A day that was supposed to be bullish turned into a rout as the Dow gave up 9000 once again. End of quarter buying was nonexistent along with volume as the indexes slipped into the red after lunch. The Russell-2000 was the best performer but it also slipped fractionally into the red just before the close. With the Fed behind us and a shortened holiday week ahead we are entering into a critical period for the markets.
Dow Chart - Daily
Nasdaq Chart - Daily
Friday was light economically but after the week we have had I think traders welcomed the pause. Personal Income rose for the seventh month with a +0.3% gain. This was inline with estimates and April was revised to +0.2% from zero. Spending rose +0.1% and posted its 3rd monthly gain. Disposable income is slowing but the coming tax cut should boost that number slightly. One more shot in the arm for the economy.
The Michigan Sentiment final for June rose slightly to 89.7 from the preliminary of 87.2. This is still well below the euphoric (just kidding) 92.1 post war number for May. The expectations component was 86.4, down from 91.4 in May. The present conditions component actually rose to 94.7 from May's 93.2. Evidently the public is still convinced the post war rebound is underway but are far less expectant that the golden promises of a roaring 4th quarter will come to pass. The discount sales at retailers still trying to get out from under a load of spring merchandise are helping consumers outlook. Buying cheap merchandise always makes consumers happy. This is carrying over to the current conditions component. The failure of the stock market to make any gains over the last three weeks is causing those same buyers to wonder if maybe we have over done it once again. That is helping increase worry for the next six months.
The earnings warning from Nike on Thursday is one more example that consumers are not stepping up to the cash register to pay big bucks for premium merchandise. Wal-Mart however is doing fine and taking market share from a diverse list of competitors. Kroger, for instance, revised its earnings estimates downward based on increased competition from Wal-Mart and other discounters. Wal-Mart has over 1300 super centers open now with over 200,000 sq ft of space including not only a complete grocery store but a complete Kmart/Target mix of department store items as well. The current unemployed generation is learning to pinch those pennies and you can bet the discounters will see more of the coming tax cut than Neiman Marcus and Lord and Taylor. It is the economic ripple down effect all over again brought on by fewer jobs.
Another change in the trend came this week when AMG Data reported that equity funds saw outflows of -$1.6 billion. This is the first week of outflows in several weeks. TrimTabs reported last week that $11 billion flowed into equity funds over the prior three weeks. Looks like the bloom is fading from the rosy outlook for retail traders. Of course this could be simply fear of the Fed and a dose of caution ahead of the Fed meeting this week.
The S&P posted the best month since the 4Q-2001 despite giving up nearly -11 points for the week. Assuming the last day of the quarter on Monday does not produce a monster drop then this would be the 3rd biggest quarterly gain for the S&P in history. Think about that. For this quarterly earnings cycle, which will begin reporting in two weeks, 51% of the preannouncements have been warnings. Last year, when we were in a recession the level of warnings was only 37% for the same quarter. This anomaly could have a lot to do with the weakness this week. Too far too fast on too few facts. The euphoria over the Iraq war ending produced the bounce but in reality there are as many soldiers getting killed in post war Iraq as during the war and the numbers are growing.
Another problem according to traders was the Fed decision and the wording of that decision. The statement for the latest 25 point cut was almost exactly the same wording as the prior cut. That was a 50-point cut in Nov-2002.
Nov-2002 statement - The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. The Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot.
June-2003 statement - The Committee continues to believe that an accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. The Committee judged that a slightly more expansive monetary policy would add further support for an economy which it expects to improve over time.
If the statement is the same then why the negative reaction? First that was a 50-point cut in November and only a 25-point cut in June. Ok, so maybe the Fed thinks things are better now than then. Hold that thought. In the June release the "risks are balanced" comment from November was replaced with "The Committee believes that the risk of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation and is likely to predominate for the foreseeable future." (edited for space and readability)
The bottom line was an additional cause for concern and a less than aggressive response. After the minutes of the May meeting were released this week there appeared to be more fear and less ability to actually do anything about it among Fed members. The market read between the lines and started taking chips off the table. Ironically the bond market has sold off strongly since the meeting. The Fed cut 25 basis points to keep rates low and stimulate the economy but real rates as set by the bond market actually ROSE by 50 basis points as of Friday's close. Even more amazing, the cash coming out of the bond market did not flow into the stock market. This is really causing concern among equity traders.
One of the reasons for the shift was a debt offering by GM. The company announced a $13 billion offering at the beginning of the week. The demand was so strong for the paper the deal was raised to $17 billion and dealers said they could have easily sold over $30 billion. With yields on the government 30-year closing Friday near 4.50% and the GM paper yielding 8.375% it was a no brainer deal for bond junkies. It is no surprise that the money was sidetracked on the way to the stock market. For those still holding bonds next week will be another chapter in the story. Do you continue to hold bonds as they free fall or was the free fall caused by the massive surge in corporate paper led by GM. Next week will be critical for the market direction of both bonds and equities.
On Friday it was clear that some funds were locking in profits for the quarter with the recent leaders in drugs, biotech, semis and home builders giving up ground. Before you get the wrong idea it was not a washout. Far from it. There was not enough volume for a washout with only 3.2 billion across all markets. This was the lowest volume day since April 28th. It was not a case of a trend change more than just a case of simple profit taking and a buyer boycott.
The $64 question is what happens now? I am not going to repeat the entire historical trend conversation from my Tuesday wrap but it is critical for understanding what is ahead of us. Read it here if you missed it.
The bottom line is cash flow. Sellers for the end of the quarter were expecting to sell into funds trying to window dress their statements with uninvested cash. It was apparent on Friday there was no cash flowing into the markets. Are the funds going to wait until Monday and do all their buying at once? I seriously doubt it. While I, like other analysts, thought we would see some end of month gains it appears now that the funds were already in the market to profit from the pre Fed speculation. This sets up a serious potential problem of which Friday may have been a clue. If all the funds are all dressed up with nowhere to go then we could see them stripping down to their undies soon as they wait out the summer heat. The only thing between the funds and the summer doldrums is the influx of retirement cash over the next ten days. The midyear July cash flow is heavy and typically the first week of July is by far the strongest if not the only bullish week of the month.
With the bond junkies running to the "safety" of corporate paper instead of the equity market then there must still be a perception by institutions that the economy is not recovering. Despite several glimmers of hope in recent economic reports is it that "substantial unwelcome fall in inflation" that is weighing on investors? Could be but I believe it is simple profit taking instead. It is not SARS impacting the market it is just a cold. That does not mean we may not spend some time resting once the fever rises.
SPX Chart - Daily
On Thursday I warned that the S&P had strong resistance at 988-990 and if we made it over that we could be ready to rock next week. Unfortunately the S&P made it to 989 and died. It closed at 976, -23 points lower. This puts us in a unique position. We are well off the highs and resting on solid support at 975. We can go either way without running into serious traffic for about 25 points. This sets up the potential for a very volatile Monday if not a volatile week. The Dow closed just barely under 9000, right on strong support and poised to either rebound or retest the next major support at 8500. This is not a cheerful thought but one all investors should consider. I suspect many of the funds considering end of quarter buying weighed the possibilities and decided the risk was too great.
The potential for volatility next week is strong due to several different influences. The Russell-3000 is being rebalanced, which means nearly 500 companies are being added or subtracted from the indexes on Monday at the close. The S&P is also being adjusted and that could cause a considerable increase in volume. Companies like IBM, which increased its outstanding shares by +2.2% will have to be bought by index funds to increase their holdings by +2.2%. Conversely Comcast bought back 66 million shares an fund managers will have to reduce their holdings. Multiply this by several dozen companies in the S&P and around 500 in the Russell and you can see why Monday could be exciting. Rebalancing puts pressure on indexes because the stocks being deleted after the close are being sold during the day and the new stocks being added/bought do not influence the index until the following day.
Beginning on Tuesday any fund that was holding winners over the 2nd qtr statement date may decide to dump those winners to lock in profits and then buy back on the annual summer dip. Considering how much profit we have in the last three months of gains this could produce a serious downdraft. Holding up this downdraft could be the influx of retirement cash in the first ten days of the month. The normally bullish holiday shortened week is also packed full of serious economic reports. Monday is PMI, Tuesday ISM and Thursday is the jackpot with Jobless Claims, Nonfarm Payrolls and ISM Services. This is not going to be a week for the feint of heart.
NYSI Chart - Daily
As traders we need to be prepared for either direction. The rising interest rates are going to impact stocks. Homebuilders are already starting to fall as mortgage rates did exactly the opposite of what the Fed wanted. The S&P is facing a crucial technical test at 950 which is the 50 DMA and a launching point for the June rally. In short the recent rally is weakening internally and this week will be a critical test. The market is due a rest and whether that rest begins on Monday or follows the historical norms for a drop later in the month, it will rest.
My recommendation remains the same only from a lower level. Instead of going long if we broke resistance at S&P 990 as I suggested on Thursday I would go long on any dip on Monday as long as we stay above 950. Friday gave us the benefit of a lower entry at strong support if there is a rebound in our future. The last day of June down eight of the last eleven years. This is probably related to the index rebalancing and the selling of the stocks being deleted.
If we do follow the July norms and move up be prepared to exit as we reach resistance points of 990, 1000 and 1015 if weakness appears. This is a critical period for the markets and one where a lot of money can be made if an investor is paying attention. It is not a buy and hold market and it could move very fast under the right conditions. Keep those stops in place regardless of your position.
Enter Very Passively, Exit Very Aggressively!