Profit taking was the order of the day on Friday as the Dow and SP500 closed out the week with losing sessions, but complacency remained the word of the month, and oil remained the king of the hill.
The SP500 dipped 2.95 on the day, the
Dow Industrials lost 31.81, but the NASDAQ Composite bucked the trend,
rising 22.14 to yet another new high as investors continued to feverishly
buy anything, and everything, technology related.
Despite Friday's losses, the stock
market ended the week with solid gains: NASDAQ gained 4.6% on the week,
the SP500 gained 1.9%, and the Dow Industrials gained 2.2%.
In the short term, the current rally
appears to have legs, and with a powerful set of factors working in its
favor, the stock market is likely to close out the month with a bang as
the Dow joins the NASDAQ and SP500 in the daily record setting game.
The Dow's odds of moving to new highs
received a boost after the bell on Friday with the announcement that a
mediator had been named in the Microsoft antitrust suit. Microsoft
shares rallied four points on the news in after hours trading, and the
news will temporarily lift the one black cloud of worry that had been
hanging over the tech sector.
before the Microsoft news, the tech stocks were poised to enter next week
with nowhere to go but up in the short term: combine the market's
traditional pre-Thanksgiving rally and a mountain of mutual fund
cash, and the pieces were already in place for one final blow off move
Blowoff is perhaps the
best way to describe the stock market's, in particular the NASDAQ's,
recent action because the current market has all the makings of an end of
trend blowoff top.
accelerated sharply during the recent surge upwards as investors
frantically pour money into the most speculative sectors of the market in
a feverish rush to get on board a streaking freight train to riches.
The most recent figures from AMG Data showed $7.1 billion, the largest
inflows in 1 1/2 years, flowing into equity funds during the latest week,
with the lion's share of that finding its way to technology and
speculative growth funds. The inflows into equity funds, in
particular technology funds, have accelerated sharply as the market's rise
buying of shares is likely to accelerate if the psychologically important
Dow Industrials break to new highs.
this surge in public buying has been a sharp increase in complacency, as
exhibited by the sharp drop in the equity put/call ratio, now at 0.32, and
the Volatility Index (VIX), which dropped to 19.63 on Friday. Since
July of 1998, each drop below 20 by VIX has been accompanied in short
order by a market decline. In each case, the market decline has
begun when VIX reversed from below 20, and climbed back above 20.
sharp increases in equity fund inflows and complacency have also been
accompanied by an explosion of activity in the most speculative areas of
the market. The mania for Internet stocks has once again reached an
extreme, with investors rushing to get a piece of anything with a .com in
its name, pushing stocks to extreme valuation levels based solely on the
hopes and dreams of an analyst's promotional pitch, rather than on the
facts. We have seen companies like Stamps.com attain market caps of
$2 billion--before they even recorded their first revenues.
activity in the IPO market has also gone off the top end of the scale,
with company's achieving levels of valuation on their first day of trading
that discount the next 5 year's of the most optimistic of growth
While blowoff tops
and their accompanying extremes of sentiment often carry prices far
further than expected, and often last far longer than expected as momentum
builds to a feverish pitch, we would expect this current blowoff phase to
run into extreme difficulties during December.
extreme levels of complacency in the market (and the almost unanimous
belief among stock traders that there will be no more rate hikes) leave it
completely unprepared for what we expect will be a string of unfavorable
The recent surge in
oil prices to $27, their highest levels since the Gulf War, will make
itself felt in next month's CPI and PPI, and if the most recent
Initial Jobless claims numbers are any guide, the November Employment
report will show an increase in labor market tightness. The demand
indicators, retail sales and housing, are also likely to show renewed strength
as consumer confidence increases in the wake of the recent stock market
surge and multi-decade lows in unemployment.
fears will also exert a dampening effect on the current rally in December.
the record setting rally until the end of the month because rampant
complacency, Y2K fears, and unfavorable economic reports could turn next
month and the upcoming holiday season into anything but a time to be
after the last rate hike of the century, the markets paused to take a
breather. Some attributed the lack of new record highs to profit
taking, while others blamed it on a bond market gone bad, but either way
you sliced it, NASDAQ 3300 was forced to wait for another day.
Composite was not the only average to flirt with new highs
yesterday. The XOI (oil index), which had quietly surged 12.5% over
the previous 7 seven trading sessions in relative anonymity as all eyes
were on the NASDAQ's record run and the FOMC meeting, soared 9.69 to
finish the day near its all-time high, a fact which perhaps more than
profit taking was responsible for the selloff in the bond and stock
OPEC's resolve to maintain production
cuts, and an unexpected sharp drop in gasoline inventories combined to
send oil prices soaring, with NYMEX December
Crude Oil futures nearing a 3 year high yesterday as they shot up 90
cents to $26.60 a barrel, and Brent crude surging over $25 to an 8 1/2
In September, we said oil was headed
towards $30 later in the year, and it now appears that our estimates were
on the low side. Bullish sentiment towards oil, when combined with
falling supplies and the side of the equation we haven't mentioned yet,
U.S. demand near its highest level of the decade, have the potential
to push oil prices well over $30 if the weather cooperates this winter--a
scenario which will not sit well with the inflation skittish bond market.
The surge in oil prices will also make
its presence felt in next month's PPI and CPI reports. Gasoline
Oil futures also surged yesterday, and these rises will be felt at the
consumer level. A 0.1% decline in energy prices was one of the main contributors
that helped October's headline CPI figure slow to a benign 0.2%, and we
would expect next month's figures to show an upward tick in the headline
While oil induced inflation worries
played their part in yesterday's reappearance of the bond market's long
running case of the rate hike jitters, signs of a pickup in demand also
played their part. Housing starts rose just 0.1% in October, but
building permits jumped 5%, indicating that the housing sector will remain
strong in the months ahead.
The building permit numbers, like the
industrial production/ capacity utilization numbers on Tuesday, suggest
that the economy's above trend growth rate is likely to continue,
increasing the odds that the Fed will be forced to act again early next
year in an attempt to slow demand.
Going forward, it is likely to be the
demand side of the equation (Retail Sales, Housing) , rather than the
price side (CPI, PPI) that determines the Fed's next move. With the
wealth effect an integral part of the demand equation, an acceleration in
asset inflation (home prices, stock prices) will be the market's own worst
enemy going forward.
Finally, we are heartened to see that
those analysts who earlier this year were urging their clients to buy a
basket of airline and oil stocks have finally caught onto the fact that
airline profitability and rising oil prices are not a good mix....now if
someone would just tell them that U.P.S.
(which rose 1.68 yesterday amidst a 3% decline in the Dow Transports) is
not immune to the effects of higher fuel
life in the Fear Free Zone, a place where Goldilocks has just been
installed as Ruler for Life, a place where the time is and always will be
the New Era, a place where the economic textbooks have been rewritten to
justify the prevailing mood, and a place where banishment is the
punishment doled out to those who dare to use the V (aluations) word.
Welcome to the latest chapter in the
decade's longest running show, The Great Bull Market of the '90's, a
chapter which opened as expected with the FOMC raising rates by 25 basis
points and moving to a neutral bias, with the added twist of a 25 basis
point hike in the discount rate thrown in for good measure.
Welcome to a world where complacency has
gone off the top end of the scale, where the wall of worry has evaporated,
and where all of the good news is already discounted. In short, welcome to
a world where, in the short term, momentum and crowd euphoria are strong
enough to carry stocks to new absurdities of valuation, but where, in the
longer term, the cheers are likely to be replaced by the ominous hissing
sound of air escaping from a bubble as euphoria runs headlong into the
The Fed did as expected, and the stock
market answered with the expected, a powerful rally borne of relief and
complacency that carried the S&P 500 and NASDAQ Composite to new
records. For the NASDAQ, it was but one of a string of recent new
highs, for the S&P 500, it was the first new record in nearly 5
months. The Dow Industrials, while failing to participate in the
day's round of record setting closing highs, did manage to break above
resistance at 10860, setting the stage for it too to reach for the heavens
in the not too distant future.
The current euphoric state of investors
could very well set off a broad based short-term rally that carries the
market well past its old highs, but the future is unlikely to be nearly as
bright for the effervescent U.S. equity market.
Although an equity market valued at more
than 1.6 times GDP is more than a concern, valuation levels will not be
the pin that pricks the bubble. While we would have no qualms in
placing a bet that the current stratospheric P/E ratios of market darlings
Applied Materials (60.6), Cisco Systems (136.2), General Electric (43.6),
Home Depot (55.4), Lucent Technologies (70.4), Microsoft (61.4), and Sun
Microsystems (99.7), will be significantly lower and perhaps cut in half a
year from now, these valuation levels will not be the downfall of
No, rather euphoria is likely to die
because of a certain incompatibility that has developed in the
marketplace: an incompatibility between the current belief that the
Fed's job is done, and soaring stock prices and falling bond yields.
The Fed's job can not be considered to be complete until the economic
imbalances that prompted its first rate hike have eased.
Perhaps the key phrase from the FOMC's
policy announcement to keep in mind going forward is "the expansion of activity continues in excess of the economy's growth potential". Although the market is celebrating what it believes to be the end of the current rate hike cycle, further rate hikes can not be ruled out as long as the current conditions of unsustainable above capacity growth and labor market tightness continue.
With the wealth effect still very much
alive and closely correlated to the direction of stock prices and to a
lesser degree interest rates, as the recent rises in consumer
sentiment and mortgage applications that occurred simultaneously with a
sharp stock market rally and a steep drop in long term interest rates
shows, it is unlikely that a scenario of "no more rate hikes"
will be able to coexist with a continuation of the recent rallies in the
stock and bond markets.
In order for the prevailing wisdom that
"3 did the trick" to translate into reality, it will be
necessary for consumer demand to ease, a scenario which will likely only
occur if the wealth effect is thrown into reverse: i.e. a rise in bond
yields and a fall in stock prices puts a strong enough damper on consumer
confidence that the consumer is forced to think twice before pulling out
In order for a drop in consumer
confidence to erase the possibility of further rate hikes, the drop in
domestic consumer demand must be of a large enough magnitude that it
negates the growth spurring effects of accelerating global economic
growth. Not until the net demand for goods and services eases from
its current blistering pace and translates into a lower demand for new
workers will the danger of wage pressures developing be erased, and as
long as the threat of an acceleration in wage pressures remains, the
potential for further rate hikes will exist.
While the Fed has made its last rate
hike of the year, it has more than likely not made its last rate hike of
the current cycle. After the Fed takes a momentary respite in
deference to potential Y2K related problems, we expect further rate hikes
to follow next year--a scenario which is not at all discounted by the
Welcome to life in the Fear Free Zone, a
place where danger is lurking around the bend.
to the FOMC and not a creatures worried, not even a mouse, for the jitters
have been wiped away, productivity has killed the imaginary inflationary
menace, financial reform is here to spark a rally, and everybody wants a
piece of the non-stop tech action--it just doesn't get any better than
this...just ask anyone, and the reply will be the same, "The Good
Times are here to last."
On the eve of the FOMC meeting the
celebration is in full force, tech stocks, Internets, and financials at
the front of the line, and not a cloud of worry in the sky.
In the technology sector, the glass is
no longer half full, it is brimming over the top, and the market is able
to pick itself up from any arrow that may be shot its way, whether that
arrow be in the form of Microsoft's anti-trust woes, a less than sparkling
earnings report from Dell, or an analyst downgrade of Intel. Buying on the
dip, and a record inflow of funds into technology funds during the last
week provide the NASDAQ with a solid safety cushion to seemingly weather
The financial stocks, too, are benefiting
from a blast of euphoria as financial reform takes center stage and
interest rate fears take a back seat.
All across the land, investors are once
again driven by a need to get in on the only game in town, to hitch a ride
on the road to endless 30% annual returns, and wherever one goes, the
refrain is the same, "the sun will always come up tomorrow, happy
days are here again".
Even the once despondent bond market has
gotten in the act, with rates tumbling from 6.40% to 6.03% on the long
bond as traders become convinced that the storm will have passed after
tomorrow's expected third and final rate hike. True, there are some
who fret that the Fed might suddenly find itself behind the curve if it
succumbs to the temptation to hold rates steady, but even here the fear is
but mild, as market participants one and all believe that whether the rate
hike comes tomorrow or early next year, three will do the trick.
The current economy, for its part, has
played a starring role in reigniting the stampede into the crowd 's
favorite issues. The economy continues to steam ahead at full force
as increases in productivity smooth the way, with productivity surging
4.2% in the third quarter, while unit labor costs inched up a measly
0.6%--the final proof needed by an eager public that inflation has been
put to bed.
Rising productivity, wage pressures
seemingly stopped dead in their tracks, and signs of a slowing
economy--enough evidence to stop the current rate hike cycle at three many
would say, or perhaps to even prevent a third rate hike from ever
materializing, others would say.
As the Goldilocks economy struts its
stuff for all to see, there is not a cloud in the sky, and not a frown
among the onlookers--a condition the cynical might describe as complacency
on steroids, and a condition that will likely cause the Fed to give a
quarter point nudge tomorrow, although even that expected nudge will do
little to dampen spirits.
The only thing with the power to darken
the skies, to put the brakes to euphoria, is the possibility that perhaps
three will not do the trick, a possibility that becomes closer with each
passing day as euphoria erases the effects of each Fed rate hike.
The underlying pressures will not
suddenly ease with tomorrow's expected Fed move--blame it on the wealth
effect. The recent surge in stock prices and drop in bond yields is
likely to quickly reverse any temporary economic slowing that occurred as
stock prices briefly slid down a wall of rate induced worry to their
recent brief date with the 10,000 mark. Already signs of a reversal are
gathering: mortgage applications picked up after the recent drop in rates,
and then there is consumer sentiment, which after a brief dip is on the
The outlook for today is bright and
inflation free, but the outlook six months down the road remains
clouded--a condition that is unlikely to ease until consumer spending is
dampened and the threat of inflation is erased.
Pressures bubbling beneath the
surface suggest that the threat of inflation picking up remains very
real. From rising prices in intermediate goods to continuing signs
that wage pressures could be about to make their presence felt, the threat
of pricing pressures working their way through the pipeline remains.
When the consensus view is that nothing
can go wrong, that the good times will last forever--that is the time to
worry, and with an overwhelming belief that the skies will be clear from
tomorrow on out, the time to worry might be now.