We are back to the point in the market where bad economic news is good news for the indexes.

Weekly Statistics

Friday Statistics

It is hard to understand why the market is so afraid of a quarter-point rate hike. The payroll report came in weaker than expected and the market spiked on the idea rate hike expectations had been pushed out to the December meeting. This is not rational since the Fed is committed to a gradual rate cycle. A quarter-point hike would not have any material impact to the economy or the market but the expectations for that hike are market negative. Old habits die hard and after decades of doing the rate hike rotation, some traders are simply stuck in a rut.

The Nonfarm Payrolls posted a gain of only 151,000 jobs for August compared to expectations for 180,000. The headline number was at the bottom of the neutral range from 150,000-190,000 and borderline negative. Like Goldilocks' porridge, it was not too hot but bordered on being almost too cold.

The June headline number was revised down from 292,000 to 271,000 but the July number was revised up from 255,000 to 275,000 making the revisions a net loss of 1,000 jobs.

August is the month where most misses occur and it is the month with the largest revisions averaging an eventual gain of 61,000 jobs. If the average revision occurred, it would raise the headline number to 212,000 jobs but take two months for those revisions to be released.

The number most analysts expected to push the Fed into hiking rates was anything over 180,000. Anything over 200,000 was considered almost a sure bet for a rate hike.

As usual, there were a lot of warts on the report. Manufacturing jobs declined -14,000. Service jobs rose +175,000. The average hourly earnings rose only +0.1% and the average workweek declined from 34.4 to 34.3 hours. That decline was the equivalent of losing -225,000 full time workers. That tenth of an hour adds up when you have 151.6 million workers.

The U3 unemployment rate was unchanged for the third consecutive month at 4.9%. The broader U6 unemployment rate was also flat at 9.7%. The labor force expanded by 176,000 workers, a somewhat slower pace than the 400,000+ worker additions over the prior two months. The labor force participation rate was also unchanged at 62.8%.

The number of people employed part time because full time jobs were not available was flat at 6.1 million. Another 1.7 million workers were marginally attached to the labor force. These workers are unemployed and would work if jobs were available but had not looked for a job in the prior four weeks. Another 576,000 workers were classified as discouraged and have given up looking for work. More than 1.1 million had not looked for work because of family responsibilities or other conflicts.

Food service employment (low paying, part time jobs) rose +34,000. Social workers rose +22,000, professional and technical +20,000, financial +15,000, health care +14,000, hospitals +11,000. Mining and energy lost -11,000 jobs bringing the total since September 2014 to -223,000. Manufacturing lost -14,000.

Since 2014, the U.S. has added 523,000 food service jobs and lost -13,000 manufacturing jobs. In 2016 alone food service jobs have risen +314,000. Food service jobs (waiters and bartenders) have risen in 77 of the last 78 months. It takes 2 or 3 part time jobs to replace the income lost from one full time job so those unable to find a new full time job have to work more than one part time job to keep food on the table and gas in the tank. Employers are also reducing hours to less than 30 so they do not have to provide insurance. That forces people to get a second job.

The ISM NY crashed back into contraction, falling from 60.7 in July to 47.5 in August. This followed the national ISM Manufacturing falling from 52.6 and back into contraction at 49.4 for August.

This was the third time in four months the ISM-NY has been in contraction following seven consecutive months in expansion territory. The quantity of purchases component fell from 48.3 to 44.6 indicating slowing orders. However, the employment component rose from 45.3 to 54.9 and the six-month outlook rose from 56.8 to 65.5.

Factory orders rebounded from the -1.5% decline in June to a +1.9% rise in July. However, the year over year unfilled order rate is still negative as it has been since early 2015. Even with the gain for July, unfilled orders are still down over the same period in 2015. This is the longest period of decline since 1956 and has always indicated the economy was in recession. Unfilled orders to all manufacturers fell -0.1% to $1.13 trillion, the lowest since June 2014.

Bloomberg Chart

The calendar for next week is very skinny with only the ISM Services and Fed Beige Book as the reports important to the market. The Beige Book is the critical report but unless activity in the various Fed regions has fallen off a cliff, it will probably be ignored.

The July report was filled with words like modest, moderate, generally, etc. Consumer spending was net positive but showed signs of softening. More districts noted slowing auto sales, which we have seen in the recent reports. Commentators said the report showed the economy was moving in the right direction but at a very modest pace. If the August report is more of the same, or worse, it could weigh on the market after the sharp declines in the ISM Manufacturing and ISM - NY.

The weaker than expected jobs numbers caused a temporary short squeeze at Friday's open after many traders had positioned for a positive report that would have pushed the Fed to hike rates in September. When the expectations suddenly changed, they were forced to cover those shorts and a low volume short squeeze was born.

The expectations for September changed dramatically. Last weekend the CME FedWatch Tool showed a 36% chance of a September rate hike. That fell to only 21% at Friday's close. Last week the odds of a December hike were roughly 64% and that decreased to 54% on Friday. So, overall the odds of a rate hike in 2016 declined on the various economic reports.

The various talking heads were tying themselves in knots trying to explain why they still expected a September hike or thought the hikes were completely off the table for 2016. The comments from Stanley Fischer last week about two hikes in 2016 were constantly rehashed. However, several analysts pointed out that Yellen has been long term dovish and while talking about the need for hikes has always said "data dependent" and "gradual." She was probably looking for a reason to remain on hold and the week's reports gave her all the reason she needed.

Another analyst pointed out that most of the FOMC voting members were making dovish comments while the majority of the hawkish comments were coming from Fed presidents that are not currently voting members. You have to wonder if they trade emails with Yellen where she suggests they talk up rates to keep the market from going into hibernation mode.

Yellen can always count on some major analyst to hype the situation and keep the uncertainty in place. Goldman's Jan Hatzius said the jobs numbers were strong enough to justify a September hike. He said the possibility of a hike rose from 40% to 55%. To offset his September bullishness he believes the odds for December fell from 40% to 25% because the economics only justify one hike. Even so, he said the Fed would likely change the post meeting statement to a dovish bias and revise the dot-plot to reflect a lower for longer rate hike cycle.

One key point came out of all the headline chatter. With the odds of a September hike falling dramatically, if the Fed is planning on hiking three weeks from now they will have to ramp up their guidance. There will have to be some pretty specific comments from multiple Fed speakers to effectively warn the market a hike is coming.

What this means for us little people is a continued period of uncertainty until the September 21st post-meeting announcement. At that point, all will be made clear for at least a couple hours. Then traders can start placing bets for the December meeting. The November meeting is not a quarterly meeting with a press conference and while they can still hike, the market does not believe they will do that at this stage in the cycle.

You may remember when the Fed hiked rates last December, their guidance suggested four additional rate hikes in 2016. Obviously the outlook changed and it could just as easily change to no hikes for 2016.

In stock news, Lululemon (LULU) posted earnings of 38 cents that rose 11.8% and matched estimates. Revenue increased 14% to $514.5 million from $453 million. However, same store sales rose 4% compared to 6% in the year ago quarter and 5.9% expectations. The company guided for Q3 to revenue of $535-$545 million and earnings of 42-44 cents. Analysts were expecting 44 cents. Shares were knocked for an 11% decline. Numerous analysts began pounding the table on LULU saying it was a buying opportunity after its 43% YTD rise.

Smith & Wesson (SWHC) posted earnings of 62 cents that nearly doubled and beat estimates for 43 cents. Revenue rose 40.1% to $207 million and beat already heightened estimates for $198.16 million. During the quarter, they completed the acquisition of Crimson Trace, a laser sight manufacturer and Taylor Brands, a knife and toolmaker. The company guided for full year earnings of $2.38-$2.48 on revenue of $900-$920 million. Analysts were expecting $1.92 and $776 million. S&W's prior forecast was $1.83-$1.93 and $750 million so business must be booming.

FBI background checks rose 6% in August to 1,853,815 and a record for August when sales are normally slow. That was down sharply from the 2,197,169 checks in July, which was a 27% increase over July 2015. June had posted a similar spike in checks to 2,131,485. Since the FBI began performing and accounting for firearms background checks in 1998 they have processed 243,558,967. In 2015 alone, there were 23,141,970. It is amazing to me that any presidential candidate runs on an antigun platform with the number of firearms in America.

The sharp drop in checks in August caused the firearms stocks to decline. SWHC, RGR and TASR all collapsed for the week.

Ambarella (AMBA) reported earnings of 54 cents that easily beat estimates for 37 cents. Revenue of $65.1 million beat estimates for $63.9 million. The company guided for Q3 revenue of $95-$99 million. The stock lost -7% because full year guidance was flat to -5% on revenue. The disaster at GoPro reduced chip sales to that company for the last year. GoPro is thought to be 25% of Ambarella's total business. The CEO was positive saying "solid product development and customer support continued to result in new design win momentum in all our markets, led by new projects in drone, home monitoring, virtual reality and wearable applications."

Gap (GPS) shares fell -2.6% after the company reported same store sales fell -5% after a -8% decline in August 2015. Banana Republic sales fell -10% after an 11% decline a year ago. Old Navy sales rose 1% but less than the comparable sales of +5% a year ago. Gap is also suffering from a fire that destroyed a 990,000 square foot distribution center in Fishkill NY on Monday. A gap executive said "basically anything you buy" under the Gap umbrella online comes from the Fishkill facility.

Hewlett Packard Enterprise (HPE) will report earnings on Wednesday. On Friday, news broke they were looking for a buyer for their software division in a deal that could be worth $10 billion. Reportedly, HPE is in talks with buyout firm Thoma Bravo LLC to sell the division. The division includes the big data analytics platform Vertica and cyber-security firm ArcSight. Thoma Bravo said HPE had received offers up to $7.5 billion and Goldman Sachs was managing the bidding process. Other firms making offers include Vista Equity partners, Carlyle Group and TPG Capital. HPE generated $3.6 billion in revenue from the division in 2015.

Carl Icahn announced after the close he had purchased another 306,846 shares of Herbalife valued at $18.5 million. He is determined to grind Bill Ackman into dust on Herbalife. Shares only moved up slightly in afterhours because the news broke after everyone had left for the holiday weekend.

Shares of Mylan (MYL) fell another 5% after two senators sent a letter to the Dept of Health and Human Services suggesting Mylan had incorrectly labeled the EpiPen product as generic in the documents submitted to Medicaid. That would have meant they had to refund less in rebates to Medicaid than they would for a non generic drug. Manufacturers have to rebate 23% to Medicaid on branded drugs and 13% on generics. The State of Minnesota estimated it had cost them $4 million YTD in 2016 because of the documentation error. The categorization error began in 1997. If this is proven to be true, Mylan could be responsible for millions in refunds, fines and legal expenses. The drug was classified correctly as a brand name drug by the FDA and Medicare.

Mylan said in a statement that it had complied with all laws and regulations regarding the Medicaid rebate classification and the drug had been classified that way long before Mylan purchased the rights to the drug.

Candidate Clinton continued the firestorm from last week calling on the Senate to create a drug price review panel where changes in prices would have to be approved based on production costs and patient benefits. This would be sudden death to many high priced drugs.

The combination of these two headlines kept the biotech sector negative on Friday. The sector is likely to remain under pressure until the election.

JP Morgan upgraded online retailer MercadoLibre (MELI) from neutral to buy and raised the price target from $133 to $200. Before you jump to the chart, the stock was already priced at $173 before the upgrade. Clearly, JPM was behind the curve on this upgrade. MercadoLibre.com is a Latin American competitor to Ebay and Amazon.

They see revenue rising 46% next year with profits rising 42%. Shares have already risen 60% in 2016. Brazil is their largest market and they only have 4% penetration. Revenue in Brazil rose 61% in 2015 so they have a long way to go as their market share increases.

Everyone is not wearing the same rose-colored glasses as JPM. Goldman recently initiated coverage at neutral with a $170 price target.

Crude prices had a lot of impact on the market last week with the big decline from $47 to $44 weighing on the Dow late in the week. The OPEC headline spam about a production freeze had faded. On Friday a plug by Vladimir Putin saying the "Oil production freeze is the right decision" was only able to cause minimal short covering. Since Russia is not in OPEC, he is hoping he can urge them along so oil prices will rise. Since Russia would be hard pressed to produce any more than they are currently doing, the best option would be to join OPEC in a freeze at the current level of maximum production.

He said the standoff with Iran over participation in the freeze could be resolved and he was confident that all parties could reach a compromise. "We believe that this is the right decision for world energy." Since Putin never does anything that does not benefit Russia, you know the cash crunch is moving into crisis mode. However, Russian energy minister Alexander Novak, downplayed the talks and the potential for a freeze. Say goodbye Alex, your next stop will be a post in Siberia.

Also surprising on Friday was a comments from Saudi Prince Turki Al-Faisal. He said Saudi Arabia could still agree to a deal to freeze production as long as "all" other oil-producing nations to the same. "All oil producers should have a role in whatever decision it taken. Everybody should play their part. Saudi Arabia is seeking a holistic approach to the issue of oil production and prices, not just within OPEC." Good luck with that approach since most non-OPEC producers are scratching for every dollar they can raise with additional production.

Active oil rigs only rose by 1 to 407 but active gas rigs spiked 7 to 88. Active offshore rigs plunged -7 to only 10 as a result of hurricane Hermine in the Gulf. That will correct next week now that Hermine is already well up the East Coast.




It is a small cap market. The S&P-600 Small Cap Index broke out to a new high well over resistance at 750 with a gain of almost 9 points. There was no hesitation for those stocks. The index is up +31% from a low of 581 in January while the S&P-500 is up +20% from that same low but up only 6.6% for the year.

The S&P-400 Midcap Index also rallied to a new high at 1,578, up +30% from the 1,215 low in January. There has been a strong rally in progress all year if we just knew where to look.

The S&P-500 has stalled since reaching the current range back on July 14th. The big caps have all the problems with Europe, China, currencies, etc, that the small caps do not have. The big caps have stagnated despite the breakouts on the small cap indexes. That will not continue forever. If the small cap stocks continue to run, the big caps will eventually follow. Conversely, if the S&P rolls over, no amount of small cap strength will rescue the market from the decline.

The 2,175 level is the current price magnet and 2,150 is critical support. The 2,193 level has been the intraday high twice over the last month. That is the line in the sand the bulls have to cross.

The Dow is 30 of the largest big cap stocks and that is why it is the weakest index. The support at 18,350 was tested three times over the last week and one intraday dip actually made it below 18,300 before the dip buyers could muster enough volume to lift it back to positive territory.

That one thing is saving this market. Buyers are willing to enter on the dips but they are avoiding the highs. Once the afternoon rebound begins to gather momentum it suddenly loses traction. They will buy the dips but not the highs.

The Dow was up 72 points on Friday but only two stocks gained more than $1. Apple was up on the Samsung battery problems and Boeing was up +$1.26 on a potential $7 billion sale of fighters to Qatar and Kuwait. The sale would include 36 F-15 fighter jets and 28 F-18 Super Hornets plus the option to buy 12 more.

More than half the Dow 30 components gained less than 50 cents. That is hardly strong conviction in the rally. Most of the Dow gains came at the open in a +125 point short squeeze but the index faded back to only +22 at 1:30. Some late day short covering or bargain hunting lifted it back to +72. There was $500 million in buy on close orders on the NYSE. Maybe there were some funds trying to get a head start on next week.

The action on the Nasdaq was similar. The index spiked +37 points at the open but fell back to only +5 at 1:30 before rebounding to close with a 22 point gain. It was purely an opening short squeeze and then some positioning at the close.

The Biotech Index and the Semiconductor Index both closed fractionally negative and were no support for the Nasdaq. The constant headlines about drug price controls and a guidance disappointment from Broadcom combined to keep both of those sectors negative.

The Nasdaq Composite has tested support at 5,200 so often it has eroded some of that level with intraday lows hitting 5,190 on three days last week. The close at 5,249 gives the Nasdaq a cushion for next week but it is still below the high close at 5,262.

We have to wonder what will be the headlines that will provide direction for the tech sector. There are no material earnings until Hewlett Packard on Wednesday and that could just as easily be a drag instead of a bullish force.

Watch the 5,200 level and prepare to bail out if it is broken significantly.

The Russell 2000 made a new 52-week high at 1,251 but it has failed to rally to the 1,295 level it needs for a historic high. The Russell 2000 components are chosen solely on the basis of market cap while the S&P-600 and S&P-400 are by invitation only from S&P. They screen out the lower quality stocks.

The Russell uptrend is still intact but the momentum has slowed. It is stuck in the middle of the uptrend channel as it approaches major resistance at 1,275.

In theory, portfolio managers will come back from vacation and begin liquidating the stocks they no longer want and begin furiously adding stocks they do want to have in their portfolio when their fiscal year ends on October 31st. One analyst said 77% of fund managers are not beating their benchmarks this year, normally the S&P-500. Another analyst said only 14% of managers are beating the benchmark. I guess both could be correct with the other 9% actually performing at the benchmark level.

Nonperformance causes managers to be replaced. That is a strong incentive to go for the gold over the next two months. They need to dump the laggards and add some movers and do it quickly. Typically the buying begins when the markets make the lows for the second half of the year in late September and early October.

However, there is nothing typical or seasonal about 2016. Market theory has failed in 2016. The market has confounded all the experts and that is why 77% are performing below their benchmarks. That suggests the next two months will not perform normally, which is usually punctuated by declines and high volatility.

The rally in the S&P-400/600 suggests there could be a continued rally in our future. It just depends on how many positions managers need to dump and will the selling in the big caps drag down the buying in the smaller cap stocks.

The next four sessions should tell us a lot about the rest of the month. We will have the constant analysis of every word that comes out of a Fed head's mouth. Fortunately, there are only three on the calendar this week and then they go into the quiet period ahead of the FOMC meeting on the 20th.

The trend is our friend until it ends. I would continue to caution not to be overly long this week. Keep some cash available and a shopping list of stocks you would like to buy on a dip. We are long overdue for at least a minor bout of profit taking and it could appear at any time.

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Random Thoughts

Bearish sentiment continued to rise last week but only slightly. The bullish sentiment at 28.6% is 10 points below the historical average of 38.5%. The most hated bull market in history still cannot find any respect. Neutral sentiment is about 8 points over the 31% historical average and bearish sentiment is just about even with the average. The majority of investors are on the fence and waiting for a direction to appear.

Holiday shopping could be a challenge. South Korea's Hanjing Shipping, a container shipper with 8% of the Trans Pacific trade and one of the world's largest shippers, filed bankruptcy. Ports are no longer allowing those container ships to dock and tugboats are refusing to service the freighters. Both are afraid they will not be paid for their services. This has essentially frozen hundreds of thousands of containers at sea with nowhere to land. To make matters worse, major shippers use whatever ship is available when they have an excess of cargo. That means other shippers have containers frozen on those ships and they cannot get them off. Several Hanjing ships have been seized by creditors.

Those frozen containers, regardless of what shipper they belong to, have a large portion of holiday merchandise on its way to U.S. retailers. Hanjing is pleading with South Korea for an immediate bailout so they can make arrangements to offload those containers. The president of the Retail Industry Leaders Association in the U.S. wrote letters to the Dept of Commerce and the Federal Maritime Commission saying the bankruptcy presents an "enormous challenge to the U.S. and could have a substantial impact on consumers and the economy at large."

The trade group is urging the U.S. government to work with ports, cargo handlers and the South Korean government to resolve the widespread disruption in freight deliveries. The WSJ said as many as 540,000 containers are experiencing delays that could range from weeks to months. In this critical pre holiday shipping season that is a disaster. The retailers most likely to be impacted are Walmart, Target, JC Penny and clothing retailers. The $25 billion U.S. toy retailing industry could also be hit hard.

The U.S. "just in time" supply chain is not prepared for events that can keep hundreds of thousands of containers of holiday goods held hostage at sea for months. This could cause a monumental disaster for retailers this holiday season. I would not be surprised to see Amazon buy up some container ships so they can be in control of their own fate in future years.

This is another warning against holding paper gold. That is some certificate that says you own gold and can take delivery at any time. A client of Xetra-Gold, a German Exchange Traded Commodity fund, has been trying for some time to take delivery of their gold. Xetra-Gold claims the gold has to be provided by the bank where the customer's account is held, even though the prospectus claims Xetra is responsible for delivery. The ETF is traded on the Deutsche Boerse. The bank responsible is Deutsche Bank. The bank responded that the gold is delivered by the bank branch where the client has his securities account and only if that branch offers this service.

Deutsche Bank responded to Xetra Gold that "the bank would attempt to review the individual cases and an individual solution will be found that works for the client." Basically, they admitted they had failed to produce the physical gold and based on the "economic efficiency of physical delivery" they would try to work something out with the client. A lot of people are reading that as "we will give them their money back rather than actual physical gold."

The problem of paper gold has been floating around for years ever since the U.S. Fed refused to produce gold supposedly held in custody for overseas banks. If you have the gold why refuse to deliver it. In one case, they agreed to deliver the gold in periodic shipments over the next two years. What? It really causes the conspiracy theorists to wonder where the gold really went?

There are currently 3,267 active stocks according to Jefferies and the University of Chicago. That is the lowest number of listed stocks since 1984. The stock market is shrinking. When you add in the number of buybacks, acquisitions, mergers and leveraged buyouts the rate of shrinkage is increasing.

IPOs have slowed significantly. Analysts attribute that to the market activity over the last two years and Sarbanes-Oxley. Many companies are deciding not to go public because of the additional regulatory costs.

Over the last several years the market is up more than 200% but the market liquidity has evaporated. Central banks are buying S&P futures and holding them rather than trading them. Companies are struggling to increase profits so they are spending all their excess cash, plus borrowing at ultra low rates, to buy back shares in lieu of spending the money on business expansion.

In theory, the continued shrinking of the outstanding shares means the share price should continue to rise. As stocks prices rise as the float shrinks it creates move volatility in times of crisis. We know there is another crisis in our future and without liquidity, the volatility could be extreme. Think "Flash Crash" on steroids.

As an extension of that prior comment, there was a Reuters article saying the ECB may be forced to buy stocks because there are not enough bonds. JP Morgan has previously warned there was a shortage of bonds for the ECB to continue buying at its stated pace. It has reached a point where the ECB is actually forced to buy bonds from itself in a roundabout fashion.

How does this work? The ECB implements its QE through several national central banks. Those banks buy bonds for the ECB based on the rules for quality set by the ECB. This reduces the amount of available securities in the marketplace. The banks are limited on how much debt they can buy from any one country and they cannot buy bonds with steeply negative yields. These same banks also sell securities as they manage their total reserves. Those bonds are then back on the open market and are bought by some other central bank as part of the QE program. Basically, these banks are swapping debt with each other on behalf of the ECB.

Since the Bank of Japan recently expanded into buying stock ETFs and then eventually doubled the amount of ETFs it could buy because there was not enough bonds available for their QE, the ECB may be approaching this threshold.

According to Reuters, the ECB may be forced to follow Japan's example and buy equities as part of their $1.7 trillion QE stimulus program.

The BoJ's Kuroda, recently admitted ETFs were an easy way to directly monetize and nationalize the stock market. "ETFs allow an investor to trade a range of assets, from a basket of stocks to government debt. ETFs, which offer a convenient way to purchase a broad basket of securities in a single transaction from an exchange, have risen in popularity with investors due to their simplicity and lower fees."

The U.S. Fed is not going to be left out either. At the recent policy conference in Jackson Hole, there were papers presented suggesting that negative interest rates and equity purchases were also in the Fed's toolbox. The subtle hints that were dropped were a way to nudge the door open slightly so they can refer back to it as an option in a time of crisis.


Enter passively and exit aggressively!

Jim Brown

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