Hawkish Fed heads convinced some high profile analysts there could be a taper in December and Santa's sleigh hit a roadblock.
Fear of the Fed caused investors to take some profits ahead of next week's FOMC meeting. You would think a December taper was almost a done deal by the way the market reacted but it is far less than that. Reuters polled 60 economists found 32 expected the taper in March, 22 expected a January move and only 12 expected a December announcement. One month ago 37 were targeting March, 16 January and only 3 saw a move in December.
That small increase in December expectations was enough to derail the normal December rally. The markets have only closed positive three times in the month of December. That is hardly a bullish event but on the flipside the Dow is only down about -2% since the last closing high. Given the +22% gain for the year it was due for a rest ahead of year end.
For the last two days the Nasdaq has stubbornly refused to give up the 4,000 level and the S&P refuses to remain below 1,775. The Russell 2000 has battled the 1,100 level for three days and won with a close at 1,107 on Friday.
The daily declines for the last two weeks have been painful but more like a damaged cuticle than a sprained ankle. You can put a band-aid on the cuticle and continue through your day but with a sprained ankle you are constantly reminded of your lack of mobility. The December decline has been a nuisance rather than a real market drop.
However, if the Fed actually puts on the QE brakes next week the market weakness could take on an entirely new aspect. Currently the street is giving the Fed a 23% chance of a December taper. I am in the group still expecting March but anything is possible.
This is the last meeting for Bernanke with a press conference to follow. This could be his last opportunity to take credit for starting the QE unwind. However, with Yellen's confirmation vote scheduled for Wednesday or Thursday there are other considerations. Conventional wisdom has Yellen being confirmed and Bernanke immediately resigning to avoid complicating Yellen's plans for the future. Even if the Senate vote does not occur because of the floor fight on every item on the calendar I doubt Bernanke will drop a stink bomb ahead of Yellen's confirmation.
The Washington budget deal removes one more economic cloud for the Fed but it is not yet law. The Senate will take up the budget bill on Tuesday and the vote is going to be very close. There are senators on both sides of the isle that don't like the compromise and are vowing a fight. News from the senate will be considered in the FOMC deliberations on QE. If it appears it will pass that could remove some objections to a taper.
However, I still believe there are too many factors that are not yet strong enough for the "data dependent" FOMC to act. Employment has improved slightly with the three month average at +193,000 jobs but considering a lot of those jobs were temporary holiday positions the expectations are for weaker numbers in January and February. Also, the weekly jobless claims spiked unexpectedly from 300,000 to 368,000 and that was the largest jump since the week after Hurricane Sandy destroyed hundreds of businesses. That was the highest level since the 373,000 claims during the October government shutdown.
It is far too early for these claims to be the result of holiday worker terminations. Some analysts believe it was adjustment issues surrounding the Thanksgiving weekend but that is just a guess.
Also, the broader U6 unemployment rate is at 13.6% with more than two million long term unemployed workers scheduled to lose their benefits over the next three months. That is far from a bullish economic trend.
The November ISM Services report last week showed activity fell to the lowest level since June at 53.9. That is hardly an accelerating economy especially when services normally rise in Q4 as a result of holiday events.
Lastly there are some cracks beginning to form in the "accelerating economy" hypothesis. Reuters tracks earnings guidance and warnings and the guidance warnings for Q4 are the worst since they begin tracking the data. Historically they are about 2.2:1 or 2.2 negative guidance events for every company with positive guidance. For Q4 they are currently at 11.4 to 1 and still growing. This is not an encouraging sign and could influence the Fed to keep the stimulus flowing. In January the analyst consensus estimates for Q4 were for earnings growth of 18%. Currently they have been revised down to 6.4% growth. That is still decent but given all the warnings we have to take that estimate on faith rather than on hard evidence.
While I am on the earnings topic I need to make another point. Stock buybacks announced in 2013 are over $635 billion. That is the largest amount since 2006. Stock buybacks increase earnings per share since they reduce the number of shares outstanding. Analysts claim buybacks have accounted for 2.4% of the earnings growth for 2013. So far in 2013 S&P earnings growth has averaged +4.6%. That means actual earnings from increased sales has been minimal. That is hardly a bullish point for the Fed's QE deliberations.
On Friday the Producer Price Index (PPI) for November fell -0.1% for the third consecutive monthly decline. Year over year prices were up only +0.7% and the weakest pace since September 2009. There is no inflation. What we are seeing is the potential for deflation and the Fed fears that more than inflation. This is a reason to maintain stimulus even if they don't want to.
The Fed wants to end QE. When they released their balance sheet on Thursday it was $3.994 trillion as of the end of November. The December QE purchases will push it over $4 trillion and that could be a magic number for the Fed. At some point they have to stop buying treasuries simply because of the stupidity of monetizing the U.S. debt. The ratings agencies and global investors are eventually going to say enough is enough and they will force the U.S. to change course. It will be very painful if we don't take control of the situation in advance instead of waiting for global investors to force action upon us.
The Fed may want to end QE but the data is not supporting their wishes. Yellen said she was not in a hurry to end QE and wanted to see sustainable economic improvement. If the Fed sees improvement in those metrics above we are in trouble.
To summarize the Fed wants to begin tapering QE but the data does not support it. While they may be looking at it through rose colored glasses I hope there is enough clarity to make the right decision rather than the political one. If the economy is actually improving then is will still be improving in January and March and they can taper then with stronger convictions.
To be clear I am not a fan of QE but it does move the market and that is what we care about. I published this chart a couple weeks ago and I am reprinting it here just so everyone understands. Contrary to what some analysts are saying about how the market will understand the taper is for the right reasons in an improving economy, I disagree. When the taper occurs it will be negative for the market. Since 2009 the only time the market really went down was when QE programs had ended. After the spike in 2013 on the latest version of QE I don't see how anyone can conclude there will not be a market impact when it ends. However, it won't end on day 1. It could take all year of progressively lower steps in treasury purchases. This is the wild card. We don't know how the market will react to $75 billion in purchases instead of $85 billion and then $65 instead of $75, etc. Just be prepared for some volatility around each announcement.
In 2013 the Fed purchased 70% of all new treasuries that were issued. Since the recession the Fed has printed/created over $3 trillion in new money, the equivalent of 20% of GDP, and spent it all on treasuries and mortgage backed securities. When the music stops the equity party is over.
The red line is the S&P and the blue line is the total purchases by the Fed.
The economic calendar for next week is a hodgepodge of reports. Obviously the FOMC announcement and Bernanke press conference on Wednesday will be the key events. Following that in order of importance will be the Philly Fed Manufacturing, Kansas Fed Manufacturing and the three housing sector reports. New home sales, existing home sales and the Housing Market Index.
The final revision of the Q3 GDP on Friday is not a critical event. It will probably be revised slightly lower. The next GDP report will be for Q4 and estimates are running from 0.7% to 1.4% growth and significantly lower than Q3.
The German ZEW economic sentiment number on Tuesday could be a market mover. It came in at 54.6 for November and the highest level since October 2009. We want that number to continue climbing.
The Eurozone manufacturing PMI on Monday is also key. The number came in at 51.6 for November and the fifth consecutive month of gains as Europe pulls out of recession. That is the fastest pace of growth since June 2011. Most of that positive input came from growth in Germany.
I don't want to spend the entire commentary on the FOMC but there was another event last week. President Obama is going to nominate Stanley Fischer as Vice Chairman to fill the seat vacated by Yellen. He is somewhat of a rock star in the financial community. He was the head of the Bank of Israel during the global recession. He also worked at the IMF and the World Bank. He is a close associate with Mario Draghi of the ECB and Bernanke once called him a "role model." As one analyst put it, "He may be the only person every nominated to the Federal Reserve that was over qualified." He is very well known in financial circles all over the world.
Some have called Fischer a hawk but he did oversee the recent QE program at the Bank of Israel. He and Yellen have generally the same view over the use of QE. Where he differs from Yellen is in forward guidance. You may remember that Bernanke was a fan of forward guidance and transparency at the Fed. That guidance and transparency has gotten him into trouble more than once. Yellen is a big fan of guidance but Fischer is not.
He said recently, "If you give too much forward guidance you take away flexibility." Also, "We don't know what we will be doing a year from now, it is a mistake to try and get too precise." Fischer's views may have to take a backseat since the Fed will depend a lot on forward guidance to convince investors that tapering is not tightening. Yellen is expected to guide explicitly for low interest rates for a long time to try and convince investors not to panic when QE begins to shrink. She will try to convince investors that reducing QE from $85 to $75 billion is still stimulus. It is and in any other reality $75 billion in QE would be very agreeable to the market. It is just that by starting to taper it will prove to investors that QE is not permanent and the removal has begun. It may take the Fed a year to remove it all so we can expect some volatile moments throughout 2014.
I think Fischer is an outstanding pick for the vice chairman position. It gives the Fed international credibility and removes some of the stigma attached to Yellen. She may be a great economist and she is married to a Nobel Prize winning economist but she is barely over five feet tall and nearly 70. She appears timid on the surface and more like a grandma than the leader of the Federal Reserve. She does have impeccable credentials and has more time in a Fed chair than any other Fed official. She started out as a Fed governor in 1994. She taught economics at Harvard in 1981 and Larry Summers was one of her students. She has the best track record for economic forecasting of anyone at the Fed. The combination of Yellen and Fischer is going to carry a lot of weight in the global markets.
In stock news Cisco (CSCO) took advantage of its analyst day and cut sales forecasts for "the next several years" from 5%-7% growth to 3%-6% per year. Profits are still expected to grow at 5% to 7% per year. CEO John Chambers said Cisco was going to use an architectural approach to beat back challenges from the so-called white box networking equipment. He also said the services business would grow to offset the slump in the core routing and switching business. He did pledge to pay out half Cisco's free cash flow every year in the form of dividends and share repurchases. Analysts applauded the more "realistic and somber tone" of the guidance but were evenly split on whether Cisco was going higher or lower.
Cisco is suffering the same fate as IBM in that the NSA spying scandal has forced many companies and governments in Asia and abroad to rethink their purchases from American companies. It is one thing to have somebody hack into your network to spy on you but it is now widely believed that American hardware comes complete with a backdoor for the NSA to access at will. Countries like China that don't want America to eavesdrop on their private conversations are balking at buying American technology.
Lastly, Cisco and others are suffering from the clone wars. Manufactrers in Asia where there is no intellectual property protection are pumping out clones of nearly every piece of technology produced by the leading edge companies. They can copy a router or switch just as fast as a Nike shoe or a Rolex watch.
Cisco did say they were going to spend $4 billion and hire 1,700 people in Canada. The Ontario operations would staff up to around 5,000 workers. Chambers has been plugging Canada for several years saying the U.S. could learn something from them. The corporate tax rate is 15% and profits made overseas are not taxed when they come back home. Cisco has terminated more than 10,000 in the U.S. since 2011.
Ford (F) said it intends to hire 11,000 workers for 2014 to handle the launch of 23 new models. The company is also opening three new manufacturing facilities, two in Asia Pacific and one in South America. The company will hire 5,000 workers in the U.S. and 6,000 in Asia. More than 80% of the U.S. workers will be in white collar positions. Ford plans to launch 16 vehicles in the USA. Ford shares have been stuck in a rut around $17 for the last four months.
Anadarko Petroleum (APC) got a nasty surprise from a judge handling a 2009 case resulting from the bankruptcy of Tronox. That was a spinoff from Kerr McGee in 2006. Kerr-McGee spun off the specialty chemicals maker in 2005. Along with the Tronox assets was a legacy problem of some manufacturing site pollution. In 2006 Anadarko bought the energy assets of Kerr-McGee. Tronox filed bankruptcy in 2009 claiming Kerr-McGee had knowingly packaged all of its environmental problems in the Tronox spinoff in an effort to escape the future cleanup expenses. Tronox ended up with cleanup costs for properties that closed decades ago under different owners.
Tronox sued Kerr-McGee and Anadarko saying the spinoff was cleverly packaged to unload all the problem assets to Kerr-McGee could then sell what was left of the company to Anadarko without any environmental problems. Tronox said Anadarko should be liable for buying assets that were fraudulently transferred by Kerr-McGee. Anadarko defended itself and was confident the acquisition had followed all the rules. In bankruptcy if assets were fraudulently transferred prior to the filing they can be recovered or levied against by the court.
The judge ruled that Kerr-McGee fraudulently packaged the good assets and bad assets and set Tronox up to fail. The judge is giving all parties the opportunity to submit damage claims and rebuttals to those claims in a prelude to establishing a dollar amount of liability by Anadarko. The judge said the award could be between $5 and $14 billion dollars. Anadarko had been so confident of their position they had not posted any reserves for the case. The company said it "vehemently" disagrees with the verdict and would pursue "every avenue available to us through the appellate process to protect the interests of our stakeholders, once a final judgment has been rendered." The appeals process could take up to ten years. Tronox said 88% of the proceeds would go into trusts to help remediate the legacy sites and 12% would go to compensate those injured "as a result of Kerr-McGee's environmental failures." APC shares declined -6% on the news.
Late Friday afternoon the Wall Street Journal released a story claiming Sprint (S) was preparing to make an offer for T-Mobile (TMUS). The story said Sprint had not made a decision and was mulling over the regulatory implications. Not only would the deal have regulatory problems but Dish Networks could also step in with a bid. They have frequently been mentioned as a possible suitor because of their desire to get into the wireless business.
Sprint is 80% owned by Japan's Softbank and T-Mobile is majority owned by Deutsche Telekom. The unnamed source said Sprint believes it cannot compete effectively against Verizon and AT&T and the acquisition of T-Mobile would provide a competitive scale. Sprint is the number 3 carrier and T-Mobile is number 4. Shares of both companies spiked on the news.
There are conflicting signals coming out of Europe and Asia on the strength of the recovery. One month the indicators are up and the next month they are flat. One thing for sure the Baltic Dry Shipping Index (BDI) is suggesting a dramatic increase in shipping rates for dry commodities. Since these rates are quoted every day based on actual rates in the industry this would appear to mean there is an uptick in actual commodity demand.
The BDI closed at a three year high on Friday. There are so many conflicting signals in the normal economic reports it is nice to have something that is relatively accurate.
However, the Baltic Index is for dry goods like iron ore, coal, grain, coffee beans, etc. Since coal shipments to China, India and Japan are increasing significantly this could be a factor in the sharp rise in the shipping rates. This does not mean that the global economy is rebounding because increased demand for dry commodities is only a small portion of the commodity picture.
However, another indicator of global demand is copper and copper prices are still stuck in the low range of $3.20-$3.40 where they have been over the last six months. There has been no material rebound that would suggest manufacturing activity has increased significantly. A breakout over $3.40 would be a key indicator of increasing demand.
The Goldman Sachs Commodity Index ($GCSI) is also lackluster and suggesting demand has not yet increased. The index has been in decline since 2011 and a drop below 600 would suggest we are entering a new period of global weakness.
The Reuters/Jefferies CRB Index ($CRB) is also showing a lack of economic rebound. The index is only slightly above its three-year low set in June 2012.
The $GCSI and the $CRB have more components than just dry commodities so they don't track well with the Baltic Dry Index. For instance the CRB has these 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.
The decline in gold and silver alone would have been enough to push these indexes lower. However, even accounting for the decline in the precious metals I think it is troubling that both the indexes are not showing a rebound in global demand.
Be careful with what you hear in the press about a global recovery. It may have started but it is far from significant. It could be several more years before it advances beyond crawl speed.
So why do all the U.S. analysts believe the economy is accelerating? There was an interesting article by Comstock Partners this weekend titled, "Been Down So Long, It Looks Like Up To Me." That has also been the title of a book, song and movie in years past but today we are focused on economics. The article basically says that economics have been so lackluster for so long that any minor blip in a number is heralded as a major change in direction. The article talks about the +203,000 new nonfarm jobs last month. Analysts and the market seemed to think it was a breakout that would force the Fed to taper. However, if that level of employment lasted a full 12 months it would only create 2.436 million jobs or +1.78% of the total employed population. Compared to prior recessions this is hardly a recovery. The National Bureau of Economic Research (NBER) looked at past business cycles and found that we averaged an increase of +2.94% at this stage in the cycle. This amounts to a monthly average of +335,000 jobs. Using this comparison for where we should be the +203,000 jobs is rather anemic. This same analysis can be carried forward to the other economic indicators with the same result. The U.S. economy is hardly accelerating and with inflation falling we could be headed for a new challenge.
David Rosenberg, chief economist at Gluskin Sheff & Associates believes differently. He believes the underappreciated economy is going to surprise to the upside in 2014. He cites a number of economic points in this weekend's article. Read it here He claims the ISM numbers are consistent with +3.5% GDP growth. He expects job gains over 300,000 in at least one month in 2014. He admits to being ridiculed at a high profile blue-chip dinner last week when he stated his forecast. He cites the rapid increase in auto sales as an offset to the weak holiday shopping saying what is more important to economic growth a car or a cardigan? All I can say is I hope David is right and everyone else is wrong.
Quite a few people are expecting a sharp increase in volatility in the coming months. There are numerous reasons that I won't go into here but many of these people are very confident in their beliefs. For instance an investor bought 40,000 April 22 calls on the VIX for $1.28 each. That cost him a cool $5.12 million. With the VIX at 15 today it would have to rise about 50% for that trader to make any real money. The option premiums on the VIX don't behave like regular option premiums so he needs the VIX to move very close to 24. I actually think this is a good bet given the potential for the Fed to taper in March or before.
The S&P declined -29 points last week to close at 1,775. This is critical support and a breakdown here could hit 1,760 or even 1,750 very quickly. This is material because the high on Monday was 1,811 and right at the closing high for the year. This is a significant change in sentiment that was caused by more than one event. The rapidly changing outlook for the Fed was the main reason given in the press but there was another reason. This is tax selling season and multiple money managers reported very strong tax selling by individuals. Winners were being sold to capture profits to offset the losers.
Balanced funds are restructuring. If you have a fund where you have a certain percentage allocated to stocks, bonds, commodities, etc then your allocations are broken. Stocks have gone up 20% to 35% in 2013 and bonds have been flat to down. This means fund managers have to sell equities and buy bonds to bring the allocations back into line. This can be done in December or January. Personally that is scary to me since we all pretty much agree that interest rates are going a lot higher and bonds are going lower. However, many retirement and pension funds don't have the ability to time the market and are required to maintain the allocations.
Regardless of the reason stocks are being sold and the markets closed not far from their lows on Friday. We can theorize all day long as to why but why does not matter. What matters is future market direction.
According to the Stock Trader's Almanac the December quadruple witching option expiration week and the week after has the most bullish record of any expiration week. Of course this week will be dependent on the FOMC decision but historically this is a bullish week.
I would follow the charts rather than the headlines next week. We saw 1,772 as the intraday low on Thursday and Friday. That makes it our line in the sand. A breakdown below that level is a sell signal. The prior support level at 1,780 is now short term resistance and could be seen as a buy signal on a break higher.
The fly in the ointment is the expected volatility. We could trade all over the map next week with both support and resistance broken more than once. It would be very difficult to specify a hard and fast rule this weekend and then stick with it. In this case I would follow the volume. The volatility spikes tend to occur on low volume and then reverse. If we get a directional move that lasts with a sharp increase in volume then I would follow that trend.
For investors not able to follow the market intraday the safe position would be on the sidelines. I know that is not fun but preservation of capital is always preferred. Once past the FOMC decision the market should become directional again.
The Dow broke through two support levels last week to lose -265 points and close at 15,755. That was only about 35 points off the low and not an encouraging sign. We normally see markets rebound on Friday's due to short covering or crash at the close on fear of weekend darkness. Neither happened and that suggests shorts were content to hold their positions.
The 15,800 support level has now become resistance. The odds are good we will see a breakdown to 15,600 which is strong support.
The Nasdaq performed a heroic feat on Thr/Fri with a goal line stand at 4,000. The index refused to move below that level for more than a few minutes and only by a few points. Buyers showed up on every dip below that level. However, as you can see in the chart the close at 4,000.90 was far from convincing. They were barely able to recover the 4K level and avoid a hit to sentiment in the weekend newspapers.
The Nasdaq lost -61 points for the week but remains the strongest of the big cap indexes. The Nasdaq is normally the strongest index in December along with the Russell 2000. Fortunately the Nasdaq is maintaining that ranking. When analysts are asked about their picks for 2014 the vast majority are naming Nasdaq stocks.
A breakdown of the 4,000 level could target strong support at 3,895. Resistance is well above at 4,070 so there is plenty of room to run should market sentiment turn positive again.
The Russell 2000 made the same goal line stand at the 1,100 level last week and then ticked up ever so slightly into Friday's close. Real support is 1,096 but it was not tested. Of all the indexes I believe the Russell is the one to watch. A break below 1,096 could suggest a bigger market breakdown in progress.
Eventually traders are going to find a level they believe will hold regardless of the Fed outcome. The closer we get to the FOMC decision on Wednesday the more aggressive the dip buyers will become. If the Russell holds 1,100 and Nasdaq 4,000 on Monday I would expect traders to become more aggressively bullish on Tuesday. Conversely if those levels fail the Fed decision may be mute.
On the world stage the U.S. and Japan are setting up for a confrontation with China. I previously wrote about the new Air Defense Identification Zone (ADIZ) established by China over international waters and the various intrusions into that zone by U.S., Japanese and South Korean planes and vessels. On Dec 5th the U.S. guided missile cruiser the USS Cowpens was challenged by Chinese vessels. The Chinese vessels attempted to halt the cruiser in international waters. The Chinese hailed the cruiser and ordered it to stop. When it did not comply Chinese vessels sailed directly in front of the Cowpens and tried to force it to stop. The cruiser was forced to abruptly change course and take on a more aggressive posture. The encounter eased and the Chinese forces moved away.
Most military officials believe the U.S. and China could be at war by the end of the decade. Most wars begin with minor events and then escalate abruptly. We can never assume that in the age of nuclear nations that a war is unthinkable. China has decided a U.S. presence in the South China Sea is no longer acceptable. Rick Fisher, a China military affairs expert, said China is deliberately staging these confrontations to test the U.S. resolve. Fisher expects them to escalate until there is an actual confrontation where shots are fired. The Chinese leadership believes President Obama does not have the will to stand up to China and they will use his final three years as president to increase their aggression and try to push the U.S. and its allies into backing off from the East Asian theater of influence. Eventually somebody will cross a line and go too far in one of these confrontations. While I would not worry about it today I would pay attention to the future headlines. Don't be caught unaware.
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