The Economy, Energy & Equites
Economy – Inflation & Recession
Let’s first talk about the economy in general, then I’ll share some trading ideas for the S&P 500 and crude oil futures. There are two economic forces that we’ve been talking about the past two quarters, and I think we’ll continue to talk about them for at least two more: inflation and recession. Will the economy expand, or contract? And will we continue to see higher commodity prices in either scenario?
According to the Chicago Board of Trade’s Fed funds futures market, traders are pricing in upwards of 90 percent odds that the Federal Reserve will cut interest rates again at the next policy meeting scheduled for January 30, 2008. So we’ll have to wait and see where the Fed feels the economy is headed, along with their opinion on inflation, as indicated by their words and actions.
Another important upcoming event to keep an eye on is the OPEC meeting, in the first week in February. Energy is acting like a tax on ordinary spending. Consumers are paying more on heat and transportation and that means they have less for discretionary purchases of other goods and services. We’ll see if the consumer continues to hold up the economy.
What’s the Definition of a Recession?
There are numerous definitions for a recession. The basic textbook definition of a recession is two declining quarters of growth, as measured by gross domestic product (GDP), in a row. The problem with this definition is that it’s too rigid and can be misleading. It doesn’t take into account variables such as the employment picture, measured through the unemployment rate and non-farm payroll growth/contraction.
We know that this report can move the equity markets dramatically. The last employment report from the Bureau of Labor Statistics showed the unemployment rate rose from 4.7 percent to 5 percent in December, triggering a big sell-off in the S&P 500, Dow Jones Industrial Average, and Nasdaq.
There is another definition from the National Bureau of Economic Research (NBER) that is a little more comprehensive. The NBER has a committee which determines the amount of business activity in the U.S. economy by looking at the following: employment, industrial production, real income, along with wholesale and retail sales.
Last week, at the start of 2008, we saw that big “R” word plastered everywhere as disappointing economic data surfaced. We have a higher probability of recession happening as these economic statistics are looking weak, and the markets are pricing in the bad news. If we go into recession, the Fed should continue to cut rates. If you believe that is true, the U.S. dollar should continue to drop, and commodities such as gold and crude oil should increase, regardless of the supply and demand fundamentals. I feel the Fed will cut the key short-term interest rate (the Fed funds rate) at the next meeting by 25 basis points, but they are a little afraid of inflation and won’t likely go too far with further rate cuts.
In addition, I don’t see two consecutive negative quarters for GDP, the standard definition for a recession. Although I don’t think we’ll have a recession, I do think we will have a major slowdown. This should put a sprinkle of water on the inflation fire. If the Fed cuts 50 basis points this month, we have a sign they are very worried about recession, but we will wait and watch what they do.
Energies – Crude Oil
Crude oil skyrocketed during 2007. The market started near $60 a barrel, and by the third week of November, rose to $96. We’ve had a huge bull run in crude oil. We’ve had bullish fundamentals so far this year, with less supply amid constant demand. Prices should move higher under that scenario, and they did—up to $100. But given talk of recession, and the potential for reduced demand, the market couldn’t hold $100.
Crude Oil – February 2008 - Daily
If the March futures hold support near $94.80, I see that as a place to consider buying. I’d recommend selling around $98 - $100. If this market closes above $100 two days in a row, or on a weekly basis, I’d also recommend buying on idea that we’ll see a new range higher. If the market doesn’t close above $100, for two days in a row, I would recommend some swing trading around $95.
If the market closes below $94.50, I would recommend dumping any long positions, and riding it down to $91 with a short position. However, keep in mind that this market can trade as low as $90 and still be in a bull trend. In a nutshell, I would recommend selling near $98 and buying near $92.
Also, keep in mind two important dates. OPEC meets at the beginning of February and the Federal Reserve meets on January 30. The Federal Reserve is expected make a cut of 25 basis points, but if they cut 50 basis points, then that means they are really worried about the economy. A 25 basis point cut means they are holding back some because they are worried about inflation.
Equities – S&P 500
The S&P 500 March futures sold off nearly 25 points, closing at 1397 on Tuesday, January 8. This market is at a major weekly technical area. In the recent past, the S&P 500 futures bounced off every major correction near 1405, 1410 and 1430.
S&P 500 – March 2008 - Weekly
From a support and resistance standpoint, I would recommend selling S&P futures if they reach the 1490 – 1510 area. Despite Tuesday’s major drop, keep in mind that we are in a bull market that has been running for five years. If we do have an economic contraction, the market should be forecasting it, and I believe it has been pricing that potential in. A close under 1380 two days in a row in the March contract would make me bearish, and in that case, I see another 40-50 points to go lower.
I see a correction this year of as much as a 15 percent in the S&P 500. However, the market should recover by year-end and close unchanged to perhaps 3 percent or so lower. The second half of this year should be better than the same period in 2007, when subprime issues hit the fan, but I’m not looking for a bull market in 2008.
At the current levels, I would buy in the range of 1385 - 1400, but only if it has a close at or below this level. In general, I would recommend selling the rallies and buying the dips. If the market happens to rally to 1460, I would recommend re-establishing a short position for the short-term trade, meaning, three to five days. From that I level, I would recommend risking 15 points and then taking a stab at 1510 to get short again. Any close under 1380, and I may consider minor buys at 1352, depending on the data.
In summary, I don’t think we’ll have a recession, but I think we’ll be very close to one. I think the Fed will find other ways to correct the subprime problems, besides rate cuts that could ignite inflation.
Jeff Friedman is a Senior Market Strategist with Lind Plus. He can be reached at 866-231-7811 or via email at jfriedman@lind-waldock.com.
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