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Market Wrap

Earnings Surprise

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      07-06-2004           High     Low     Volume   Adv/Dcl
DJIA    10219.34 - 63.50 10280.26 10191.40 1.46 bln 1192/1932
NASDAQ   1963.43 - 43.20  1995.40  1958.69 1.89 bln  784/2273
S&P 100   543.33 -  3.84   547.17   541.76   Totals 1976/4205
S&P 500  1116.19 -  9.19  1125.38  1113.21 
W5000   10896.09 -101.50 10997.55 10870.11
SOX       439.14 - 18.31   457.31   435.23
RUS 2000  572.41 - 10.31   582.72   571.47
DJ TRANS 3116.49 - 29.70  3146.39  3113.91
VIX        16.25 +  1.17    16.75    16.13
VXO (VIX-O)16.17 +  1.08    16.94    15.55
VXN        22.11 +  2.22    22.38    21.41 
Total Volume 3,653M
Total UpVol    488M	
Total DnVol  3,126M
Total Adv  2229
Total Dcl  4747
52wk Highs  145
52wk Lows   140
TRIN       2.45
NAZTRIN    3.76
PUT/CALL   1.08

The market reacted strongly to the continued flurry of earnings warnings and definitely surprised traders. The constant drone of company after company warning that large corporations are not spending money has soured expectations and traders took their wrath out on stocks.

Dow Chart - Daily

Nasdaq Chart - Daily

SOX Chart - Daily

The past has come back to haunt us as earnings and economics continue to deteriorate. Both are slipping from their highs from the last couple quarters and are still well above crisis levels but traders always want more. The ISM Services this morning dropped to 59.9 from 65.2 in May and was well under consensus estimates of 63.0. The internal components showed mostly gains with New Orders, Deliveries, Employment and Exports continuing to rise. Imports shrank to 56.5 from 59.5. Problem areas were a +3.5 jump in inventory levels to 57.5 and the highest Prices Paid component since records were started in 1997. The mixed message of a new high in employment and a new high in prices paid was even more confusing with the substantial drop in the headline number. This was the first drop under 60 in six months and at 59 it is still well into expansion territory. Analysts claim the dip is a lag caused by higher energy prices and the argument sounds reasonable to me. Next month will be a critical indicator if the decline from 68.4 in April extends to a third month.

The only other economic number was the Challenger Layoff Report and the news was good. Layoffs in June dropped to 64,343 and nearly -10,000 below May. This was the lowest level for the year and compares to June's -59,715 from last year which was also the lowest for 2003. This is a seasonal trend where layoffs decline in late spring, early summer and then rise again in the fall. Do not be surprised if we see this number begin to rise next month. YTD announced layoffs are down -25% compared to 2003 and that is definitely a good sign. Unfortunately planned hiring declined to only 38,377 from May's 55,307. The sudden increase in earnings warnings will put the need to cut expenses right back in the forefront and cutting employees produces strong permanent cost reductions.

The mixed economics did nothing to rescue the markets from the pain of continued earnings warnings. With the quarter over companies now know what the final sales numbers were and for many their expectations fell short. The two major names leading the drop this morning were VRTS and CNXT. Since VRTS just affirmed estimates only three weeks ago the warning was definitely a real surprise. VRTS saw $4 billion in market cap erased today and distrust of management soared to a new high only weeks after the company recovered from a prior accounting scandal that cost the CFO his job. According to VRTS sales are normally concentrated in the last part of the quarter and anticipated order flow did not materialize. Multiple companies have said corporations are just not committing to new expenditures because of the uncertainty in the economy. Major software purchases are definitely in that category.

CNXT lost -40% of its value after warning of weak sales in the broadband wireless market. CNXT said it would only earn two cents instead of the five cents analysts had expected.

Intel, the target of choice lately, was cut by Lehman on fears that PC demand for the back to school season was weak. Lehman also said problems in the Grantsdale chipset would also impact profits. Intel has been the daily target for the last week as each analyst gets his 15 min of fame for his downgrade.

Other warnings/downgrades before the open included MUSE, EMBT, KVHI, LSCC, AMCC, BRCM and BOBJ. BRCM lost nearly -$4 on the Lehman downgrade of the sector. After the bell today the warning parade continued with KANA, JDAS, ASCL, SCUR, FILE, TFX, WDHD and NTPA. The damage is not restricted to the chip and software sector but it is definitely concentrated in those areas. The SOX dropped another -4% on the news and closed well under 450 support at 439. This is a major break in the chips and only a week after the Semiconductor Association said billings rose +36.9% compared to the same month last year. The problem appears to be perception that the peak has passed. The analysts are quoting order and backlog surveys that suggest April was the peak in chips and the sector will decline into 2005. Many analysts are now noting that institutional investors are exiting chips in expectations of the end of the cycle.

Earnings warnings have been thicker than mosquitoes at a summer picnic. How thick is a cause for discussion and there is no clear consensus. A report on CNBC today quoted 43 of 60 S&P pre-announcements as warnings. They were claiming it was the worst warning series since March of 2003. However, First Call said that though Thursday night there were only 1.4 negative outlooks for every positive outlook. They claim that overall 981 companies had issued guidance, 344 positive, 148 inline and 489 negative. For the S&P they quoted a ratio of 0.8 to 1 negative to positive. First Call said that was the lowest ratio since they began tracking eight years ago.

Something does not compute. If warnings are so few then why is the market imploding on every warning? Could it be that hopes were simply too high after the last four quarters of very strong performance? If you answered yes to that question give yourself a gold star. The market was priced to perfection assuming the economy was in breakout mode with good times ahead. We celebrated the monster job gains in April/May and the markets pulled out of the May decline on the assumption that the early signs of cracks in the economics were just superficial. Earnings in Q1 hit +26% and Q1 GDP was +4.4%. No challenge there. Suddenly they are quoting only +19% for Q2 and possibly lower and as little as +5% for Q4. (First Albany) Earnings deceleration is rapidly increasing and those that are warning are some high profile names. It also does not help that almost every analysts has taken it upon himself to downgrade techs in some fashion.

Is this smoke or is it real? We really won't know until next week. We do get earnings from AA, DNA, ACN and YHOO tomorrow and GE on Friday but the real parade of blue chips does not start until next week. If the ratio of warnings is really that low then in theory the earnings will surprise to the upside and everyone will breathe easier once again. Of course there is always the chance this will be an inline quarter and you know how well investors react to only inline performance. The challenge is of course the guidance and not really the earnings. Beginning with Q3 the comps to Q3/Q4-2003 become very tough and posting double digit growth will become increasingly harder to accomplish. Thus the very low earnings estimates for the 4Q amid the weakening economics.

As if the market did not have enough to worry about today there was a huge amount of news. Sabotage in Iraq and troubles in Norway and Nigeria sent oil prices soaring once again to near the $40 level. The trial in Russia and tax claims against oil giant Yukos has sent ripples through the sector. The Kremlim hit them with a $3.4 billion tax bill and caused a shake up on the board. While nobody expects a slowdown in exports there is always that possibility for a company in turmoil. The sharp jump in oil prices did not help stock market sentiment.

Kerry announced John Edwards as his running mate and the anti business complainers came out of the woodwork. On every channel and every medium were talking heads claiming Edwards would be bad for business and the fight was on. In what may have been a good move for Kerry on one front by adding the young, handsome trial lawyer it was a negative on another. The Bush camp was quick to point out that Edwards was the second choice and had repeatedly claimed he would not accept a VP position. But then he is a politician and his lips were moving. Part of the market drop today was the uncertainty principle as the chances of a Kerry win and the impact of a Kerry/Edwards administration were weighed.

According to a recent survey 92% of Wall Street analysts wanted to see a Bush win to continue the market rebound. A new study by the Wharton School of Business showed that in general it makes no difference which administration is in power with only the year surrounding the election highly volatile. The survey showed a +3.74 jump in the month after the election if a republican won and only a +1.59% rise for a democrat. However, in the year following the election a democrat win averaged a +7.55% gain compared to a +1.28% gain for republicans. The study went on to show that since 1897 the Dow had gained nearly twice as much under democratic administrations. Since 1945 the S&P had averaged a +10.7% annual return under the democrats and only +7.6% under republicans. Please remember that statistics can be skewed to show anything the researcher wants to portray and this survey did not take into account things like who controlled congress. It is widely known that a divided term with opposing forces in control will produce gridlock and very little damaging legislation can make it through successfully. It also did not take into account things like wars and 9/11. Regardless the markets reacted to the Edwards announcement three weeks before the convention and it may continue to react in the weeks ahead.

According to one report today mutual fund cash is nearing record lows. TrimTabs claims inflows to equity funds have increased over the last six weeks with $2.3 billion added to stock funds last week. AMGData claimed +$3.8 billion for the same week ended June 30th with $2.25 billion going into the iShares Russell 2000 Index fund alone. TrimTabs claims +$9 billion inflows for the entire month of June. Most of the money is coming out of bond funds with a highly anticipated rate hike driving investors from bonds to equities. Money market funds lost -$48 billion according to AMGData. Despite all the shuffling of deposits it is rumored that funds are walking a tight rope between being fully invested and retaining cash for disbursements. This suggests a positive bias but it is sure not showing up in the markets. This weeks fund flows will be very telling.

The markets are on the verge of some critical technical damage. I said on Sunday the Dow could move to 10150 and the Nasdaq could see 1965 without any material change in status. I did not expect it to happen in only one day. The Dow hit 10191 intraday and the Nasdaq fell to 1959 and closed just above critical at 1967. We have definitely seen a change in the trend and that change was led by techs. The Nasdaq has seen 1962-1964 as support since May 26th and that support has held through three separate tests. As long as this test holds, the range for the last six weeks will be intact. A break here by the Nasdaq could easily take us back to 1900. This is a critical support level that must be defended if the bulls have any hope of a summer rally. The Dow fell to 10200 and barely recovered into the close. This is well below the recent range support at 10300 but it is still within the broader range of 10100-10500. This 10200 level is decent support but a break here could see Dow 10K very quickly.

Personally I think the selling is overdone. I think it was a knee jerk reaction to several high profile warnings as well as outside events like oil, the elections and the almost unanimous downgrade of the chip sector. I think all the expectations of upside earnings surprises has been removed from the market and earnings risk has been negated. However we still have three days before real earnings volume will appear and the truth begins to come out. I looked at the internals today and they were terrible. The declining volume across all markets was 6:1 over advancing. Decliners beat advancers 2:1 but compared to the volume figures it was not that bad. Stocks that warned got crushed on heavy volume. (VRTS -9.55, -36%, 81 million shares) but other than chips the rest of the market was passive. The TRIN closed at 2.45 and the Nasdaq TRIN at 3.76. The put call ratio is 1.08. All of these indicators suggest the market is very oversold and a relief bounce could be in our future.

Many blue chip stocks have declined to very strong support and they appear to be holding this support. Intel at $26 is at its 200wk average and at strong horizontal support. Can it be knocked lower? Yes but it will take a lot more negativity to push it over the cliff. IBM at $86 has imploded on chances it would warn but $86 is strong support and its warning window has passed. IBM announces earnings Thursday of next week. In short I think the pressure should ease tomorrow.

We could always have some new event appear or some new warning from a high profile company but the Intel story is over. The SOX story is over. The software sector has been decimated but the JDAS warning tonight could still produce weakness. Further serious drops from here will require some new event. That event may be just fear of the event risk around the democratic convention or a real earnings miss from some blue chips next week. I doubt YHOO earnings tomorrow night will tank the market since it has already dropped -$4 from its highs of $36.50 last week and $32 is strong support. It can fall more but earnings expectations have already been removed.

My thought process for a trading play would be to buy the dip. However, my long-term outlook is still for weakness ahead. I think the summer event risk coupled with investor apathy will continue to give us a range bound market with risk to the downside as the summer progresses. How do you play that market? Very carefully! Until we find out where the next rebound will fail we are in unstable territory. I would be very surprised if it was much over 10300 and a lower high in that range would send a very negative signal to traders. Until we see what those 300+ companies actually say with earnings next week I would be very cautious about any long positions.

Enter Passively, Exit Aggressively.

Jim Brown


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