The long awaited headline war has begun with opposing sides in Washington digging in for a major battle.

Market Statistics

September has gotten off to a great start after multiple headline events failed to play out as expected and quickly faded into the market's rear view mirror. Syria went from imminent crisis to something the U.N. will worry about. The ominous threat of a Larry Summers nomination as Fed Chairman disappeared last Monday. The FOMC taper threat evaporated on Wednesday as a very dovish Ben Bernanke reiterated the "data dependence" of any future taper and the data did not support it at this time. QE taper estimates catapulted to December or even into January. The market celebrated the disappearance of each event and new highs were set on all the indexes.

The day after the FOMC decision the long awaited Washington headlines began to heat up. The battle over the debt ceiling, budget and Obamacare took center stage and it appears next week will be an all out war.

Investors began to take advantage of the early week rally to take profits ahead of what some analysts were saying could be the biggest decline of the year. The term "government shutdown" was being used as a threat by both sides and the hostility was growing. Filibusters were threatened and leaders were promising not to negotiate and have their principles held hostage by the impending budget deadline.

The Dow declined -185 points, Nasdaq -14 and S&P -12. On the Dow that completely erased the post FOMC spike but the Nasdaq and S&P retained some of their gains.

There were several other events also weighing on the indexes so it was not just Washington worries. This was a quadruple witching options expiration Friday. That means stock and index options, futures and single stock futures all expire on the same day at the end of every quarter. Options expiration always provides an extra dose of volume and volatility. In a quarter where the markets have been moving sharply higher the expiration pressures are normally to the downside.

Also on Friday was the quarterly rebalance of the S&P. At the end of each quarter the S&P assigns new weightings to each of the S&P stocks. For instance Apple has been buying back a significant amount of its stock so its weighting went down. It was the same with Disney and others. Funds indexed to the S&P had to sell those stocks and dozens of others to bring their weightings back inline. On the flipside Google and GM saw their weightings increased so fund managers had to buy more shares of those stocks and the dozens of others that had share increases. This creates a lot of volume at the close. With some $1.75 trillion in funds indexed to the S&P that is a lot of share shuffling.

This Friday we had another index change that increased volatility. The Dow Industrials saw Hewlett Packard (HPQ), Bank of America (BAC) and Alcoa (AA) kicked out at the close to be replaced by Goldman Sachs (GS), Visa (V) and Nike (NKE). Funds indexed to the Dow had to exit the old members and buy new positions in the additions. With Goldman and Visa having relatively high market caps and prices their addition caused a ripple in the weightings of the other Dow stocks. However, with only about $60 billion in funds indexed to the Dow it was a much smaller shuffle than the S&P.

At the close there was $4 billion in stock for sale on the NYSE and $4 billion for stock to buy as funds restructured their portfolios.

The total volume on Friday was 8.85 billion shares and the most since June 28th when 9.7 billion shares traded. That was the last Friday in June and the date of the rebalance for all the Russell indexes covering about 5,000 stocks. Russell claims that more than 72% of all index funds are indexed to Russell indexes. They track $4.1 trillion in assets so a reshuffle of the Russell creates a monster volume day.

We needed some headlines to move the market on Friday because there were no economics of note. The regional and state employment for August was mostly unchanged and investor interest was zero. Employment increased in 29 states and declined in 20 states plus DC. Montana was unchanged. Unemployment rose in 18 states plus DC, 17 reported a decline and 15 were unchanged. Nevada had 9.5% unemployment, Illinois 9.2% as the two highest and North Dakota had the lowest at 3.5%.

The economic calendar for next week has a lot of reports but the headlines driving the market will be coming out of Washington.

The Richmond Manufacturing and Kansas Manufacturing will be important with the GDP revision also likely to attract a lot of attention. The Q2 GDP is expected to be revised slightly lower at +2.5% but there are whisper numbers well under 2.0%.

The German Elections on Sunday could be a major challenge if Angela Merkel were to lose and she is currently in a dead heat statistically. Her opponent Peer Steinbrueck is anti-euro and he has been rapidly gaining in the polls as the election nears. A shakeup in Germany would mean a serious disruption to the Eurozone.

The deadline for a U.S. budget deal is September 30th with the new budget beginning on Oct 1st. According to the Treasury they will not be able to fund the government past about Oct 9th. They have been running under "special rules" for more than a month and prioritizing what they pay and what they can put on hold.

We know the headline and sound bite war will continue to heat up until the last minute and then something will be done. Defining the last minute will be the key. Since Treasury has said they can operate until the 9th the actual Sept 30th deadline may be missed and that will escalate the negative headlines significantly because every news reporter in America will seize on those headlines as the news story of the day.

Late in the afternoon on Friday Blackberry (BBRY) preannounced earnings a week earlier than expected and the term earnings was a misnomer. Blackberry said they would lose 47 to 51 cents ex-items on revenue of $1.6 billion. The consensus estimate was for a loss of 17 cents on revenue of $3.1 billion. Cash on hand fell from $3.1 billion to $2.6 billion. They announced they were cutting 40% of their workforce or 4,500 workers and writing down inventory by $950 million because of a large number of unsold Z10 touch screen devices. Apparently diehard Blackberry users want the keyboard not a touch screen. The company sold 5.9 million phones and 3.7 million were the older Blackberry 7 devices. They have taken inventory write downs in prior quarters of $485 million for Q4-2011, $267 million Q1-2012 and $335 million in Q2-2012.

Analysts believe the patent portfolio and the enterprise business is worth about $6 per share. The handset business has a negative valuation. The cash is worth about $8 per share but in any wind down, split up, etc, there would be additional costs to deplete that cash hoard.

Blackberry hired accounting firm PriceWaterhouseCoopers to evaluate the company for potential buyers. Previously they hired Perella Weinberg Partners and JP Morgan to help explore options for selling all or part of the company. Apparently they are having trouble finding buyers.

Blackberry shares fell -17% on the unexpected earnings news.

Darden Restaurants (DRI) shares fell -7% after the company said profits fell -37%. Earnings declined from 85 cents to 53 cents compared to expectations for 70 cents. Revenue fell -6.1% to $2.16 billion compared to estimates of $2.2 billion. Overall costs rose +9.6% thanks to a +9.9% spike in labor costs. The CEO blamed the weak earnings on the "slow and uneven economic recovery" and consumers remaining cautious on their spending. They plan to cut costs by $50 million through workplace reductions and spending cuts. Despite the lousy earnings the company affirmed the earlier forecast for full-year EPS to decline 3% to 5%, which would be an improvement from Q2 results.

Zillow (Z) had coverage initiated by CRT Capital at "fair value" or the same thing as hold. This followed an initiation by RBC Capital last week at hold. Citron Research posted bearish comments about Zillow's business model on Friday. Citron is a short seller so you would expect them to be bearish. The combination of events knocked Zillow shares for a -6% loss.

Apple (AAPL) lost $5 on the first day of sales for the iPhone 5. There were long lines at all of the Apple stores but not because of unusual demand. Apple did not allow online presales for the iPhone 5s unlike all the past models but the 5C model was available online. That means if you wanted an iPhone you had to stand in line. The gold colored iPhones were immediately sold out in several locations. At one store in California customer #37 got the last gold phone so you have to wonder how many of each model Apple actually had for sale. Customer #50 in New York was told they were sold out. The phones were going for $1,000 on Ebay from those people who actually stood in line for days to be assured of getting a phone. Verizon said orders for gold phones would not ship until Nov 4th.

Analysts were confused about the lack of presales and assumed Apple wanted to create the "hard to get" buzz as a way to hype the phones. Another theory making the rounds had a very low quality control acceptance rate on the fingerprint scanner that was limiting the amount of inventory Apple had available to sell.

With the quarter ending in ten days we should get some iPhone 5 details with Apple's Q3 earnings on Oct 22nd. The iPhone is still in demand despite its declining popularity. Android phones now equate to 77% of smartphones sold in the first six months of 2013. Samsung alone sold more than twice the 31.9 million iPhones Apple sold in the first six month of the year. Apple is expected to ship 35 million units in Q3 and rise to 55 million in Q4. Apple CEO Tim Cook said he did not care how many phones anyone sold because Apple was going to concentrate on the high end market and there were enough buyers to give Apple a really good business. The iPhone will be sold by 270 carriers by the end of 2013.

Some IPOs were hot on Friday as companies took advantage of the new market highs to generate enthusiasm for their offerings. Rocket Fuel (FUEL), a digital advertising company, saw its shares soar +94% from the $29 offer price to close at $56.10. The company helps website owners place ads on their websites. The company's revenue rose from $16.5 million in 2012 to $106.6 million in 2012. The company offered four-million shares and volume was 5.6 million so there was a lot of trading in progress. Shares found a floor at $55 so somebody was supporting the stock.

Security company FireEye (FEYE) rose +80% to $35.29 after a $20 offering price. They sold 15.2 million shares and the expected price range was $15-$17. The company provides cyber security to help companies thwart malware and cyber-attacks. Revenue doubled to $61.6 million in the first half of 2013 BUT they still lost -$67.2 million, up from $14.3 million in the year ago period. That makes the IPO suspect when the company can lose more than it made in revenue and still rise +80% on the IPO. Shares were diving at the close.

Not all the IPOs were positive. BIND Therapeutics (BIND) fell -6% to close at $14.09 after raising $70.5 million in the offering. BIND priced 4.7 million shares at $15 and in the middle of the expected range. The company has no products on the market but they have a lung cancer and prostate cancer drug in mid-stage development.

Another poor performance was ClubCorp (MYCC), which priced 18 million shares at $14 and below the expected range of $16-$18. An existing shareholder sold 4.8 million shares so that does not bode well for the company outlook. The stockholder would have held their shares if they thought the price was going higher. The stock closed at $14.50 and that appears to be where the market maker was providing first day support. The company operates 152 golf and country, business, sports and alumni clubs.

On Friday North Korea fired on and boarded a Russian fishing boat in the Sea of Japan. The captain of the Russian ship Altay reported the North Korean navy did not attempt to contact the Altay before shooting in the path of the vessel and forcing it to stop. It was then boarded, searched and the captain questioned extensively before being allowed to proceed. Apparently North Korea is willing to pick a fight with anybody to generate headlines. Where is Dennis Rodman when you need him?

On Saturday Muslim extremists attacked the upscale Westgate shopping center in Nairobi Kenya killing 39 people including children and taking hostages. Any hostage that could recite a Muslim prayer was freed. The Shabaad terror group is linked to Al Qaeda and claimed responsibility for the attack.

Mortgage delinquencies hit a new record high in Spain and the builder default rate hit 29%. We have not heard a lot about the continuing crisis in Spain, Italy, Greece and Portugal because nobody wants to rock the boat ahead of the German elections. Once (if) Merkel is reelected the headlines will start up again and all the PIIGS nations will begin heading for the bailout trough again. The eurozone financial crisis has not gone away, only gone quiet.

On Friday the House passed a spending bill that would continue funding the government at the annual rate of $986.3 billion but stripped funding for Obamacare. The vote was 230 to 189. The bill goes to the Senate where Harry Reid has said it would be dead on arrival. Several republican Senators led by Ted Cruz and Utah senator Mike Lee have vowed to filibuster to force a vote. It is highly doubtful they will be successful in passing the measure and President Obama has already said he would veto it. The Obamacare funding will be added back into the bill and sent back to the House where it will be amended again.

Meanwhile the House is working on a proposal to raise the debt ceiling but require spending cuts and defunding Obamacare. The bill would remove the spending limit until 12/31/14 rather than establish a hard ceiling. This may pass the House but it has no chance in the Senate.

The multiple defunding efforts are an attempt to get every Senator and Representative to make several recorded votes showing their position on Obamacare. When the law is implemented and generates wrath from the public once they really find out what is in it the republicans will be able to point to the repeated democratic votes and focus the public ire on those candidates in the 2014 and 2016 elections.

The last "risk" of a government shutdown in August 2011 caused a significant market decline over a three week period. However, in the prior government shutdowns the market impact was minimal. The government was shut down for five days in November 1995 and 20 days in Dec-Jan 1995-1996 when Clinton and Gingrich could not agree on spending. Of course that was before the Internet investing revolution started in the late 90s and CNN was the only major 24 hour news station. Shutdown headlines today will be seen by an entirely new generation of investors that seem to scare easily.

Bernanke said in his press conference the potential for a budget disaster in Washington was a factor in the Fed keeping QE at the present rate. If Bernanke is worried the market should be worried.

He also said the declining labor force participation rate was a factor in the decision. Unemployment is falling but only because the LFPR is falling. People are dropping out of the workforce faster than new jobs are being created. I am glad Bernanke and Bullard both mentioned it because it is a growing problem.

The real reason the FOMC did not taper QE is because they have lost control. Economic growth is slowing. The yield on the ten-year almost hit 3% just on the taper talk. Rising interest rates will slow the economy even more and further choke the recovery. The jolt to the housing market over the last three months is a clear example of rate fears. Just the threat of a taper has slowed the growth. What would happen if the Fed actually ended QE? The Fed can't taper until the economy is accelerating regardless of their taper talk.

The Congressional Budget Office (CBO) warned last week the U.S. debt is on an "unsustainable" course and would reach 100% of GDP in the years to come. The CBO said if the current sequester spending cuts were removed the debt to GDP would rise to 190% of GDP. Most analysts believe the projections by the CBO are vastly understated. The debt is currently $16.7 trillion and 73% of GDP and will rise another $685 billion in 2013. Removing the sequester cuts is a major goal of the democrats in the current budget battle.

The national debt is triple what it was in 1996 but the interest payments on that debt are roughly the same thanks to the Fed's QE program. I am sure it is not lost on the Fed that halting QE and watching interest rates eventually return to a normal range could actually push the government towards disaster. The government currently pays an average of 2.75% for all its debt. That came to $454 billion in 2012. If rates were to return to "normal" the debt service would almost double to roughly $800 billion a year or nearly ONE-THIRD of the government's $2.7 trillion income. Since the government does not actually pay on the debt and simply adds the interest payments to the debt each year we are on track to owe $25 trillion by 2022 and the debt service will be $1.125 trillion a year at normal rates. Investors need to understand this fact of life when they see the budget battle headlines out of Washington.

Hundreds of companies are announcing major layoffs, revision to part time employment and kicking millions of workers off company healthcare plans. Instead of every family saving $2500 as Obama claimed when he was promoting the plan the cost of insurance has risen an average of 24% per year over the last three years as insurance companies prepare for the influx of previously uninsurable customers.

Walgreens (WAG) joined hundreds of other major companies last week in moving 160,000 employees from the corporate plan to a health exchange under Obamacare. Because of the rise in premiums the majority of employees are now going to be forced to choose an exchange plan that covers less. Basically they will be paying the same amount or more for less coverage. They will have more choices under the Aon Hewitt exchange since Walgreens only offered two plans from Wellpoint and UnitedHealth. What we are seeing is the end of corporate healthcare and the beginning of government healthcare and another social program that will escalate deficits forever.

Target announced this weekend they will hire 18,000 fewer seasonal workers this holiday season. That is a 20% drop from their normal hiring. Other retailers are expected to do the same. Target said their current employees were begging to work more hours during the holiday season. I guess it is tough to pay bills and raise a family on 29 hours a week. We should get accustomed to our full time economy transitioning to a part time workforce. More than 77% of the new jobs created in 2013 have been part time jobs thanks to Obamacare planning.

Janet Yellen appears to be on the fast track for the Fed Chairman nomination. The White House contacted several democratic senators on the Senate Banking Committee last week asking them to "talk up" Yellen so the confirmation process would go smoothly. This suggests the president has decided to go with the safe choice and avoid another political fiasco. Since she was his plan B choice for the position Obama probably feels the need to generate some positive chatter for her ahead of the nomination. She cancelled an Oct 1st speech at the Economic Club of New York in anticipation of the nomination. Yellen is seen as the most dovish of the Fed officials.

Bank of America Merrill Lynch reported the largest weekly inflow of money into stock funds ever. BAML said inflows for the week ended Sept 19th were $26 billion. Of that amount $18 billion went into U.S. equity funds and $5 billion into global equities. More than $24 billion went into ETFs - SPY, IWM, GDX and the emerging market EEM ETF. Note to investors, peak inflows tend to occur at market peaks.

Source BAML, EPFR Global, Lipper FMI, Business Insider


Besides all the index shuffling and expiration pressures the markets got an unexpected push lower from a Fed member. After the super dovish performance by Bernanke on Wednesday that pushed expectations for QE tapering out to December or even January you would have thought the Fed heads would be on the same page.

St Louis Fed President, James Bullard, a voting member of the FOMC, said on Friday the Fed could begin tapering in October. That was a shock to the markets after they thought the all clear signal had been sounded. Bullard said the FOMC vote was a "close decision" and stronger data before the Oct 29th meeting could make officials "comfortable with a small taper in October." He said the lack of a regularly scheduled press conference after the October meeting was not a hindrance as some had suggested. He said the Fed could schedule one on the spot if it was needed to explain their taper decision.

Now investors are back on the alert for taper talk by Fed speakers as a clue to October. What they should be looking at is the economic data. Bernanke stressed that on Wednesday and Bullard also stressed it in a speech on Friday. Ignore the talk and watch the economic reports.

The consensus estimate for a taper announcement is now December but that could change on a daily basis depending on the economics and Fedspeak. The return of Fedspeak on QE is going to weigh on the markets depending on how many people gravitate to a microphone in the near future.

The market is maximum overbought according to the McCellan Oscillator. This is the highest level in 2013 and only the fifth time at this level since early 2009. The last peak was July 2012. Look it up on a Dow chart for a -450 point drop. Overbought peaks in the oscillator are not always followed by a major market crash but they do indicate short term tops.

So far the S&P-500 has posted the best gains for the first nine-months of the year since 1997. It is the 8th best start since 1957. Of the top ten years only three times did the fourth quarter post a loss. Twice was fractional at -0.2% and -0.7% but the third time was in 1987 with a -23.2% loss in Q4. The odds appear to be in our favor but past performance is no guarantee of future results.

Scott Krisiloff was doing some research into this history and found that 1967 was the closest matching performance of the S&P in 2013. In fact it is eerie how close it has been complete with a new high in late September. Unfortunately Q4 was a loser in 1967 so let's hope the similarity ends at the September highs.

Source Scott Krisiloff

The S&P rallied post FOMC to 1729 and change on Wednesday and Thursday. Friday only managed a high of 1725. The highs correspond with long term resistance at 1730 and Friday's close of 1709.91 was right at the prior resistance high of 1709.67, which should now be support.

The market is overbought despite the decline on Friday. I view Friday's decline as related to index shuffles and option expiration rather than some change in market trend. It may be a change in trend but we don't have any evidence to back it up today.

Typically the market declines in the weeks that follow a post Fed bounce of more than 1% according to the Stock Trader's Almanac and a study of the FOMC meetings since 2008. Again, past performance is no guarantee of future results.

Even if the S&P were to decline to next level support at 1685 it would not be a big deal. However, with the battles in Washington and what is expected to be a lackluster Q3 earnings season it could set the stage for a bigger decline. A break below 1685 would be a major directional signal.

Earnings for Q3 are currently estimated at +3% and declining daily with revenue flat to down. That is not much to excite investors but it has been pretty much the same for earnings all year.

Resistance is 1730 and support 1700, 1685.

Some of the Dow weakness on Friday was the decline in Dow rejects BAC, AA, HPQ but their fractional losses were insignificant compared big declines in BA, CAT, IBM and UTX. The new stocks added to the Dow will begin this new stage of their life at the open on Monday. There are probably a few index funds that did not complete their buys at the close on Friday and I would expect those three stocks to see some residual buying on Monday. However, traders who bought those stocks ahead of the inclusion in hopes of getting a bounce will be dumping them on Monday now that the event is over.

The Dow was the biggest decliner of the major averages on Friday and sank well below the weekly high at 15,709. The Dow closed at 15,451 and below the 15,485 level where the Fed statement was released. Support should be 15,400 and 15,300 then a long drop to 14,800. Resistance is 15,550 and the new high at 15,709.

As you can see by the chart the Dow was extremely overbought after two weeks of vertical ascent. I would expect we will see further weakness in the days ahead.

The Nasdaq barely declined after setting a new 13 year high at 3798 on Thursday. That makes round number resistance at 3800 even stronger. The Nasdaq is showing amazing strength despite the weakness in Apple. That is due to a very strong run in stocks like AMZN, TSLA, NFLX, PCLN and the biotechs. If Apple ever catches fire it could be an even stronger move higher.

However, fund managers may be ready to bail out on some of those high flyers as we near their fiscal year end on October 31st. Selling a few of those high dollar monsters would offset a lot of losses from the stocks that did not pan out.

I view real support at 3700 and 3600 with resistance at 3800.

The Russell 2000 spiked to a new historic high on Wednesday at 1080 and then moved sideways for two days with only a -2 point drop on Friday. Think about that. The Dow lost -185 and the small caps lost -2. There is no other adjective to describe that other than bullish. All good things eventually come to an end and surely the Russell will be susceptible to some fund manager profit taking in October but there are no signs of that yet.

Support is 1050 and resistance 1080.

I see next week as lacking any positive catalysts but the potential for negative news is very strong. Washington will be the source of plenty of market killing headlines. Also, we are only two weeks away from the start of Q3 earnings so earnings warnings should be in full bloom.

I would continue to keep a watchful eye on the market because it rarely telegraphs the next big decline. Stay long until the trend changes but be prepared for the unexpected.

Enter passively and exit aggressively!

Jim Brown

Send Jim an email

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on Euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."
Sir John Templeton


Advertise for Option Investor