Sunday, November 18, 2007

The Fed Was Talking Tough On Friday

- Up and down expiration ends positive with no real fanfare.
- Fed changes its focus on the week and was talking very tough on Friday.
- Foreigners still cool on US assets for the second straight month.
- Light holiday trade into Thanksgiving may allow stocks to make an interim bounce. Stocks bounce up and down in typical expiration fashion.

We expected volatility on expiration and that was the case though it was not a violent whiplash session. Futures were flat in the very early morning, but they jumped sharply on news of CSCO enhancing its buyback by $10B, an HPQ upgrade, and some dollar support from Paulson that was more than the now trite 'strong dollar is good for the US' one liner.

It was surprising to see the futures improve given the other side of the ledger that was less than inspiring for stocks. The earnings outlook continued to weaken as SBUX blamed higher milk costs due to higher grain prices due to using our corn for producing ethanol. Of course no one is going to cry because a $5 cup of joe costs a bit more. The story may change, however, as milk and other food staples surge in price because our government forces us to use our corn to produce fuel that only the corn producers love. In addition to SBUX, ANN and KSS provided weak outlooks as well. No word as to whether they blamed ethanol or not. Foreign purchases of US instruments was weak for a second straight month. The Fed-speak was negative with Krozner saying the Fed expected weakening economic data but that the data would not lead to rate cuts. Bummer.

The futures held up into the open, but as soon as the bell rang and stocks started higher, they started selling back. Before things even started expiration volatility showed up. Stocks started higher then sold to negative within the first half hour. Double bottomed, then rallied back to the opening high, a 44 point round trip for NASDAQ, 140 points or so on DJ30. Then it was back down in the afternoon with SP500 and DJ30 hitting session lows with a couple of hours to go. NASDAQ held well above its session low. They were set to close lower but a sharp short covering surge in the last hour pushed the large cap indices positive. That made the session look better, but there really was not a lot there.

We did not get too involved because expiration Friday is an untrustworthy mistress. Positions are shuffled, rolled over, closed, etc. There are many undercurrents driving stocks other than good old buying and selling just to own or to get out of a position. We did take some nice gain on some downside plays (SBUX and CMI), putting the early plunge to negative to use. After that we did not do much, just watched what sectors were trying to establish leadership, how support and resistance were holding, and how the indices reacted to same. NASDAQ and its large caps may be trying to set up for an interim bounce above the 200 day SMA, but the Friday action didn't change the outlook of the market overall.

Technical. The action was overall rather lackluster for an expiration Friday. As noted, it did not change the character of the market, but expiration rarely does. The indices bounced positive to negative all session, managing a positive close on that last spurt of buying. Decent intraday action.

Internals. Volume was stronger, but that is expiration's calling card. After a week of declining, but still above average trade, a bounce higher on options expiration was nothing unexpected. Breadth was negative even as the large cap indices closed positive. All that shows is that the move was led by a few large caps, i.e. a narrow rebound into the close.

Charts. The indices bounced off the lows for a positive close, holding the recent lows on the test. That holds out the possibility of an interim bounce on the light volume Thanksgiving week, particularly with NASDAQ still above its 200 day SMA. SP500 and DJ30, however, are still below that key level as the tug of war between NASDAQ and the NYSE large caps continues. For the moment the large cap techs look as if they could make the bounce, but after that there is more work to do before a sustained run can set in once more.

Leadership. Some of the alternative energy solar stocks are trying to shine the light to the upside. As noted, some large cap techs are trying to put in an interim bottom at the 50 day EMA; after some pretty nasty selling the pressure has abated for now. With the low volume Thanksgiving week they could pull off an interim bounce. After that the sellers will take their shot once more, and after any bounce we will be looking at some more downside positions to play another bout of weakness.


Bernanke announces course change, Krozner drives it home.

With little coverage during the week the Fed changed its focus from the core PCE to the overall inflation number, i.e. including food and energy in its target as it battles inflation. Of course with the overall rate running in excess of 3% that puts inflation back at the forefront of Fed activity. Just when inflation at the core rate showed it was really under control with several months of the annual core PCE at 1.9% and 1.8%, the Fed changes the game and now all bets are off.

Why the change? Pressure. Bernanke just explained to Congress a couple of months back as to how the core was historically a more reliable inflation indicator. Yet now they are suddenly very important. Maybe it was oil flirting with $100/bbl and the 1% rise in food the past few months (thanks to ethanol) that pushed the Fed to the notion that energy was going to bleed over into consumer prices. It certainly is not the inflation data suggesting that. Outside of some specific areas inflation has been on the decline. Thus there is not a lot of bleed over from energy, at least as the government measures it. If you look at boat prices or basically anything that uses petrochemicals in a significant portion of its manufacturing prices you see the inflation. It isn't just education and healthcare; there is more though it is not surging inflation.

Doesn't really matter the reason. The Fed has made the change. If it was not enough that Bernanke announced it, Krozner filled in the gaps on Friday. Sure the Fed still saw the economy as heading lower near term. Krozner called it a 'rough patch.' The sub-prime and credit issues were going to cause further economic declines. The Fed anticipates the consumer will lower spending. Krozner clearly stated, however, that weaker economic data does not equate to rate cuts.

That makes a count of 3 Fed officials and the last FOMC policy statement stating that no more rate cuts are coming anytime soon. The market has never been the same since the 25BP rate cut, as it builds in a significant economic slowdown based on the sub-prime and credit issues and the Fed's response. The Fed has shifted from heading off economic slowdown as its first goal back to inflation fighting.

We will see if it is right as it was in August of 2006 when it paused its rate cuts. At that time, however, the stock market started a strong7 month rally. It tested in March, putting in a double bottom, then was off and running again. Now it looks to have peaked, however, with some twin peaks and extreme volatility even as the indices hit new highs. That first round of selling was when the credit issues piled on top of the sub-prime worries, resulting in the massive selling volume in July and August. The market recovered to a new high, but then the Fed, after starting with a 50 BP rate cut to stave off trouble, cut just 25BP, and the market saw that as not enough to make the difference, and the selling has resumed.

To recap: Fed announced a pause in August 2006 and the market runs 12 months. It announces a 25BP rate cut and says it is done cutting. Market sells off in heavy distribution as leaders break their uptrends. You make the call.

Industrial production plunges, no one wants US securities.

Industrial production is falling off again. It faded early in 2007 as that second half 2006 slowdown continued. It came out of the slump in Q2 and Q3 as the economy recovered. Now the credit issue has slowed the economy again and now production is down, falling 0.5% when a 0.1% gain was expected. Largest drop in 9 months.

Looks as if the slowdown just gave birth to a more serious slowdown. This is the latest in a series of key data that is really showing a struggle in the economy. Slower Chicago PMI, declining ECRI, plunging dollar, distributing stock market. With the Fed on the sidelines it is unlikely things will get all that more positive.

US Securities getting lonely.

On top of that, support from foreigners is waning. For the second straight month buying of US financial instruments is down. It was down $26B in September, but that was better than the $70B decline in August. It is a good thing exports are rising as rapidly as they are thanks to a still solid global economy and a still weak US dollar.

Unfortunately, they are not able to rise fast enough to get rid of the massive imbalance in the current account and thus the US still needs foreign investors to finance our buying. The Chinese and Indians realize that they are getting wealthier and that they can buy some of their own goods. Their governments are diversifying to other countries' assets in addition to the US as well. That means selling dollars to buy currencies of other countries, and that brings more dollars coming home, and that means lower dollar levels and the potential for more inflation. It is not a pretty picture, adding to the really bad pile of muck left by the last Fed that the current Fed has to mess with.

No Greenspan bashing tonight.

That opens the door to more Greenspan love notes about how that Fed printed too much money and has left the US with issues that are going to be painful to deal with. No doubt that is true, but does that mean Greenspan is to blame?

The Fed has a dual mandate: keep a steady currency (i.e. low inflation) while growing the economy at its fastest sustainable rate. With the Federal government running up huge tabs on Social Security and Medicare, just to name two entitlement programs, and amassing debts that we simply cannot pay as a result (surplus or no surplus), Greenspan HAD to print money to keep things going. He didn't like doing it. Think. How many times did Greenspan go before Congress and plead the case that the entitlements were out of control and had to be fixed? He spend his last several years doing just that.

Why did he do it? Because he knew what was coming in printing all this money. But his mandate said that was all he could do. Sure, he could have broken outside of his authority as authorized by Congress, but unlike the Federal courts, to his credit he did not. He pleaded with Congress to act, but it did not, and that left him no room but to print money. If he broke rank as many wanted him to do he could have let the economy tank and let the US suffer some pretty awful deflation as the unfunded entitlements wrote down the economy, forcing savings the old fashioned way after our financial markets collapsed as a result of the write down.

Greenspan stuck to his mandate to the end. Bernanke is doing the same, but the irony is, even as he talks of more reporting this week to open transparency, he is changing the focus to inflation when it is not really a major issue. We speculate he is setting up for some kind of epic fight to raise the currency and balance the current account. Could get interesting as the Chinese say. For certain the market does not like whatever it is smelling.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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