Weekend Weimar

While we usually have this on Friday, it's on Sunday today. Why? Because it's Sunday. And no -- it's not because I'm a football fan (I like hockey). It's because I need a day off from writing. So, admire these two fine examples of a great breed of dog.



For those of you who are not dog people, here is a video from YouTube that I have always found to be really funny.

Where The Market Stands

I have been working on the theory that the market was consolidating in a head and shoulders formation and was going to make a short rally as the rate cut expectations grew. Everything was about where I expected it to be through Friday morning. The market was still uneasy, but was consolidating gains and staying above the H&S neckline. The daily action wasn't great, but wasn't horrible

Then came the employment report. It wasn't just bad. It stunk. Mish completely takes it apart. He and I are in complete agreement on what this report said: This jobs report was nothing short of a disaster. In short, this wasn't just weak enough to add credence to a rate cut scenario. It increased talk of an outright recession. That is a development I wasn't expecting and that is the reason for the heavy action yesterday.

I will add in my own defense that I have consistently put up the NYSE and NASDAQ new highs/new lows chart from stockcharts.com and mentioned they indicate the uptrend isn't that strong (see this post). And I also mentioned the transportation average was not confirming the rally along with another mention of the weak high/low average here. This demonstrates that while I was short-term bullish I was still not completely sold on my own idea.

However, let's look at a broader idea I mentioned in this article -- that the idea of a rate cut has put a floor under the market.

Here's a daily chart of the SPYs:



As I mentioned below, yesterday's action did a great deal of technical damage. First, it broke the uptrend the market started in late July. Trends are very important in the market. Traders will follow them irrespective of the underlying market conditions. If the market is moving in one direction, traders will simply stare at their screens, block out any contrary information, and keep making bets in the trends direction. That's how market work. Yesterday's action ruined a few weeks long trend.

In addition, it took out the theory of the market consolidating in a head and shoulders formation and rallying on rate cut events. With yesterday's close breaking the neck line the possibility of a higher move are greatly diminished.

All that being said -- what is the downside risk right now? First, there is a ton of technical traffic in the $144-$148 area. The market has to move through this area convincingly before another serious downside move. There is also the issue of the 200 day SMA, which has acted like a center of gravity for the market for the last month. While the market hasn't moved convincingly higher over the 200 day SMA, it has not moved convincingly lower either. That tells me the jury is definitely still out regrading the downside risk. Then there is the issue of overall valuation. According to Barron's The Dow's PE is 15.73 and the S&P's is 17.08. While these aren't cheap, they certainly aren't expensive either. In other words, traders aren't going to sell based on the theory the market is really expensive.

Then there is the Fed. The market is expecting a rate cut in September, and the jobs report adds a great deal of credence to that expectation. I would add a word of caution that last week four Fed governors gave speeches that did not telegraph a 100% possibility of a rate cut. I work on the assumption that Fed officials have advanced economic information, meaning they probably knew about the jobs report when they gave their speeches. However, despite these speeches, I would not be surprised to see the Fed cut rates later this month.

However, I think the market is now moving into a different thought pattern. The jobs report increased talk of a recession. And the market may now be really on edge as it awaits more data that either confirms or denies that possibility. Until there is a firm idea as to which way the underlying economy is going I would expect the market to remain very weak, but not weak enough to send the market into a complete meltdown. Therefore, I think the market is going to move back into a very neutral stance where the 200 day SMA is the big trendline to watch.

Now that I've said that, I'm sure the market will again make an ass out og me within the next few weeks.

Today's Markets

The employment report sent the market down today. However, once the market dropped it stayed within a range. This is encouraging. However, the market did sell-off 1.44% as of this writing. Also note there was buying interest later in the day which is encouraging.



Here's a 5-day chart. The market broke trend on Wednesday, traded in a range for two days waiting for the employment report, then sold-off today.



Here's an 8-day chart. Notice that even though the market has broken the uptrend and sold-off, we're now at the 61.8% Fibonacci retracement level from the rally.



Here's the daily chart. Notice the following:

1.) The SPYs have broken the neck line of the head and shoulders formation.

2.) The SPYs are back at the 200 day SMA.

3.) The SPYs broke the uptrend stared in mid-August.

Employment Report Stinks

From the BLS:

Nonfarm payroll employment was essentially unchanged (-4,000) in August, and the unemployment rate remained at 4.6 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Over the last 3 months, total payroll employment changes have averaged 44,000 per month and private sector employment changes have averaged 72,000 per month (as revised). In August, employment in manufacturing, construction, and local government education declined, while job growth continued in health care and food services.

The details aren't very good.

First,

Manufacturing employment declined by 46,000 in August. This industry has lost 215,000 jobs over the past year. In August, declines were widespread among component industries. Within durable goods, there were job losses in motor vehicles and parts (-11,000), machinery (-7,000), wood products (-7,000),furniture and related products (-4,000), and semiconductors and electroniccomponents (-4,000). In nondurable goods manufacturing, job losses continued in apparel (-4,000) and in textile mills (-2,000).

In addition,

Construction employment declined in August (-22,000), with most of the loss occurring among residential specialty trade contractors. Since its most recent peak in September 2006, construction employment has fallen by 96,000.

"Blue collar" employment isn't doing very well. Manufacturing has been shedding jobs for the last year, and the decline in construction employment indicates the housing slowdown is finally translating into job losses.

In addition, gains were in low-paying sectors. Education and health services added 63,000 jobs, and "leisure and hospitality" (read, "do you want fries with that?") added 12,000. These lower paying sectors are where job growth was strongest.

Yesterday, Bob Pisani wrote the following on his blog:

The jobs report. This leaves tomorrow jobs data as the key economic report before the Fed meeting September 18th. There have been some signs of weakness in the employment trends recently. Very strong data will clearly reduce the chances of a cut; very weak data will revive the belief a cut is imminent. The worst case scenario for the stock market is a jobs report that is in line or just slightly below expectations; this will leave traders confused about the Fed's intentions and put more weight on the weekly jobless claim numbers.

I think Pisani is correct in his analysis here. This number is clearly negative and all really ups the probability of a rate cut at the next Fed meeting.

T-Bill and Yen Update

T-Bills and the yen index are very important right now. I'm going to add a third chart to this, which is the SHY. This is the ETF for the 1-3 year Treasury market. It's a bit broader than simply looking at T-Bills.

Here's the yen, which is an obvious proxy for the carry-trade (borrowing where rates are cheap and lending where returns are higher). Notice the yen is consolidating above long-term resistance. While we haven't seen a move above this consolidation, we also haven't seen a move below this area either. A move over this area of consolidation will probably spell some real trouble for the market because it will indicate traders are probably moving away from the carry trade.



T-Bills

T-Bills -- the extreme short-end of the Treasury market -- have moved back to near post-run-up levels. This is a good sign overall.



However, the short-end of the Treasury curve is still consolidating advances after it broke through resistance. This indicates traders are still concerned about the credit markets and are simply parking money in short-term conservative debt for now.

New High/New Low Index Stil Bearish

Here is the chart for the New York and NASDAQ New High/New Lows, respectively. Notice they are still moving sideways. Until these indicators start to make upward advances this is a skeptical rally.

Fed Officials Upbeat

From Marketwatch

Federal Reserve officials said Thursday that current economic conditions are good and the financial turmoil hasn't hurt Main Street.

In a luncheon speech to the Atlanta Press Club, Atlanta Federal Reserve President Dennis Lockhart said there are no signs of spillover from the housing and mortgage market woes into other sectors of the economy such as consumer spending.

Lockhart said his comment relied on real-time information from business contacts around the South because much of the new government indicators are "backward looking."

"So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy," Lockhart said.

His remarks echo the sentiment in the Fed's Beige Book report on current economic conditions that found that growth continued across the country at a moderate pace through August with little sign that the credit crunch and financial turmoil have slowed activity. See full story.

But in an earlier statement to reporters following a speech in London, St. Louis Fed President William Poole said the risks of recession have risen as a result of the market turmoil. But Poole said, "I don't think we should take for granted that the economy is going to nosedive."

Later in the afternoon, Dallas Fed President Richard Fisher was upbeat about current conditions.

In answer to a question after a speech in El Paso, Fisher said recent economic data has been "rather positive," and pointed specifically to the August ISM services index, which was unchanged at 55.8%.

Let's make an assumption that Fed governors are in regular contact with one another. In addition, let's also assume they loosely coordinate their public statements. That would make sense at a time like this with everybody looking to the Fed to cut rates later this month. If all of those points are true then a rate cut is not a definite possibility.

So, let's assume the Fed doesn't act. What happens to the market? My guess is a day or two of selling but nothing drastic. After the initial sell-off, my guess is traders would come to the opinion there was no reason for the Fed to cut, meaning things aren't as bad as perceived. I have no idea if that is what will actually happen, but it makes sense. Non-action means the economy is doing fairly well.

Here's how Bloomberg reported the speeches:

Four regional Federal Reserve bank presidents declined to endorse a cut in the benchmark interest rate this month, as policy makers gauge the impact of the credit- market rout on the U.S. economy.

The markets are probably not happy about this development.

Foreclosures Still Increasing

From the Mortgage Banker's Association

The delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 5.12 percent of all loans outstanding in the second quarter of 2007 on a seasonally adjusted (SA) basis, up 28 basis points from the first quarter of 2007, and up 73 basis points from one year ago, according to MBA’s National Delinquency Survey.

The delinquency rate does not include loans in the process of foreclosure. The percentage of loans in the foreclosure process was 1.40 percent of all loans outstanding at the end of the second quarter, an increase of 12 basis points from the first quarter of 2007 and 41 basis points from one year ago.

The rate of loans entering the foreclosure process was 0.65 percent on a seasonally adjusted basis, seven basis points higher than the previous quarter and up 22 basis points from one year ago. This quarter’s foreclosure starts rate is the highest in the history of the survey, with the previous high being last quarter’s rate.

The main problem here is not the current news, but the future news. We have a ton of resets coming in the first half of next year. That means this number is only going to get worse at this point.

Today's Markets

Today was pretty much a holding patterns day since most traders are waiting for tomorrow's employment report. After 11 the market traded sideways until the close.



Here's today's action at the 5-day level. It's simply more of the same sideways action.



And here's the action on the daily chart. About the only thing to notice here is the second inside day after Tuesday's move up. This is nothing more than consolidation.

About The Unemployment Number

Barry at the Big Picture nails it. Go read this now.

Food Inflation is Here To Stay

From the WSJ:

"The genie's out of the bottle when it comes to food inflation," said Michael Swanson, an agricultural economist at Wells Fargo & Co.

.....

Corn prices over the past year have reached near-record highs thanks to growing production of ethanol, which is made from the grain, as well as rising demand. Corn futures closed at $3.29 a bushel yesterday on the Chicago Board of Trade, up from about $2.89 a bushel last year.

Prices have softened some because of this year's bumper crop. U.S. farmers are in the process of harvesting 13.1 billion bushels of corn, up 24% since last year and the largest crop since 1933, says the Agriculture Department. But it's unlikely that the crop will send prices down to levels seen a year ago.

The higher grain costs have trickled down throughout production lines. Mr. Bond cited the price of corn, the predominant feed for cattle, as a problem for Tyson's beef business. Prices for live fed cattle averaged about $93 per hundred-weight through August, versus about $85 last year, said Kevin Good, senior analyst at Cattle-Fax, a cattle marketing information firm based in Englewood, Colo.

Consumers can expect to pay as high as 4.5% more for groceries and restaurant meals this year over last, according to the Agriculture Department. That means shoppers who spent $100 on groceries during an average shopping trip last year can expect to pay as much as $104.50 this year for the same groceries.

But remember -- all that matters is core inflation.

Beige Book

Yesterday, the Federal Reserve released the Beige Book.

Here are some highlights.

Most Banks reported that the recent developments in financial markets had led to tighter lending standards for residential mortgages, which was having a noticeable effect on housing activity, and several noted that the reduction in credit availability added to uncertainty about when the housing market might turn around. While several Banks noted that commercial real estate markets had also experienced somewhat tighter credit conditions, a number commented that credit availability and credit quality remained good for most consumer and business borrowers. Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited.

The emboldened sentence is very important. In Bernanke's last big policy speech, he said he was looking for any signs the housing market was spreading beyond the housing market. Here is the hey sentence from his speech:

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

Putting these two sentences together and the possibility of a Fed rate cut diminishes.

Here's the summary paragraph from the beginning of the document:

Retail sales were generally positive, with increases characterized as modest to moderate. However, several Districts described motor vehicle and furniture sales as slow. Manufacturing activity expanded across most Districts, with reports of softening demand for building materials and autos. The weakness in the housing market deepened across most Districts, with sales weak or declining and prices reported to be falling or flat. Most Districts reported a continuing contraction in the residential mortgage market. Commercial real estate activity was generally stable to expanding. Demand for business loans held steady or weakened, while consumer lending was mixed. Agricultural conditions varied widely across Districts, with several reporting damage to crops and pastures as a result of excessive heat and drought conditions. Activity in the energy and mining sectors remained positive in all of the Districts reporting on these sectors. Nearly every District reported at least modest increases in employment during the recent survey period. Most Districts characterized their wage increases as moderate or steady. Wage pressures were intense only in isolated professions in short supply. And most Districts reported little change in overall price pressures.

Let's take these one at a time:

Retail sales were generally positive, with increases characterized as modest to moderate. However, several Districts described motor vehicle and furniture sales as slow.

According to the latest GDP report personal consumption expenditures increased 1.4% in the second quarter. This figure was revised .1% lower. However, the latest monthly income statistics from the BEA showed a fairly good increase. In other words, a new trend of expanding personal consumption expenditures may be emerging but we need more data.

Although this month's auto sales were a decent surprise, overall auto sales have been declining for most of the year. This is a big cause for concern. As for furniture sales, the decrease shouldn't be a surprise considering the housing market is a mess and will be for sometime.

Manufacturing activity expanded across most Districts, with reports of softening demand for building materials and autos.

This has been a bright spot in the economy. Exports are doing well thanks to an expanding global economy and cheap dollar.

The weakness in the housing market deepened across most Districts, with sales weak or declining and prices reported to be falling or flat. Most Districts reported a continuing contraction in the residential mortgage market. Commercial real estate activity was generally stable to expanding. Demand for business loans held steady or weakened, while consumer lending was mixed.

Residential housing has the following problem: massive supply + constricting loan situation = falling prices. Don't expect this to change anytime soon. As for commercial, the growth in spending has been solid for the last few quarters, although I have to wonder when the problems in the residential market start to bleed over into the commercial market (or if they will).

Nearly every District reported at least modest increases in employment during the recent survey period. Most Districts characterized their wage increases as moderate or steady. Wage pressures were intense only in isolated professions in short supply. And most Districts reported little change in overall price pressures.

Employment is a huge wild card right now. First, although the official employment numbers show a very low unemployment rate, that does not jibe with "moderate to steady" wage increases. In addition, the labor participation rate is still low for this part in the economic cycle. The fed noted this situation in passing later in the report:

Though some Districts described employment condition as tight, most reported that wage increases were moderate or steady. Wage pressures were intense only in isolated professions in short supply.

I'm expect employment to get weaker. I've written about this before. The short version is construction, financial services and retail employment are all vulnerable right now.

As for prices,

Most Districts reported little change in overall price pressures.

This may give the Fed some wiggle room. Remember, the Fed has consistently stated inflation was their number one priority for the last 6 months or so. Yet that concern is completely absent from their general overview of the economy in this report.

Short version, this report shows an economy that is in fair shape. There are strengths (manufacturing) but some glaring weaknesses (auto sales and housing). The employment situation is a conundrum.

BCA Projects Subprime Losses at $200 Billion

From BCA Research:

About 60% of subprime mortgages carry an adjustable rate, and $650 billion will reset at a higher interest rate in the next 16 months. Even without factoring in a recession, we estimate that the losses on bad subprime and alt-A paper could amount to about $200 billion over the 2007-2011 period (1.5% of today’s GDP). This compares with $153 billion (2.5% of 1990 GDP) in losses associated with the S&L meltdown in the late 1980s. Spread out over several years, such losses do not seem overwhelming on their own. However, it is the knock-on effects that are the larger risk to the economy, including a hit to consumer confidence and wealth, a curtailment of credit availability, and increased selling pressure in the housing market. Bottom Line: Fed rate cuts cannot solve the subprime mess, but can limit the negative impact on the economy.

I can't comment on the veracity of this analysis. Consider it merely food for thought.

Today's Markets

The market sold-off today. There are plenty of reasons. The ADP employment report didn't help, nor did the 12% drop in pending home sales. However, once the market dropped at the open, it traded in a range for the rest of the day. In addition, it didn't close on a low point.



Here's the 5-day chart. This helps to place today's sell-off in a bit more context. First, note the average broke the 5-day uptrend. However, also note the market sold-off to about the 38.2% Fibonacci level. Finally, note the average had support right at the $147 level. My guess is there were some buy programs activated at that level.



Finally, here's the daily chart, which really puts today's action in a better perspective. Notice we have a pretty clear inverted head and shoulder formation with two possible necklines. Also note today's price action was an inside day. The short version is today's sell-off was hardly fatal to the markets recent upward move. My guess is traders were simply using today's negative news as a reason to sell.



Finally, here's the same chart with the SMAs. Notice we are still above the 200 day SMA.



However, it's important to note the problems with the market listed in the post below. The transports aren't confirming this upward move and the new highs/new lows are not encouraging. While the market can still move up in this environment, the lack of confirming action means there isn't as much support for the move in the broader market. That means the market is probably still susceptible to sudden downward moves.

Transports Aren't Confirming Rally; New Highs/New Lows Not Advancing

There are two big warning signs with the current market.

1.) The transportation average is not confirming the recent run-up.



The new highs/new lows are still neutral at best.

NY New High/New Lows



NASDAQ New Highs/New Lows

ADP Employment Report Shows Weak Job Growth

From CBS.Marketwatch

Employment in the U.S. private sector grew by 38,000 in August, the weakest in four years, according to the ADP employment report released Wednesday.

The ADP report suggests nonfarm payrolls may have grown much slower than the 120,000 anticipated by economists. See Economic Calendar.

It was the second straight weak reading in the ADP index; July's reading was revised lower to 41,000 from 48,000 initially reported.

"A deceleration of employment may be under way," ADP said in a release.

First, there is some debate about the accuracy of both the BLS data and ADP data. The BLS data has to deal with the birth/death model adjustments, and the ADP data is a fairly new statistic that is still getting the kinks out.

That being said, this is not the news the economy wants to hear. However, it does play into the bad news = good news because it adds to the possibility of a Fed rate cut at the September meeting.

We'll know more with the Beige Book's release later today.

I've looked at several employment areas that will probably be the first to show weakness here

Commercial Real Estate Also Taking A Hit

From Bloomberg:

U.S. commercial real estate prices may fall as much as 15 percent over the next year in the broadest decline since the 2001 recession as rising borrowing costs force property owners to accept less or postpone sales.

``People aren't willing to do deals right now,'' said Howard Michaels, the New York-based chairman of Carlton Advisory Services Inc., which has arranged financing for real estate purchases including the Lipstick Building in midtown Manhattan. ``The expectation is that prices will come down.''

Investors in July bought the fewest commercial properties since August 2006 and apartment building acquisitions were down 50 percent from June, data compiled by industry consultants at New York-based Real Capital Analytics Inc. show. Archstone-Smith Trust in August postponed its $13.5 billion sale to a group led by Tishman Speyer Properties LP until October. Mission West Properties Inc., the owner of commercial buildings in Silicon Valley, said on Aug. 13 that the company's $1.8 billion sale may fail after a bank withdrew funding.

Assuming A Market Rebound, Where Will We See Movement?

I have been speculating the Fed's announcement last Friday essentially placed a floor under stock prices (at least for now). So the question now becomes where will the money go?

It won't be financials. The market has sold-this sector off and there is no reason to think this trend won't continue. Analysts are lowering their earnings estimates for a variety of industry players, there is concern about the commercial paper market, and the mortgage market is in turmoil. Traders have been selling this area of the market for the last few months and there is no reason to think this trend won't continue.



Health Care is a possibility. While this sector broke a two year uptrend in the last market sell-off --



It is currently sitting on a a shorter trend line. In addition, this is considered a safer market area to invest in. People are always getting sick. While this area isn't as sexy as the latest IPO, that's the point. As market participants start to look for possible safe havens this sector may benefit.



There are two other areas that look interesting. The first is the industrials/basic materials play. India and China are still growing. Other regions are as well. The dollar is cheap. Take all of these factors together and you have a recipe for higher earnings. Both the Industrials (XLI) and basic materials (XLB) sectors have sold-off to technically meaningful levels. Price action over the last few months may have formed a cup and handle formation, possibly signaling more upward movement. My guess is the latest sell-off is simple profit taking in a choppy market. It's important to look for companies that have international exposure here.

Industrials



Basic Materials.



Finally, there is tech. It has been forever since I have said tech looks good. But the charts are showing these sectors are starting to see some action. In addition, there isn't any mortgage exposure. Assuming the rest of the world continues to grow, this sector may benefit.

Tech ETF



QQQQs

Wheat Prices Surge

One of the main problems I have with Fed policy is their annoying reliance on core inflation as a primary inflation indicator. This is fine when food and energy prices are rising on a regular basis. But with India and China growing at high levels, it's not too off-the-wall to think basic commodities like food and energy will have continuing price increases.

Here is the latest from the wheat market:

Wheat prices piled on 30 cents a bushel within the first minutes of trading -- the maximum limit permitted by the Chicago Board of Trade -- and rose to an all-time high of $8.055 a bushel. Wheat has been trading in record territory for weeks amid worsening supply concerns. Poor weather ravaged crops in the U.S., Europe and the Black Sea region this year, and now conditions in the Southern Hemisphere as it enters the growing season don't seem much better. At the same time, high market prices haven't deterred global demand.

Here's a weekly chart of wheat which goes back a few years. Notice how prices are increasing at a fairly consistent rate.



Here's a monthly chart. Notice how we're clearly in new pricing territory.



Most importantly, here's a chart of the Goldman Sachs Agricultural price index. Notice that wheat prices aren't the only prices increasing -- it's happening across the agricultural price spectrum.

Today's Markets

Today's market action illustrated a point I made over the weekend. The market is clearly anticipating a Fed rate cut in September. As such, there is little downside in the market right now. Bad news simply adds to the perception the Fed will cut rates while good news means the economy is in fact doing well.

While the market started lower today it rallied throughout the day. While the market sold-off on high volume at the end, this shouldn't be too surprising. The market made a strong advance today and my guess is traders were taking profits off the table.



Here's the 5-day, 5-minute chart. Notice the uptrend we started mid-last week is still firmly intact.



Here's the 3-month daily chart. Notice we are starting to move away from the cluster of activity around the 200 day SMA and are going into rally mode.