Option Investor
Market Wrap

Exactly As Expected

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WE 03-18

WE 03-11


WE 03-04







+  98.95



-  33.81


-  29.01


+    5.21

S&P 100


-    5.61


-    9.68


+    4.66

S&P 500


-  10.43


-  22.04


+  10.75



-  91.78







-  13.75


-    5.50


-   10.32



-    4.27


-  18.11


+    7.42



-  81.51


+   1.12
















Exactly As Expected

Last Sunday I suggested that the S&P rebalancing would weigh heavily on the major indexes and support at SPX 1185 and Nasdaq 2020 would be tested. A Nasdaq break of 2020 would set up a serious psychological test of 2000. The rebalancing caused selling that sent us to SPX 1183 and the Nasdaq to 1999.98 before the dip buyers appeared. Quadruple witching provided added volatility and the indexes closed at lows for the week, month and even for the year in the case of the Nasdaq.

Dow Chart - Daily

Nasdaq Chart - Daily

The big news for Friday was the added volume and volatility from the S&P rebalance but the economics were not to be ignored. Leading off the Friday list was a drop in Consumer Sentiment to 92.9 for the initial March reading. This was down from 92.1 in February. This was the third consecutive monthly drop from the recent December high at 97.1. Choppy markets, gas prices over $2 and rising interest rates are pressuring consumers and the constant droning on oil prospects is having an adverse effect. Actually with the negativity on oil we should have seen a lower number but the positive jobs number in early March supplied positive support.

Import Prices rose +0.8% in February and that was slightly higher than estimates at +0.6% but only slightly over the +0.7% from January. For the month petroleum prices jumped +3.9% so it was almost a miracle for the headline number to gain only +0.8%. If you take out the oil price jump the import prices for everything else rose only +0.2% for the month. The gains should not be a serious impact to the PPI/CPI next week but there is fear behind the scenes that we will see some higher inflation numbers as the FOMC meeting begins.

Another overriding weight on the market was the huge drop in the Philly Fed report on Thursday. The drop to 11.4 and the lowest level in 20 months suggests there was a dramatic slowdown in the manufacturing sector. If this is an anomaly then we should see a rebound next month. BUT, since this is the second month out of the last three for a number in the low teens it suggests the manufacturing sector in general may be softening. This worry around a continued series of conflicting economic reports is preventing the market from gaining traction as we head for Q1 earnings.

Another minus for techs was the semi book-to-bill for February, which was announced late Thursday night. The BTB came in at 0.78 and unchanged from January and while it is the cycle low it is far from the 0.44 we saw back in April 2001. At 0.78 we are back at the levels we saw in October 2002 and well off the 1.23 we saw in Dec-2003. While the market was preoccupied with the S&P rebalancing the SOX still managed to lose nearly -1% on the news. Now at 413 with decent support at 400 I believe the lack of a continued drop in the BTB could be a positive for next week. Semis have been weak for two weeks and it is time for a bounce. The 420 support failed but it could have been a byproduct of expiration and the rebalance. Over 400 I might nibble at some SMH calls for a short-term bounce but would be out before April closes.

While the volatility was due to options expiration the volume was due to the S&P reweighting. Over 5.25 billion shares traded and down volume was 3:2 over up volume. It was exactly what we expected with large cap stocks with high ratios of captive shares receiving a lower weighting resulting in index fund selling. Smaller stocks found themselves rising on the rating scale and saw buying from index funds. In my opinion Friday was much ado about nothing. The selling was artificially induced and had nothing to do with market sentiment, earnings or expectations. It was simply an index adjustment day complicated by option expiration.

While the very large big caps like WMT and MSFT attracted the most adjustment due to the large insider holdings it was not limited to them. Tech stocks, EBAY and ORCL, were also examples of stocks with large insider blocks. This week's adjustment was only for a portion of the S&P and the balance will be adjusted in September. The second round is not expected to cause as much disruption but it is coming just ahead of the normal October volatility.

Crude Oil Chart - Daily

If you had to pick one story for the week it would have to be oil once again. OPEC formally raised their quota by +500,000 bbls per day on Wednesday and prices soared. Why? Because OPEC members were already busting quotas and producing all they could sell to take advantage of the price. The oil minister from Kuwait said OPEC was already producing well over quota before the meeting. How did he know this? Because Kuwait was already pumping +500K over quota by itself. There were several industry experts who suggested OPEC was actually producing 1.7 mbpd over quota before the meeting. This means any "official" production increases under 1.7 mbpd would already be priced into the market. If you need any further proof that OPEC is behind the curve we only need to move forward to Thursday. OPEC was surprised that oil went higher on their announcement and made the unprecedented move of announcing ANOTHER +500K increase as soon as next week IF prices failed to decline. Prices immediately rose to another new all time high at $57.50 on the second announcement. Anybody watching and putting 2+2 together should realize that OPEC is no longer able to control prices with choppy press releases. The genie is out of the box and all hell is about to break loose.

Move forward to Friday and OPEC issues another press release saying they were prepared to pump 30.3 mbpd in Q4 to offset expected production shortfalls. Their current quota is only 27.5 mbpd. Demand in Q3 is expected to rise to more than 28.5 mbpd but that is just the tip of the iceberg. In its monthly report for March OPEC said that production in February was estimated to have been 29.6 mbpd. With their quota at 27.5 mbpd and actual production 29.6 mbpd you would have expected prices to fall. Instead oil prices continued to rise because DEMAND IS STRONGER THAN MOST "EXPERTS" REALIZE. OPEC also said in their report on Friday that that Q4 demand is expected to rise to 86 mbpd or higher and OPEC will have to pump at FULL CAPACITY of 30.3 mbpd to meet that demand.

Personally, if they busted their quotas that badly and pumped 29.6 mbpd in February and they could barely stay ahead of demand I have a hard time believing that full capacity at 30.3 in Q4 when demand is expected to be much higher is going to do the trick. OPEC's own document said non-OPEC supply is expected to rise ONLY +1.1% to 50.8 mbpd in 2005. Doing the simple math and using their numbers Q4 looks like this. Non-OPEC 50.8mb plus OPEC at 30.3mb equals 81.1 mbpd. Their own demand estimates for Q4 are for 86 mbpd. That would be a -5 mbpd shortfall. I did not make this stuff up and I find it hard to believe anyone with a 4th grade education still believe their ocean of oil story.

I am going to try and simplify this. The graph below shows the average demand for the last four years and the expectation for 2005. I will emphasize it is the average quarterly demand for the year. An average means you can be standing with one foot in a bucket of ice water and the other in a bucket of boiling water and your average temperature will still be 98.6. The demand for Q4-2004 was 84.3 mbpd and Q1-2005 is estimated at 84.3 mbpd. In both Q4 and Q1 oil prices soared as demand hit 84 mbpd because that stresses the limits of production for usable oil. (light sweet crude) The average for all of 2005 is estimated to be 84.0 and right at our production ceiling but that is not the whole story.

Annual Crude Demand Graph - Five Years

For 2005 the demand picture looks like this. Demand is expected to drop seasonally in Q2 and then accelerate into Q4. Estimated demand in Q4 is rising daily with current estimates between 85.9-86.3 mbpd. If the system is stressing and prices hitting new highs just trying to pump 84 mbpd then we could be looking at a serious shortfall in Q4.

Quarterly Crude Demand Estimates for 2005

The black line at 84.5 represents the maximum sustained production we have seen in the last year. Once demand moves over 84.5 mbpd we are in the danger zone where bidding for available supplies could turn into a bidding war rather than just trying to get the best price. Refiners will be faced with idling their plants or outbidding everyone else just to maintain product flow. Heaven help us if we have a series of early cold fronts that accelerates heating oil demand. The bottom line here is that refiners are not stupid. They will be looking to lockup supplies on any dip in Q2 and then keep the pipeline flowing as demand increases.

The real problem is the annual demand growth as evidenced by the first graph. With China on a crash build out process trying to get ready for the 2008 Olympics and demand exploding in India, Brazil and several other countries it is entirely possible demand for 2006 could start at 86.1 mbpd and move up from there. Several analysts are talking about 89-90 mbpd for 2006. This is not going to happen! The demand may be that high but there is not any huge production blocks of light sweet crude coming online in that time frame to satisfy the demand. I hate to keep harping on this but I want our readers to be prepared for the disaster ahead.

Goldman Sachs raised their estimates for the oil sector on Friday to levels unheard of just a year ago. They said Exxon could jump by +49% over the next year despite its huge gains in 2004. Chevron Texaco could increase by +102% and Conoco Phillips by as much as +126%. They finally came to their senses and recognized a fatal flaw in pricing oil stocks. Current prices are based on oil valuations averaging $35 a barrel. This is a new level up from the prior OPEC band in the mid $20 range. Given the various factors of increasing demand and shrinking supply they finally realized that oil under $40 would be a miracle and the new bottom could be in the $46-$50 range and only briefly. Given that new paradigm oil stocks could move in doubles and triples over the next three years and still retain their 12-15 PE ratios. If anyone reading my commentaries fails to capitalize on this move it will not be my fault. I have gone out of my way to paint the picture for the last nine months. If you read and acted on my end of year Oil Crisis report you are already well ahead of the pack with some stocks already up +$20 or more. I am telling you again to buy any Q2 dip and expect doubles and triples over the next three years. End of rant!

Bush played the nuke card on Friday and called for a new era of safe nuclear energy and a move away from fossil fuels. While the U.S. has not had a new plant in 30 years the world has not been dormant. There are 440 operational plants worldwide with 35 currently under construction and more planned. China is building or in planning stages on 28. France is working on ten with other countries on slower growth paths but heading to the same conclusion. Worldwide nuclear power accounts for 16% of all electricity generation. For reference the rest of the breakdown looks like this, oil 9%, coal 36%, gas 21% and renewable sources that include hydroelectric, wind, solar and various types of burned materials 18%. Uranium or yellow cake has more than doubled in price from 10.20 lb to 21.75 lb in two years. Cameco, a producer of uranium and one of my Oil Crisis picks at $96 hit $148.50 intraday on Friday, split adjusted for a 3:1 split in January.

This energy explosion is not lost on the market and I believe it will be a major reason why the highs for 2005 are already in place. This week's market action, while somewhat artificially induced, is still indicative of problems with the underlying sentiment. The Dow struggled with support at the 100-day average at 10590 and spent much of Friday below it and the crucial psychological support level at 10600. Only a buy program just before the close rescued it from a nasty defeat. Even at 10600 the Dow is still technically in an uptrend but it is not a pretty picture. 10450 is looking more likely as critical support ahead. Just bear in mind that the Dow was definitely hurt by the big cap rebalance and could rebound next week.

The Nasdaq hit 2000 and triggered a couple of weak buy programs but they were unable to provide much relief with a close at 2006. The Nasdaq has broken below all the major averages with the exception of the 200-day, which is waiting patiently for its chance at 1992. The Nasdaq close was a five-month low and definitely suggests worse times ahead. The Nasdaq was also hurt by the rebalance with MSFT, EBAY, ORCL, DELL, etc, suffering from the index fund selling. Still there was little buying interest even at these levels.

As I mentioned earlier the SOX appears to have a date with support at 400 but I expect some buyers to appear either at that level or slightly higher. This should help the Nasdaq recover if it does happen. I would not bet the farm but I believe a bounce from 400-405 would be tradable.

Goldman also said on Friday that IT spending for 2005 could rise +3.6% with tech Capex spending at +2.9%. Full year tech spending could reach +4-5%. Those are pretty anemic numbers and they added to their recommendation that Q2 could be rocky. We are moving into Q1 earnings warning cycle next week and all ears will be on the lookout for signs that the guidance is slipping. If you remember guidance was less than stellar when Q4 earnings were released in January. This could also keep tech buyers on the sidelines with performance anxiety.

Ironically the S&P, the cause of the index unrest, is still holding well above its lows and only allowed a brief dip below 1185 support before recovering. The net change on Friday was less than a point and that is due specifically to fund managers having to put any money from selling big caps right back into the smaller companies that found their status moving higher. This kept the S&P from breaking the 100-day average at 1187 for more than a brief program related dip.

SPX Chart - Daily

Wilshire 5000 Chart - Daily

The relative strength in the S&P is the number one reason I suspect we could see a bounce next week. The Wilshire 5000 is showing the same strength and suggests the broader market is still in good shape. The Dow and Nasdaq may have been pummeled by the reweighting but the broader market is hanging in there. Monday could still suffer from a confusion hangover but I would not expect any material drops without a material news event. All the indexes are at critical levels and in many cases are oversold. The Dow bottomed at 10557 and -427 points off its March 7th high just two weeks ago. The Nasdaq is -100 points off its recent highs. This oversold condition could attract buyers ahead of the Q1 earnings parade but possibly not until after Tuesday.

The Fed meets on Tuesday and all indications are they will raise +25 points and toughen up the measured pace language. Why they would do that with the Philly Fed implosion and the markets at the lows for the year is beyond me but they don't ask for my opinion. Bonds have leveled off with the ten-year yield holding at 4.5% and waiting for the Fed announcement. Next week is full of economics with the PPI, CPI, Durable Goods, New Home Sales and two Fed surveys, Chicago and Richmond. This should be plenty of data to either quiet the inflation hawks or send them soaring.

My recommendation for this week was to buy the dip to SPX 1185 if oil fell under $53. That turned into wishful thinking on oil prices but the SPX is holding at 1185 and waiting. At this point I would expect a trading bounce next week from that 1185 level and one that could last a couple weeks. Oil back at new highs could kill that thought quickly but I am still leaning in that direction. I am still looking for a dip in oil prices as we exit March and I believe that will be just what equities need. Once oil cracks the drop could be swift given the magnitude of profits traders have accumulated. We are also approaching the end of the quarter and I believe mutual funds could take profits in oil and buy this dip in equities in anticipation of dressing up their statements for quarter end. If we do get a dip in oil I would look to buy oil stocks at their 100-day average. Once we get into mid-April I would not want to be long equities. That is about as black and white as I can lay it out for the next six weeks and it is just my opinion. There is plenty of easy money ahead of us but patience is the key. Enter passively and exit aggressively!


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