The Matador Usually Wins
We had an interesting batch of conflicting data and news stories this morning. First of all, the markets tanked on news from J.P. Morgan that they would be reducing their earnings forecast due to credit losses and lower trading revenue. The reaction was dramatic, as earnings forecasts were slashed on the bank. Lehman cut its forecast from 0.58 to 0.38 and lowered its price target on JPM from $31 to $23. Fitch ratings downgraded the bank's debt, as did Standard and Poor's, which said that it could lower the rating once again if trading problems persist in the fourth quarter. JPM has been estimated to have as much as $20 trillion (yes, I said trillion) of derivatives positions on its books, which is another source of tremendous risk for the company. They are the world's largest holder of gold derivatives. Two percent of a bank's derivatives exposure is usually considered at risk in the normal course of business. Two percent of $20 trillion is $400 billion. Considering a market cap of $37 billion for JPM, we could be seeing a lot more red on its chart than we already have. I am not saying that JPM could not profit from this portfolio, rather than lose, but the risk is enormous. The credit problem was pinned on loans to the telecom sector, which resulted in an increase of $1 billion in bad debt.
If JPM is seeing high default rates from the telecoms, there are undoubtedly other banks with similar problems. While they may not have the same amount of exposure, we could still see some heavy losses. Taking this pattern a step further, there are other sectors that have performed horribly and seen financial problems as well. How many of these are also having problems making payments? How many banks are suffering from bad debts that we have not yet heard about? I think this announcement could just be the tip of the iceberg and I would stay away from playing the banks long on anything but a short-term basis.
On the positive side, the U.S. trade deficit decreased by 6 percent in July, to $34.6 billion. Exports increased for the fifth straight month, while June's record trade deficit was revised downward to $36.8 billion from $37.2 billion.
Inflation also appears to be peaking its head back out, as the consumer price index rose 0.3 percent. The core rate, which excludes the more volatile food and energy components, was also up by the same amount. Those increases were a bit higher than forecasts of 0.2 percent.
Oracle released earnings after the bell yesterday. They met expectations, but issued cautious statements. The company's earnings fell 33 percent from last year and Jeff Henley, Oracle's CFO said, " We think the worst is over, and we think we'll see gradually better year-over-year numbers ... but it's still a difficult, slow recovery. We're being very cautious with our business planning at this point." These comments weighed heavily on the markets this morning as well, as the Nasdaq started the day down 15 points. Oracle ended the day down 8 percent (0.73) at $8.30.
I have been writing recently about the bearish head and shoulders pattern forming across the broader indices. Yesterday's action in the Dow led to a definitive neckline break, as the index closed below 8305, which was the 50% retracement of its gains from July 24 to August 22. The neckline can be drawn from several different points, but there wasn't much to argue about in yesterday's Dow breakdown. The previous low at that support level was set on September 5 in the Dow. The Nasdaq Composite (COMPX), however, is a slightly different story. The September 5 low, which is also the point at which there is little argument about a neckline break, was 1251.00. The September 5 low is also the last significant support level above 1200. The Nasdaq traded as low as 1233.08 this morning and a breakdown appeared certain. However, much like the action in the Dow when it was testing the 50% retracement level the week of September 5, a rally boosted the Nasdaq back above the crucial level.
Chart of the Nasdaq Composite (COMPX)
After the bell, Electronic Data Systems (EDS) warned that they would miss expectations for the third and fourth quarters, as well as the full year. EDS said that lack of demand for infrastructure technology services is very soft and lowered earnings estimates from 74 cents to 12 to 15 cents for the third quarter. Although it was halted in after hours trading, rival IBM was trading down $3.55 to $66.00. This should be the kicker that takes the Nasdaq back down below that 1251 level and on its way to 1200. While neither IBM nor EDS are Nasdaq stocks, IBM is the biggest of the techs and should tip the scales. As a Dow stock, it may also lead us back below today's low of 8051.91. IBM is the third heaviest weighted stock in the Dow, and a significant move could speed the process toward re-testing July's low.
Today's low got us within 21 points of 8030, which is the last significant support level between where the index is currently trading and the July low of 7532. I had planned on writing about the strength of the intraday turnaround, but if IBM does not rebound from its $3.50 dollar drop after the close, it is likely we will see tomorrow's action take us below 8030. This afternoon's rebound brought us back above the 61.8% retracement level and it appeared that this might be the next level of consolidation. However, given the news after the bell, I am no longer confident that this level will hold.
Chart of The Dow
In what appears to be more bad news for the brokerage sector, Merrill Lynch announced after the bell that they have fired Vice Chairman Thomas W. Davis and Schuyler Tilney, an investment banking managing director, for refusing to testify in the SEC and Department of Justice investigation of financial transactions Merrill completed with Enron. Merrill sold off after the announcement, as investors worry what the two executives are hiding. A refusal to testify does not always mean the subject is hiding something, however. The way the law is structured, it rarely benefits a potential defendant to speak up on his own behalf. Statements made for your own benefit are not admissible in court, while statements made against your own interest are allowed. Therefore, there is little to gain by speaking up on your own behalf and many attorneys counsel clients to simply remain quiet. Regardless of this rule, investors don't like hearing about non-cooperation in a government probe, especially when it has turned up many violations already.
A development that did not get much media play today, but could have serious effects on our economy, was an informal agreement between OPEC members to leave oil production quotas unchanged. There had been predictions that they would raise their official quota of 21.7 million barrels a day at the September 19 meeting in Osaka, Japan, in order to bring the per barrel price down to palatable levels. But even Saudi Arabia, the world's largest producer of crude oil, apparently has agreed to leave current quotas unchanged. They had previously come out in support of raising quotas. This is partially the result of the fact that the OPEC members have actually been overproducing by about 1.7 million barrels per day, and will simply "cheat" on the current quota, rather than raise it. The problem for the U.S. is that the country's crude oil inventories have contracted by 15.3 million barrels in the last three weeks, and now stand at the lowest level, 287.8 million barrels, since March 2001. Heading into the winter, this could squeeze prices even higher than they are now - and that does not include the possibility of an invasion into Iraq. Crude Oil Futures jumped again today, as news of the unchanged quotas seeped out. A vote by Congress authorizing military action in Iraq will almost certainly push the price of futures over $30 per barrel. With an economy that is already growing at a very slow pace, increasing fuel costs could have a pronounced effect on all industries, as well as cutting into discretionary spending by consumers who will be paying higher prices at the pump.
Chart of Crude Oil Futures
With so many factors weighing on the markets today, look for a much lower open tomorrow. A hold above the 8000 level in the Dow could be viewed as bullish, however, the overall trend appears as though it is just a matter of time before we re-test July's lows. The put/call ratio is once again growing and now stands at 1.36, which shows an even greater number of puts trading than calls. While this is not an exact science, experience on the floor has taught me that puts trade when the smart money is bearish, and they trade more than calls when the smart money is very bearish. There will be pockets of opportunity from the long side, but remember that when the trend is down, the longs are usually short-term plays. Choose your plays carefully and don't lose sight of the big picture.