Fed Stands Pat - Market Unimpressed

In a trading session characterized by a feeling of denouement, traders carried out their expected roles in response to the FOMC announcement that the Fed Funds target rate would remain at 6.5%.

Market participants had already discounted the notion that the Fed would leave rates unchanged, so Wall Street focused on the bias indicated by the FOMC press release.

The statement was accompanied by slightly different language than that used in previous announcements. The June 28th statement was slightly more cautionary, with references to aggregate demand/supply pressures accompanied by less optimistic verbs. Today's statement confirmed that demand "is moderating toward a pace closer to the rate of growth of the economy's potential to produce", rather than June's less affirmative "may be moderating…". The Fed press releases are quite short and make for some interesting reading. While nowhere nearly as entertaining as deciphering Greenspan himself, the press releases at least demonstrate the power of language and how quickly the financial markets interpret and translate sensitive information into gains and losses. The releases are available at the Federal Reserve website www.federalreserve.gov.

Of course, the big question now is when, if at all, the Fed will pursue any further rate increases. As of Monday, traders were pricing in a 40% chance of a rate increase by the end of the year according to the Fed Fund futures market. Most traders and analysts seem to think that the Fed will avoid any rate increases before the election in November, thus drawing attention to the December 19th FOMC meeting.

This week we have Initial Jobless Claims due out Thursday and GDP due out Friday. Both have the potential to move the market as the Fed is still leery of inflationary pressures.

Tuesday's Data:

The markets traded higher ahead of the 2:15 p.m. announcement and then some selling pressure took stocks off their highs of the day before the close.

The Dow Jones Industrial Average (INDU) closed at 11,139, up 59 points for the day. The Dow had been up over 100 points earlier in the session but failed to hold those gains. Volume was light on the NYSE with only 819 million shares changing hands.

The Nasdaq (COMPX), with remarkable precision, closed just over 3,958, but slightly under the pesky 200-dma of 3,958.59 on a gain of just 5 points. The COMPX has found the 200-dma a difficult barrier the last few days, never quite managing to rally above this key technical indicator. Nasdaq volume was relatively light at 1.4 billion shares.

The light volume didn't help convince traders that today's rally is sustainable. Summer trading volume is normally muted due to vacations and lack of institutional order flow. Nevertheless, the NYSE Composite index (NYA) closed at 671.62, a new all-time high. The S&P 500 index (SPX) lost 1.35 points to close at 1498.13. The Russell 2000 (RUT) moved up just over a point to close at 517.46.

The bond market's reaction mirrored a largely nonplussed equity market. The 10-year note edged up 1/32 to yield 5.77%, down slightly from 5.78% yesterday. The 30-year bond held steady while the Fed sensitive 2-year note also advanced slightly to yield 6.26%, down from 6.27% yesterday.

Ahead of the Fed report, we saw financial issues and brokerage stocks advance on the expectations for a more stable interest rate environment. JP Morgan (JPM) powered ahead 3.50 points to close at $148.50, a new all-time high. Asset managers such as Amvescap (AVZ) +1.88 and T. Rowe Price (TROW) +1.75 also helped to drive the financial services sector. The recent strength has helped to propel the Bank Sector Index (BKX) to the highest level since June 2nd, but near resistance at the 900 level.

Our favorite index, the Philadelphia Semiconductor index (SOX), recaptured some of Monday's loss, gaining 12.66 points to close up 1.1% to 1,124.19.

Retail stocks and aerospace stocks also performed well today. Industry bellwether Boeing (BA) closed just under $50 in a failed attempt to reach a new 52-week high. Aerospace and defense stocks have been generally rising the past few weeks as both presidential candidates have announced their intentions to increase military spending.

The Amex Biotech index (BTK) rallied 2.58% today as Gilead Sciences (GILD) advanced just under 10 points to close at a new all-time high of $105. Millenium (MLNM) and Genzyme (GENZ) also helped to rally the sector with each stock posting strong gains. The rally seemed largely technically oriented as no major news, aside from the Fed announcement, served as a catalyst to the biotech sector. However, biotech stocks are highly sensitive to interest rate changes as the R&D pipeline pushes out significant expected cash flows from expected drug sales. Thus, on a discounted basis, small fluctuations in rates can substantially affect biotech issues.

GM continued its price surge today, adding on 1.31 points. GM has advanced over 21% this month on good volume. Ford, (F) +0.75, on the other hand, for reasons associated with the Firestone tire recall, has been mostly flat this month. In fact, two investment firms lowered their earnings estimates for Ford today, although any impact is expected to be immaterial. Short-term momentum favors a GM trade, while Ford should rebound eventually, once the sales impact from the tire issue is known. The two stocks are now trading at roughly equal earnings multiples, indicating that Ford was priced at a premium to GM. The two companies normally trade at similar valuation multiples around 7-11 times expected earnings.

In other market news, Gillette (G) +1.31 announced that it would sell its stationery business to Newell Rubbermaid (NWL) +0.50. The anticipated move comes as Gillette struggles to refocus on its core businesses while shedding other operating units such as its Braun household products division. A strong dollar and soft foreign sales have forced Gillette shares down 25% so far this year.

Looking Forward:

Well, the earnings season has just about come to a close. According to First Call, earnings growth should come in at around 22% compared to the second quarter last year. While some companies have already trimmed earnings estimates for the latter part of this year, growth is still expected to remain fairly strong in the S&P 500 companies. Fourth quarter growth has been ratcheted down from over 16.8% to current levels around 15.6% and could sink lower depending on future estimate revisions and pre-announcements. The +20% earnings growth of the past four quarters is not a reasonable expectation going forward. However, it is important to remember that earnings are still growing, just not as rapidly as they have the past four quarters.

The energy sector especially had a spectacular earnings season. Coupled with a stable commodity pricing environment and huge demand for natural gas, the energy sector could outperform the overall market going forward. Natural gas producers and service stocks should all benefit from increased activity in the sector. Transocean Sedco Forex (RIG +2.38%), regained some ground today on an upgrade from Southwest Securities following yesterday's sell-off in wake of the merger announcement with R&B Falcon (FLC +0.34).

Technology stocks are obviously investor favorites and the chip stocks are likely to outperform if industry demand remains strong. Should the interest rate scenario remain positive, the financial sector could continue its already impressive gains.

While summer volume may be thin, investors are already looking ahead to a strong fourth quarter. Hopefully, we'll help you beat the rush to the best performing stocks.

Good luck and trade wisely.

Chris Pikul, CFA
Assistant Editor