May 14, 2004
Ed Schuller
Senior Investment Strategist
(800) 445-8312
edward.schuller@rbcdain.com
A Year of Living Dangerously
These are certainly interesting times. Just a short year ago the markets had embarked
on an upward ride that brought back memories of earlier rallies and put most
investors in rather pleasant moods. Today's trend, as measured by this past week's
market performance, is to worry about everything and wonder how much worse it
will get. A year ago, there was still another 25 basis point drop in the federal funds
target rate in the offing, while today thoughts are turned to when, and how far, the
Fed will raise rates. A year ago, there were thoughts of a quick resolution to the Iraqi
conflict and the notion that oil prices would decline once the military action was
concluded. This past week, with new and unsettling revelations on the situation in
Iraq coming to light daily, the price of oil reached a 21-year high on Friday of $41
per barrel.
In fact, even as energy futures stalled a bit on Friday morning, coming under some
pressure from profit taking, dealers in London saw the potential for a rally through
the $42 level. Hedge fund buying coupled with short covering helped to spike prices
levels through the $41 level on Thursday, setting the stage for the higher move to a
record high on Friday. Many observers felt that traders would not want to be short
over the weekend, which could help another upward push early next week. There
was little reaction to the announcement on Thursday by OPEC president Yusgiantoro
of Indonesia who joined the call of Saudi oil minister Ali Naimi for an increase in
OPEC production to cap ever-increasing oil prices. There appears to be little
consensus inside the cartel, however, and many traders view the potential of a
substantial increase in output as highly unlikely.
The Nasdaq composite, which was in the midst of its own surge one short year ago,
continued on its current downward trend. Earnings reports from both Cisco Systems
and Dell Inc. this week could not stem the tide. In fact, many analysts on Wall Street
found some negative news in both company's releases. While Cisco reported April
quarter pro-forma earnings of $0.19 vs. $0.15 the prior year, and cash flow of $2.4
billion, a quarterly record for the company, we believe the announced 20% sequential
increase in inventory was a cause for much of the concern. Some view this as a
potential risk if demand expectations are not matched, creating a situation where the
company is vulnerable to slowdowns. Dell noted a decline in margins due to rising
component costs and intensified pricing. In fact, this was the fourth consecutive
quarter-to-quarter decline in margins for the company. Some analysts found the
company interesting, but the stock fairly valued and somewhat un-compelling as a
new investment.
Following the prior week's FOMC meeting, bond market participants appeared to find their
market un-compelling, as the spectre of higher rates loomed over the trading pits. Except for
those making day trades on moves that were news or dollar related, we believe many credit
investors seemed to be content sitting on the sidelines waiting for the dust to settle (or the Fed to
hike the target rate). There wasn't a lot of consistency in the week's economic releases to help
smooth things out, either. Good news came from the April trade price index, which rose 0.2%,
below the expectation of 0.4% and March's revised index of 0.8%. Also in the positive column
was initial jobless claims report for the week ended May 8, which rose by 13,000. The four-week
moving average now stands at 335,750, down 7,750 from last week, and at the lowest point since
the recovery in the labor market began. April industrial production surged 0.8%, almost triple the
expectation of a 0.3% rise, and well above the 0.1% decline the prior month. Gains were pretty
much across market and industry groups. The negative news came from a number of areas. First
off was the March trade deficit, which rose $3.9 billion to $46.0 billion, higher than the estimate
of $43 billion. The report indicates that U.S. consumers continue to purchase foreign goods
which, coupled with the continued weak dollar may continue to amplify this number in the
coming months, in our opinion. The April PPI rose 0.7%, driven mainly by surging energy
prices. Retail sales for April fell by 0.5%, reversing the previous month's trend. The May
University of Michigan consumer sentiment survey was flat at 94.2, equalling last month's level.
Expectations were for a rise to 96. Finally, in the neither fish nor fowl category, was the April
CPI, which rose by 0.2%, under the estimate of a 0.3% rise. However, the core CPI was up 0.3%
for the month, exceeding the expectation of a 0.2% rise. Overall, the core CPI is up 1.8% year
over year, at the upper end of the Fed's target range of 1%-2%.
In a week that saw the Dow drop 127 points on Monday, and then experience a wild ride on
Wednesday where the index declined by 167 points before staging a 193 point rally to finish the
day in the black by 25 points, the Nasdaq composite and S&P 500 were content to finish near the
point at which they started. The old trader's adage of "sell in May and go away" seems to be
holding true, as the growing geopolitical news appears to be weighing on many investors. With
the next FOMC meeting more than a month away, the focus next week will no doubt be on
energy prices, and where (and when) the peak will be. External forces will continue to buffet
both oil and the markets in general, adding to the uncertainty that has already reached a stage
that could be best described as palpable—which seems to be exactly the right place for a market
that we believe gives the impression of being dangerously on the edge.
