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THE DAY AFTER GREENSPAN – STOCKS MOVE LOWER

Stock prices slid lower right from the opening bell this morning. There wasn’t much in the way of economic reports or announcements from policy makers, but stocks sure had trouble digesting all the bad news out from companies from many different sectors of the economy. Negative reports came from many diverse sectors such as restaurants, transportation, finance, manufacturing, and technology. Some of the money moving out of stocks today found its way once again migrating to longer-dated Treasuries pushing the yield down to 4.77% for the 30-year bond and 3.98% for the 10-year note. After being pounded yesterday following the statement from the Federal Reserve, the dollar regained some of its losses today closing 0.44% higher at 88.70 on the U.S. Dollar Index. The weakness in stock prices and strength in bonds are moving in directions that conflict with a strengthening economy. The strength in bonds yesterday is confirmed today with weakness in stock prices…economic momentum is very gradually slowing for the U.S. economy.

Stocks were hit from all different directions with negative news coming from many companies. Following are a few of today’s highlights:

• Deutsche Bank AG cut Cisco Systems from a “buy” to “hold.”

• Wendy’s International restaurant chain reduced its 2004 profit forecast due to rising beef costs and closing locations in five states stricken by the recent hurricanes.

• General Motors said they would cut 3,000 jobs in Europe and reduce production capacity.

• Morgan Stanley said third-quarter profits fell to $0.76 per share from $1.15 after analysts expected profits of $0.95 per share.

• Bear Stearn’s profit fell 10% from $2.30 per share a year ago to $2.09 for the last quarter.

• Fed-Ex said fiscal 2005 profit will lag estimates.

• AutoZone sales were lower than a year ago, but earnings were higher due to the companies’ share re-purchase program.

• Fannie Mae hammered lower today by over 6% with the announcement of an SEC investigation into their accounting practices…this is the tip of the iceberg. I still believe Fannie and Freddie will eventually get bailed-out and become permanent fixtures at the Treasury Department within the next year or two…the trigger will be mortgage defaults and losses on interest rate derivatives.

• Interstate Bakeries, makers of Hostess Twinkies and Wonder bread filed for bankruptcy today.

By the end of the trading session the Dow Jones Industrial Average fell 135 points to close at 10,109, the NASDAQ Composite dropped 35 points to 1,885, and the S&P 500 lost 15 points to close at 1,113. Many observers didn’t think we would see a 100 point down day for the Dow prior to the elections, but here it is. The bulls would sure like to keep prices moving higher, but their job should become increasingly difficult as we move through the second half of the year. I suspect they will fight hard to keep the broad stock indices higher for window dressing to close out the third quarter next week. Watch out for a short squeeze to push stock prices higher between now and September 30th to close the books, but overall things are not looking very good for most sectors in the stock market. I have short stock index positions now, but am still keeping some powder dry for the next six trading days prior to the close of the quarter in case we get a quick squeeze.

Weekly Data on Oil and Mortgages

With the supply disruptions from Hurricane Ivan last week, analysts were anticipating a decline of crude oil inventory in the range of five to eight million barrels. The Energy Department reported a drop of 9.1 million barrels and the American Petroleum Institute figured a drop of 12.9 million barrels. The Energy Department and the API differ from week to week on their inventory estimates, but this week they both have the crude inventory pegged at 266.7 million barrels. According to analyst John Person, this is close to the lowest level in 28 years, and that’s not the worst of it. When looking at distillates (including heating oil) we are not building supply as we get closer to the winter season. In an article on Investors.com Mr. Person states, “The main concern is that this is the most important time to be building heating oil supplies, and instead they are showing huge draws with no crude on tap anytime soon to make up the difference…The bottom line is everything is so far behind, it will be a struggle to get through winter and will sock it to the consumer this winter.” According to the Energy Department distillate inventories fell by 1.5 million barrels and the API reported a decline of 2.4 million. The November crude contract reached an intra-day high of $48.65 a barrel, just ten cents below the record high a month ago and ended-up settling at 48.35, up 3.4% or 1.59 for the day. Unleaded gasoline was higher by 4.2% to $1.34 per gallon and heating oil moved 3.1% higher to close at 1.34. The U.S. Minerals Management Service said yesterday that oil output in the Gulf of Mexico is still 39% below normal and gas production was down 23%. High energy costs will continue to drain disposable income from households around the globe!

The Mortgage Bankers Association reported its application index rose by 1.8% with the purchase index adding 0.2% and the refinancing index higher by 4.1%. The 30-year fixed-rate mortgage dropped two basis points to 5.66%, but refinancing as a whole remains well behind the pace of a year ago. This is about it for lower mortgage rates unless we have some kind of crisis or panic to cause a rush of money into bonds.

Greenspan vs. Bond Market

Yesterday Alan Greenspan raised short-term interest rates, but long-term interest rates moved lower…and they moved lower again today. So what’s up? Why are long-term rates going down when the Fed keeps talking about measured increases? These four-decade low interest rates and the current tightening cycle are currently based on an improving economy with benign inflation. I believe the move we are seeing with money moving into bonds is telling us the economy is not as strong as the perma-bulls would like to believe. Inflation is not a problem based on the statistics we are given in the CPI and PPI, but they fail to include many items that we have to pay for in the real world. We are not seeing retail inflation because of global deflationary forces, primarily lower labor rates from offshore. We also have a lack of retail pricing power, excess manufacturing capacity globally, and increased competition that all work to keep a lid on consumer prices. We are witnessing asset price inflation rather than retail price inflation. Look how home prices have inflated without a corresponding increase in incomes. We have inflation; it has just taken a different form than what we saw back in the Seventies.

I also think this move into bonds is telling us the move higher for interest rates is not going to happen as quickly as what was priced into the bond and currency markets. The dollar took a big nosedive after the statement from the Federal Reserve yesterday while money rushed into bonds. Mr. Greenspan was more dovish on inflation than the markets expected with the change of verbiage from inflation being “somewhat elevated” to “inflation and inflation expectations have eased.” The markets interpreted his statement by concluding the Fed won’t be as aggressive as we thought when all the Fed governors were collectively making speeches with hawkish comments toward inflation. Rates will move higher, but very slowly. The interpretation of slower rate increases weakened the dollar and put a bid in Treasuries. Personally, I believe the Fed is actively monetizing the long end of the yield curve, but I have no way to prove it. (That’s why they discontinued issuance of the 30-year bond back in October 2001…with no new supply the Feds (or agents of the

Fed) can buy long-bonds off the market thereby keeping a floor on bond prices and a lid on long-term interest rates….just a theory…wish I could quantify the theory for proof or get a true look at FOMC open market operations.

For now suffice it to say the jury is still out on the strength of the economic recovery. The movement in bond prices is telling us to be careful about being overly optimistic. I believe the big bad bear is getting hungry to take a bite out of stock prices and the dollar is clawing and scratching for support with deteriorating fundamentals. Precious metals are certainly frisky with the HUI Gold Index holding most of its gains from yesterday. Hopefully you have used this “correction” time to study and pick the best of the precious metals mining companies. When the dollar breaks decidedly lower the gold and silver mining shares will take off as they have from the prior consolidations…the commodities bull market is here to stay for at least a few more years!

Have a Great Evening

Mike Hartman

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