At Last, The Dip

I’ve been calling for an August/September setback for some time, and it finally reared its head last week. Profit taking on overbought conditions sent the market lower:

Dow ……………. 11,392 -0.6%
Nasdaq …………. 2,166 -1.2%
Nasdaq 100 ……… 1,575 -0.9%
S&P; 500 ………… 1,299 -0.9%
S&P; Midcap 400 ….. 739 -2.0%
S&P; Smallcap 600 … 364 -1.6%

Is this the beginning of something bigger, the buying opportunity I’ve been wanting before the year-end rally? Or is it just a slight correction before the uptrend of last month resumes?

Let’s look at the evidence.

Homebuilders maintained their drumbeat of negative news when KB Home (KBH) and Beazer Homes (BZH) both reduced their earnings expectations on Thursday. Then, on Friday, Lennar (LEN) lowered its Q3 earnings forecast. The National Association of realtors said home prices may drop for the first time since 1993. Stuart Schweitzer, a global markets strategist at J.P. Morgan, said that these warnings are “a sign that the damage on the rest of the economy is all still in front of us.” Think that sounds bad? Ian Shepherdson of High Frequency Economics said the housing market is so far gone that “it’s not rescuable anymore.”

On Wednesday, a red sun rose on Wall Street and its name was Unit Labor Costs. How appropriate that during the week of Labor Day, the Labor Dept. reported that workers are becoming a big expense. Second quarter unit labor costs were revised up dramatically from a 4.2% estimate to 4.9%, putting the year-over-year increase at 5%. That’s the highest it’s been since 1990. Plus, first quarter was revised even more, from an initial 2.5% estimate to 9%.

The report pilloried the recent sense that inflation is receding. In the words of Econoday Senior Economist Mark Rogers, “These two revisions paint a very different picture for the Fed in its evaluation of underlying inflation trends and how far the economy needs to decelerate. Of course labor costs are just one part of the inflation equation — but it is a significant part.”

Oil prices provided good news for stocks all week. Rising inventories, a mild hurricane season so far, and a slackening of demand now that summer is over combined to send prices down $2.91 to close the week at $66.33 a barrel. That’s 15% below their July 14 high of $78.40 and the lowest they’ve been since April 4. This provides some inflation relief and is already showing up in the form of lower gasoline prices. After hitting $3 per gallon, the national average is down to $2.70 and heading for $2.20 by the end of next month, according to AAA.

Oil prices are hard to project, as you know.

On the one hand, we have Chevron’s (CVX) big discovery last week in the Gulf of Mexico that could boost U.S. reserves by 50%. Jim Cramer wrote:

An oil discovery worth noting — hallelujah! From the beginning of this historic run in oil, I have said that you will not get a peak until we discover more oil and oil companies can flood the market with oil that’s in safe, non-political areas.

Like the Gulf of Mexico.

What’s important about this find. . . is that I believe this will be the first of many finds that would have seemed uneconomic three or four years ago.

Douglas McIntyre at 24/7 Wall St. thinks that increasing supply and decreasing demand could bring $60 oil, not $100 as some have predicted.

On the other hand, we have Stephen Leeb’s The Coming Economic Collapse teaching how to thrive when oil costs $200 a barrel. I haven’t read it, but gather that we should avoid oil-dependent stocks such as airlines, auto related, chemical related, cosmetics, food businesses that depend on shipping, retail that relies on faraway factories, and so on. As for why Mr. Leeb thinks prices are going up, demand from emerging China and India coupled with peak oil, no doubt.

I don’t know what’s going to happen to oil prices, neither do you, and neither do Jim Cramer, Douglas McIntyre, nor Stephen Leeb. What we do know is that if oil prices go up, it will create inflationary pressure on the economy, mess up the soft landing scenario, and could bring further interest rate increases. If they go down, it will provide inflation relief, help the soft landing, and may stay the Fed’s rate-raising hand.

What we should all hope for, then, is a short-term increase in oil prices and one more rate hike to drive the stock market way down. Then, we’ll pounce on firesale stock prices. After that, we should hope that oil prices drop, the economy gets going again, the Fed takes a long break, and stocks rise into the new year.

That’s what I want, and what I’m prepared for. Here at The Kelly Letter, we’ve been saving cash, taking advantage of lower prices where they occur, and defending our long positions with a hedge against a dropping market. Even if a dropping market doesn’t come from oil, it could come from the housing slowdown, seasonality, inflation, or a host of other near-term threats.

One Barry Hyman, equity market strategist at EKN Financial, says I’m going to get what I want thanks to seasonal weakness this month and next:

This pattern shows up in the technical-overbought status of the market as we enter the post-Labor Day season, as well as the upcoming sets of economic data on inflation that we expect would bring the worry back to the market.

But, after that…

The correction we see, which we now characterize as a potential retest of the bottoms in May and June rather than a bear market correction, is our objective before a rally to finish the year around 1280 on the S&P; 500.

It closed last Friday at 1299, so clearly Mr. Hyman expects a fairly significant downdraft on the horizon if his follow-on rally ends the year 1.5% below current levels.

As ever, we’ll have to keep an eye on the data. Here’s what’s coming up this week.

Tue 9/12: The July international trade balance will be reported. In May it was -$65 bil and in June the deficit dropped to -$64.8 bil. The U.S. has run a deficit since the 1980s. A smaller deficit boosts economic growth while a larger one stymies it. Investors are watching to see how much the economy will be affected in coming quarters. Are we slowing too much? Not enough? The consensus is for -$66 bil.

Thu 9/14: Jobless claims will be reported for last week. The consensus calls for 315,000. If they decline too much, it will boost payrolls and add to inflationary pressure, thus increasing the chance of another Fed rate hike. Also, August retail sales will be reported. They dropped 0.4% in June and rose 1.4% in July. The consensus is for -0.2% in August. The Fed wants to see a slowdown because it will reduce inflationary pressure and help clear the way for a soft landing.

Fri 9/15: The consumer price index will be reported. It rose 0.2% in June and 0.4% in July. The core CPI rose 0.3% in March, April, May, and June before finally dropping to 0.2% in July. The Fed i
s calling for — and expecting — a drop in the core rate as part of its soft landing scenario. Its eventual goal is an annualized rate of 1-2%. Another 0.2% core reading with signs of slowing further would be good news, and the consensus thinks we’ll get it.

Want to take advantage of lower prices before a year-end rally? Come and see what I’m up to at The Kelly Letter.

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