The markets lost their upward momentum at 2:30 on Friday when the President said he would veto any legislation that did not raise taxes on the wealthy.
That speech at 2:30 ended a +150 point rebound from the Dow's 12,743 low for the day and knocked the Dow back into negative territory. Only a brief bout of short covering at the close lifted the Dow back into positive territory by +4 points at 12,815.
The election is over and the battle lines are being drawn ahead of the fiscal cliff only 48 days away. Going over that cliff is expected to remove $600 billion from GDP in the first half of 2013 and push the country back into recession.
The president has said over the last couple weeks that he is sure he can reach a compromise with Congress about the cliff issues over the next six months. Unfortunately that means we will go over the cliff and the damage will be done.
The president's position on the cliff has seen the fifth largest bout of post election volatility in the last 112 years. Investors see the writing on the wall and they are running for cover. With taxes on capital gains and dividends slated to rise on January 1st there will be continued pressure on equities into year end. Investors will want to take profits while the taxes are lower and not see their gains erased by higher taxes in 2013.
The warning by Obama was met by similar position building by House Speaker John Boehner. He said the demand by Obama would meet stiff resistance in the House. Raising taxes on those making more than $250,000 would be the equivalent of raising taxes on the majority of small business owners and would have a resounding impact on future economic growth. "This is part of the cliff we are trying to avoid and increased taxes will destroy jobs."
The battle lines are drawn and the participants are getting ready for battle. The president has asked Boehner and other congressional leaders to meet with him at the White House next Friday to see if there is common ground for a future deal. Boehner has suggested the republicans would be open to additional revenue by cleaning up the tax code to eliminate deductions.
With Obama's reelection the fiscal cliff has moved to the front of the problem list. This problem has a deadline and that is the major sticking point. The President and congressional leaders will have to come to an agreement over the next 48 days. Unfortunately nothing ever gets done until the last minute so there will be plenty of time for selling stocks ahead of the tax deadline. The damage would be less severe if they came up with some solution in the next couple weeks because that would keep many investors in the market. By dragging out the process it will increase the uncertainty and increase the likelihood of selling.
While the market is becoming increasingly worried over the impact of the fiscal cliff there are a few realities we need to face. First, the administration and Congress cannot afford to let the U.S. fall off the cliff. The impact of a full cliff dive is estimated to be as much as -4.5 GDP points and a severe recession. No politician wants to be branded with being responsible for that kind of recession. The various groups will come together to agree on some watered down cliff dive. Let's call it a slope instead of a cliff.
Some taxes will go up but there will be deals on others. The sequestration required spending cuts of $1.2 trillion will likely be delayed. Politicians will find some way to kick the can down the road.
The key point for investors will be any news on capital gains and dividend tax rates. That will be the focal point for the markets. Everything else is just political theater. Getting a deal done on extending the capital gains tax rates could be the turning point for the markets.
Analysts believe the lack of a resolution on the capital gain tax could subtract -150 points from the S&P by year end. That means every day that passes without a resolution will increase the selling pressure.
On the positive side the president no longer faces reelection. That means he does not have to please his party or humor his contributors. If he wants to go down in history as the president that resurrected the economy from the worst crisis since the Great Depression then he has to move to the center, compromise on a whole host of issues and end the gridlock that has paralyzed Washington. The republicans suffered defeat against a previously ineffective president and that shocked the party to the core. If they want to have a chance in the 2016 elections they have to also compromise with the president and get things done in Washington or they will be pushed farther out of the picture by the next democratic candidate. This desire by both sides to do something and claim the credit for the future economic rebound will fuel the compromise.
The economics were mostly ignored on Friday with the total focus on the cliff and worries over Europe. Greece is continuing on its path to oblivion. Many analysts still believe it will leave the euro zone within the next six months simply because there is no mathematical way out of its current death (debt) spiral. Unemployment is 25.4% with youth unemployment at 58%. Greece is choking on Troika enforced austerity and will eventually repudiate the entire deal. The Troika is going to end up eating the 240 billion euros of debt. The Greek Finance Minister reported on Friday that the cash reserves were almost depleted. Greece will attempt to sell 3.125 billion euros of debt on Tuesday in order to stave off a default for another couple of weeks. My question is, "who will lend Greece three billion when default is imminent?" Greece has 4.06 billion euros in debt coming due next Friday. Greek debt will rise to 450 billion euros in 2013 or 180% of their GDP of 250 billion. It is unsustainable in any form.
Lastly, Spain may ask for a full bailout before the weekend is over. Even with the Troika's history of bad decisions on Greece, it is expected to welcome the request by Spain for a full bailout and bond buying to reduce their market yields.
Just in case you thought the European debt crisis would be over soon Angela Merkel dispelled that idea on Friday. Merkel said that although Europe was on the right path to overcome the crisis "Whoever thinks this can be fixed in one to two years is wrong. We need a long breath of five years or more."
It is no wonder that Europe is still broken. Talk is cheap. The 100 billion euro Spanish bank bailout has not yet been completed. Regulators talked the markets off the cliff on the banks but they have not yet spent any money. The long awaited European Stability Mechanism (ESM) was finally launched but it still has no funds and has not stabilized anything. The "whatever it takes" speech was followed by no interventions and no actions. The Outright Monetary Transaction scenario (OMT) was announced to buy bonds of troubled nations. None have been bought. The European officials have become adept at announcing fixes but so far none of their fixes have been implemented. This is a series of accidents waiting to happen.
There are plenty of problems for investors to worry about outside the USA. There are continued rumors that Obama is trying to schedule a meeting in January with Iran's Supreme Leader to personally negotiate an end to the nuclear problem. That would give Iran a face saving exit if a U.S. president met with them in Iran. Syria continues to be a problem and now that the election is over the president will have to get involved there or risk being blamed for the slaughter of thousands more Syrians.
I would expect a resolution of the BP oil spill case soon. BP may have been holding out on the settlement in hopes a Romney victory would find an energy friendly president in the White House. Now that those hopes have been dashed and the trial is scheduled to start in February the onus is on BP to settle before going to trial. A trial risks an even bigger fine if the courts found them liable of gross negligence.
On the economic front the news on Friday was not bad. Consumer Sentiment for November rose to 84.9 from 82.6. That is the highest level since mid-2007. That would suggest the consumer was not concerned about high unemployment or the fiscal cliff. Can the economy continue to lag if consumers are ignoring the January cliff dive? Even more unusual is that hurricane Sandy had no impact on sentiment. Normally major disasters depress sentiment for several weeks.
The present conditions component rose from 88.1 to 91.3 for the biggest gain in the internals. The expectations component rose from 79.0 to 80.8.
The economic calendar for next week is highlighted by the FOMC minutes and the Philly Fed Manufacturing Survey. The minutes are not likely to show any surprises but you never know.
The Philly Fed Survey is expected to post its second consecutive month of growth after declining to a low of -16.6 in June. The Philly Fed Survey is expected to show a rise to 6.0 for growth for November. That is up from 5.9 in October so the gain is minimal.
On the earnings front JC Penney (JCP) reported a stinker of a quarter with a -27% drop in revenue. The everyday low price campaign is not catching on with shoppers who favor sales, coupons and special bargains. Same store sales fell a whopping -26.1% and much worse than the -17.6% drop analysts expected. Store traffic declined -12% from the year ago period. JCP lost -56 cents compared to analyst estimates for a loss of 15 cents.
CEO Ron Johnson continues to express confidence in his everyday low price conversion. When he assumed control he cancelled the 600+ sales advertised annually by JCP and instituted a three tiered strategy that permanently lowered prices on all items in the store by 40%, offered month long discounts on select items and periodic clearance events throughout the year. After posting a 20% loss in Q1 Johnson cancelled the month long discount portion of the plan. When the sales disappeared so did the customers. Penny's said they lost $20 million a week in sales from ending the month long discount program.
Johnson still expects to return to a profit in 2013. He said every step we take we learn more and use that knowledge to improve the next stage of the conversion. Johnson said JCP will have a Black Friday promotion but declined to say what it would be.
JCP shares declined -5% on Friday to close at $20.64. That is still above the July lows at $19. Is it time to buy? There are analysts that believe JCP has hit bottom and Q4 will be a turning point for the stock. Others suggest waiting for signs of life. Declining same store sales of -26.1% and a -12% decline in traffic suggest shoppers are avoiding JCP and it could be a long time before they are persuaded to return. In theory the everyday low price strategy will work once shoppers find out that all items really are cheaper. That will require a change in advertising by JCP and a massive education program.
Groupon (GRPN) shares imploded with a -30% decline after reporting miserable earnings. Shares closed at $2.76 with a market cap of $1.81 billion. Groupon was valued at $20 billion in their November 2011 IPO.
Groupon posted a loss of $3 million, a breakeven on a per share basis, and blamed the poor performance on sales in Europe. Total revenue was $568.6 million compared to estimates of $590 million.
Groupon is seen as a broken model because of the hundreds of copy cat sites and competition for a limited number of retailers willing to accept the tough terms of the discount deals.
Amazon just wrote down $566 million of its purchase of Living Social, a Groupon competitor, because of the decline in value of the coupon sector.
Earnings continue to be lousy. Only 37% of the S&P have beaten on revenue for Q3. That is the lowest number since Q1-2009. More than 72% have warned on guidance for Q4 and quite a few have warned on 2013. However, of the 428 S&P companies reported more than 70% have beaten earnings estimates. That is in line with the average over the prior four quarters according to S&P. Apparently cost cutting still adds to earnings even when revenues are slowing. Overall earnings growth for Q3 now stands at -0.1%. If that is how the Q3 cycle ends it will be the end of an eleven quarter streak of positive earnings growth.
Companies claim economic uncertainty, the fiscal cliff, weakness in Europe and China as the main causes for concern. Many are holding off on capital expenditures and hiring until the uncertainty cloud clears. David Kostin of Goldman Sachs listed these companies that have complained about those conditions in their earnings. AA, BHI, C, COST, DO, DRI, EMC, GCI, GE, GPC, HON, JPM, MCD, MWV, RHI, T, VZ, ABT, BTU, CAT, DD, DOW, FCX, FDX, IBM, INTC, JNJ, KMB, KO, MAR, MKC, MMM, NKE, OI, OMC, OXY, SLB, TRV, UNP, and WHR.
With the earnings cycle winding down the focus will shift to Q4 estimates. Those estimates have declined -2.3% in the last three weeks. Sixty two S&P companies (72% of those issuing guidance) have warned on Q4 and only 24 have given positive guidance. Earnings estimates for Q4 have declined from 11.1% at the beginning of the quarter to 5.6% today. Seven of the 10 S&P sectors have seen a decrease in projected earnings growth for Q4. Those are led by the materials, industrials and technology sectors.
Facebook (FB) is quickly losing its luster after beating estimates on earnings in the prior week. FB spiked from $19.50 to $24.25 after earnings but in the last two weeks the selling has been brutal and shares closed at $19.19 on Friday. Insiders are dumping shares after the Oct 24th lockup expiration. COO Sheryl Sandberg sold shares worth $11 million. Chief accounting officer David Spillane sold $5.4 million and general counsel Theodore Ullyot sold $3.13 million. Those are just a few of the hundreds of insiders dumping shares. At the end of September Facebook had about 692 million shares in the float. That has risen to 1.3 billion with another 1.3 billion still to be released. More than 777 million new shares will be free to trade on November 14th. The odds are very good FB will see a new low in the weeks ahead. The old low was $17.55 in early September.
On a positive note for the market China announced on Saturday that it was turning the corner on the economy and would likely meet its growth target of +7.5% for the year. Zhang Ping, head of the NDRC, spoke to reporters at the 18th Party Congress at which outgoing president Hu Jintao said China should double its 2010 GDP and per capita income by 2020. That would be a huge jump and dramatically position China as a leading economic force. Data out on Saturday showed the trade surplus rose to a 45 month high for October and export growth rose to a five-month high above 11%. If China has really turned the corner on their decline then the outlook for the world economy for 2013 just got better.
While a multiyear high in Consumer Sentiment suggests retailers are in for a strong Q4 the same might not be said for the markets. There are serious worries that a bigger decline could be just ahead. The chart below shows a long term trend line that supported the underlying symbol for a long period before that trend was broken. The rebound back to that uptrend support was unable to break back above it.
The technicians claim the failure at what is now uptrend resistance gives more validity to the second formation now appearing. That is a long term head and shoulders. A long term pattern is typically move reliable than a short term pattern.
My question for you before we go to the next chart is, "Would you buy this chart?"
I did not show the labels on the initial charts because I wanted everyone to look at them objectively. If I showed everyone a chart of Apple you would already have a preconceived bias on Apple shares. Admit it, we are all human and we have a bias on almost everything.
The chart in question is the NYSE Composite. The NYSE is an index of more than 2,000 stocks from the smallest to the largest on the NYSE. It is normally a more accurate representation of market direction than a Dow chart and it has four times more stocks than the S&P-500.
The chart in question is the 35 year chart of the NYSE. The support points were the 1987 crash, 1991 Gulf war, post Y2K Nasdaq crash and then the financial crisis. It has been four years since the financial crisis broke through 20 years of support and yet the index has not been able to break back above that support line.
At the very least we "could" expect the NYSE to retest the neckline at 4,000. That would be a 50% drop. However, I am NOT predicting that. I am only reporting what some technicians are worried about.
NYSE 35 Year Chart - Quarterly
The market has some serious headwinds besides the fiscal cliff and the debt ceiling, which is soon to be the lead topic in the financial news. The rising capital gains tax rates have already started a further exodus from the market. We have seen cash leaving the market for the last four years in favor of bond funds and safety of fixed income investments.
The financial crisis and the flash crash have scared the boomer generation. They are retiring at the rate of 10,000 a day and they don't want any further surprises for their retirement nest egg. Bonds may be boring but they are safe. Equities have proven not to be safe over the last ten years. The Nasdaq lost 80% of its value from 2000 to 2002. It was cut in half again between 2007 and 2009.
The country has $16.4 trillion in debt and that is expected to grow to $22 trillion by 2020. There are major changes coming for America and the recent political campaign highlighted the potential for financial disaster in the years ahead.
Put all those factors together with the potential for capital gains and dividend tax rates rising in January and you have a recipe for a declining market. Boomers will take cash out of the market by the truckload unless the tax issue is resolved almost immediately and you and I both know that is not going to happen.
On the slightly longer term companies are still beating earnings estimates. China claims it has turned the corner and there was an article out this weekend claiming a positive turn for Europe by the first quarter. Personally I will believe it when I see it but it is possible. I do believe the fiscal cliff will turn into the fiscal slope and the damage will not be as dramatic as some expect. There will still be damage just from going through the fiscal cliff and debt ceiling exercises. We will probably see the U.S. hit with additional debt rating downgrades. In fact we can count on it.
That means we have some additional volatility ahead but there is light at the end of the tunnel. Once we move past the year end and Q1 legislative challenges we could see a real recovery begin. Uncertainty will have passed and companies will begin to loosen the purse strings. Consumers will also be relieved to have the headlines behind us instead of staring at financial Armageddon every time they turn on the news.
The S&P closed one point below the 200 day average at 1381 on Friday. The 200-day on the S&P is fairly reliable as a directional indicator. If the market continues lower next week then odds are good we can expect a correction phase with a retest of 1265. The overriding problem will be the capital gains tax hike chasing investors out of the market. More than a third of U.S. stocks are owned by individuals making more than $200,000 a year. Higher taxes will force them to sell some of their holdings.
Since corrections normally overshoot, the lack of any positive news on the tax problem could overpower support at 1265 and send us even lower. Eventually some compromise will be reached and there will be a buying opportunity. Where or actually when that opportunity appears is unknown. I doubt it will be in the next couple of weeks. We will have a lot of bluster and positioning by lawmakers before anything concrete gets done. Meanwhile the markets could continue lower.
The debt ceiling is currently $16.4 trillion. That will have to be extended soon or the U.S. would be forced to default on its debts. Since Congress and the President are not going to let that happen there will be another compromise but you can bet it will involve another headline war in the news. Eventually there will be a stop gap change in the limit and they will kick the can deep into 2013 on the hopes of getting some kind of agreement before it comes around again.
Even though we know there will be a compromise and the U.S. will not default the daily headlines will pressure the market just like in July/August 2011 when the S&P lost -350 points. I don't expect that kind of reaction this time because of the mandate from the election. There will be a compromise sooner rather than later.
S&P-500 Chart - Daily
The Dow is not reactive to the moving averages because the index is so thin with only 30 stocks. The Dow tends to be more reactive to support and resistance levels and the break below 13,000 was critical. That suggests the next target is 12,500 or even 12,000. Once these sell offs begin to gain momentum they tend to take on a life of their own. Boeing and Caterpillar gained a combined $3.50 on Friday but were offset by a -$3 loss in Disney. The rest of the Dow stocks only posted fractional changes.
Dow Chart - Daily
The Nasdaq was crushed for a -2.6% decline for the week thanks to a -$30 decline in Apple. The tech giant fell to a six month low at $533 on Friday before rebounding to close at $547. Analysts are claiming this is a buying opportunity given the blowout quarter Apple is expected to have in Q4.
Google gained nearly $11 after touching $650 intraday. That is roughly a -$110 decline since the October 17th print at $759.
I view both of those gains on Friday as short covering after a very ugly week for both Apple and Google. With big profits for the shorts there was a lot of risk carrying those trades over the weekend.
I believe the Nasdaq gravitated to 2900 as a round number support point but I don't give it any specific validity. I suspect we will see 2800 in the weeks ahead.
Nasdaq Chart - Daily
I don't see any material reason for the markets to move higher and quite a few reasons for them to move lower. The historical range for market movement between a presidential election and year end is +7.8% to -9.6%. That is a huge range and represents the reaction to the new set of post election political parameters. That is in normal years. This year we have the fiscal cliff and debt ceiling to complicate the issue so the range could be even greater.
Should a miracle occur and these problems be resolved I think the market would rocket higher. However, I have a greater chance of seeing Santa Claus come down my chimney than a quick and painless resolution to these political problems.
I want to thank everyone for their patience over the last three weeks while Keene and Thomas wrote for me. My wife and I moved after nearly 15 years in the same home and to a house half the size. We both turned 65 this year and this was the mandatory downsizing event for boomers. I kept telling my wife if we did not downsize soon it would be our kids making the decisions instead of us. It was traumatic but also cathartic. They say two moves is as good as a fire for forcibly detaching you from your possessions. About half way through the process I was almost hoping for a fire.
Definitely, enter passively and exit aggressively over the next few weeks!
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"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the worldâ€™s greatest civilizations has been 200 years."
Alexis de Toqueville