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At the opening bell stock prices showed weakness across the board as declining stocks outpaced advancers by a four to one margin. The semiconductor sector was hit hard when Intel announced disappointing guidance for fourth quarter sales, and Kraft Foods reported a 13.5% drop in third quarter earnings due to higher commodity and energy costs. In a recent survey conducted by Merrill Lynch & Co., three out of every four U.S. investors believes profit growth for publicly traded U.S. companies will slow in the next 12 months. According to the survey, global investors were the most pessimistic on U.S. stocks in more than six years. High energy costs and rising interest rates are taking their toll on the stock market, but the residential real estate market is still on fire! The Commerce Department announced housing starts unexpectedly rose in September to 2.108 million annualized units while analysts were calling for a decline to 1.97 million units. Builders broke ground on 2.108 million units and the number looks even stronger when we see the preliminary figures for August were revised higher. Building permits were forecast to decline to a 2.075 million annual rate, but came in much stronger than expected at 2.189 annualized. This is a 32-year high for building permits! The Fed hasn’t been able to take the punch bowl away from the party in real estate because long rates are still not rising significantly, though mortgage rates are beginning to creep higher. The Mortgage Bankers Association reported its application index rose 6.1% with the purchase index higher by 7.3% and refinancing activity higher by 4.5%. The 30-year fixed rate rose to 6.09% and the average one-year ARM moved higher to 5.34%. Home buyers appear to be concerned with higher rates to come and figure it’s time to load, lock and fire to secure today’s low mortgage rates. Back to the Markets The stock bulls are now saying, “What a great turn-around for stocks after such a weak opening!” Stocks got a mid-morning bounce with the release of oil inventories from the Energy Department. Crude was expected to build 2.25 million barrels, but the bigger than expected inventory increase came in at 5.6 million barrels according to the Feds, and the API reported a build of 11.3mb. Unleaded gasoline was forecast to decline 1.5mb, but instead grew larger by 2.9mb per the Energy Department, and the API reported a build of 2.8mb. Distillates were forecast to decline 2.3mb, but declined slightly less by 1.9mb, and by 0.9mb according to the API. Clearly the oil numbers were better than expected and worked to push the entire energy complex lower. Crude closed 99 cents lower at $61.45 a barrel, unleaded gas was hammered almost 4% lower to $1.67 and heating oil declined just over 1% to close at $1.91. We should know a little better in a few days how Hurricane Wilma will affect oil production in the Gulf of Mexico. Based on the anticipated direction of the hurricane’s path, oil infrastructure won’t be affected much, but I expect a short-term disruption in shipping imports to the Gulf over the coming days. The good news on energy prices helped to jump-start stock prices and good earnings reports from the financial sector gave stocks the follow-through needed to post gains for the day. The Dow Industrials added an impressive 128 points to close at 10,414, the NASDAQ gained 1.7% or 35 points to close at 2,091, and the S&P 500 added 17 points to close at 1,195. On the whole, technology shares got a nice bounce, and the Semiconductor Index crawled back to show a very slight gain after the AM decline took it down by more than 3%. (Could the Working Group on Financial Markets have “goosed” the S&P futures to help the stock turn-around, or just a simple short squeeze to take the market higher??…please decide for yourself.) In regards to the stock market, it just came to my attention that today marks the 18-year anniversary of the crash on October 19, 1987 when the Dow Industrials were clocked for the biggest one-day loss in history. This describes what happened on that infamous Black Monday: Key Event: "Black Monday" Crash of 1987 Rocks Stock Markets "The largest stock-market drop in Wall Street history occurred on 'Black Monday' -- October 19, 1987 -- when the Dow Jones Industrial Average plunged 508.32 points, losing 22.6% of its total value. That fall far surpassed the one-day loss of 12.9% that began the great stock market crash of 1929 and foreshadowed the Great Depression. The Dow's 1987 fall also triggered panic selling and similar drops in stock markets worldwide." (Note: A similar drop today would be worth a one-day decline for the Dow of a whopping 2,345 points) After this historic event, the Reagan Administration imposed the Working Group on Financial Markets and in my opinion, permanently changed the landscape of how the financial markets operate in a system of pure fiat money. I believe this is directly the reason the Federal Reserve has no desire to regulate the over-the-counter interest rate derivatives market…why should they, if they can use high leverage to “influence” market direction, especially with respect to interest rates. Right now it looks like interest rates and inflation are the only two things the Federal Reserve is looking at, with little respect toward future growth for the U.S. economy. They are very openly saying the high energy costs are going to slow the economy next year…to the tune of a 1% reduction in GDP growth. The Fed is now at the point where they can easily add insult to injury with continued rate increases, thereby slowing the economy even more. We now have inflation running at the understated rate of 4.7% and now they are saying GDP growth could fall from 3.5% to 2.5% going into 2006. Also note the yield on ten-year treasuries is below 4.5%. GDP growth and ten-year yields are below the rate of inflation. According to Bloomberg, over the past decade the spread between the rate of inflation and ten-year yields has averaged 2.7 percentage points. If that were true today, we would add 2.7% to 4.7% inflation to get a ten-year yield of 7.4%...a far cry from the 4.46% we see today. It’s no wonder fixed-income seniors are getting killed with income relative to rising prices. Overkill by the Federal Reserve The Fed is being relentless in their mantra to raise interest rates…it came out in their Beige Book today and was reiterated by four more Fed Governors out on the speaking tour. Will they cut off their nose to spite their face??? It looks like the deflation scare a couple years ago was nothing more than a smokescreen for the Fed to inflate, and now they have to deal with the aftermath of an overshoot to the 1% Fed Funds rate. The 1% Fed Funds rate came as a response to the bursting of the stock bubble, but that overshoot to 1% is now getting another overshoot to higher rates when the economy really can’t take it. I will be very curious to see where real estate prices go in a few years if mortgage rates move back to the 8% to 9% area. So far, the Fed has been impotent to move long-term rates higher. The yield for ten-year Treasury paper on June 29, 2004 was 4.69% and the following day the Fed began to raise the Fed Funds rate in “measured” steps. Fed Funds has moved from 1% to 3.75%, but ten-year yields have gone from 4.69% to 4.46% at today’s close. The yield curve is flattening which means economic weakness ahead. It also means we could see the bottom fall out of the stock market if the Fed continues to the point of inverting the yield curve. Make NO MISTAKE about it folks; the Fed knows what they are doing, just as they knew they were the ones DIRECTLY responsible for popping the stock market bubble back in 2000. In 1997 Mr. Greenspan talked of “irrational exuberance” and three years later he took ACTION to cave the stock market. Have a look at the next two charts to see that the yield curve was considered “normal” (I used a snapshoot in mid-1999) and stock prices were moving higher. Now look at the second yield curve at the very top of the stock market…the Fed raised rates so much that they inverted the yield curve with the carnage in the stock market to follow.
After the Fed went to overshoot in raising rates, they did the same thing again with an overshoot to the downside hitting half-century low interest rates with Fed Funds at 1%. Have a look at the “normal” yield curve back in 2003 when stock prices were coming off the lows of 2002…the curve was normal and stocks were doing just fine. Since the Fed has continued to raise the short end of the curve and the long end is not responding, the Fed is getting closer and closer to inverting the yield curve just like they did back in 2000.
There has been eight times since the 1950s the yield curve has been inverted. After every inversion of the yield curve, the U.S. economy has gone into recession, with the exception of 1967 (see chart).
If you are invested in stocks, it’s a good idea to keep an eye on the curve. The only infallible economic indicator that I know of is an inverted yield curve. If the Fed continues to hammer out rate increases to 4.5% Fed Funds and the ten-year Treasury yield remains below 4.5%, the curve will invert! Greenspan did it back in 2000, so what’s to stop him now… Have a Great Evening! Mike Hartman Chart courtesy www.stockcharts.com
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