Bulls Braced for Jobs

Stocks hesistate ahead of the employment report, which could change the outlook for the Fed's interest rate policy.
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Every time the market finds a good argument to rally, as it did on Tuesday and somewhat on Wednesday, the risk is that the validity of the argument is revisited shortly afterwards.

That's what may happen with Friday's employment report which -- if it shows more strength or wage inflation than the market expects -- may lead investors to reconsider Tuesday's happy consensus that the

Federal Reserve

is nearly done with rates.

Following the release Tuesday of the minutes of the Fed's Dec. 13 meeting, market bets were that the central bank would raise rates one more time to 4.50% on Jan. 31, while the odds of another hike on March 28 dropped to 56%, from 62% previously.

By Thursday's close, the odds of such a hike, which would lift the fed funds rate to 4.75%, had dropped to 48%. Even the odds of a Jan. 31 hike dropped to 88% from 100% previously, according to Miller Tabak.

That means hopes of a gentler Fed are indeed running high. So high, in fact, that "anything that would cast doubt on

these hopes could derail the current happy momentum in the stock market," says Marc Pado, market strategist at Cantor Fitzgerald.

After adding 2% in just the first two trading sessions of the year, the market stalled on Thursday, with the

S&P 500

index rising only fractionally to 1273.48. A drop in crude oil and natural gas prices weighed on energy stocks, and by extension, the broader index. The Amex Oil and Gas Index fell 0.9% and the Philadelphia Stock Exchange Oil Service Index slid 2%.

There also was evidence that a slowing economy, the logical reason that would lead the Fed to soon stop lifting rates may be in the cards. Economic growth has been powered by strong consumption, itself bolstered by a strong housing market, over the past three years.

But Thursday brought further evidence that housing is cooling. The National Association of Realtors said pending home sales dropped 2.5% in November, the third monthly decline in a row.

And before the open,

Wal-Mart

(WMT) - Get Report

warned that fourth-quarter earnings would be at the lower end of previous guidance as holiday sales came in below expectations. Other retailers -- such as Wal-Mart rival

Target

(TGT) - Get Report

and apparel specialist

Aeropostale

(ARO)

-- seemed to fare better. But the holiday performance of retailers seems mixed at best.

The S&P retail index dropped 0.3%

Wal-Mart's 1.4% decline pressured blue chips on Thursday. The

Dow Jones Industrial Average

advanced just 2.0 points, or 0.02%, to 10,882.15.

The

Nasdaq Composite

rose 13.41 points, or 0.59%, to 2276.87. Tech shares were boosted by hopes of more consolidation in the sector amid reports that both

Hewlett-Packard

(HPQ) - Get Report

and private-equity group Blackstone are considering a purchase of

Computer Sciences

(CSC)

.

Meanwhile, the weak housing data and the mixed picture in retail sales were counterbalanced by Thursday's unexpected drop in jobless claims and strength in the service sector of the economy.

As things stand, two key opposing scenarios about the economy -- a slowing housing market possibly undermining consumption vs. strong businesses and employment growth -- appear to be neutralizing each other in terms of their implications for Fed policy.

That's why Friday's employment report will be an important piece to the central banking puzzle.

The consensus of Wall Street economists is for the economy to have added 200,000 jobs in December, roughly matching November's 215,000 gain. The unemployment rate is expected to remain unchanged at 5.0%, and average hourly earnings are expected to have risen 0.2%, in line with November.

The immediate risks are that either payroll growth or earnings overshoot expectations. Whisper numbers are that payrolls may rise by 215,000, according to Miller Tabak. But a bigger rise in payrolls, say 250,000, a drop in the unemployment rate or a larger-than-expected rise in hourly earnings would spark concerns over wage inflation.

On Tuesday, the market rallied as the Fed's minutes clarified why the bank had stopped referring to its policy as "accommodative" to growth. This was to signal, the minutes said, that "given the information now in hand, the number of additional firming steps required probably would not be large."

But in another section of the minutes, which got less media attention, it appeared that some of the Fed officials voting on rates were less sanguine on inflation.

"In the view of a number of participants, the economy was possibly producing in the neighborhood of its potential, and the persistent strength in spending of late suggested that resource markets could tighten further and inflation pressures build," the minutes said.

Indeed, the strength in the December payrolls, as in November, is expected to be led in large part by the continued rebound in activity that followed Hurricane Katrina's devastation last summer, and also as retailers hired more part-time employees for the holiday shopping season.

Given the tepid performance of retailers, however, those jobs won't necessarily last.

But what the Fed's December minutes didn't mention, although some Fed officials had previously, is that the economy is expected to rebound somewhat in the first quarter, in part driven by government spending to rebuild regions devastated by Katrina.

Perhaps the spending that will end up worrying the Fed will come not from consumers, but from the government. In the December non-manufacturing survey by the Institute for Supply Management, high on the list of rising commodity prices was aluminum, copper, asphalt, construction materials, cement and construction labor.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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