The Dow closed positive for the 9th consecutive Friday after a week of major volatility.
The president's sequester program is now reality and the stock market did not implode. Despite all the warnings about the impact to the economy and the end of life as we know it the equity market ignored the event. That is not to say it won't react in the near future but so far it was just another brick in the wall of worry.
The much touted $85 billion in spending cuts are actually only about $44 billion in the current fiscal year. In reality there is no cut in total spending because the government will spend more in 2013 they it did in 2012. This is a cut in "spending growth." Some departments may see their budgets cut so the money can be used somewhere else where it is deemed more important.
With the sequester discussion now behind us the next challenge is the expiring budget resolution on March 27th. Congress will have to authorize a new "continuing resolution" to fund the government by April 15th or there will be shutdowns of nonessential services while the two parties duke it out again. Since the president has never passed a budget since he has been in office the House has been forced to pass a continuing resolution to fund the government on a temporary basis for the last three years. The Senate voted 98-0 against the president's last budget and he has yet to even present one this year. It was due by law the first week of February. Now that the election is over and the two sides are more opposed than ever the budget battle could be ugly. After the budget battle is over the debt ceiling debate comes back to haunt us in May.
What this all means is we could get a grand bargain in late March that revises the president's sequester, includes a new continuing resolution and addresses the debt ceiling all at one time. I am not hopeful it is possible. The more likely scenario is a continuing monthly crisis where each month the parties square off over the budget and spending.
The difference this time is that there will be no backroom deals. The House republicans want everything to go through the "regular order" of business. That means the administration through the Senate will have to present a budget bill that will have to be voted out of the Senate and then move to the House. That way there is full debate of the merits in both the Senate and the House. Lawmakers can amend it and vote on it in full view of the press and the public. In the prior debates over the debt ceiling and fiscal cliff there were last minute deals cut by party leaders and the rank and file had to vote on the bills as agreed rather than bills debated and formed in the normal course of Congress and the Senate.
In the normal course of business the lawmakers providing input to the bills are identified and they have to lobby for their amendments. That means the voters at home know how they voted and where they stand. If the republicans are successful in forcing the normal course of business the light of day will eliminate some of the shenanigans pulled in the last several crisis events. I believe lawmakers on both sides should act responsibly and in the public forum. Unfortunately the process can be ugly and it is rarely smooth. That suggests the coming budget battle could be a whopper. It will only be worse because they will be trying to fix the sequester as part of the new budget resolution and that is going to gum up the works.
For the time being the sequester should fade from the headlines and that should be positive for the equity markets.
The markets needed some help on Friday morning when the Dow opened -116 points lower. Dragging the markets lower was a flurry of bad data from overseas. The official Purchasing Managers Index (PMI) for China came in at 50.1 for February. That was down from 50.4 in January. It was the weakest reading in five-months. The HSBC-Markit Economics PMI fell from 52.3 to 50.4 and a four-month low. Readings above 50 represent expansion and below 50 represent economic contraction.
The rebound in the Chinese economy appears to be failing. New orders, an indication of expected conditions in the months ahead, fell to 50.1 and a five-month low while export orders contracted for the second month. China lives on exports and two months of contraction is a bad sign.
However, analysts point to the weeklong Chinese New Year celebration that fell in February this year as the reason for the weakness. Businesses and markets are closed for the celebration. The State Council Development Research Center said declines mean "economic growth will move from rebounding to stabilizing." The GDP for China rose +7.9% in Q4 and is expected to rise +8.2% in Q1.
In the U.K. the PMI declined dramatically from 50.5 to 47.9. This put the index well into contraction territory and sent the pound to a 2.5 year low and the dollar to a new six-month high. The S&P GSCI commodity index fell to the lowest level of the year and its fourth weekly decline. That is the longest losing streak since June. Copper fell -1.4% to the lowest level since November as a result of the Chinese PMI. Crude prices also declined with WTI trading as low as $90.04 intraday. That is a three month low. Aluminum prices dropped for the 10th consecutive day and the longest streak of declines since June.
British Pound Chart
Dollar Index Chart
Unemployment in the 17-nation euro area rose to 11.9% in January. That is the highest level since the data stream began in 1995. The table below shows the unemployment in the various countries in the eurozone.
EU Unemployment Rates
While you are pondering the high numbers in the EU let me give you one more statistic. In Egypt half the population of 82 million are age 30 or younger. (41 million) Unemployment for those 30 or younger is 75% or roughly 20.75 million. Civil unrest is normally caused by unemployed youth. Is it any wonder that Egypt is struggling with political unrest? This unemployment problem is growing all across the Middle East and that suggests growing civil unrest. I included the Egypt numbers because they relate to our global economic health.
Italy's PMI fell to 45.8 and far worse than the estimates of 47.6. Italy's deficit to GDP was above 3.0% and pushed the debt to GDP to the highest level in more than 20 years. Spain's manufacturing PMI rose slightly from estimates of 46.5 to 46.8. Both of those countries are in contraction.
The market opened lower because of overseas economics but once the U.S. numbers were released the rebound began. The ISM Manufacturing Index surprised to the upside with a 54.2 reading compared to 53.1 in January and estimates for a decline to 52.5.
The internal components were positive and suggest the economy was stronger than expected. The new orders component rose from 53.3 to 57.8 and that was the largest gain since 2010. Backorders rebounded back into expansion territory at 55.0 from 47.5. The only real negative was a decline in employment from 54.0 to 52.6.
This was the third consecutive monthly gain in the headline number from the 49.9 reading in November.
The final reading on the February Consumer Confidence rose to 77.6 from 76.3. The present conditions component rose from 85.0 to 89.0. The expectations component rose from 66.6 to 70.2. This was the second consecutive monthly gain since the huge -10 point drop in December on worries over the fiscal cliff. Strangely the sequester failed to impact sentiment in the same way. Apparently a 2% spending cut is not as important to consumers as the potential shutdown of the government.
Consumer Sentiment Chart
Sentiment may not be as rosy next month after the impact of high gasoline prices and rising taxes finally hits home. Personal Income for January fell -3.6% after rising +2.6% in December and +4.2% in November. The big year end gains were due to the accelerated dividends and bonuses being moved into 2012 to avoid the rising taxes. The decline in January came from the restart of the FICA taxes and the lack of many normal dividends in January. Many of the regular quarterly dividends were pulled forward into December. This should equalize once we get into March.
Moody's Personal Income Chart
Construction spending for January fell off a cliff with a drop of -2.1% compared to an average gain of +1.5% for the prior three months. Residential construction was flat at zero but non-residential construction declined -5.1%. The decline was blamed on the uncertainty around the fiscal cliff and future tax rates. However, the non-residential decline was caused by a sharp decline in power and utility structures. I would not apply too much importance to this report unless the weakness continues.
Moody's Construction Spending Chart
Vehicle sales for February rose to an annualized rate of 15.4 million units compared to 15.3 million in January. The slight gain was due to a small increase in light truck sales. Given the sharp rise in gasoline prices I am not surprised those truck sales were lethargic. They rose from 48.6% to 49.3% of total sales. Sales of imported vehicles rose to 23.8% of all sales. The average age of existing vehicles in the U.S. is more than 10 years old and the increase in fuel mileage and ready availability of auto credit should continue to push sales higher.
The economic calendar for next week is headlined by the payroll reports and the Fed Beige Book. The employment reports will be the key. The ADP report on Wednesday is expected to show a decline in jobs to +175,000 from +192,000. The Nonfarm Payrolls on Friday is expected to be flat at +160,000 jobs. The future payroll reports are expected to show even fewer job gains as the sequester impact is felt.
The last Fed Beige Book covered the period from mid November to mid January and showed that all 12 districts either had modest or moderate growth. This report may show more of the impact from the fiscal cliff decisions on January 2nd and could be bullish for sentiment. However, if the Beige Book shows any improvement in the economy we will see an immediate return to worrying about a halt to QE. Conversely if the economy remained flat or weakened it would guarantee QE for the rest of the year.
There was a major blow to investor sentiment this week. The AAII Investor Sentiment Survey saw the bullish contingent decline a whopping -13.4% from the prior week to 28.4% and the lowest level since July. This compares to 41.79% last week and 52.34% of respondents just four weeks ago. Those leaving the bullish camp did not migrate to the bearish side with an increase of only +4.1% to 36.6%. They went to a neutral corner with a +9.3% increase to 35.0%. This put the bullish contingent at 28.4% below both the neutral and bearish numbers.
In theory this would be a contrarian signal to buy because the sentiment has changed so dramatically. The long term average is 39.0% bullish and 30.5% bearish.
TrimTabs.com reported on Friday that February insider buying of company shares fell to the lowest monthly amount since records were started in 2004. At the same time the ratio of insider sales to insider buying exceeded 50:1 and that is also the highest ratio since records were started in 2004. Charles Biderman tracks payroll taxes on a real time basis and he claims the government tax receipts rose more than 8% in February and that has pushed the real income of consumers to a multiyear low. He said the country entered a recession in late February as a result of higher taxes and lower consumer spending.
Berkshire Hathaway reported earnings after the bell on Friday. They earned $1,704 per share compared to estimates of $1,755 per share. For only the ninth time since the company started in 1965 the value of the shares rose less than the S&P-500. Buffett called the year "subpar" for that reason. The share price rose +14.4% and the S&P rose +16%. Since 1965 Berkshire shares have had a 19.7% compound annual growth rate or roughly 568,817%. Over the same period the S&P growth rate was 9.4% for a total of 7,433%. Berkshire is a big, actively managed mutual fund with zero turnover.
Berkshire's insurance businesses have generated $73 billion in free cash. That cash can be invested in acquisitions until it is needed to pay claims. As policies expire the reserve claim on the cash disappears but the investment continues. The insurance business alone is worth the investment in Berkshire. Any business that generates billions in investable cash every year is a gold mine.
Berkshire apologized for not finding any "elephants" to purchase in 2012. He said they worked hard on several but were not able to do a deal. The Heinz acquisition at year end cost them $12 billion for 50% ownership. Berkshire said their elephant guns are still loaded with cash and they are still on safari in search for a major elephant to acquire.
Buffett said he planned to buy more shares of Coco-Cola, American Express, Wells Fargo and IBM. Berkshire has no intentions of paying a dividend. Buffett said their size requires larger and larger acquisitions to move the needle and they need to save cash for the next big acquisition.
Herbalife (HLF) said it was adding two board members chosen by Carl Icahn after the investor acquired a 13.6% ownership position in the company. The board will expand from 9 to 11 directors. The company also agreed to let Icahn boost his stake to 25%. This will seriously aggravate Bill Ackman with his 20 million share short position. Icahn said Ackman's high profile short position has allowed investors to buy a good company at a cheaply discounted price. "They are in 87 countries. I think it is a really good product." While I seriously doubt Icahn has begun sucking down Herbalife vitamins and protein shakes the positive comments definitely helped the stock price when the news hit on Thursday afternoon.
This is probably one of the few companies that really welcomed Icahn with open arms. Most are terrified when the activist shareholder expresses interest in their company. Icahn has said the company should be private. The Herbalife president said on Feb 27th the company would "certainly" consider going private in a buyout "in the right circumstances." If Icahn does continue adding to his stake the noose around Ackman's short position is going to get tighter. With every point gained the investing public is going to increase their bets for the "mother of all short squeezes" as Icahn has prophesied. Icahn hates Ackman and he has the money to force that short squeeze.
Best Buy (BBY) reported earnings that were better than expected although still a loss on a GAAP basis. The company posted an adjusted profit of $1.56 per share but that was a -24.8% decline over the year ago quarter. Revenue rose slightly to $16.71 billion. Same store sales rose +0.9% and that was the best performance in 11 quarters. The company also said it did not receive a buyout bid from co-founder Richard Schulze by the Thursday deadline. Three private equity firms working with Schulze offered to purchase a minority stake for $1 billion but the company turned them down saying it was not in the best interest of the company. Schulze still has the option to appoint two nominees to the board so the saga may have a few chapters left.
Best Buy Chart
Apple (AAPL) collapsed -$11 to a new 52-week low at $430 after a $1.05 billion award in a prior patent-infringement case against Samsung was cut to $598.9 million. The judge said the jury based its award on an incorrect legal theory. The new award covers 12 Samsung phones and the judge called for a retrial on 14 other phones included in the initial award. Meanwhile Samsung has more than a dozen new phones in the pipeline that are sure to take additional market share away from Apple. CEO Tim Cook has not been successful in filling the product pipeline with new products and the revised iPhones have not been that different from the older ones except for the 4G capability. Investors are frustrated with the broken stock and the new low on Friday could trigger an entirely new round of selling. There was no stock split announced at the shareholders meeting and the excitement over Apple shares is fading fast.
Groupon (GRPN) shed its CEO on Friday after posting another disappointing quarter of earnings. CEO Andrew Mason sent a farewell letter saying "I am leaving to spend more time with my family. Actually I am just kidding. They fired me today. If you have to ask why, you were not paying attention." He said the company was struggling and as CEO he was responsible. As a co-founder of Groupon he said "For those concerned about me, please don't be - I love Groupon, and I am terribly proud of what we have created. I am OK with having failed at this part of the journey." He joked he needed to go find a "fat camp" to lose the 40 pounds he had gained in the CEO role. The board will now be faced with finding a new CEO that is willing to take on a challenge with the current chairman of the board also the largest shareholder at 17.5%. Groupon is suffering from deal fatigue. There are too many clones including offerings from Google and Amazon. Consumers have turned off their email subscriptions and the daily deal fad is officially over.
Intuitive Surgical (ISRG) may have won the title of volatility king. The stock is all over the charts even in normal markets. On Thursday the stock lost -$64 after the FDA said it was launching an inquiry into the robot surgery giant. It quickly rose to the forth most heavily shorted stock on the Nasdaq with more than nine days of normal volume short. Immediately several analysts came out to defend the stock saying the selloff was overdone. ISRG rebounded +$43 on Friday.
Gasoline futures prices rallied +0.6% on Friday to $3.13 and retail prices rose to $3.77 nationwide. Coastal prices are well over $4 with $4.36 the average in California. We have reached the point where prices will begin to impact consumer spending. The $4 level nationwide is the breaking point where significant changes occur. This is going to provide additional braking power for the economy in addition to the higher tax rates and the sequester spending cuts. Eventually all of these factors are going to matter and the market is going to pay attention.
Gasoline Futures Chart
The testimony by Bernanke last week robustly affirmed his plans to continue QE well into 2014 or beyond. In a speech late Friday he restated his goal to keep QE in place until the economy was self sustaining and unemployment at 6.5% and said it could be a long time given the potential impact of the sequester. The arrival of the sequester cemented the QE into place for the rest of the year.
Currently the Fed is buying $4 billion a day in treasuries and mortgage backed securities. If the QE program remains in place the Fed will buy 86% of all U.S. Treasury debt issued in 2013 and that could rise to 95% in 2014. I remain dumbfounded the rest of the world is not up in arms at this blatant monetization of the US debt. Eventually the outrage will occur.
David Rosenberg at Gluskin Sheff believes it is a reasonable scenario the Fed could continue its zero interest rate policy (ZIRP) through 2018 instead of mid-2015. That is how long it will take to reduce unemployment to 6.5% assuming the labor force participation rate remains at the current 30 year low. The economy has to add 200,000 jobs per month to account for new workers and immigrants entering the job market. You would need to add an additional 150,000 jobs per month to reduce unemployment to 6.5% by mid 2018. We have not seen 350,000 a month in job gains in a very long time.
On January 1st 2009 there were 31,983,719 individuals receiving food stamps. (Supplemental Nutrition Assistance Program or SNAP) On February 1st 2013 there were 47,622,363 individuals receiving SNAP coupons. That is a gain of 15,638,647 people. Over the same period there have been a net of 231,000 jobs created. If you eliminate all of 2009 when there were huge job losses from the recession and only count the job gains since January 2010 there were 4,971,000 net jobs created. That means there were three people added to the food stamp program for every person hired. The food stamp program provided an average benefit of $278 per month per household and cost $75 billion in 2012.
Food Stamps vs Jobs
Jonathan Krinsky at Miller Tabak warned last week the divergence between the S&P-500 and copper prices was a warning to the market. Typically "Doctor Copper" is a leading indicator for global economic activity and the S&P and copper move in tandem. Since early 2012 the price of copper has been falling while the S&P was rising.
We saw last week the decline in manufacturing activity in multiple countries and that is a scenario we have been seeing for some time now. This copper divergence suggests the equity markets are likely to face problems ahead.
S&P-500 & Copper Chart
The Baltic Dry Shipping Index is also telling us that economic activity is very low. This is the index rate to ship freight along various ocean routes. The rate was up in the $10,000 a day range in 2008 and has fallen to $776 per day in 2013. Global import and export traffic has slowed to a crawl.
Baltic Dry Index Chart
Despite the declining economic fundamentals the market will remain supported because of QE. So far in 2013 the S&P is up +7.5%. Historically that would be a good year but we have 10 months to go. Sam Stovall at S&P said the index has risen in both January and February 26 times since 1945. In those years the S&P had an average gain of +24% and all 26 years ended with positive gains. In theory that is a good sign for 2013 but Stovall did not have a statistic for how many of those years the global economy was weakening. We all know past performance is no guarantee of future success but it is interesting to know the historical facts.
The dip last week was short, sharp and scary as are most bull market corrections. However, it was not a correction. The -2.9% dip in the S&P was just a speed bump. There are quite a few analysts that wished it was the start of a decent dip but they were disappointed. Every tremor is not followed by an earthquake. You never know which one is the real deal.
The end of the month and first day of a new month are typically powered by retirement fund contributions. Friday's opening decline and rebound to positive territory came on the lowest volume of the week at 6.7 billion shares. When fund flows decline late in the week so will volume.
The decline in the AAII Investor Sentiment survey to 28.39% bullish and the lowest level since July 19th has not yet impacted the equity markets. The percentage of stocks in the S&P-500 that are over their 200-day average is currently 86.6%. That is a minor decline from mid February but still bullish. However, the percentage over their 50-day average has fallen to 74.2% and the momentum indicators on the 50-day chart have gone negative. In English, the market momentum is slowing.
S&P-500 Over 200-Day Average Chart
S&P-500 Over 50-Day Average Chart
The Nasdaq 100 big cap tech index is showing the strain more than the other indexes. The NDX is looking suspiciously like a head and shoulders in progress. The relative strength (RSI) is declining. The MACD is declining. There is a clear series of lower highs. I would not buy a stock with this chart.
Nasdaq 100 Chart - Weekly
The S&P chart I showed last week has not changed. The volatility increased with a penetration down to 1485 but overhead resistance remains. The rebound on Thursday came to a dead stop at 1525 the same level as the short squeeze rebound on Monday. That 1525 level has returned as strong resistance.
There is nothing that prevents us from moving higher in response to the QE support but the internals and market sentiment are weakening. If we get another dip to the 1485 level and support holds then we could see a stronger rebound. However, should that 1485 level break on the next test the result could be a significant decline.
S&P-500 Chart - Daily
The Dow chart is different from the S&P. The Dow made a higher high on Thursday at 14,149, only 15 points below its historic high close at 14,164. Friday's close at 14,089 was a new five year high close. The positive close was solely on the back of IBM with a gain of $2.08. The next highest gainer was WMT at 96 cents and then Disney at 74 cents. Only 18 of the 30 stocks finished positive. It was FAR from a bullish day but it was a higher high close.
We can't argue with results. Despite the negativity in some other indexes the Dow was the leader. The Dow opened the day with a -116 point loss so rebounding in the face of the sequester to close with a +35 point gain was impressive.
The megaphone pattern on the Dow is in danger of breaking out to the upside. That would negate the topping pattern and turn it into a consolidation-continuation pattern.
The Dow is targeting that 14,164 historic high level. There are numerous precedents suggesting a climax spike to close over that level could result in the long awaited bout of profit taking. However, indexes making new highs by more than a handful of points tend to keep making new highs.
Dow Chart - Daily
The Nasdaq is consolidating around the 3150 level with a pattern of lower highs and higher lows suggesting a breakout is near. The only question is direction. The Dow should determine that direction. If the Dow does break to the upside the Nasdaq will likely follow. Key support is now 3100 and critical support 3085.
Nasdaq Composite Chart - Daily
The Russell 2000 chart is a clone of the Nasdaq with a consolidation pattern after the new highs in mid February. Support at 895 remains a critical level and traders will load up on shorts if that level breaks. The high close was 932.00 so that remains the ultimate target with resistance at 920. Watch the Russell as a fund manager sentiment indicator.
Russell 2000 Chart - Daily
The market surprised everyone with the swift rebound on the Dow. Unfortunately the other indexes did not follow through with the same excitement. The Fed is still driving the train and QE may overcome the declining global economics. However, global economics is a longer time horizon. The market can remain unconcerned in the context of a change in the global economic picture until suddenly panic appears. This is not something we can juggle day to day.
The payroll numbers will be the headlines to fear this week. Analysts don't expect any sudden change in the numbers but they never do until the headlines surprise them.
The Fed is in control. Don't fight the Fed. Resistance is futile.
Enter passively and exit aggressively!
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"I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them."
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