Fed Stands Pat, Stocks Still Decline

The Federal Reserve Board decided to leave interest rates unchanged for the third meeting in a row today. The market had a knee-jerk positive reaction for about fifteen minutes and then the selling began, as traders and investors began pondering the implications of the Fed policy statement, which revealed their lingering concerns over the threat of future inflationary pressures.

I'd like to say that the market "bought the rumor and sold the news," but there has been no buying leading up to today's announcement. I'd like to say that the market is now worried about the possibility of future inflation and increasing interest rates, but Fed Fund futures for December are in-line with the current Fed target of 6.5%. What's more, the April 2001 contract is yielding under 6.5%, indicating the market's belief that rates could actually decline over the coming six months. So how do we gauge the market's negative reaction to today's news?

Well, the scenario that we have been telling you about the past few weeks has manifested itself. The market simply lacks a strong fundamental reason to move higher. We believe that a fourth quarter rally will probably come on the heels of a strong earnings season and increased expectations going forward. Until that scenario can manifest itself, we have warned of the possibility that earnings warnings could drive the market lower.

When all was said and done, the Nasdaq (COMPX) closed 113.37 points lower to 3,455.17. Volume was heavy during today's decline, with over 1.9 billion shares being dumped by distraught investors. Breadth was negative as 25 issues declined for every 15 that advanced.

The Dow Jones Industrial Average (INDU) was able to hold on to earlier gains despite the breakdown in the Nasdaq. The Dow finished 19.61 points higher to close at 10,719.74. Volume crested just under 1.1 billion shares on the Big Board today. Advancing issues lagged declining issues by a 13 to 15 margin.

The broader market indices didn't fare much better than the Nasdaq. The S&P 500 (SPX) closed 9.97 points lower to end the day at 1426.26. The Russell 2000 (RUT) also moved lower, closing down 6.38 points to 505.29.

That pesky potential double-top we have been talking about in the Nasdaq is quickly becoming a reality. Today's breakdown puts the composite decidedly below the August low. Look for tomorrow's activity to confirm the bearish side of this formation. Should a rally ensue tomorrow, thus making today's breakdown of less technical significance, the 3,500 mark will be a key level of support/resistance for the Nasdaq. However, the lack of any real buyers in today' session and weakness into the close suggests that we could be revisiting 3,000 before any meaningful rally occurs.

Xerox (XRX) didn't fail to disappoint investors (again) with its fourth profit warning in five quarters. The company cited slower sales due to a restructuring of its sales force and a weak Euro among other factors contributing to weaker expected earnings. The company's shares closed down over 26%, ending the day at $11.25. Xerox shares have dropped almost 75% since last October. $11.25 is a new 52-week low for the company.

Chips stocks fared well in early morning activity, spurred by a report issued from the Semiconductor Industry Association (SIA), but dropped off in late afternoon trading. The SIA reported that worldwide chip sales reached a high of $18.9 billion in August, a 52.7% increase over the same period last year. The fastest areas of growth came in the wireless and Internet infrastructure markets, which is no surprise as companies serving those industries, such as Applied Micro Circuit (AMCC) have been outperforming the broader semiconductor sector of late.

Chip-equipment stocks also moved lower today on the heels of a Wit SoundView downgrade of Applied Materials (AMAT). AMAT broke down almost 9% to close at $51.63. Chip-equipment makers will generally be ahead of the industry cycle and will be the first to bear the brunt of any slowdowns in the industry. While this downgrade doesn't exactly jive with the SIA report we mentioned, the market isn't exactly overconfident in any industry looking forward.

Biotechs continued Monday's horrendous decline. The Amex Biotechnology index (BTK) runs into some real resistance at the 800 level. A look at the chart below shows the market's resistance to bid the stocks through this level. However, biotech stocks have been reaching a series of higher lows and could be shaking sellers out of the market, setting the stage for a surge above 800.

Banking issues were up today as the Amex Banking index (BKX) rose over 1%. Financial stocks rallied on the news that the Bank of Canada would be purchasing Dain Rauscher Wessels (DRC) for $95 in cash. The deal is priced at 2.6 times book value, in-line with other broker transactions, but less than the 3 times book value that PaineWebber commanded earlier in the year. Other brokerage issues that had been advancing on takeover speculation, sold off later in the day. The Amex broker/dealer index (XBD) closed off 1.56% to 653.44.

Gateway (GTW) responded nicely to an upgrade from Merrill Lynch. The firm raised its opinion to a "buy" from "accumulate." The stock has been hurt recently in connection with Apple Computer's (AAPL) profit warning last week. Gateway stock rose 2.5% to close at $50.

It is worth reviewing the Fed policy statement to familiarize ourselves with their concerns so we can be better prepared to interpret economic information going forward. The FOMC statements are available at www.federalreserve.gov. The language used in today's statement closely mirrors that of the August 22 meeting. The Fed is concerned with a continuing historically low level of unemployment. New to today's statement was the specific mention of rising energy costs and their capability of producing inflationary pressures.

The effect of higher oil prices cannot be ignored, despite the technological gains achieved in the world economy recently. Oil prices not only result in higher gas prices and higher heating costs as some might think. The effects are much more far-reaching than the direct toll on the collective consumer wallet.

The distribution of goods, from food to furniture, is dependent on the nation's trucking and transportation infrastructure. Increased fuel costs, at some point, must be passed on to the customer. We have seen ticket surcharges on passenger airlines as well as freight carriers, a trend that will most likely continue. In addition, petroleum-based products are raw materials for many industries, from plastics to chemicals, resulting in higher prices across a range of consumer goods.

But the oil issue is more complex. The real danger, as seen by the Federal Reserve, is twofold. As consumers are faced with higher overall price levels, due in part to the high cost of oil, spending on other items is curtailed. As consumer spending is the engine that fuels roughly two-thirds of the country's gross domestic product, it is a vital and necessary element for growth.

So the Fed is concerned with inflationary pressures in the short-term and a possibly significant decline in consumer spending in the long run. Thus, going forward, inflationary pressures arising from a low level of unemployment will be of less concern to the Fed, as such concerns have been largely offset by increased productivity resulting from continued investments in new technology. The threat of continued higher price levels resulting from high oil prices, cannot be muted by subsequent gains in productivity.

In light of these concerns, investors should keep an eye on the American Petroleum Institute's weekly update of petroleum supplies. Supply figures are released Tuesday afternoon. Today's release indicated larger than expected increases in oil and gas inventories. This should have a negative effect on oil prices and provide a potential boost to the market tomorrow.

Looking ahead, we have no major earnings news this week, as companies prepare to release third quarter earnings results beginning next week. Although October is traditionally associated with weakness in the market, a strong earnings season here could ignite the market, given the lack of a sustainable summer rally.

Good luck and trade wisely.

Chris Pikul, CFA
Assistant Editor

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