All of my investing life the only axiom that always proved to be true was don't fight the Fed. They have an unlimited supply of money and investors have limits.
When the Fed wants the market to react in a certain way they can apply all the power they need to make it happen. It may not be an immediate reaction but they will apply pressure until they get the desired result. Their influence on the markets can outweigh and cancel prevailing historical trends both on the upside and the downside.
For instance the markets normally decline in September and October but an aggressive Fed can negate that trend as we have seen in 2010. The markets normally rally in November and December but a Fed with a strong tightening bias can create a bear market in any environment.
It all boils down to the cost of money. If the Fed decides to launch a major quantitative easing program to drive down rates and stimulate the economy then the dollar suffers. Dollar denominated assets like metals, oil, commodities, real estate and even stocks are forced to rise in dollar cost in order to maintain parity with their prior real valuations. An ounce of gold is still an ounce of gold and it worth the same today as it was the same time last year. It just takes more cheap dollars to buy the same ounce of gold today. The reverse for everything is true when the Fed is raising rates. Our dollars rise in value and that pushes down the price of everything denominated in dollars because it takes fewer expensive dollars to purchase those items.
Everyone reading this should understand this relation between Fed actions and the reaction of the stock market. As commentators we get caught up in the technical and fundamental reasons for market movements or lack of movements. It is hard to mentally make the continued connection on a daily basis between an extremely overbought market that continues to rise for no specific reason and a three-cent drop in the dollar. Most investors don't really understand the complex linkage that goes on in the currency markets. Hedge funds, institutional investors, sovereign funds, large banks and even companies like Berkshire Hathaway play the currency game with trillions of dollars in trades.
A 3-cent drop in the dollar may not seem like much but when played using billion dollar trades in the derivatives market that is a big move. There are roughly $653 trillion in outstanding derivatives contracts and much of that is currency based. Traders are shorting the dollar, which produces cash they use to go long another currency, commodities or stocks. This is a VERY crowded trade today but it is still gathering momentum. Suffice it to say there are thousands of entities still leveraging up these trades as each day passes. That is putting upward pressure on everything denominated in dollars including stocks.
For the time being this trade will continue. Bernanke alluded to another QE program in his speech on Friday. As long as the Fed is applying pressure to rates and the dollar the market will continue higher. Eventually it will end badly. Probably very badly but that could be weeks, months or even a year down the road. Don't fight the Fed.
One of the most common quotes used in the market came from John Keynes. "The market can remain irrational longer than you can remain solvent." He was making a case that the markets could remain overbought or oversold for a very long time and far longer than an investor who was betting against the market could remain solvent.
Every investor has a bias. It is either bullish or bearish based on the tone and content of the articles they read. If you only paid attention to the whining about the U.S. debt and unemployment you could not help but be bearish. If you only paid attention to the random green shoots in the economics and S&P company guidance then you could be bullish and have blinders on to the things the bearish investor was seeing. It is what makes a market. If you only listened to Larry Kudlow and Jim Cramer you would probably be a raging bull today. If you only listened to Robert Prechter and Nouriel Roubini you would probably be turning all your assets into gold and hiding it under your bed. Your bias depends completely on what information sources you listen to daily.
At Option Investor we have always prided ourselves for giving a balanced view by having a different commentator do the market wrap every day. That way you can profit from receiving input from multiple sources. If we were all bullish or all bearish we would not be doing our readers a service. There are some times when there is overwhelming evidence for one direction or the other but that is rare. We nearly always have a difference of opinion and that is a positive point for readers. That also means some of the writers may not be correct in their bias on any given week. If we were always 100% right the newsletter would cost $10,000 a month and be worth every penny. Nobody is ever right 100% of the time even when they are making seven figures for their services like analysts at Goldman Sachs.
In this period of Fed induced market rally I have asked everyone on staff to make an extra effort to present both sides of the market. Every market has three potential outcomes and by knowing the factors that could influence each direction you can make a better decision in your personal trades. Our goal is to produce the best independent market analysis possible. If you feel we are not achieving that goal please click on the email link at the top of the page and let us know.
Friday's economic reports were led by the NY Empire State Manufacturing Survey for October, which rose to 15.7 from 4.1 in September. This was a very strong rebound and the internal components were explosive. The new orders component surged to 12.9 from 4.3 in the prior month. Inventories fell sharply to -11.5 from +1.5 producing a monster inventory/order gap of 24.6 suggesting business is increasing significantly. The headline number was the highest since June. If the rest of the regional manufacturing reports come in this strong it would indicate a significant improvement in conditions.
NY Empire State Manufacturing Survey
That was the only report with a major gain. The Retail sales for September rose +0.6% compared to +0.4% in August. In this report August was revised higher to +0.7%. Sales rose +7.3% over September 2009 but that comparison was more favorable because of the post cash for clunkers decline in 2009. That is the strongest year over year performance since April. Electronics and appliances had a strong monthly gain at +1.5% with motor vehicles and parts rising +1.6%. Despite the decent results most retailers reported a lackluster back to school shopping season.
Consumer Sentiment for October declined fractionally to 67.9 from 68.2 in September. This is the preliminary report and will be revised in a couple weeks. The present conditions component declined to 73.0 from 79.6 and offset a rise in the expectations component from 60.9 to 64.6.
Consumer Sentiment Chart
Consumer Prices were nearly flat again in September with a +0.1% gain. The core rate was zero for the second consecutive month. This pushed the core inflation rate to the lowest in nearly 40 years at 0.8%. This is what the Fed is fighting with the additional policy accommodation. Headline inflation should increase due to the rise in grain prices and the price of oil but the core rate is stuck in a rut. The threat of deflation is low but the Fed wants to make absolutely sure there is no chance for it to occur. Just the threat of further Fed easing is already pushing prices higher because of the falling dollar. I am not sure this is a winning situation to artificially inflate the price of goods by making dollars cheaper but we don't get a say in the matter.
Consumer Price Index
Another green shoot was the slightly better than expected gain in Business Inventories. The headline number showed a +0.6% gain for August. This is a lagging number so little attention was paid to it but this was the eighth consecutive month of gains.
Next week has two reports that should get the market's attention. The Fed Beige Book is the latest update of economic conditions in the various Fed districts. This is a detailed report that should tell us if the August soft patch is really behind us or still dragging us down. I suspect, based on the Fed speakers recent tone, that it will show only minor improvement. Otherwise they would not be talking up QE2 in every appearance. You know the various Fed presidents talk to each other and they know which districts are improving and which are not.
The second report is the Philly Fed Manufacturing Survey. This is viewed as a proxy for the national ISM at month end. The Philly Fed will give analysts a last chance to alter estimates before the end of October. Expectations are for a minor improvement in the Richmond district.
It was a tale of two markets on Friday with the Nasdaq posting a +33 point gain while the Dow posted a 31 point loss. The problem with the Dow was the decline in Bank of America, JP Morgan and GE. Pushing the banks lower was a downgrade on Bank of America by S&P due to the new mortgage foreclosure crisis. GE was suffering from disappointing earnings.
On Friday S&P cut Bank America to a hold from a strong buy due to ongoing foreclosure woes. The problems stem from the major banks using robo-signers to sign tens of thousands of foreclosure documents without adequately researching each loan. These employees simply signed thousands of affidavits testifying to facts about the loans when they actually had no real knowledge of the specific loan. They were just pushing paper as fast as they could in order to process foreclosures.
The use of robo-signers has prompted foreclosure halts by the major lenders until a review of the process can be completed. At least one state has already sued Ally Financial and expects to sue the other major banks. The allegations of fraud at "every level of the process" is prompting thousands of homeowner suits as well as suits from the investors who bought the packaged loans. Earlier this week attorneys general from all 50 states launched a joint investigation into allegations that mortgage companies mishandled documents in foreclosing hundreds of thousands of homes. There were foreclosure proceedings on 930,437 properties in Q3 according to RealtyTrac. One in every 139 homes received a foreclosure notice in Q3 and a record 288,345 homes were actually seized by the banks.
Dick Bove, with Rochdale Securities, said the banks could lose up to $80 billion from the various suits and forced buybacks. The investors who bought the original loans may have a way to force the banks to buy back all the mortgage securities at face value if they can prove there was fraud at any point in the process. The Federal Home Loan Bank of Chicago sued the major lenders claiming they failed to disclose various underwriting standards and had errors in the documentation. They are trying to recover more than $3.3 billion they paid for residential mortgage bank securities that soured.
Banks were struggling to post decent profits before this mess and now they are faced with having to take charges for litigation expenses and potential settlements. If this progresses to the point of having to buy back previously packaged loans it could set them back several years in the recovery process. The halt in foreclosures as the mess is sorted out will slow down the housing market even more as the nearly 300,000 homes slated for foreclosure in Q4 are pushed out into Q1 or even Q2 with an associated slippage of even more distressed sales in Q1. Since more than a third of home sales are distressed homes this delay will be a serious blow to the housing industry. The same homes will eventually be foreclosed but it will be many months down the road. When the foreclosure halt is eventually ended there will be an even bigger surge of homes in foreclosure and all those homes coming on the market at the same time will depress prices. Banks have to pay an estimated $1,000 per month for every home in foreclosure to cover upkeep, property management and legal fees. Extending the foreclosure period for 3-6 months on hundreds of thousand of homes will be very costly to the banks.
We are also likely to see the major lenders like BAC, WFC and JPM slow or even halt making new loans until they decide what the impact of the foreclosure problem will be to their balance sheets. That will retard the home market even more than the foreclosure halt. The housing sector is 20% of the economy and this mess could be a material impact. This could be the next shock that pushes us back into a recession. For that reason the administration should be proactive in making sure the investigation and resolution is done quickly and with a minor amount of pain to the system.
Bank America Chart
Late Friday is was revealed the SEC has opened a probe into the banks foreclosure practices. This is in addition to investigations by the Department of Justice, Office of the Comptroller of the Currency and the FDIC.
While on the subject of banks, Countrywide CEO, Angelo Mozilo, agreed to settle with the SEC over insider trading charges. His trial was due to start on Tuesday but Friday's settlement ended that proceeding. He agreed to pay $67.5 million in penalties to settle civil fraud and insider-trading charges while admitting no wrongdoing. Actually Mozilo will end up paying ony $22 million of the fine. Bank of America will be forced to pay the rest under an indemnification agreement signed when BAC acquired Countrywide in 2008. Bank of America said in a statement it will advance funds on Mozilo's behalf as required by the agreement. BAC is insured to some extent for this loss. Mozilo, otherwise known as the "tan man" for his frequent tanning visits will be banned for life from being an officer or director of a public company. At age 71 I suspect he will spend the rest of his life living large on the remnants of the compensation he received from 1998 to 2008 of $250 million plus an additional $406 million from sales of Countrywide stock.
GE earnings disappointed with revenue of $35.9 billion and $1.7 billion short of estimates. Earnings per share of 29-cents was 2-cents over analyst estimates but disappointing for retail investors. CEO Jeffrey Immelt said both equipment and service orders increased for the first time in two years and he projected better results in 2011. He said they were seeing a "slow recovery in a few areas." Income fell -18% over the same period in 2009. GE had to put up an additional $1.1 billion in reserves for a finance subsidiary and that dragged down earnings. GE shares gave back 86-cents to close at $16.30.
Better earnings news came from Google on Thursday night and the stock gained +60.52 on Friday to close at 601.45. Google's earnings garnered a $700 price target from Goldman Sachs and after Friday's gains they are well on their way.
Amazon blasted off to another new high with a +$9 gain after news broke that margins on e-books were improving significantly. Evidently Amazon's volume has increased to the point where they have even more clout with publishers. Also, I have noticed prices for e-books rising. One I bought last week was $12.99 and the highest price I have paid for an e-book although I have seen some higher. Since they are selling more e-books than paper books the rise in margins is a good sign. Citigroup raised their price target to $194 and the stock closed just under $165.
It must have been new high Friday in the tech sector. Apple also broke out to a new high with a $12 gain after Goldman gave them a new price target at $500. Apple will report earnings on Monday and they are expected to beat estimates by a mile. Sales of the iPhone, iPad and Mac computers are improving briskly. This will be the first full quarter of sales for the iPhone 4 and it has been sold out all quarter with most sales backordered. Net income is expected to rise +130% to $3.83 billion. That equates to earnings per share of $4.09 on revenue of $18.9 billion. IPad sales are expected to be 4.8 million units. IPad was about the only tablet in the market in Q3 but that will change dramatically in Q4 as everyone else rushes to get products out for the holidays. Should Apple stub its toe when it reports earnings the drop could be dramatic.
I did see an advertisement for the iPad from Verizon on Friday. That will help their sales somewhat but the catch is the device has to be anchored to a hotspot rather than 3G. Since all the Verizon Android phones are also hotspots it makes any Verizon Droid customer a prospect for an iPad.
Shares of Seagate (STX) rose +22% on Friday after news broke they could be taken private by either KKR or Bain Capital. Sources at Seagate said on Thursday it was in talks with TPG Capital about a potential buyout. Silver Lake Partners reportedly held talks with Seagate in September about a buyout. With all this activity it is only a matter of time before they get a deal done. Seagate is the leading disk drive maker and has a market cap of about $7 billion.
One problem all the manufacturers have is the high drop out rate of the new drives. The extremely dense media on 1TB through 2TB drives means there is no margin for error. I have heard of extremely high reject rates and very high failure rates upon installation. If you go to the sites with a large quantity of user reviews like NewEgg.com there is a very large number of RMA requests for drives that were DOA or died in the first couple weeks. The tolerances are simply so close there is little margin for error. This has got to be impacting margins.
Chip stocks posted only a minor gain on Friday after an analyst expressed worries that the falling dollar would impact margins on a product that was already commoditized. Earnings are already depressed due to competition and excess capacity and another hit from currency translation could be deadly. An 8% to 10% currency hit could be the difference between profits and losses. Texas Instruments reports on the 25th and several other chip stocks including LSCC, XLNX and CREE report earnings next week.
The dollar rebounded on Friday after Bernanke's speech. Bernanke warned that a prolonged period of high unemployment could delay the U.S. recovery and the low level of inflation presented an uncomfortable risk of deflation. "There would appear, all else being equal, to be a case for further action." This was seen as a guarantee that the Fed would add some more bond purchases when it meets in November.
Ironically interest rates on treasuries ROSE along with the dollar after the speech. Analysts claim the rebound was due to expectations the Fed would be successful in its actions. Personally I believe it was just a sell the news event. Bond traders knew the Fed was planning to act and they knew the speech was Friday. It was simply a sell the news event given the already record low yields and severely oversold dollar.
Bernanke also left himself an escape clause saying the Fed was still analyzing the costs, limitations and risks of a new program. One risk is the 10-month low on the dollar on Thursday night. This is causing some severe irritation to emerging market economies as capital chases yields around the world and forcing other countries to react to this capital flight.
Dollar Index Chart
Gold prices declined slightly after hitting an intraday high of $1388 on Thursday. Goldman Sachs raised its twelve-month target price to $1,650. Goldman said gold could rise another 28% by the end of 2012, also Silver +30%, Copper +28% and Cotton +54%. Their estimate was based on rising demand in Asia and the falling dollar.
After a strong rally crude oil has been stuck under resistance for the last two weeks and gave up -$1.44 on Friday as the dollar rebounded and demand faded. U.S. gasoline demand for last week fell to the lowest level since November. Oil demand may be rising around the world but the U.S. is still mired in the quicksand of high unemployment. The various factors supporting prices last week including the dollar, hurricane, OPEC, closing of the Houston ship channel etc, have all faded from view and the current November contract expires next Wednesday. I would expect some volatility over the next three days.
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Crude Oil Chart
The Business Council, a group of the CEOs from the 150 largest U.S. corporations, said a recent survey of members showed a decline in sentiment. Only a third believe their industries will improve over the next six months. This is down from two-thirds in the prior survey back in May. The Council said the majority of members now believe the acceleration phase of the recovery is over. More than 75% of the CEOs expressed some hesitancy about the ability of the economy to grow at all.
The survey results did not project another recessionary dip but suggested 2011 would be more like 2010 in terms of overall economic growth. Over 70% of CEOs said the Federal budget deficit, the increased risk of regulation and unemployment were the biggest problems. 27 million Americans are either out of work, underemployed or too discouraged to even look for work according to the Labor Department. Jamie Dimon, JPM CEO, penned the introduction to the survey saying, "The momentum in the U.S. and global economy evident in recent surveys has subsided." Let's hope he is wrong.
Earnings are now expected to increase +24.2% over Q3-2009. This was a slight improvement from the 23.6% estimate just a week ago. A total of 109 S&P-500 companies report next week along with 11 Dow components. Only 46 S&P companies have reported with 83% beating estimates and 9% missing their targets. Since 1994 an average of 62% normally beat. That has risen to 77% over the last four quarters due to easy comparisons in the prior year.
However, analysts are expecting earnings of only $20.46 for the S&P-500 and that would be the first quarter-to-quarter decline since the recession. This reflects the soft patch experienced in August.
There are some important earnings next week with Apple, IBM and Citigroup starting the week off with a bang. I expect to see more upside surprises and I hope to see them from IBM and UPS. IBM is important because of the number of big ticket service contracts that will give us an idea on whether companies are going to spend some of their cash hoard. From UPS we will get an idea of package flow and the rate of business shipping. Hopefully it is increasing.
There is a pretty diverse array of companies reporting next week and by Friday we will know how the earnings season will end.
When you look at the indexes for Friday it was a six stock story. Google, Amazon and Apple powered the Nasdaq 100 to a new high and BAC, JPM and GE tanked the Dow. We have not seen such a strong divergence between the two indexes in a long time.
The clearest evidence of the tech strength came on the Nasdaq 100 where Google, Apple and Amazon forced a breakout of major proportions. After two days of being pinned to the prior resistance at 2050 the index tacked on more than 40 points for a major breakout. This would be extremely bullish if the gains were not focused in just those three stocks. On a technical basis it looks great but on a macro basis there is reason to worry. With Google posting a $60 point one day gain what will it do for an encore next week?
Hopefully Apple will copy Google's performance with earnings on Monday and keep the move alive. Then we have to wait for Thursday and Amazon to have another chance for a big move on the index. I personally find it unlikely that anyone would choose to go long on Google early next week after a 60-point gain. Same with Apple after a 12-point gain on Friday and the potential for another big move on Monday. In normal times these would be perfect setups for the shorts. Eventually this insanity will run its course and we will see some profit taking.
Nasdaq 100 Chart
The Nasdaq Composite moved to a new five month high on the strength of those same three stocks. Unfortunately it has yet to return to the same resistance high at 2519 that the NDX succeeded in crossing on Friday. The chip stocks are holding it back. Of course "back" is a relative term with the +33 point gain on Friday.
Even though the composite is over extended I could see it running to 2519 on the strength of Apple and others next week. There are dozens of Nasdaq companies reporting so plenty of reasons for the normal trader to remain long.
Nasdaq Composite Chart
The S&P is far less bullish than the tech indexes. Friday's minimal gain of only two points was held back by the financial sector. The mortgage mess is going to be a drag on financials for weeks and we need to prepare ourselves now for some tough times ahead unless BAC and JPM mount a strong offense against the claims and do it quickly. As long as analysts like Dick Bove and Meredith Whitney are quoting liabilities in the $70-$80 billion range the banks are not moving higher. This is a major blow to market sentiment. Other sectors may continue higher but we will be dragging the financials along behind us.
The S&P closed out the week still shackled to the prior resistance at 1175. We closed over that level twice in the last three days but only by a couple of points. There is still a gravitational pull at that level. Should it break free the next major resistance is 1210-1220 and that could be a difficult level to cross even with the Fed cheerleading from the sidelines. A breakout there could run to 1300. I know that sounds crazy but don't fight the Fed and the anticipation of the elections.
For the Dow I believe we will test 11,200 next week even with the drag from JPM and BAC. The initial shock value of the mortgage mess has passed and it will require another chapter in the saga to knock another 10% off those banks in a single day. They will probably be laggards but they should not sink the Dow. There are 11 Dow components reporting next week and all should beat street estimates. Unfortunately that is now expected so anything less than a really good report could produce some selling in the individual stocks.
The Dow has support at 10,975 and resistance at 11,200. As long as we stay in that range next week I would be a happy camper because it would allow individual stocks to move without being hampered by a big Dow decline.
Over the last 62 years the S&P averaged a +4.7% gain in Q4. Only 14 times in those 62 years has the S&P been negative. While that sounds promising, prior performance is no guarantee of future results. Also, 4.7% is only 55 points and the S&P has gained +35 since October 1st. That only leaves another 20 points to meet the average. Fortunately this is probably going to be an above average year.
Most analysts believe the market will finish the year higher. I believe Abby Joseph Cohen is expecting 1275-1300 on the S&P. I have heard a lot of analysts talking in that 1250-1300 range. The positive factors are of course the Fed and the election. I have already discussed the Fed so the election is the next topic.
Most polls have the republicans gaining control of the House and polls are split on control of the Senate. For the market to continue moving higher only one body needs to switch to republican control. That would guarantee gridlock for the next couple years and a lot of regulatory efforts would die a slow death. That would be bullish for the markets. How much of that is already baked into the current rally is unknown.
What we do know is that any continuing rally will struggle without the participation of the financials. Secondly we know that there is a potential for the mortgage mess to cause another shock to the system that could be seriously damaging. We are at that point where accusations and flying and government agencies are gearing up to make a nuisance of themselves. Unless this escalation of intensity is ratcheted down really quickly I fear we could have another crisis on our hands. Fortunately $80 billion, to use Dick Bove's number, is not the end of the world. It would be painful for the banks but they would survive. I am just not sure they would survive another cycle of investor flight. Mutual funds are still reporting withdrawals from equity funds and another crisis of confidence could accelerate that process.
We made it through option expiration without any major volatility and that is slightly bullish. The Dow declined nearly 100 points on Friday and recovered once again. That is slightly bullish because it had plenty of excuses to stay down. Volume accelerated beginning on Wednesday to nearly nine billion shares per day with expiration Friday trading 9.56 billion shares. Obviously the increase in volume for all three days was expiration related but higher volume is normally positive. Unfortunately two of those days were lopsided with 2:1 declining volume to advancing volume. Even with the selling imbalance the markets broke out to new relative highs and that is also bullish.
I believe the majority of traders are still in denial that the rally has come so far in the last six weeks and denial is normally bullish because it means many people are still shorting the rally. Until proven wrong I am still in buy the dip mode.
The government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it. - Ronald Reagan.