What Will the Fed Do?
12/16/2008 1:15:28 PM
This week, we feature a number of short subjects that together shape our Market Outlook. We have created a slightly different flow and are interested in reader feedback. We still include our Week in Review and end, as we always do, with our Conclusion.
24th and 25th Bank Failures of 2008
The latest bank failures were announced Friday as another Atlanta area bank and a Texas bank went under.
Haven Trust of Duluth, GA was closed by the Georgia Department of Banking and Finance. This is the fifth Atlanta area bank that has failed and the FDIC was named the receiver. Branch Banking & Trust (BB&T) of Winston-Salem, N.C. will assume the deposits, which number $515 million on December 8th. Total assets were $575 million. BB&T will purchase about $55M of the failed banks assets. The FDIC will retain the remaining $5M in assets. BB&T paid $112,000 to assume the $515M in deposits.
In addition the fifth Atlanta area bank to fail, Sanderson State Bank of Sanderson, TX was closed by the Texas Department of Banking. The Pecos County State Bank (PCSB) of Fort Stockton, TX will assume all of Sanderson's deposits ($27.9M) for a 0.55% premium and will also buy $3.8M of the $9.1M in additional assets with an option to buy owned premises and equipment.
Inflation is easing
Friday, the Producer Price Index (PPI) data was released which showed a decrease of 2.2%, mostly driven by a drop of 11.2% in energy prices. This follows the 2.8% drop in October (again driven by energy prices).
The core rate (excludes food and energy) rose a mild 0.1% in November, down from a rise of 0.4% in October. This is the smallest gain since March. The rate beat analyst expectations (to the downside), which were for the core rate to remain at 0.4% while the headline rate fell 2.0%.
U.S. Households are paying down debt
For the first time since 1952, Americans are paying down their debts. Other nations are savers while Americans have been profligate spenders. In fact, the export nations depend heavily on the American consumer to buy they goods in order to support their economies.
As of September 30th, households' total outstanding debt shrank at an annual rate of 0.8% from $13.94 trillion to $13.91 trillion, the Fed said in its quarterly flow of funds report. It's the first decline in household debt ever recorded in the report. Households paid off more mortgage debt than they took on for the first time on record. Mortgage debt fell at a 2.4% annual rate to $10.54 trillion.
Other consumer debts, such as credit cards and auto loans, increased at a 1.2% annual rate in the quarter to $2.6 trillion. Total U.S. domestic nonfinancial debt increased at a 7.2% annual rate, boosted by a postwar record 39.2% increase in debt taken on by the federal government.
Retail sales recorded their fifth straight monthly decline
Retail sales fell 1.8%, mostly due to a decline in gasoline prices and automobile sales. Economists actually expected a drop of 2.1%, so this is an improvement of sorts. The drop in gasoline prices caused a drop in sales at gasoline stations of some 14.7%. Excluding that drop, retail sales fell just 0.2%. Many retail sectors reported their biggest sales increases in years.
Fed Policy Options
The Fed (Federal Reserve Bank) will release its policy statement on Tuesday, December 16th following two days of meetings by the Fed Open Market Committee (FOMC). It is widely expected that the Fed will cut the Fed Funds rate and Discount Rate. The Fed Funds rate stands at 1.0% and the Discount rate stands at 1.25%.
The Fed is expected to slash rates by fifty basis points to 0.5%. Historically, the Fed Funds rate is at a low, and cutting it further would represent a new low. The Fed is running out of room to cut the rate, but the rationale is to relieve pressure on homeowners by reducing the rate of adjustable mortgages tied to the Prime rate.
Fed Funds rate target currently sits at 1.0%. The effective Fed Funds rate has dipped to nearly 0.0% ending Friday at 0.15%. The Fed trades U.S. government securities in an attempt to achieve and effective Fed Funds rate (the rate that money is loaned between members of the Federal Reserve System).
The Fed began paying interest on deposits within the system in an attempt to place a floor under the rate, but that hasn't worked due to Fannie Mae and Freddie Mac dumping funds into the system. Fannie and Freddie are prohibited from receiving interest from the Fed so can't put funds on deposit there. Until this is worked out, the Fed is having problems controlling the Fed Funds rate.
The Fed has another option. That option is to begin buying up U.S. long term government securities. In reality, this would drive prices for these securities higher and further decrease yields from those securities. The Fed is attempting to drive interbank lending due to inadequate returns from low yielding longer term U.S. government securities.
It seems evident, at this time, that many investors are front running the Fed by purchasing long term U.S. government securities. Prices have continued to rise and yields fall in anticipation of the Fed stepping in to purchase these securities, which will drive yields down further and make these investments less attractive.
The Fed's objective is twofold. The Fed needs to build its assets since the amount of liquidity it has created needs to be soaked up. Second, banks are still fleeing to safety and purchasing long term U.S. government assets. If the Fed can reduce the returns on those assets sufficiently, then member banks could achieve relatively better returns by placing funds on deposit with the Fed and those funds can be loaned to other member banks. A lot of the economic recovery is tied to the easing of credit, and this is initially exemplified by interbank lending. That is why we follow the TED Spread every week.
The Santa Claus Rally
The Santa Claus rally is a regular bullish tendency for the markets to rally from mid-December to the first week in January. The Santa Claus rally tends to shape the thoughts of market participants. It doesn't always prove to be the case that the market will rally during that time, but the multi-decade performance record for the U.S. indexes is overwhelmingly positive during that time frame. This is important since professional money managers will all be aware of it and will therefore have a bullish bias in their trading.
There is a case to be made that market participants try to anticipate and position for this rally by entering the market prior to this period and exiting toward the end of this timeframe. Markets are built on beliefs and anticipation, so the widespread knowledge of participants may have eliminated an edge in trading it as traders try to front run its effect.
The argument is that long only fund managers must support their positions by buying shares at the end of the year before they have to record annual performance numbers. This improves the reported performance but this effect is transient in nature as the fundamentals didn't drive the price increases for the stocks begin purchased.
We'll have to see whether the Santa Claus rally occurs this year. The time frame begins in the coming week.
Looking at the market's potential, the factors that most influence the direction the market will take are:
Earnings outlook of market participants
Economic health of the overall economy
The health of our financial systems and the availability of credit
Fed policy and it's impact on the U.S. economy and market participants
Risk and attitudes toward taking on more or less risk
Alternatives to investing in equities
This isn't a complete list, and many of the subjects are related to each other. If we take a look at the fundamentals of each, it provides the perspective we need to determine where we think the market will go.
Our subjects of interest, already covered, included measures of the economic health of the overall economy and Fed Policies currently enacted, as well as future policies that may be announced as early as Tuesday, December 16th. We have also discussed the Santa Claus rally and its strong bullish seasonal bias.
We have also touched on alternatives to investing in equities, but let's bring this into focus. The safest fixed income investments have risen in value as their yields plummet as market participants have been using them as a safe haven. The real estate market has fallen precipitously and hasn't yet shown size of stabilizing, let alone beginning to move higher. In fact, the commercial side of real estate is only beginning to topple from its lofty levels.
Currency markets are in a state of decline, but gold and other precious metals aren't continuing their ascent. Commodity markets have fallen significantly, with oil 70% off the highs reached during summer, and metals and grains have toppled as demand has fallen. The alternatives to equities don't look particularly attractive at this time.
We haven't addressed the attitude toward risk directly so let's bring it into focus. Clearly investors have been fleeing to the safety of U.S. government securities. That is a risk-averse behavior. Also, small cap stocks are out of favor relative to large cap names. Small cap stocks are perceived to be higher risk than large cap stocks so once again demonstrates an aversion to risk.
Let's finally look at interbank lending rates, because a thaw in those rates will indicate the availability of credit is increasing and the economy will begin to expand.
The TED Spread fell twenty-seven basis points since last Friday closing at 1.91. We are still looking for the TED Spread to drop below 180 basis points at a minimum. Without that, it shows that credit remains tight. Still, a twenty-seven basis point drop is significant showing the interbank lending is thawing. A continued move lower will catch the attention of the smart money as it will break down through support and indicate that banks are finally loosening their hold on their cash hoard.
The importance of the TED Spread isn't a secret and the smart money watches it all the time as a barometer of the health of the credit markets. We will continue to cover it until the credit crisis has subsided and a sufficient thaw has occurred in credit markets that we can focus on the early stages of an expansion, rather than worries about a contraction.
The week saw continued signs of a flight to safety as U.S. Treasuries moved down to close only two basis points above a multi-decade low, which was recorded a week ago Thursday. The yield on the 10-year note closed at 2.59%.
Last week the near term futures contract for a barrel of oil rallied 13.4% to close at $46.28. Trading suggests that the market is hammering out a bottom for the price of crude.
We believe that the rally seen since the low before Thanksgiving will fail in the short term and we are looking for a test of the bottom to occur. It should be noted that from mid-December to the first week in January, the Santa Claus rally seasonal bullishness can force the markets higher. If this occurs, we believe the markets will still need to retest the lows.
We will take a look at all the daily charts and offer comments on them as a group. First, let's take a look at the QQQQs (NASDAQ:QQQQ), as they are the ETF that mimics the NASDAQ-100.
The NASDAQ has moved into the lead, either up or down, for the major indexes. The NASDAQ-100, as modeled by the QQQQs have moved up to expected resistance and are now trading mostly sideways. A break in either direction may wait until the end of this week, due to triple witching (the expiration of index futures, stock index options, and stock options.
We would look for a break below the 20-day or a break above the 50-day simple moving averages to cause more money to come off the sidelines to try to chase a trade up or down.
Next, let's take a look at the DIAmonds (Amex:DIA), as they are the ETF that mimics the Dow Jones Industrial Average.
The DIAmonds have the same sort of important support and resistance levels as the QQQQs, so we are looking at a similar scenario.
Let's take a look at the chart of SPYders (Amex:SPY) since they mimic the S&P-500.
The SPYders weren't able to recover as much as the other major indexes due to a continuing negative bias toward financials. They have a similar pattern to the other two ETFs we regularly cover, but have not been as strong as either of the others.
As we suggested last week, the index ETFs traded up to the upper Bollinger Band/50-day moving average. Subscribers should be mostly in cash at this time, having closed their index call options and entered some short trades or bought index put options when the major indexes reached the 50-day moving averages. We believe that only a minor amount of a trading stake should be put to work at this time as there will be better trading opportunities in the near future. We would exit these positions in stages when price hits the fist horizontal support area, the lower Bollinger Band and near the overall lows if such a retest takes place in short order.
The week in Review - Events & Fundamentals:
Monday, December 8th:
There were no economic reports of interest released. Instead, the markets focused on President-Elect Barack Obama's plan to create the largest public work project in 50 years. The goal would be to put 2.5M people to work as he cited a loss through November of 2.0M jobs. He intends to create a stimulus package irrespective of the growing deficit. Other governments are considering stimulus packages as well.
The Big Three automakers were also the subject of a radio address by Barack Obama who said they must not be allowed to fail, due to the large number of jobs they provide. Democrats reportedly sent a $15b package to the White House for consideration.
Dow Chemical (DOW) and 3M (MMM) will layoff part of their workforces to cut costs and recognizing that the economy has slowed and with it, their economic prospects. McDonald's (MCD) same story sales rose 4.5% in the U.S. and 7.7% worldwide.
There was a single economic report of interest released:
- Pending Home Sales (Oct) fell -0.7% versus an expected fall of -3.0%
The report wasn't released until a half hour into the trading session and it resulted in equity indexes moving immediately higher and reversing the downtrend that had started from the open in the Dow and S&P-500. In fact, the S&P-500 moved briefly into positive territory on the news but succumbed to selling pressure later.
Before the open, Fedex (FDX) reduced its FY2009 guidance and shares were pushed down 14% causing the Dow Jones Transport Index to fall 5.6%. This cast a negative pall on the market, which brought out the sellers. In contrast, even as a half dozen semiconductor companies took down guidance, investors/traders ignored the negatives and drove the index 4.9% higher.
Late in the session, Wal-Mart (WMT) announced that they were ceasing their stock repurchase plan in the face of degrading economic conditions. They indicated they had repurchased roughly $10B of their announced $15B in repurchases. This caused a rally attempt to fail and the Dow and S&P-500 lost more than two percent, while the NASDAQ and NASDAQ-100 losses were more modest.
The Big Three automakers were once again holding out their hands but Congress hasn't yet been able to pass any legislation. Some lawmakers hope to pass a bill to help the ailing automakers on Wednesday.
Wednesday, December 10th:
There were two economic reports of interest released:
Wholesale Inventories (Oct) fell -1.1% versus an expected fall of -0.2%
Treasure Budget (Nov) came in at -$164.4B versus an expected decline of -$171.0B
The Big Three automakers took center stage, once again, as the White House confirmed it had reached a deal with congressional Democrats to provide funding to the automakers. The deal provided $15B to the automakers now to forestall failure, and they must present a plan for long term viability by March 2009. If they are not able to convince the government of their long term viability by then, the government will ask for the money back, and the automakers would likely have to file bankruptcy. GM and Chrysler will be receiving these funds initially as Ford is in better financial shape.
Thursday, December 11th:
There were two economic reports of interest released:
Export Prices ex-agriculture (Nov) fell -2.9% versus October's -1.3%
Import Prices ex-oil (Nov) fell -1.8% versus October's -0.9%
Initial Jobless Claims for last week came in at 573K versus an expected 525K
Trade Balance (Oct) came in at -$57.2B versus an expected -$53.5B
The House passed legislation to provide $14B in funding for GM and Chrysler, while Ford didn't ask for short term financing, but rather desired a longer term line of credit. This helped the market to rally in the morning but when it became apparent the Senate might reject the bill, stocks tumbled. As it turned out, after the market closed, the Senate did reject the bill due to desire by Senate republicans to have the labor unions make concessions on wages to bring wages in line with largely non-union plants operated by Toyota and Honda in the U.S. Toyota has has become the largest manufacturer of automobiles in the U.S., surpassing GM recently. Senate republicans say they won't provide funding without union concessions as they don't believe the Big Three automakers can be competitive with the costs of higher wages (nearly double) that they have to incur over their rivals.
Two drug companies, Eli Lilly and Glaxo SmithKline announced positive newsm with the former reaffirming 2008 earning and raising the 2009 guidance, while the FDA unanimously approved the marketing of Advair to adults. This left Healthcare (+0.2%) as the only sector to finish higher on the day.
Friday, December 12th:
There were six economic reports of interest released:
Core PPI (Nov) rose 0.1% as expected
PPI (Nov) fell -2.2% versus an expected -2.0%
Retail Sales (Nov) fell -1.8% versus an expected -2.0%
Retail Sales ex-auto (Nov) fell -1.6% versus an expected -1.8%
Business Inventories (Oct) fell -0.6% versus an expected -0.2% decline
Michigan Consumer Sentiment Preliminary (Dec) came in at 59.1 versus an expected 55.0
The first four reports were released an hour prior to the U.S. equities markets open. The numbers were mostly better than expected. The numbers were also clearly better than the October numbers with the October ex-auto retail numbers even being revised upward from -2.4% to -2.2%. In addition, the final two reports were released a half hour into the session and were largely ignored by market participants.
Foreign markets recorded losses or were down significantly as U.S. markets opened. This was the largest factor in U.S. markets opening lower. However, foreign markets were reacting to news that the Senate had rejected a $15B bailout for GM and Chrysler. The White House and Treasury Department made statements that suggested that TARP funds may be used to bailout U.S. automakers, but this was shortly after markets opened, which was a factor in Friday's rally.
Former NASDAQ Chairman, Bernard Madoff was arrested on allegations he orchestrated a $50B scheme that was a variant of a Ponzi Scheme. The investment company bearing his name bearing his name was apparently taking in new deposits to pay out returns but the actual value of the assets was declining. Madoff revealed concerns over insolvency to employees who blew the whistle on him.
The rally was led by tech (+2.4%) and financials (+2.1%). Even retailers (+1.1%) gained in the face of negative November retail sales numbers.
Equities have moved up to resistance as volume decreased (a bearish sign). We see potential for a move higher, due to a Santa Claus Rally, but we don't expect that it will be a permanent move higher. We also see potential for equities to collapse back down to retest the lows as well as a prolonged sideways move.
For now, there is little advantage to tying up a large amount of cash in the market. The important thing is to have cash when probabilities of return are highest.
We have been using Bank of America (BAC) as a bellwether for financial stocks. BofA fell thirty-one cents for the week to $14.93. Confidence doesn't yet exist that financials are ready to move higher but money is being positioned to take advantage of this possibility. If the TED Spread continues to move lower, we believe that financials will rotate back into favor and will eventually lead the markets higher.
Oil prices appear to be firming having bounced in the last week and OPEC is meeting shortly to likely cut production by two million barrels per day which should support prices.
You should have exited your index call options at the resistance areas we outlined last week for nice profits of around 100%. You are either in cash now for your trading stake or you entered short positions or bought index put options when they reached the 50-day moving average or the upper Bollinger Band.
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