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Market Wrap

The economy may be slowing but so are profits.

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         WE 6-9           WE 6-2          WE 5-26         WE 5-19
DOW    10614.06 -180.70 10794.76 +495.52 10299.24 -327.61 + 17.41
Nasdaq  3874.84 + 61.46  3813.38 +608.27  3205.11 -185.29 -138.65
S&P-100  779.70 - 12.99   792.69 + 56.61   736.08 - 16.87 -  8.72
S&P-500 1456.95 - 20.31  1477.26 + 99.24  1378.02 - 28.93 - 14.01
RUT      523.06 + 10.03   513.03 + 55.66   457.37 - 22.33 - 11.24
TRAN    2790.17 - 39.19  2829.36 +141.81  2687.55 - 54.45 -132.02
VIX       25.19 +  1.08    24.11 -  3.38    27.49 -  1.28 -  1.23
Put/Call    .45              .41              .65             .89

The economy may be slowing but so are profits.

These good news, bad news stories are killing us. The good news, the PPI was announced Friday morning and was unchanged from last month, which was lower than expected. Food and energy actually went down which surprised analysts. The market celebrated with the Dow soaring +95 points to 10763 with traders convinced that the Fed would not raise interest rates again. Party time, right? The bad news quickly deflated the rally balloon and sent traders to the sidelines again. The bad news was a flurry of earnings warnings from high profile companies. Warnings that prove the economy is slowing but call into question the most important aspect of stock prices, earnings.

Without increasing earnings the entire market will grind to a halt and we have entered earnings warning season with a bang. Leading the parade today was McDonalds, which reported slowing sales of between -4% and -9% depending on the geographic area. MCD dropped almost -$5 to $31.63 on the news and knocked over -25 points off the Dow. If sales are slowing in this very low level consumer product then other areas are suspect. Analysts were divided on whether it was a sector problem or just a MCD problem. Still the results were the same, a drag on the Dow. Of course MCD is a food stock not a tech stock so who cares? It is strictly a sentiment reaction. The name is the key. A big name will elicit a big response regardless of the sector.

Tech stocks were not immune either. EDS warned that revenue would fall into the low single digits but gains would continue to be made in cost savings and productivity improvements. OOPS! Not what investors want to hear. Making money by spending less is not music to investor's ears. EDS was punished severely with a -$14 drop.

Retailers got hammered again with worries about sales at Walmart and Target after a warning from Lands End today. Dillards started the run with a huge earnings miss in May followed by news last week that sales were down again. Boise Cascade warned today after the close that slowing home sales and higher interest rates would cause it to miss estimates. This will further depress the wood and paper stocks on Monday.

Financial stocks headed for the cellar again as analysts traded downgrades and concerns about profits going forward. JPM led the drop again with -4.19 followed by CMB at -3.19. Not to be out done, H&R Block, HRB, warned that earnings would not make estimates and dropped -$4 at the open. Almost every sector was represented today with even the hot biotech's having their own warning poster child. Mylan (MYL) warned they would miss estimates by about -50% and lost about -$7 at the open.

We are just getting started in the earnings-warning season and the applications for ugliest contestant are piling up. Only one week into the season we have had PG, CC, MCD, EDS, HRB, LE, GPSI, MYL and several others I have already forgotten. As if the warnings were not enough, the follow on downgrades on the appropriate sectors are starting to take their toll. The economy is clearly slowing but that is a catch 22.

The PPI report was flat from last month and the CPI is now expected to come in below estimates also. If it does it would be two months in a row that prices fell. Also, it is almost a given now that Retail Sales next Tuesday will come in less than expected and will mark the third month in a row that they fell. Isn't this what we want?

Fed expert Lyle Gramley is now predicting no rise in June along with many others. If the Fed is on hold then why is the market falling? The earnings for the S&P-500 are still estimated to grow at +18% for the second quarter. This number has not changed recently but many think it is eminent. Ouch! It appears the Fed rate hikes are finally working too well. The old adage of don't fight the Fed is finally proving correct. Fed governor Poole said today that the Fed was in no hurry to change it's policy and would wait for a clear trend to emerge. While most think the Fed is on hold there is still noise from the Fed that maybe they still have a +.25% hike on their mind. They are probably thinking about this as an election year and don't want to be politically incorrect in raising rates the closer we get to November. By taking a last shot in June they risk over kill but also cement a no hike posture until after the election. Remember it takes 9-12 months to filter a rate hike through the system so we still have four working their way through. The challenge appears to be the profit squeeze. Companies are not able to raise prices due to the competition of the Internet even though their costs are going up. The great productivity of the Internet era meets the high price competition of the Internet era. The losers - corporate America and stock prices.

The picture beginning to emerge is building overhead resistance. If profit estimates are going to start shrinking then prices are quick to follow. The tech stocks appeared to be immune to these problems this week with many adding decent gains even after a +20% tech gain last week. While the Nasdaq only managed a +61 points gain for the week it was still a gain while undergoing a consolidation. Unfortunately most of the gain was in the biotech sector but we will take it where we can get it. If it were not for tech stocks the Dow would have really been in the tank. HWP added +14 for the week and IBM added almost +11. This is +125 Dow points. Take those points out of the Dow and it would have been down over -300 points for the week to close under 10500. That is right I said 10500!

Bear market rallies are short, sharp and die on low volume. The Nasdaq gained +800 points last week on only moderate volume. Friday the Nasdaq only managed 1.2 bln shares and the NYSE only 785 mln shares. While the volume was terrible the advance decline line was actually strongly positive. We have short, sharp and low volume but there is still an underlying positive sentiment. On Friday there was some institutional selling and no buying which drove down the prices. Retail buyers were still active.

So what should we expect for next week? The right answer and $5,000 would pay for a Lexus by the weekend. We have two distinct possibilities. On the positive side you could point to the bullish wedge building on the Nasdaq, the strong advance- declines from today and the expected market friendly economic reports scheduled for next week and back up the truck. That would be quite a gamble but if you were right you could be amply rewarded. The key reports are the Retail Sales on Tuesday and the PPI on Wednesday and both are expected to be in our favor. Friday is also triple witching options expiration and expiration week normally has a bullish bias.

On the negative side you could point to the same facts and say "so why did the market die on Friday?" All these things were already known and the market always moves in advance of the facts. So where was the move?

The key here is of course the Fed and the profit warnings. The Fed will be less and less a factor as the reports are made public unless of course there is an upside surprise. So that leaves the earnings warnings. These are only trouble on the surface. The day they are announced they contain sentiment value which acts like a shot of poison to investors. While the news of the warning is bad for that stock price the overall benefit is more subtle. Each warning is a sign that the Fed hikes are working and everything is under control. The smart money knows from experience that when the Fed moves aggressively to raise rates for an extended period of time that there is a limit to what they can do without crashing the economy. That limit is here. In 1994/95 when the Fed raised rates in rapid succession the market actually firmed around the sixth increase because investors knew the hikes had to stop or slow for 9-12 months until the real impact to the economy could be evaluated.

We are there. The meeting on June-27th is a non-event because they will either hold on further hikes or take one last +.25% shot. Either way they are done. The Fed is out of the long term picture. This will setup a longer-term outlook for investors but it does not mean that we may not move lower before we move higher. The earnings warnings for the next several weeks will cause sporadic sector events but in the long term be beneficial. While a strong dose of poison will kill you, a routine exposure to a smaller amount will actually make you immune to the poison. Warnings and Fed news may make us sick but hopefully these "vaccinations" will also make us well.

Cash is still piling up on the sidelines. Trimtabs.com reported that over $3 bln in cash came into equity funds in the week ended on Wednesday. Only half of the $7 bln from the week before but the second week in a row that the number was positive. Investors waiting for a pull back from the monster gains from last week are growing tired of waiting and starting to nibble at the leaders. The market is still seeing strong gains in individual stocks even though the major indexes are flat.

I want to be bullish but the weakness on the Dow is holding me back. Remember, without IBM and HWP the Dow would be below 10500 today. We experienced this divergence earlier this year and the end result was disaster. The only thing that could turn this around is the financial stocks. If they turn based on favorable reports next week then the Dow could firm. This would give support to the Nasdaq rally and we could see several weeks of decent gains. The wild cards of course continue to be the warnings. A steady stream of warnings will dull investor interest keep us range bound into the July earnings.

I was encouraged by the Nasdaq failing to sell off this week. I think this is the most positive point in the entire picture. The Nasdaq, the QQQ and the IIX are all building a bullish wedge and showing no signs of retreat. Historically, IN MY OPINION, this is a bullish sign. There is no guarantee or we would all be driving a Lexus.

The key to trading in this environment is to either be market neutral or out of the market. The Nasdaq is creeping up on 3900. I think that is the key this week. If the Nasdaq can breakout over 3900 on decent volume I would go long. If it falls back under 3900 I would stay flat. By setting an arbitrary entry point above resistance you avoid all those "should I or shouldn't I" questions. The decision is simple and precise. Of course I would also want the stock and sector positive also. By making your decision on Nasdaq 3900 you ignore the Dow problem until it impacts the Nasdaq. Once into the position be faithful about setting those stop losses in case the stock you bought is the next on the warnings list!

My play of the day is on the QQQ. See the Editor's Plays section for the description.

Because we have so many new readers we are updating and reprinting my ten part educational series from last fall. I started this week with Entry Point, Entry Point, Entry Point. Look for it in the Options 101 section of the website.

Trade smart, sell too soon.

Jim Brown

On a personal note, Jodi Mayo, a long time customer service employee here which thousands of readers have communicated with in the past, delivered her first child, an 8lb, 7oz baby girl named Abby on Friday. The baby was still born with the cord wrapped around it's neck. Please remember Jodi and her family in your prayers. Notes may be sent to Contact Support

***Attention OI Readers***

Starting today, we are proud to introduce a new section to further help guide you in the markets. This section is devoted to playing the HOLDRS, such as the QQQs. I have been very excited about the development of this new feature and have tapped the mind of our most tenured researcher, Buzz Lynn, to guide us through it. The section is called Sector Trader and will be updated on Tuesdays, Thursdays and Sundays. Look for it in section one of your email or in the Strategies section of the website.


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