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Mid-Week Analysis

Natural Gas Futures prices
Heating Oil Futures

Tumultuous conditions continue this week in global financial markets. Investor discontent is certainly growing here at home, with the Dow declining 2% and the S&P500 3%. With energy prices once again on the rise, the Transports have declined 4%. The Morgan Stanley Cyclical index has declined 2%, while the "defensive" Morgan Stanley Consumer index has bucked the trend, adding 1%. The Utilities have risen 3%, and the AMEX Biotech index has a marginal gain. The small cap Russell 2000 and the S&P400 Mid-Cap indices have both declined 3%. Throughout the technology sector, the rout continues. So far this week, the NASDAQ100 and the Morgan Stanley High Tech index have dropped 6%, while the Semiconductors have sunk 12%. The Street.com Internet index has declined 7% and the NASDAQ Telecommunications index has dropped 6%. Financial stocks are faltering, with the S&P Bank index declining 7% and the Bloomberg Wall Street index sinking 4%. Gold stocks continue to sink, dropping about 2%.

Unsettled conditions continue in the credit market. Faltering profits and weakening corporate financial position is understandably creating heightened investor nervousness. According to reports, corporate spreads have generally widened about 15 basis points the past week, as a flight to safety intensifies. So far this week, 2-year Treasury yields have declined 4 basis points, the 5-year 6 basis points, the 10-year 4 basis points, and the long-bond 2 basis points. Mortgages continue to perform well, with benchmark Fannie Mae mortgage-back yields declining 5 basis points to 7.57%. At the same time, agency securities have underperformed, with yields generally only 1 or 2 basis points lower. The benchmark 10-year dollar swap spread, despite narrowing 3 basis points today, has increased 4 basis point thus far this week to 120. The spread on double-B junk bonds has widened 3 more basis points to an alarming 581.

The dollar has so far held together well considering the unfolding U.S. financial quagmire, with the dollar declining about ½ percent this week. After a brief respite, energy prices are again moving higher. Tensions in the Middle East, and specifically unnerving comments from Saudi Arabia that they would "respond appropriately" to any Israeli military excursion in the region, come at a most inopportune time for the global energy complex. For the week, crude oil prices have moved sharply, gaining 8% to end today at $33.25 a barrel. The unfolding energy crisis gained new momentum this week as, much to the surprise of industry analysts, the American Petroleum Institute (API) reported yesterday that U.S. distillate inventories (including diesel and home heating oil) actually declined over 3 million barrels to 113 million. This was the largest drop since February. Bloomberg quoted a market analyst: "We are not getting the supplies we need. The heating oil number is scary." Heating oil supplies are currently running 35% below last year. In addition, one must keep in mind that last year was an unusually mild winter. We may not be so lucky this time. Forecasters are already calling for a return to more normal patterns after several years of atypical influences from El Nino and La Nina systems. Bloomberg quoted an oil trader as stating "the fact that the weather turned cold early while stocks are low has got people nervous. We have little room for error going into the heating season." API data also had crude oil stocks at near 24-year lows. And while natural gas inventories did achieve the expected gain, they remain 13% below year ago levels while demand rises sharply. With prices having more than doubled this year, it is expected that the tab for keeping homes heated will rise more than 40% this winter. Today, natural gas surged 7% to close at a record high. For the week, natural gas has jumped almost 10%.

Today the BBC ran a story underscoring a warning given by the International Energy Agency: "The global oil market is running close to capacity and will be stretched to meet demand this winter. With declining stockpiles and refineries near peak production, the agency warns that 'the system is strained and running hard just to keep even. There is precious little room for contingencies…the market remains on edge, and prices are responding accordingly." The International Energy Agency also forecast that during the final three months of the year demand was to grow by 1.4 million barrels per day in Asia, 1 million in Europe, and 400,000 barrels in North America. "Refineries can only process so much crude; ships, barges and pipelines can only transport so much product…the global energy market is coming to grips with the reality that there are physical limits on what can be accomplished before the winter." One final note, responding to a question on CNBC as to how long until adequate refining capacity can come on line here in the U.S, an oil industry analyst stated "three or four years."

Apparently, the media is finally coming to grips with some key issues for this unfolding crisis. This morning, the Washington Post ran a story "A Resurgent Asia Craves Oil." According to the article, "Asia now consumes 21 million barrels - or 27% - of the 77 million barrels of oil the world burns every day," and demand is expected to continue rising. The article quotes our good friend from Hong Kong, Mark Faber: "If all the global-healing apostles and all the Asian bulls are right, and the world continues to grow, with Asia fully recovering, then oil demand is likely to explode over the next two years." The article also highlights analysis by Cambridge Energy Research Associates that expects a huge surge in demand going forward from China. Consumption is expected to rise sharply from today's 4.4 million barrels per day, to 7.2 million barrels in 2010 and 10.7 million in 2020. At this point, it is reasonable to presume that the days of inexpensive and abundant energy are very much a thing of the past.

Garnering more investor interest were the three major earnings reports from Lucent, Motorola, and Yahoo. The biggest story came from Lucent as it announced that earnings would fall short of analyst estimates for the third consecutive quarter. Lucent attributed the shortfall to three different areas. First, the optical business grew slower than anticipated, which Lucent said was caused by missing a product cycle. Second, sales of voice circuits have slowed. Lastly, Lucent stated it will increase its allowance for doubtful accounts because of credit concerns at startup telecommunication companies. Not only were the stocks hammered, Moody's downgraded the outlook for Lucent to negative from stable. It cited: "Lucent's account receivable quality issue promises to continue to be a challenge for the company as many of its customers are having a harder time accessing the capital markets and therefore will depend further on equipment suppliers for financing." The spread on Lucent's 10-year notes widened 10 basis points today, while the spread on it's 30-year bond increased 15 basis points. Lucent and its competitors, especially the optics players, will be under increased scrutiny as investors seek to determine whether this is strictly a Lucent problem or evidence of a more problematic general industry slowdown. Concerns of credit quality are already spilling over to its competitors.

Motorola was able to meet analyst's earnings projections, but reported disappointing revenues. Importantly, the top-line shortfall was almost entirely due to lower handset sales. The handset business was weak across the board, as margins came in lower than analysts were forecasting. Motorola also guided analysts down on the number of units it expects the industry to sell to 410-425 million units in 2000 and 525-575 million in 2001. While the number of handsets for 2000 only declined marginally, 2001 forecasts were reduced by about ten percent, as Merrill Lynch had forecast of 420-440 million and 580-620 million respectively. This is notable; as forecasted demand of wireless phones was contributing to the continued growth of semiconductor demand and the impetus for the massive semiconductor capital expenditures boom. Just today, IBM announced a $5 billion capital expenditure plan, the largest investment in IBM's history.

Industry bellwether, Yahoo reported earnings for the third quarter, bettering estimates by a penny, and posting stronger than expected top-line growth. However, there were several key trends at Yahoo that caused investors to be less than euphoric. Yahoo disclosed that 40% of its revenues came from dot-coms. Additionally, the number of advertisers actually declined 250 to 3450. Investors are obviously still concerned and have increasing "going concern" issues for much of the dot-com universe.

Elsewhere, the Bureau of Labor Statistics (BLS) released the employment situation last Friday. The overall employment numbers were stronger than expected, even after massaging for the Verizon strike. We did see the spin-masters nonetheless trumpeting a slowing economy, focusing conveniently on the reduction of manufacturing jobs. We do not view manufacturing jobs as indicative of the strength of the overall economy, as they have in the past. Why? Well, we now do have monthly trade deficits of almost $32 billion. Having gutted our industrial base - we presently import over $100 billion worth of goods each month - we are now predominantly a service sector economy. This has been increasingly the case since 1982 when consumers started spending more on services than goods. This trend continued unabated until 1998 when the percent of expenditures spent on services peaked at 59%. Since then, the portion spent on goods has climbed steadily, but still accounts for just 42% of purchases. Additionally, the BLS numbers revealed that the pool of available workers dropped to 9.83 million, down over 200,000 from August. It is obvious that the labor market is not only tight, but getting tighter. Remember a month from now retailers will be hiring additional seasonal help for the holiday shopping season.

While there might be shortages of employees, there is no shortage of companies with aggressive staffing plans. Last week the Milwaukee Journal Sentinel reported that Ameritech plans to add 3,300 technicians just in the Great Lakes region. IBM intends to employ 1,000 workers in the plant mentioned above. In the Seattle Times today, Stephen Dunphy reports that: "Statewide job growth picked up in the first half of the year after a long, slow slide from its peak in 1997 of more than 4 percent. Job growth had slipped to less than 2 percent in 1999 but stands slightly above 2 percent now." While workers are enjoying a spectacular job market by any measure, executives are even more sought after. The LA Times carried a story detailing the problems companies face attracting executive level employees. In 1999, demand for executives hit an all-time high, growing 14% over the prior year, according to Executive Search Consultants Inc. For the first three months of 2000 demand accelerated, growing 17% over the year ago period. Not only is the number of executives increasing, but the pay packages are growing three times that of the average worker. For 1999, the average worker's pay increased 4.2%, while the CEOs at the largest 800 companies earned 12.8% more. "Never in my wildest dreams or nightmares did I ever imagine that I would have chief financial officer assignments that paid $300,000 a year, had bonus potential for another 50% and lucrative stock options - and have great difficulty in filling those positions," says Gary Kaplan, founder of a Pasadena-based search firm bearing his name.

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