Sunday, January 7, 2007

More Thoughts on Last Week's Market Action

From the Street.Com

Investors' repositioning for the new year collided with interest rate fears to kick off 2007 with trepidation and anxiety running through the financial markets, with the notable exception of tech and biotech stocks.

Friday's stronger-than-expected jobs number forces the markets to wrap their arms around the idea that a recession is unlikely, and that is a relief. But they also need to embrace that the Federal Reserve is not opening the door to rate cuts anytime soon, and that is disappointing to many investors.

The minutes from December's FOMC meeting, released Wednesday were, in sum, hawkish in that the Fed maintained a bias toward tightening amid concern about inflation. That wasn't a big surprise, but an early morning rally reversed when traders realized the central bank was not discussing a move to a more neutral policy stance.

Friday's stronger-than-expected 167,000 non-farm payrolls report was a surprise, given payroll processor ADP's earlier employment forecast of 40,000 jobs lost in the month. To cut rates, the Fed would need to see some softening in the labor market to mark a true slowdown in the economy.

Let's put the market on the couch to see what it is thinking.

As the chart's below illustrate, the S&P, NASDAQ and Russell 2000 were all either in a trading pattern (SPYs and IWMs) or had actually sold-off a bit (QQQQs) over the last few weeks/months. Trading patterns mean supply and demand are near equal in the market; there is no reason for buy aggressively, but no reason to sell. So the markets have been waiting for something to happen. The question is, "what are they waiting for?"

The general consensus is the markets are waiting for a clear sign regarding interest rates. The economy slowed do 2.2% growth in Q3, indicating the possibility of a Fed rate hike is a bit higher. At the same time, most market prognosticators have been noting that corporate earnings -- which have done very well this expansion -- would have to come down a bit in a slower growth environment. Putting these two strains together, it seems the markets are waiting for the first signs of either slowing corporate growth to sell or a firm indication on the direction of interest rates.

While the Fed won't come right out and say, "we're not going to raise/lower rates until x," the latest FOMC minutes were pretty clear:

All meeting participants remained concerned about the outlook for inflation. Although readings on core inflation had improved modestly since the spring, nearly all participants viewed core inflation as uncomfortably high and stressed the importance of further moderation. Participants expected core inflation to edge lower over time, in part as the pass-through of higher prices for energy and other commodities ran its course and as the moderate growth in aggregate demand likely led to a modest easing of pressures on resources. Some participants also highlighted the impact that movements in the prices of individual components of the price index, such as owners' equivalent rent and medical costs, could have on near-term readings on core inflation. More generally, participants stressed there was considerable uncertainty as to the probable pace and extent of the moderation in core inflation and that the risks around this desired downward path remained to the upside. Moreover, participants expressed concern that a failure of inflation to moderate as expected could entail significant costs if an upward drift in inflation expectations ensued.

That's about as clear as you're going to get from the Fed. Friday's employment number was strong for the current expansion (+167,000). In my opinion, it pretty much knocked the idea of a rate cut back or even off the table for at least awhile.

In short, right now the market's don't have a strong reason to buy based on the idea of interest rates going lower.

At the same time, we have not moved into first quarter earnings season yet. So, we don't have a reason to sell yet based on declining corporate earnings. That means heavy selling action will probably be tempered with some hope for one last quarter of good corporate results.

So -- the market appears to be very nervous about the future, but unwilling to commit in either direction -- at least not yet. That could all change at a moments notice.