The material economic reports for the rest of the week are New Home Sales, GDP, Kansas Fed Survey and the Chicago ISM.

Economic Calendar

Red Hat (RHT) shares fell -4.3% after missing analyst estimates on Q2 earnings. RHT earned 28 cents and less than estimates at 29 cents. That was not the only problem pushing the stock lower. RHT lowered estimates for Q3 to 28.5 cents compared to estimates of 30 cents. They lowered revenue estimates as well. The company said a slowdown in the services side of the business was the reason for the lowered outlook for Q3.

Red Hat Chart

Jabil Circuit (JBL) reported earnings of 54 cents compared to analyst estimates of 58 cents. Revenue rose to $4.34 billion and beat estimates of $4.23 billion. Earnings declined -28% due to weak demand in most of its business segments and higher costs. Selling costs rose +7% and R&D rose +9%. JBL took a charge of $5.9 billion for startup costs of a new program in its specialized services unit. They said the macroeconomic environment remained challenging but they were still expecting earnings growth of 5% to 10% in 2013. JBL shares fell -2% during regular trading and -3% in afterhours.

JBL Chart

Carnival Corp (CCL) reported earnings of $1.53 compared to estimates of $1.43. This was 3 cents above the year ago period. Carnival had predicted in June that is would earn $1.42 to $1.46. Revenue declined -8% to $4.68 billion due to lower bookings and flat ticket prices after the Coast Concordia disaster in January where 32 people died. Carnival said bookings over the last six weeks were up +9% but prices remained flat. Carnival narrowed full year guidance from $1.80-$1.90 to $1.83-$1.87 but analysts were expecting $1.85 so it was right in line with estimates. Carnival shares rallied sharply at the open after the earnings but declined to close flat at $37.09.

Carnival Chart

Tesla Motors (TSLA) cut revenue estimates for 2012 because of a slower than expected rollout of the Model S sedan. Shares of TSLA fell -10% on the news. Revenue is now expected to be $400-$440 million, down from $560-$600 million. The company said supplier deliveries continued to be a problem. The rate of production increase for the Model S has been lower than expected and would continue to increase at a methodical rate. Tesla expects to roll out a SUV crossover vehicle in 2015 and a smaller sedan code-named Gen III in 2015. A Morgan Stanley analyst said the slow ramp in production was already priced into the stock. He said their insistence on getting everything right the first time was the right plan and would prevent problems in the future. Tesla expects to deliver 225 S cars in Q3 and ramp to as many as 3,000 in Q4. As of Sept 23rd reservations for the S car had risen to 13,000 from 11,500 at the end of June. For 2013 Tesla expects to sell 20,000 S cars with a gross margin of 25%.

Tesla Chart

Research in Motion (RIMM) surprised investors today by saying they had gained two million subscribers in the quarter to push total subscribers to 80 million. The CEO reported the subscriber gain at the RIM developer conference in San Jose. RIMM reports earnings on Thursday. RIM showed off the BlackBerry 10 operating system at the conference.

RIMM Chart

Crude oil continued to decline and closed at $91.45 and could be in danger of falling below $90 in the days ahead depending on the EIA inventories on Wednesday and events in the Middle East. The dollar rebounded slightly on the worries over Spain and the demonstrations. It is one thing to design an austerity package and a significantly different problem to try and implement it.

WTI Crude Chart

Gold declined slightly to $1766 but today was the expiration of options on gold futures and likely the cause of the decline. Gold prices have been flat for the last week since the QE3 announcement with support at $1760.

Gold Chart

The S&P declined to break support at 1450 and close at 1442. This is still well above the next support level at 1430 and was likely a temporary event driven by the Spain and Federal Reserve headlines. Any real bout of profit taking would likely retest 1400.

Blackrock Inc, one of the world's largest asset managers, raised its estimates for the S&P for 2012 to 1450 at year end and 1525 by mid 2013. Their prior targets were 1350 at year end and 1400 by mid 2013. Blackrock has $3.56 trillion under management with equities representing $297 billion. Blackrock believes the current rally has run its course with a +7% gain since early August and the road to the 1450 year end close will be rocky.

I had theorized in the weekend newsletter we would see some window dressing by fund managers this week. Typically that occurs midweek and then weakness appears in the last two days of the quarter as traders try to anticipate which stocks will be sold when the new quarter begins. The Fed news and the Spanish riots were the wild cards along with the CAT earnings warning.

We had been moving sideways for nearly two weeks and it was time for a breakout move. The headlines combined to make that breakout to the downside. Unless 1400 breaks this is just a dip. October is going to be the real market test.

S&P Chart

The Dow was handicapped by the large loss in Caterpillar of $4 or -32 Dow points. Resistance at 13600 had held for eight days and we were due for a headline event that broke the stalemate. The Caterpillar warning was not a big deal for the company but the headline helped end the status quo. Next support is 13,300 followed by 13,000.

Dow Chart

The Nasdaq was handicapped by a major loss in Apple. Shares of AAPL declined -$17 for the second major decline this week. Apple buyers fled on Monday when Apple said they only sold 5.5 million iPhone 5s in the first week compared to analyst estimates of 6.5 million. The problem is in manufacturing. Suppliers, especially Sharp, have had problems in production and parts have been slow in arriving at Foxconn in China. Sharp makes the glass for the screens and they have had quality control problems slowing production. Foxconn has 150,000 workers assembling Apple products in China. Apple shares have declined -$27 since that news broke. Also impacting Apple was a comment from the Google CEO saying they had no plans to offer a Google Maps app for the iPhone unless Apple requested it. That was a gotcha! Apple removed the Google Maps application from the OS on the new phone and replaced it with a primitive version of their own mapping application that was not ready for prime time. Users have been complaining loudly and demanding Google Maps be returned. Google rallied to a new high at $764.89 intraday but fell back to close flat at $748 then the market rolled over.

Apple Chart

The $17 drop in Apple crushed the Nasdaq to cause a -43 point loss. The Nasdaq fell out of its uptrend channel but remains out of trouble as long as support holds at 3085. We were due for a pullback in the overextended Nasdaq and this drop was nothing we should be concerned about, yet. If the Nasdaq moves under 3085 we should be worried. That could happen in October.

Nasdaq Chart

I don't believe today's market drop was a big deal. I think it was just a release of pressures built up over the last eight days when the markets could not press higher and traders had tightened stops just in case the next move was a breakdown instead of a breakout.

We had a flurry of headlines on QE3, Spain, Greece and China and the warning from Caterpillar. What was unusual is that the market reacted as it should have instead of ignoring the news and pushing higher. This is a welcome departure from recent weeks.

We could see a return of window dressing on Wednesday, headlines permitting. However, I continue to be worried about the potential for an October surprise once the quarter is over. I would definitely keep my stops tight heading into next week. We could see some cracks in the foundation later this week.

Enter passively, exit aggressively!

Jim Brown

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